The recession is over! In the third quarter GDP grew by 2.8% (3.5%), slightly below (comfortably ahead) of expectations for 2.9% (3.0%) growth. This is a huge improvement over the 0.7% decline in the second quarter and the 6.4% plunge in the first quarter.

The internals of the report were strong as well, although it appears that much of the growth came from things like the Cash for Clunkers program and the extraordinary levels of support that are currently being given to the housing sector.

Growth Rates

The overall 2.8% (3.5%) growth of GDP was almost matched by its biggest component, Personal Consumption expenditures, or PCE, which grew 2.9% (3.4%), a big improvement over the 0.9% decline in the second quarter and the 0.6% increase in the first three months of the year.

It is important to note that during the recession, consumer spending declined far less than did overall GDP, especially in the first quarter, so the consumer was becoming a much bigger part of the overall economy. This is not healthy over the long run, but at this point I think people are happy to get some growth where ever we can find it

Now, you might wonder, what caused the recession to be so nasty last winter when Consumer spending wasn’t really all that bad? The answer is that Investment really fell of a cliff. The good news is that it is starting to come back.

Fixed investment is broken into two parts, Non-Residential or business investment and Residential investment, which is mostly homebuilding.

Overall Fixed investment rose by 0.3% (2.3%) following declines of 12.5% in the 2Q and 39.0% in the 1Q. Business investment, however, continued to decline, but at a much slower rate, falling 4.1% (2.5%) after 9.6% and 39.2% declines in the 2Q and 1Q, respectively. With massive amounts of unused capacity it is not surprising that businesses are cutting back on their capital spending still.

Spending on Equipment and Software (E&S) on the other hand is starting to come back, if only feebly, rising 2.3% (1.1%) after a 4.9% decline in the 2Q and a 36.4% plunge in the 1Q. Look for some stability in this line going forward as the new Microsoft operating system will probably generate a new PC cycle, but with capacity utilization still around 70% I would not expect a boom in orders for new factory equipment.

The real star of fixed investment though came on the residential side, which rose 19.5% (23.4%). This is the first increase in almost four years, and follows declines of 23.3% in the 2Q and 38.2% in the 1Q. The long string of declines had brought residential investment to a record low share of GDP. The extraordinary support of the housing sector by the government, including the first time buyer tax credit, the Fed buying up $1.25 Trillion of Fannie (FNM) and Freddie (FRE) backed paper to artificially suppress mortgage rates and the FHA acting like the old New Century Financial or Washington Mutual on their worst days have played a big role in the turnaround. I seriously question the sustainability of it after the support is removed, and I don’t think the support can continue indefinitely.

Government spending grew by 3.1% (2.3%) in the 3Q, a big slowdown from the 6.7% increase in the 2Q, but more than the 2.6% decline in the 1Q. It was all at the Federal level where spending rose at an annual rate of  8.3% (7.9%) down from a 11.4% increase in the 2Q, but up from the 4.3% decline in the 1Q.

Remember this measure of government spending does not include spending on transfer payments like Social Security and Medicare, which are largely captured in the consumption numbers. Defense spending was the big driver -- we are still a nation fighting two wars. It grew at an annual rate of 8.3% (8.4%) down from a 14.0% rate of increase in the 2Q but up from a 5.1% decline in the 1Q.

International trade has started to rebound, and we saw an increase in both imports and exports. Increasing exports are good for GDP and increases in Imports are bad for GDP, and unfortunately imports rose more than did exports. We were able to improve our overseas sales by 17.0% (14.7%) in the 3Q -- a nice turnaround from the 4.1% decline in the 2Q and the 29.9% plunge in the 1Q. Unfortunately we also increase what we bought from overseas by 20.8% (16.4%), a big turnaround from the 14.7% decline in the 2Q and the 36.4% plunge in the first three months of the year. Keep in mind that we import a lot more than we export, so not only was the percentage increase bigger for imports, it was coming off a higher base.

Contributions to Growth

Not all components of GDP are created equal.  Some are very big, and others relatively small. Some tend to be very stable over time, and some tend to swing violently from quarter to quarter. The bigger and more volatile they are, the more they will impact the overall growth rate of GDP. Thus looking at just the percentage changes in the componenets does not tell the full story. Of the 2.8% (3.5%) total growth, how many points were added or subtracted by each part of the economy?

The biggest part of the economy is the Consumer or PCE, over all it contributed 2.07 (2.36) of the 2.80 (3.50) points of total growth. In the second quarter it caused 0.62 of the 0.70 total decline in the 2Q. In the first quarter it actually offset 0.44 points of the 6.40 total decline. In other words, excluding the consumer the economy would have contracted 6.84% rather than 6.40%.

Within consumer spending, spending on goods added 1.60 (1.79) points after subtracting 0.71 points in the 2Q and adding 0.56 points in the 1Q. Spending on durables was the main driver, adding 1.34 (1.47) points after subtracting 0.41 points in the 2Q and adding 0.28 in the 1Q.  Non durable goods added 0.26 (0.31) points after subtracting 0.29 in the 2Q and adding 0.29 in the 1Q.

Investment spending was a big swing factor in the 3Q.  It added 0.91 (1.22) points to overall growth. That is a HUGE improvement over the 3.10 point subtraction in the 2Q and the 8.98 point implosion in the 1Q.  Unfortunately. 0.87 (0.94) points of that contribution came from inventories. Inventory investment is the “worst" type of GDP growth since large increases in one quarter are usually reversed in the next quarter, or in this case, large declines being reversed upwards. 

In the 2Q inventory investment subtracted 1.42 points from overall growth and in the 1Q they subtracted 2.36 points.  Even in the 4Q they subtracted 0.64 points from growth.  Three straight quarters of sharply lower inventories is highly unusual and we were due for a bounce.  Perhaps we have one more quarter of a solid contribution from inventory investment, but I would not expect it to last much beyond that. 

Overall fixed investment added just 0.04 (0.28) points to growth, but that sure was a nice improvement over the 1.68 point subtraction and the 6.62 point disaster that was the 1Q.

However, it was not coming from the business side.  Business investment subtracted 0.40 (0.24) growth points in the 3Q, so it is still very soft, but at least it is not imploding like it was earlier in the year.  In the 2Q it subtracted 1.01 points and in the 1Q it took away 5.29 growth points.  Within business investment it was spending on structures that caused the problem with a deduction of 0.55 (0.32) growth points while spending on E&S offset 0.15 (0.08) points of that.  In the 2Q both sides of business investment were drags on the economy with investment in Commercial real estate subtracting 0.69 growth points and spending on equipment deducting 0.32 points.  The 2Q was in turn a major improvement over the 1Q disaster where spending on structures subtracted 2.28 growth points and equipment spending subtracted 3.01 points.

Housing finally helped the economy in the 3Q, adding 0.45 (0.53) points to growth, after a string of 15 straight quarters where it was a drag on the economy.  In the 2Q it was a 0.67 point drag and in the 1Q it was a 1.33 point drag.  The long decline has, however, made housing a much smaller share of the overall economy.  In the 3Q residential investment totaled only $360.9 billion, or 2.52% of the overall economy.  At the peak of the housing bubble it represented 6.34% of the overall economy.  Thus the 19.5 (23.3%) increase in residential investment had far less of an overall impact than it did in the past.

Direct government spending had a small but positive impact on overall growth in the 3Q, adding 0.63 (0.48) points a fairly significant slowdown from the 1.33 contribution in the 2Q, but better than the 0.52 point drag in the 1Q.  All the help came from Washington , not city hall or the statehouse.

The Federal government added 0.65 (0.62) growth points, down from 0.85 points in the 2Q but up from a 0.33 point drag in the 1Q.  The Pentagon was the main factor in all three quarters, with defense spending adding 0.48 (0.45) points in the 3Q following a 0.70 addition in the 2Q and a 0.27 point drag in the 1Q.  Non-defense spending was sort of a non issue, adding just 0.17 (0.17) points in the 3Q, not much difference from the 0.15 point contribution in the 2Q, and up a little bit from the slight 0.06 point drag in the 1Q.

State and Local governments are not allowed to run operating deficits, and so when faced with declining tax revenues they have to cut back, unless Uncle Sam helps them out.  Well Washington is helping, but its not enough and S&L spending was a 0.02 (0.14) point drag in the 3Q.  The Federal help was enough in the 2Q and so the contribution to growth in the 2Q was a positive 0.48 points.  In the 1Q, before the stimulus package could get much traction S&L spending was a 0.19 point drag.

Net exports had been just about the only bright spot in the first half of the year, even though it came the wrong way, from both imports and exports plunging, only with imports falling more than exports did.  That reversed in the 3Q as both showed a nice expansion, but our appetite for foreign goods outstripping the desire for U.S. goods and services abroad.  The increase in exports added 1.71 (1.49) points to growth, but the increase in imports was a 2.53 (2.01) point drag, for a net negative contribution from net exports of 0.82 (0.52) points. In the 2Q falling exports subtracted 0.45 points but plunging imports added 2.09 points, for a net imports net help to the economy of 1.64 points.

Overall

Relative to the first cut at the data, the downward revisions were broad based, with smaller contributions from all major areas of the economy, with the exception of the government.  Of particular concern is that fixed investments contribution to growth virtually disappeared.

 
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market-beating Zacks Strategic Investor service.

Fortunately during recessions, the federal government usually will step in and provide emergency extended benefits. However this recession has gone on for so long, and we have so many long-term unemployed, that millions were in danger of losing even those extended benefits. Fortunately the Senate finally got around to extending those benefits for up to another 20 weeks (depending on the overall level of unemployment in that state). Still, unemployment benefits only replace a fraction of what people were earning before they lost their jobs. This means that as soon as people get their pink slips, they will reduce their spending. However, depending on how long they expect to be out of work, they do not bring their spending levels down all the way to their new unemployment insurance income level. There are all sorts of spending categories that are at least semi fixed. If you think you will get a new job soon, you don't cancel little Jimmy's ballet lessons, or Betty's karate lessons. Instead you draw down your savings and use your American Express (AXP) card more.

However, as the weeks go by and you get no response from all the resumes you sent out, more and more things start to go by the wayside. But still does it make sense to quit the country club and lose the $20,000 initiation fee you paid, especially now that you actually have time to use it? Well after a few months you have to bite that bullet too. In the meantime, your non-retirement savings are probably about gone. Going into this recession the savings rate had been close to zero, so it is a pretty safe bet that most people did not have a lot of savings outside their 401-ks or IRAs. You have probably run up your balance on your credit card, but the card companies are getting wise to that and are starting to cut back the available credit limits for millions of accounts. That is a wise move on their part individually, but collectively for the economy, it acts to reduce overall demand.

Oh, and since a big factor in your credit rating is how much credit card debt you have relative to your available limit, both increasing your balance and the bank cutting back your maximum availability will conspire to knock off more than a hundred points from your FICO score. In past downturns, especially recent ones, if the unemployed person were a homeowner, he could tap the equity in the house. Now with millions and millions of homes worth less than the amount of the mortgage, or at least very close to it, that option is not open. Indeed this time around it seems that people are more likely to go in the other direction.

To survive, they are simply not paying on their mortgage and waiting for the sheriff to show up at the door to kick them out. Given the huge numbers of people who are falling behind on their mortgages, and to political efforts to slow the rate of foreclosures, this is actually a very rational strategy. In many parts of the country it has been possible to live rent and mortgage free for well over a year before actually getting kicked out of the house. That can free up a lot of cash to spend on other things. However, it is very bad news for the banks that lent the money like Bank of America (BAC) and Wells Fargo (WFC). It is also going to become a serious issue for the Federal Reserve since it is in the process of buying $1.25 trillion worth of mortgaged backed paper. True, the paper is guaranteed by Fannie (FNM) and Freddie (FRE), but since the taxpayers own 80% of both of them, what is the difference? People have to start tapping their 401-ks and IRAs. While the stock market has recovered nicely, it is still far below its peak, making that option even more painful, along with the 10% penalty imposed if you start to withdraw money from those accounts before retirement age.

By the time people have been out of work for six months or more, they have usually depleted their financial resources. Remember that on average, someone who is out of work has been out of work for 26.9 weeks now, and half of all the unemployed have been looking for work for more than 18.7 weeks. That smashes any record prior to this downturn. At the worst point in the Reagan recession, half of all the unemployed were out of work for more than 12.3 weeks. In fact, since the median duration started being tracked at the beginning of 1967, the median duration has only been in the double digits for 36 of those 502 months, and 14 of those have been during his downturn.

To those who say the stimulus bill has not helped, tell that to the almost 5.6 million people who have been out of work for more than six months. If not for the emergency benefits in that bill, they would be left with no income as soon as they passed that mark. I suspect that the vast majority of people who are in that category assumed that they would have found a new job by now when they first got laid off, and thus did not cut back their spending as fast as, in retrospect, they should have when they first got their pink 
slip.



It is long term unemployment that is the hallmark of a recession. The graph below shows the number of unemployed (in thousands) in each duration group back to 1960. This is not adjusted for the rather substantial increase in the total population over that period, so some upward trend to the numbers would be normal. Notice how stable the pink short term unemployment line is. There are always people getting laid off, and people getting hired. In good times, the number of people becoming unemployed does not really fall that much, it is just that they don't stay unemployed for all that long. They are either able to find a new job quickly, or in the case of many manufacturing jobs, get called back to work by their previous employer.

The light blue line of moderate length unemployment (5 to 14 weeks) shows a little bit more cyclical behavior, but nothing like the two longer term measures, the yellow 15 to 26 week group and the dark blue over 26 week long term group. What is striking about this recession is just how high that long term dark blue line has soared. While these graphs do not have the recession bars in, I would note that the level of long term unemployment usually continues to rise for many months after a recession ends. The shorter term groups tend to turn down well before the long term group does. This means that the situation is likely to continue to get worse before it gets better.



When these people do return to work, it is highly unlikely that they will be earning anything close to what they were earning before they got laid off. Many will be homeless, without any savings and in pretty desperate shape. We have already seen a steep rise in the poverty rate, which rose to 13.2% in 2008 from 12.5% in 2007 (see Census Bureau: Poverty Rising and Income, Poverty & Health Insurance).

Among children, the poverty rate rose to 19.0% in 2008 from 18.0% in 2007. I would be shocked if it does not exceed the one in five level when the statistics come out next summer for 2009. Since health care coverage is largely tied to employment in this country, the rising number of unemployed means that the number of people without health insurance, already at 46.3 million in 2008, is likely to jump further. While it is true that the stimulus package did subsidize COBRA insurance by as much as 65%, by the time people are unemployed for more than six months, it is very difficult for most of them to be able to afford even those subsidized premiums. When those people get sick, their only option is to go to the hospital emergency room, which is a very expensive and inefficient way of being treated. It is not free either, the hospital will try to bill them for the services, and even send debt collectors on them, although in most of these cases they will be trying to get blood from a stone.

For many, it simply means that they go without treatment, other than over-the-counter medicines they buy at Walgreen's (WAG). If it turns out to be something more serious, it very often results in death. A Harvard study recently estimated that 46,000 Americans die prematurely each year because of a lack of health care coverage. That is a national disgrace.

While unemployment is a lagging indicator of the economy, it does play a role in the economy going forward. It will be very hard to sustain the surprisingly strong growth we have seen in recent months if we don’t start to see some improvement in the employment picture. Yes, huge improvements in productivity are good, but people on the ground need jobs.

The graph below (from http://www.calculatedriskblog.com/) tracks both the unemployment rate, which is rapidly approaching a post war record (10.7% in 1983) and the year-over-year change in employment, which is actually starting to turn up (become slightly less negative). As the horrific job losses of last winter start to roll off, that measure should improve more in coming months. But remember: job losses have been going on since December 2007, which is closer to two years ago than one year ago. That can make the year-over-year change a bit misleading. Even with the improvement, the year-over-year job change is still far worse than previous recessions.

The job losses were wide spread by sector. In goods-producing industries we lost a total of 129,000 jobs, including 62,000 construction jobs and 61,000 manufacturing jobs. Since the recession started we have seen 1.6 million construction jobs go away and 2.1 million manufacturing jobs. Just to put in context how devastating the losses have been in those areas, there are only 5.966 million construction jobs and 11.675 million manufacturing jobs left in the country. The sharp loss in manufacturing jobs is in distinct contrast to the ISM survey earlier this week that indicated that manufacturing jobs were expanding. It does look like ADP got it pretty much right in their survey on Wednesday when they predicted a total of 203,000 jobs lost, including 65,000 in manufacturing.

The service sector lost a total of 61,000 jobs. The bulk came from retail, which lost 40,000 jobs. That's not exactly what you want to see leading up to the holiday shopping season. Health care and education continued to buck the trend and added 45,000 jobs, including 29,000 in health care. In one encouraging sign, looking forward, temporary jobs increased by 44,000. At the bottom of a cycle those are often the first jobs to show an increase as employers realize they need more staff, but are not confident to add permanent employees. At least it is good news for firms like Kelly Services (KELYA).

The Unemployment rate, which is calculated from a different survey, painted a much gloomier picture, jumping to 10.2% from 9.8% in September and reaching its highest level since April of 1983. That survey showed the number of unemployed spiking by 558,000 in October, for a total of 8.3 million jobs lost since the start of the recession in December of 2007. Demographically all major groups saw their unemployment rate rise. For men, the rate is now 10.7%, an increase of 0.4% from September's 10.3% and up from 6.4% a year ago. For women, the unemployment rate increased to 8.1% from 7.8% last month and 5.4% in October of 2008. Teen unemployment soared to 27.6% from 25.9% last month and 20.7% a year ago.

It is true that a job for most teens means money to put in the gas tank (or maybe to spend on clothing at Abercrombie and Fitch (ANF)), not a matter of paying the mortgage or keeping the lights on. However those first jobs teach important skills for the future, like the importance of showing up on time. Unemployment rates in the high 20s are something you associate with third-world countries, not the U.S.

By race, the unemployment rate among whites is now 9.5%, up from 9.0% in September and 6.0% a year ago. Hispanic unemployment is now 13.1%, up from 12.7% in September. Among blacks, 15.7% are now unemployed, up from 15.4% last month and 11.3% a year ago. 

If one is looking for silver linings in the report, there are a few. The average manufacturing work week increased by 0.1 hour to 40.0, and average overtime increased by 0.2 hours. Employers will usually lengthen the number of hours their current employees are working before they start to add new staff, especially if those hours had already been drastically cut back. Also, for those with jobs, average hourly earnings increased by $0.05 or 0.3%, versus just a 0.1% increase last month. Over the last year average hourly earnings have increased by 2.4%. However, since people are working fewer hours, average weekly earnings are up just 0.9%. That does not provide a lot of firepower for people to take to the malls this Christmas season. The number of people working part time for economic reasons was unchanged at 9.3 million. That number had been increasing rapidly, so perhaps there is a little bit of stabilization on that front.

Still there are other measures in the internals of this report that are a troubling. One number that does not get nearly enough attention is the ratio of people working to the total population, what I like to call the employment rate. While it will never get close to 100%, unless you plan on eliminating child labor laws and have people in their 90s work, it is a very important measure. Ultimately it is the employed in a society that support everyone else, either directly or indirectly. The employment rate fell to 58.5% in October from 58.5% in September and 61.7% a year ago. The high for this cycle, was 63.4% in December 2006.

This cycle broke a long string of higher highs and lower lows stretching back over 50 years. That massive uptrend was largely the function of demographic changes that have largely played themselves out. Women are pretty much fully integrated into the work force and the baby boomer pig has pretty much moved through the python.

However, view this graph in conjunction with the first one. When a related measure, the civilian labor force participation rate was rising (it was unchanged in October at 65.1%), the rate of job creation (red line above) had to be much higher to generate the same unemployment rate (blue line above). The employment rate is now down to its lowest level since October 1983. Back then we still had large numbers of baby boomers that were trying to enter the job market for the first time, and far fewer women worked outside the home. 

This has easily been the worst recession from the point of view of employment since the Great Depression, even though the unemployment rate was marginally higher under Reagan, hitting 10.7%. Consider the next graph (also from http://www.calculatedriskblog.com/). It shows the job losses as a percentage of the prior peak employment levels for every recession since the end of WWII. We have now exceeded the prior record set by the 1948 recession in terms of depth. We were going through a huge structural adjustment in 1948 as we demobilized the wartime economy and shifted back to civilian production. Nothing of the sort is occurring now.

Also in all but four of the prior recessions, not only had we stopped losing jobs by this point, but we had actually gained back all the jobs lost and had more people working than at the start of the recession. Next month we will pass that mark for the 1958 recession. The scary part is that the three recessions that took longer than 22 months to get back above the prior peak employment levels are the three most recent downturns, the ones that stated in 2001, 1990, and in 1981. Further, each of those lasted longer than the one before. Since we are still losing jobs at a fairly rapid rate, it could be October 2011 before we have more people working than we did in December 2007, and that is if we were to match the record of 2001. If the pattern of lengthening the time to get back to even continues, it could be far longer than that. 

One of the most disturbing signatures of this recession is the length of time that people are out of work. There are now 5.594 million people who have been out of work for more than six months. The median duration of unemployment is now 18.7 weeks, a jump of 1.4 weeks from September’s 17.3 weeks. The previous record was set in June at 17.9 weeks, but prior to this downturn we have never seen anything remotely comparable to this level. The only other post-war recession that challenges this one in terms of severity is the 1981-83 downturn. The peak in the median length of unemployment in 1983 was just 12.3 weeks. A year ago we were at 10.6 weeks. The average (mean) duration of unemployment tells a very similar story. Since it is impossible to be unemployed for fewer than 0 weeks, the mean will always be higher than the median. On average if a person is out of work, he or she has now been out of work for 26.9 weeks, up from 26.2 weeks in September and 19.8 weeks a year ago.

As the chart below shows, it has historically been very rare for the average to exceed 20 weeks (and for the median to exceed 10 weeks). The only good sign I could find in the unemployment duration numbers was that the ratio of long term (over 26 weeks) to short term (less than 5 weeks) unemployed dropped slightly to 1.78 from 1.83 in September. However, let's not get too excited about that. A year ago it stood at 0.74, and prior to this cycle had never gone above 0.80. The reason for the decline was a 6.1% increase in the number of short term unemployed, which is disturbing since that number had been trending down. The number of long-term unemployed increased by 2.9% on the month and is up 146% from a year ago. If those long-term unemployed were members of the middle class, it is unlikely that they are any more, and as the length of their unemployment continues to grow, their chances of rejoining the middle class diminish. This long term unemployment is going to cause a serious increase in poverty. 

All in all, a disappointing jobs report. Yes we are making some progress, but it is not nearly fast enough. The unemployment rate is now far above the peak seen even in the "more adverse" scenario of the bank stress tests. People who are out of work for extended periods of time are going to have a hard time paying their mortgages. This means more foreclosures are going to be in the pipeline, and hurting the earnings of major mortgage lenders like Bank of America (BAC) as well as Fannie (FNM) and Freddie (FRE). By extension, it is also going to hurt us, the taxpayers, who now own 80% of both of them.

Chicago, IL – November 5, 2009 – Zacks.com announces the list of stocks featured in the Analyst Blog. Every day the Zacks Equity Research analysts discuss the latest news and events impacting stocks and the financial markets. Stocks recently featured in the blog include: Time Warner Inc. (TWX), Fannie (FNM), Freddie (FRE), Citigroup (C) and Bank of America (BAC).

Get the most recent insight from Zacks Equity Research with the free Profit from the Pros newsletter: http://at.zacks.com/?id=5513

Here are highlights from Wednesday’s AnalystBlog:

Time Warner Tops Zacks Consensus

Despite tough macro-economic conditions, Time Warner Inc. (TWX), the global leader in media and entertainment businesses, reported better-than-expected third-quarter 2009 results that topped the Zacks Consensus Estimate.

The quarterly earnings of 61 cents a share beat the Zacks Consensus Estimate of 52 cents, but dropped 6% from 65 cents delivered in the prior-year quarter. On a reported basis, including one-time items, quarterly earnings came in at 55 cents a share, sharply down by 38% from 89 cents posted in the year-ago quarter.

On account of better-than-expected results at its Content Group -- comprising Networks, Filmed Entertainment, Publishing and Corporate segments -- Time Warner boosts its business outlook. The company now expects its full year 2009 earnings to be $2.05 per share, up from $1.98 previously anticipated.

The Fed Stays on Easy Street

The Fed did back off its quantitative easing program slightly. It is done with the program of buying $300 billion of longer-term T-notes, and is continuing its program of buying $1.25 trillion of mortgaged-backed securities. It did, however, slightly reduce its planned purchases of Fannie (FNM) and Freddie (FRE) debt, from $200 billion down to $175 billion. In the overall context of the quantitative easing program, the reduction is trivial. It is, however, a sign that the program will not be expanded, nor is it likely to be renewed after the current program is completed by the end of the first quarter.

There had been a few Fed types who had been making speeches about the need to bring things back to normal sooner rather than later, but when the rubber hit the road, they are still on board with the program.

Overall, the Fed seems to understand that the weak economy is the overriding problem. Yes, things are getting better, but given the sluggish pace of improvement, this is not the time to be taking away the punch bowl.

This would be in keeping with historical precedent. Following the end of the 2001 recession, the Fed waited 32 months before it started to raise rates, and then it did so at a very gradual 25 basis points at a time. Following the 1991 recession it waited 35 months.

So assuming that the NBER eventually determines that the recession ended in July 2009, history suggests that the Fed will not begin to raise rates until the first quarter of 2012. The last two recessions were far milder than this one, which would argue that the Fed should stay on easy street for even longer this time around.

The problem is that keeping rates so low for so long the last time was a key factor in allowing the housing bubble to form. Still, the balance of risks seems to be on the side of an economic relapse, not of an overheating that causes inflation to soar.

Keeping rates low means that we will have a steep yield curve. A steep yield curve allows banks to make a lot of money, since their economic function is to borrow short term, and lend long term. The idea is that if the curve is kept steep enough long enough, even basket-cases like Citigroup (C) and Bank of America (BAC) will be come solvent again.

Want more from Zacks Equity Research? Subscribe to the free Profit from the Pros newsletter: http://at.zacks.com/?id=5515.

About Zacks Equity Research

Zacks Equity Research provides the best of quantitative and qualitative analysis to help investors know what stocks to buy and which to sell for the long-term.

Continuous coverage is provided for a universe of 1,150 publicly traded stocks. Our analysts are organized by industry which gives them keen insights to developments that affect company profits and stock performance. Recommendations and target prices are six-month time horizons.

Zacks "Profit from the Pros" e-mail newsletter provides highlights of the latest analysis from Zacks Equity Research. Subscribe to this free newsletter today: http://at.zacks.com/?id=5517

About Zacks

Zacks.com is a property of Zacks Investment Research, Inc., which was formed in 1978 by Leonard Zacks. As a PhD in mathematics Len knew he could find patterns in stock market data that would lead to superior investment results. Amongst his many accomplishments was the formation of his proprietary stock picking system; the Zacks Rank, which continues to outperform the market by nearly a 3 to 1 margin. The best way to unlock the profitable stock recommendations and market insights of Zacks Investment Research is through our free daily email newsletter; Profit from the Pros. In short, it's your steady flow of Profitable ideas GUARANTEED to be worth your time! Register for your free subscription to Profit from the Pros at http://at.zacks.com/?id=5518.

Visit http://www.zacks.com/performance for information about the performance numbers displayed in this press release.

Follow us on Twitter: http://twitter.com/zacksresearch

Join us on Facebook: http://www.facebook.com/home.php#/pages/Zacks-Investment-Research/57553657748?ref=ts

Disclaimer: Past performance does not guarantee future results. Investors should always research companies and securities before making any investments. Nothing herein should be construed as an offer or solicitation to buy or sell any security.

Contact:
Mark Vickery
Web Content Editor
312-265-9380
Visit: www.zacks.com

But perhaps more important than when to exit is the question of how and whether indeed it will be so easy and simple for central banks to simply wind down the supply of medicine. In the context of the ECB for example, I remain rather sceptical.

However, this day is all about the Fed decision  and although I only rarely delve into account of US monetary policy decisions (comparative advantage you know!) this one is important since it was always going to be parsed very closely for signs of hawkishness on rates on the one side as well as indications of the future wind down of asset purchases. Now, for those who expected a big bang, I have to side with Macro Man that it seems to be much ado about nothing in the sense that the Fed basically reiterated the general view that although economic activity had been showing positive signs lately and especially in the context of leading indicators pointing to a strong bounce in Q3 and Q4 activity, the fundamentals of very low capacity utilisation and deleveraging across the real economy remain intact. In the context of Fed speak this translates into maintaining the current rate target at the zero bound and the the forward looking statement that rates are to kept low for an extended period; 

Conditions in financial markets have improved further, and activity in the housing sector has increased.  Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.  Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.  Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.

In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability.  The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

So far so good then and this was really all we needed, one would imagine, to extent the rally in risky assets as well as the downward trend in the USD as the new funding currency for carry traders and others of their ilk. So far, there has been no signs of panic anywhere and everything seems to be all engines go.

Meanwhile, the Fed did actually give away some details as to how the future bout of asset purchases are to be conducted. On the matter of treasury purchases the Fed will its total purchase of $300 billion by the end of October. Most of us would naturally like to be able to predict what this will to do yields and prices and really you could spin this two ways. In the context of supply side worries, the Fed's withdrawal from the treasury market should push down yields if we add the, perhaps dubious assumption, that the $300 billion worth of supply of treasury bills has only been there to the extent that the Fed has been the main bidder (Say's law and everything). On the other hand it could also push up yields in a world where one assumes that there has been a decisive need to issue such bills and now that the Fed is stepping aside new buyers must step in and notwithstanding those with a printing press of their own, it should push up yields. Although this may seem quite innocuous and technical (i.e. unimportant) it may turn out to be important in a general context when it comes to the ability of economies (not just the US) to lift themselves out of the mire without the crutches of stimulus to lean on.

In the context of the Fed's outright asset purchases, the statement delivered good news for bulls/doves in so far as goes the fact that although the Fed was invariably going to issue a deadline, it seems to have been pushed somewhat out in the distance; well, at least a quarter. Consequently, the Fed will buy $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt, purchases which are set to be concluded by the end of the first quarter and not by year end which was the final date I had been led to believe judged by the points made in various economics report digested over the last week.

So, it is here perhaps that we may be looking at a disappearing bid in the context of the Fed gradually but surely reducing its presence in the market for MBS turds not to mention the agency market which went belly up as Fannie and Freddie crashed and burned. In the nice soothing light of efficient markets it is difficult to expect the decision to wind down purchases to be a big market mover as long as the incoming bout of data continues to provide plenty of upside and no downside. But if we get a setback just around the time when the Fed had envisioned to stand down its most aggressive measures of QE, one finds it difficult not to expect general sentiment and thus, in a forward looking perspective, real economic activity to take a hit which is exactly what we would all like to avoid; the double dip recession or "WL" recession if you will.

Ultimately, it is of course all still a great big mess, something which was neatly conveyed by the way Bloomberg handled the message carried by the IMF envoy to the G20 summit. On the one hand, the IMF was quoted for urging central banks to map a viable and transparent exit strategy and on the other hand Managing Director Dominique Strauss-Kahn was quoting for urging policy makers to not withdraw fiscal stimulus to quickly. Lost in translation are we?

Well, I am perhaps being unfair here to the editors of Bloomberg not to mention the IMF in particular since ultimately; talking about exit strategies is not the same thing as enforcing them. However, I do feel rather strongly about the need to make the following point that the two are of course intimately connected and withdrawing QE cannot but affect the trajectory of fiscal stimulus. This is a point which I believe for example is absolutely crucial to understand in the context of the Eurozone where the ECB's refinancing operations seem to be implicitly underpinning national governments' efforts to shore up their capsized economies.

In this context and assuming that both the BOJ and the ECB will be trailing the Fed somewhat, it will be most interesting to see whether Bernanke manages withdraw the bid on financial markets currently offered by the Fed's policies and indeed whether others may follow in his footsteps and withdraw theirs.

Chicago, IL – September 16, 2009 – Zacks Equity Research highlights Joy Global (JOYG) as the Bull of the Day and Zions Bancorporation (ZION) the Bear of the Day. In addition, Zacks Equity Research provides analysis on Fannie (FNM), Freddie (FRE) and J.P. Morgan (JPM).

Full analysis of all these stocks is available at http://at.zacks.com/?id=2676

Here is a synopsis of all five stocks:

Bull of the Day:

We are confident about the long-term fundamentals of the mining industry, which is further supported by a sustainable secular shift in commodity demand in the emerging economies. This will provide Joy Global (JOYG) substantial growth potential once the global economy emerges from the ongoing turmoil.

Joy Global aims at maximizing operating efficiency and useful life of mining equipment through value-added aftermarket services, which gives the company significant edge over its competitors. Additionally, the stable revenue stream from the high-margin aftermarket operations help Joy Global offset its cyclical original equipment business.

Of late, Joy Global management has implemented several strategies to optimize cost-structure and realign production capacity to cope with the slowing customer orders and stay competitive amid the ongoing global slowdown. The company is pushing its overall inventory and working capital efficiency. Moreover, Joy Global is looking at increasingly relocating production capacity to low-cost regions like China, Poland, and South Africa. These actions will improve operational efficiency, boost profitability and also solidify long term viability of the company.

Bear of the Day:

Given the high competitive pressures in the banking industry, we expect continuous deposit pricing pressures as well as growth in higher cost funding accounts to weigh on Zions Bancorporation's (ZION) net interest margins (NIM), creating headwinds on the revenue front.

Loan growth has remained solid, but slowing growth in core deposits could cause a negative mix shift, another setback for the NIM. Management expects deposit growth to continue to lag loan growth and that a portion of future loan growth may be funded from alternative higher cost funding sources.

The growth through acquisition model exposes the company to the risk of overpaying for targets. We are concerned about Zions commercial real estate (CRE) exposure. CRE represents over one-third of Zions overall loan portfolio. Continued weakness in the residential development and construction activity in the southwest has resulted in further deterioration of credit metrics in the past several quarters. Given the sluggish economic conditions, we expect credit to further deteriorate across the industry in the coming quarters.

Latest Posts on the Zacks Analyst Blog:

Obama and Market Regulation

Some of the proposals that President Obama has made sound reasonable and possibly workable, but the real devil is in the details. He will attempt to solve the 'too big to fail' problem by requiring the bigger, TBTF banks to hold higher levels of capital than smaller non-systemically important banks. The big question is how much higher?

If it is only a nominal difference, then the big banks will be in a great position. The Federal government will be in effect guaranteeing the debt of those banks (just like it did for Fannie (FNM) and Freddie (FRE) before taking them over). This will result in a much lower cost of capital for a TBTF bank like J.P. Morgan (JPM) than for your average mid sized bank. The big banks will then be free to take the money and pile it all on 23 red on the roulette wheel (metaphorically). If they win, the bank makes a fortune, which it will then share generously with its top executives. If they lose, the taxpayers will pick up the tab if the amount lost exceeds the bank's capital. Debt obligations of the big banks will be almost as safe as treasuries.

Get the full analysis of all these stocks by going to http://at.zacks.com/?id=5507.

About the Bull and Bear of the Day

Every day, the analysts at Zacks Equity Research select two stocks that are likely to outperform (Bull) or underperform (Bear) the markets over the next 3-6 months.

About the Analyst Blog

Updated throughout every trading day, the Analyst Blog provides analysis from Zacks Equity Research about the latest news and events impacting stocks and the financial markets.

About Zacks Equity Research

Zacks Equity Research provides the best of quantitative and qualitative analysis to help investors know what stocks to buy and which to sell for the long-term.

Continuous analyst coverage is provided for a universe of 1,150 publicly traded stocks. Our analysts are organized by industry which gives them keen insights to developments that affect company profits and stock performance. Recommendations and target prices are six-month time horizons.

Zacks "Profit from the Pros" e-mail newsletter provides highlights of the latest analysis from Zacks Equity Research. Subscribe to this free newsletter today by visiting http://at.zacks.com/?id=5508.

About Zacks

Zacks.com is a property of Zacks Investment Research, Inc., which was formed in 1978 by Leonard Zacks. As a PhD in mathematics Len knew he could find patterns in stock market data that would lead to superior investment results. Amongst his many accomplishments was the formation of his proprietary stock picking system; the Zacks Rank, which continues to outperform the market by nearly a 3 to 1 margin. The best way to unlock the profitable stock recommendations and market insights of Zacks Investment Research is through our free daily email newsletter; Profit from the Pros. In short, it's your steady flow of Profitable ideas GUARANTEED to be worth your time! Register for your free subscription to Profit from the Pros at http://at.zacks.com/?id=5509.

Visit http://www.zacks.com/performance for information about the performance numbers displayed in this press release.

Follow us on Twitter: http://twitter.com/zacksresearch

Join us on Facebook: http://www.facebook.com/home.php#/pages/Zacks-Investment-Research/57553657748?ref=ts

Disclaimer: Past performance does not guarantee future results. Investors should always research companies and securities before making any investments. Nothing herein should be construed as an offer or solicitation to buy or sell any security.

Contact:
Mark Vickery
Web Content Editor
312-265-9380
Visit: www.zacks.com

In general I liked the speech, but think that the steps he has proposed are, at best, only a good first step. I hope that the proposals are strengthened in Congress, but have zero hope of that happening. More likely they will be watered down significantly. The end result is that we will face another market meltdown in the future; the only question is when.

Regulation of the financial industry is one of those extremely important, yet dry and dull subjects, that the general public will ignore, and the lobbyists will own. The bank lobby is extremely powerful and is going to fight things tooth and nail. Obama got a distinctly cool reception from the financial executives in the audience, with only a single round of applause.

However, one year after the government spent hundreds of billions to save the banking system, not a single major bank CEO even bothered to show up for the speech. The sense of entitlement and the lack of gratitude by Wall Street is simply stunning. Look for a big push by the industry to preserve the status quo, probably with folksy TV ads full of dishonest scare tactics. It could include stuff about killing innovation and all that, attempting to convince people they are safer without someone in D.C. trying to protect consumers from abusive financial products. How many really useful financial innovations have there been in the last 30 years that have helped consumers?

The big useful innovations like credit cards and ATMs all happened back in the 1960s and 1970s, when banks were more closely regulated. Back in the days of 3-6-3 banking, when a banker would borrow at 3% in the form of checking and savings deposits, lend at 6%, and be on the first tee by 3 PM. When that was the shape of banking, we didn't have to worry about meltdowns.

On the other hand, bankers were just members of the upper middle class, not regularly bringing home 8 figure compensation packages. The proposed consumer protection agency for financial products is probably the most important part of the reform package. It is also the one that the banks are going to try the hardest to kill. It is the acid test if the reform package is real, or just a fig leaf. I'll go one step further and say that any congressman of either party who votes against this is representing his big campaign contributors on Wall Street, and not the interests of his or her constituents.

Some of the proposals that Obama has made sound reasonable and possibly workable, but the real devil is in the details. He will attempt to solve the 'too big to fail' problem by requiring the bigger, TBTF banks to hold higher levels of capital than smaller non-systemically important banks. The big question is how much higher?

If it is only a nominal difference, then the big banks will be in a great position. The Federal government will be in effect guaranteeing the debt of those banks (just like it did for Fannie (FNM) and Freddie (FRE) before taking them over). This will result in a much lower cost of capital for a TBTF bank like J.P. Morgan (JPM) than for your average mid sized bank. The big banks will then be free to take the money and pile it all on 23 red on the roulette wheel (metaphorically). If they win, the bank makes a fortune, which it will then share generously with its top executives. If they lose, the taxpayers will pick up the tab if the amount lost exceeds the bank's capital. Debt obligations of the big banks will be almost as safe as treasuries.

On the other hand if the higher capital requirements are big enough, the lower leverage will greatly reduce the ROE of the big banks. The big banks will have more of their shareholders money at risk and might want to play it much safer.

Putting the Fed in charge of being the overall systemic risk regulator is somewhat problematic, given how slow the Fed was in recognizing the severity of the problems last year. However, I don't see a better alternative among the existing agencies.

A case could perhaps be made for the FDIC, but their expertise is only with the banks, and the shadow banking system was a big part of the problem. Putting it in the hands of a committee of different agencies is just an excuse to do nothing. Would you be reassured if it was in the hands of some inter agency council? I know I would not be. I would however couple the increased authority for the Fed with the requirement that the Fed actually be audited, a proposal that Rep. Ron Paul has been pushing.

So given how complicated financial regulation is, how should consumers try to follow it? Perhaps the best way is to look at who is pushing for what. If the mortgage bankers association is pushing for a change in the regulation package, you should know that it is not in the best interests of consumers.

For more on this subject, I highly recommend reading this post by Simon Johnson, the former chief economist at the IMF over at the Baseline Scenario.

Here's the argument Paul Krugman gave for why $9 trillion maybe isn't as huge a sum as it sounds:

even if we do run these deficits, federal debt as a share of GDP will be substantially less than it was at the end of World War II. It will also be substantially less than, say, debt in several European countries in the mid to late 1990s.

Political Math (hat tip: Russ Roberts) takes a closer look at Paul's first comparison:

implicit in his observation is the concept that since we did fine after WWII, we'll do fine now. But the years after WWII saw drastic reductions in the inflation-adjusted debt driven by drastic reductions in spending. Mr. Krugman points to no similar possibility in the post-Obama world.... Back in 1945, at the height of the spending that saw our national debt rise so dramatically, entitlement spending and interest on the national debt made up a meager 5% of our total budget.

Source: Political Math.

And whereas in 1945 Americans could reasonably look ahead to a huge decrease in military expenditures, in 2009 when I look ahead what I see is a looming increase in federal medical expenditures.

I also believe it is relevant to compare these deficits not just with GDP but also with current federal tax revenues. $1 trillion is approximately the total personal income tax receipts of the federal government in 2006. My preferred metric for what each additional trillion dollars would require from me personally is to take what I paid in federal income taxes in 2006 and double that amount. To pay off $9 trillion, I'd have to do that for 9 years.

Unfortunately, $9 trillion may not be the whole iceberg. Diane Lim Rogers highlights the Concord Coalition estimate that current policy would imply a cumulative $14.4 trillion deficit over the next ten years.

You also can't ignore the off-balance sheet federal liabilities, such as the $5 trillion in debt and loan guarantees from Fannie and Freddie. A quarter trillion dollars worth of those loans we've guaranteed are currently nonperforming. That's just Fannie and Freddie-- doesn't include FHA, FDIC, Federal Reserve,...

If the government tries to double taxes on people like me, it's in real political trouble. If it doesn't try to double taxes on people like me, it's in real solvency trouble.

It looks like we may have a problem here.

Chicago, IL – August 26, 2009 – Zacks.com announces the list of stocks featured in the Analyst Blog. Every day the Zacks Equity Research analysts discuss the latest news and events impacting stocks and the financial markets. Stocks recently featured in the blog include: Equity Residential (EQR), Apartment Investors (AIV), Fannie (FNM), Freddie (FRE) and ArvinMeritor Inc. (ARM).

Get the most recent insight from Zacks Equity Research with the free Profit from the Pros newsletter: http://at.zacks.com/?id=5513

Here are highlights from Tuesday’s Analyst Blog:

House Prices Actually RISING

Most of the adjustment in home prices is behind us, but I am not totally sure we are out of the woods. With the soft economy and rising unemployment, median incomes are not going up and are probably falling.

Major apartment REITs like Equity Residential (EQR) and Apartment Investors (AIV) have been reporting that they have had to lower stated rents recently and effective rents even more (i.e. throwing in a few free months of rent when you sign a lease). This means that rents are most likely going down nationwide, although it has not yet shown up in Owners Equivalent Rents, which is how the government tracks housing for calculating inflation. Declining rents and incomes will put more pressure on housing prices.

This will be particularly true once the artificial prop of the first-time home-buy tax credit expires. The other major prop to the market has been the Federal Reserve, which has turned into the mortgage buyer of first and last resort as it is in the process of buying $1.25 trillion in Fannie (FNM) and Freddie (FRE) backed securities. Eventually the Fed will have to reverse those actions (or inflation will spiral out of control), and when it does, the mortgage market is likely to get much, much tighter.

ArvinMeritor Loses Its Wheels

Earlier this month, auto parts supplier ArvinMeritor Inc. (ARM) agreed to sell its Wheels business to focus on its core business. Lochpe-Maxion, a Sao Paulo, Brazil-based producer of wheels and frames for commercial vehicles, railway freight cars and castings, will buy the segment from ArvinMeritor.

The sale is expected to close by the end of 2009. ArvinMeritor’s Wheels business has manufacturing facilities in Limeira, Brazil and San Luis Potosi, Mexico.

ArvinMeritor plans to invest up to $10 million in its commercial vehicle business in Brazil to support expansion into new product segments and new manufacturing technology. Despite the worldwide slump in automotive industry, the company's production in South America grew by 9% in the last quarter. Meanwhile, the company is also pursuing the sale of its light vehicle systems business, which includes the body systems unit.

Want more from Zacks Equity Research? Subscribe to the free Profit from the Pros newsletter: http://at.zacks.com/?id=5515.

About Zacks Equity Research

Zacks Equity Research provides the best of quantitative and qualitative analysis to help investors know what stocks to buy and which to sell for the long-term.

Continuous coverage is provided for a universe of 1,150 publicly traded stocks. Our analysts are organized by industry which gives them keen insights to developments that affect company profits and stock performance. Recommendations and target prices are six-month time horizons.

Zacks "Profit from the Pros" e-mail newsletter provides highlights of the latest analysis from Zacks Equity Research. Subscribe to this free newsletter today: http://at.zacks.com/?id=5517

About Zacks

Zacks.com is a property of Zacks Investment Research, Inc., which was formed in 1978 by Leonard Zacks. As a PhD in mathematics Len knew he could find patterns in stock market data that would lead to superior investment results. Amongst his many accomplishments was the formation of his proprietary stock picking system; the Zacks Rank, which continues to outperform the market by nearly a 3 to 1 margin. The best way to unlock the profitable stock recommendations and market insights of Zacks Investment Research is through our free daily email newsletter; Profit from the Pros. In short, it's your steady flow of Profitable ideas GUARANTEED to be worth your time! Register for your free subscription to Profit from the Pros at http://at.zacks.com/?id=5518.

Visit http://www.zacks.com/performance for information about the performance numbers displayed in this press release.

Follow us on Twitter: http://twitter.com/zacksresearch

Join us on Facebook: http://www.facebook.com/home.php#/pages/Zacks-Investment-Research/57553657748?ref=ts

Disclaimer: Past performance does not guarantee future results. Investors should always research companies and securities before making any investments. Nothing herein should be construed as an offer or solicitation to buy or sell any security.

Contact:
Mark Vickery
Web Content Editor
312-265-9380
Visit: www.zacks.com

Let's start with Fannie Mae, the government-sponsored enterprise that was allowed to function as a quasi-private company from 1968 to 2008 and is currently under conservatorship of the Federal Housing Finance Agency. Prior to conservatorship, Fannie earned a profit two ways. First, it used borrowed funds to purchase mortgages that it held directly. Because investors perceived the GSE's debt to be implicitly backed by the federal government, Fannie's borrowing costs were very low, and it had an incentive to engage in arbitrage on a huge scale, borrowing cheap and buying as many mortgages as regulators would allow. As of June 2009 these assets came to $793 billion. Second, Fannie would bundle mortgages into securities on which it provided a guarantee of timely payment of principal and interest, in exchange for which it received a modest fee, and assumed a staggering off-balance-sheet liability. As of June 2009, Fannie's guarantees involved an additional notional liability of $2.4 trillion. Fannie's equity was never remotely sufficient to make such guarantees credible, and this game, too, is best interpreted as arbitraging an implicit government obligation to pick up the tab should things turn sour.

On August 6 Fannie reported (hat tip: Calculated Risk):

Total nonperforming loans in our guaranty book of business were $171.0 billion on June 30, 2009, compared with $144.9 billion on March 31, 2009, and $119.2 billion on December 31, 2008.

This doesn't mean that taxpayers are now out $171 billion, because the salvage value on these properties is not zero. On the other hand, more defaults could be ahead.

Fannie's GSE brother, Freddie Mac, had over $2 trillion in mortgages held outright or guaranteed, last time I checked. Freddie reported $15 billion in non-performing assets that it holds outright and an additional $62 billion in non-performing assets on which it has issued guarantees (Table 2 in their second-quarter 10Q). But on top of this is the imminent bankruptcy anticipated from mortgage originator Taylor, Bean & Whitaker, following last week's allegations of "irregular transactions that raised concerns of fraud". Freddie Mac filed this report (hat tip: CR):

TBW accounted for approximately 5.2% and 2.7% of our single-family mortgage purchase volume activity for full-year 2008 and the six months ended June 30, 2009, respectively. We are in the process of determining our total exposure to TBW in the event it cannot perform its contractual obligations to us. The amount of our losses in such event could be significant.

And the Federal Housing Administration is stepping in where Fannie and Freddie leave off. A recent report from the Office of Inspector General noted that the FHA's current single-family insured exposure totals over $560 billion and invites preventable fraud. TBW was the third biggest originator of FHA loans, with the overall delinquency rate on FHA-guaranteed loans now up to 7.42%.

Then there's the $1 trillion in mortgage exposure that Ginnie Mae is about to take on.

Total public debt outstanding of the U.S. Federal Government is currently $11,490 billion, or $124,000 per taxpayer. But a fair chunk of that total public debt-- $4,350 B to be exact-- is money that the government owes to itself, about half to the Social Security Trust Fund, and the remainder to other government accounts such as Civil Service Retirement and Disability, Military Retirement, Medicare, and Unemployment Insurance Trust Funds. The debt actually held by the public is "only" $7,140 billion, which amounts to half of last year's GDP. The Congressional Budget Office estimates that debt held by the public will rise to 56.6% of GDP by the end of this year. That will put the number well above the peaks reached in the Revolutionary War, Civil War, World War I, or the Reagan years, though still significantly below the debt run up from World War II.

Figure 1. Federal debt held by the public as a percent of GDP, 1790-2008, and projected for 2009. Data source: Congressional Budget Office.

But is it correct to subtract off the $4.3 trillion that the government owes "to itself"? These intragovernmental accounting entries represent an intention of the government to deliver real resources to certain parties, such as retirees, at a future date, so perhaps we should include them in a reckoning of all that the government has promised to pay. On the other hand, given what is currently promised, and given trends in the aging population and rising medical costs, if benefit formulas continue as present, the amount that the government would be obligated to deliver far exceeds the sums acknowledged in the intragovernmental debt accounts or what could be covered with future tax revenues.

One calculation that the CBO has performed is what they call an "alternative fiscal scenario" representing

one interpretation of what it would mean to continue today's underlying fiscal policy. This scenario deviates from CBO's baseline even during the next 10 years because it incorporates some policy changes that are widely expected to occur and that policymakers have regularly made in the past.

According to the CBO, in the absence of a significant increase in taxes above historical rates or change in benefit policies, growth in Medicare, Social Security, and Medicaid would quickly produce an explosion of federal debt.

Figure 2. Debt held by the public as a percent of GDP, 1790-2008, and projected for 2009-2083 under the "alternative fiscal scenario". Data source: Congressional Budget Office.

Of course such a path is completely infeasible and unsustainable. Then what exactly is the government promising to provide in the way of retirement medical care and income for those currently working, and what will the government actually deliver? The answer to both questions is unclear to me, though I have no doubt that this category of off-balance-sheet liability represents a potentially staggering sum.

But whatever you think future spending on Medicare will be, consider some of the other off-balance sheet federal promises. At the end of 2008, the Federal Deposit Insurance Corporation had insured $4.8 trillion in deposits. Fannie and Freddie, which are now effectively nationalized, bring perhaps another $4.9 trillion in notional liabilities to the table. Those two alone sum to an amount well in excess of the current federal debt owed to the public.

Ah, but the federal government wouldn't actually be asked to honor more than a small fraction of those guarantees, would it? Only a few banks will fail, and the prime loans insured by Fannie and Freddie are safe, right? Right?

Still, even a modest fraction of $10 trillion sounds like a lot of money to me.

Then there's the loose change, such as the $1.1 trillion in obligations of the Federal Home Loan Banks. The federal government does not officially acknowledge responsibility for the liabilities of these government-sponsored enterprises, though that of course is what it had also claimed about Fannie and Freddie. Government-owned Ginnie Mae has issued guarantees on another $577 billion in mortgage-backed securities, while the Federal Housing Administration has insured $532 billion in mortgages. The U.S. Federal Reserve has added $1.1 trillion to its liabilities since September. And now loan guarantees appear to be the instrument of choice for U.S. energy policy ([1], [2]).

Of course there's a simple reason why all this happens. There is tremendous pressure for politicians to deliver in the form of off-balance-sheet commitments. Voters credit them for giving us what we want now, and blame somebody else when the time comes to pay for it. I'm amazed that no one is being held accountable for the fiasco of Fannie and Freddie, and indeed leading elected officials continue to advocate more of the same policies that created the original problem.

Some might look at Figure 1 and conclude that the U.S. could issue much more debt and still find ready buyers. But I worry that Figure 1 is only the tip of a very big iceberg.

The Wall Street Journal reports:

Bernanke faced open hostility from lawmakers who barraged him during a Congressional hearing over his handling of the financial crisis and the central bank's role in reshaping the banking system.

Setting aside the deferential tone usually reserved for Fed chairmen, members of the House Committee on Oversight and Government Reform repeatedly interrupted Mr. Bernanke at Thursday's hearing to review the Fed's role in engineering a government aid package for Bank of America Corp. The lawmakers pored over internal Fed emails subpoenaed by the committee and projected on a screen in the hearing room.

It is one thing to have different views from those of the Fed Chair on particular decisions that have been made-- I certainly have plenty of areas of disagreement of my own. But it is another matter to question Bernanke's intellect or personal integrity. As someone who's known him for 25 years, I would place him above 99.9% of those recently in power in Washington on the integrity dimension, not to mention IQ. His actions over the past two years have been guided by one and only one motive, that being to minimize the harm caused to ordinary people by the financial turmoil. Whether you agree or disagree with all the steps he's taken, let's start with an understanding that that's been his overriding goal.

These interrogations reveal more about those doing the grilling than they reveal about Bernanke. I see this as pure political theater, and I don't like it.

If Congress wants to explore more usefully the wisdom and motives behind some of the decisions that have been made, it might want to investigate why some legislators are now pushing for Fannie and Freddie to guarantee a riskier category of mortgage condo loans.

Chicago, IL - May 11, 2009 - Zacks.com releases the latest Industry Outlook. Today's interview is with senior analyst Greg Sukenik, who talks about the REIT Industry, including Avalon Bay Communities, Inc. (AVB) and Vornado Realty Trust (VNO).

A synopsis of today's Industry Outlook is presented below. The full article can be read at http://at.zacks.com/?id=2678.

In this environment, we like well-capitalized companies that have adequate liquidity to fund maturing debt at least through 2010. One name we still have Buys on is Avalon Bay Communities, Inc. (AVB), an apartment REIT with low debt and assets in infill markets where little new supply will be coming on board. Fannie and Freddie are still heavy lenders for apartments, which gives the sector access to relatively cheap capital.

In addition, we like Vornado Realty Trust (VNO), another company with low comparative debt, lots of cash and class-A office assets in some good long-term, heavily supply-constrained areas.

Zacks "Profit from the Pros" e-mail newsletter provides highlights of the latest analysis from Zacks Equity Research. Subscribe to this free newsletter today by visiting http://at.zacks.com/?id=2679.

About Zacks

The performance of the Zacks Rank portfolios shown above for annual and year-to-date periods are the linked monthly total returns (price changes + dividends) of equal weighted hypothetical portfolios, consisting of those stocks with the indicated Zacks Rank, assuming monthly rebalancing and zero transaction costs. These are not the returns of actual portfolios. The hypothetical portfolios were created at the beginning of each month from Jan 1988 forward based on the values of the Zacks Rank available to Zacks' clients before the beginning of each month.

The portfolios created monthly from 1988 through September 2006 exclude ADRS and are comprised of stocks that have the indicated Zacks Rank and were covered by at least two analysts at the time of the stocks inclusion in the portfolio. Starting in October 2006 and going forward, the portfolios are comprised of all stocks with the indicated Zacks Rank and do not exclude ADRs, which is more reflective of the list of stocks that customers will find on the Zacks web sites. 2007 returns are for the period of Jan 1 - Jun 30, 2007. These performance numbers have been audited from 1995 through 2003 by Autschuler Melovan, a division of American Express Financial.

Contacts:

Mark Vickery

312-265-9380

Visit: www.zacks.com

OPPORTUNITIES

* Many REITs are still trading at discounts to NAV [net asset value], a good buy signal. Historically, over the past 7 or so years, REITs have traded near or in excess of NAV
* Even with dividend cuts and share price gains, the average yield for equity REITs is still over 6%. Yields are well in excess (300 bps) of the 10-year Treasury, although the spread has narrowed considerably.
* Most companies have been shoring up balance sheets by raising cash and paying down debt.
* The credit freeze will have a positive effect on commercial real estate down the road; new office, apartment, and retail construction has slowed considerably which will benefit owners in a couple of years. Many companies that we cover have ceased all new construction.
* Commercial real estate fundamentals are deteriorating, although not as much as some feared.
In this environment, we like well-capitalized companies that have adequate liquidity to fund maturing debt at least through 2010. One name we still have Buys on is Avalon Bay Communities, Inc. (AVB), an apartment REIT with low debt and assets in infill markets where little new supply will be coming on board. Fannie and Freddie are still heavy lenders for apartments, which gives the sector access to relatively cheap capital.
In addition, we like Vornado Realty Trust (VNO), another company with low comparative debt, lots of cash and class-A office assets in some good long-term, heavily supply-constrained areas.

WEAKNESSES

On the other hand:

* REITs still depend on access to debt to fund growth, and with the credit markets still tight, it will be difficult for companies to raise cheap debt.
* Going forward, many REITs will raise capital through property level debt, dividend reductions, and equity offerings. Property level debt is harder to obtain and more expensive as commercial real estate prices continue to plummet. Many companies are writing down the value of assets. Share offerings are generally dilutive at low prices, and dividend cuts make the sector less attractive to income-oriented investors.
* A few companies are now paying a large portion of their dividends in new shares, which we view as a negative. This could become more common over the next few quarters if fundamentals decline bank lending does not increase.
* REITs will be dependent on asset sales to raise cash. Overall commercial sales volumes decreased dramatically in 2008, and going forward it will be difficult to unload assets. There is still a large bid-ask spread between sellers and buyers. Sellers are holding out for pre-recession pricing. In addition, financing is hard to obtain.
* Commercial real estate delinquencies are ticking up at a fast pace, which makes lenders nervous about exposure to the CRE sector.
* Expect share prices to be volatile over the next two quarters. Headline risk, notably job growth and consumer spending patterns, which will both be negative in 2009 will continue to weigh on the sector.
* Specifically, we are negative on suburban office and industrial going forward. Suburban office and industrial vacancies are ticking up at a rapid pace, and absent job growth, filling space will be difficult. Zacks Investment Research

Equity REITs have rebounded nicely over the past few months. So far this quarter, equity REITs have posted total returns of 36% (total return FTSE NAREIT Index). All sectors are up in the 2nd quarter; the best performing sectors were lodging (102%), regional malls (68%), shopping centers (42%), and industrial (37%).

Overall, REITs are still down 7% in 2009, vs. a drop of 3% in the Dow and a gain of 2.8% in the S&P.

OPPORTUNITIES

* Many REITs are still trading at discounts to NAV [net asset value], a good buy signal. Historically, over the past 7 or so years, REITs have traded near or in excess of NAV 

* Even with dividend cuts and share price gains, the average yield for equity REITs is still over 6%. Yields are well in excess (300 bps) of the 10-year Treasury, although the spread has narrowed considerably. 

* Most companies have been shoring up balance sheets by raising cash and paying down debt. 

* The credit freeze will have a positive effect on commercial real estate down the road; new office, apartment, and retail construction has slowed considerably which will benefit owners in a couple of years. Many companies that we cover have ceased all new construction.

* Commercial real estate fundamentals are deteriorating, although not as much as some feared. 

In this environment, we like well-capitalized companies that have adequate liquidity to fund maturing debt at least through 2010. One name we still have Buys on is Avalon Bay Communities, Inc. (AVB), an apartment REIT with low debt and assets in infill markets where little new supply will be coming on board. Fannie and Freddie are still heavy lenders for apartments, which gives the sector access to relatively cheap capital.

In addition, we like Vornado Realty Trust (VNO), another company with low comparative debt, lots of cash and class-A office assets in some good long-term, heavily supply-constrained areas.

WEAKNESSES

On the other hand:

* REITs still depend on access to debt to fund growth, and with the credit markets still tight, it will be difficult for companies to raise cheap debt. 

* Going forward, many REITs will raise capital through property level debt, dividend reductions, and equity offerings. Property level debt is harder to obtain and more expensive as commercial real estate prices continue to plummet. Many companies are writing down the value of assets. Share offerings are generally dilutive at low prices, and dividend cuts make the sector less attractive to income-oriented investors.

* A few companies are now paying a large portion of their dividends in new shares, which we view as a negative. This could become more common over the next few quarters if fundamentals decline bank lending does not increase. 

* REITs will be dependent on asset sales to raise cash. Overall commercial sales volumes decreased dramatically in 2008, and going forward it will be difficult to unload assets. There is still a large bid-ask spread between sellers and buyers. Sellers are holding out for pre-recession pricing. In addition, financing is hard to obtain. 

* Commercial real estate delinquencies are ticking up at a fast pace, which makes lenders nervous about exposure to the CRE sector. 

* Expect share prices to be volatile over the next two quarters. Headline risk, notably job growth and consumer spending patterns, which will both be negative in 2009 will continue to weigh on the sector. 

* Specifically, we are negative on suburban office and industrial going forward. Suburban office and industrial vacancies are ticking up at a rapid pace, and absent job growth, filling space will be difficult.

OPPORTUNITIES

• 1) Most REITs are trading at large discounts to NAV [net asset value], a good buy signal. Historically, over the past 7 or so years, REITs have traded near or in excess of NAV
• 2) Even with dividend cuts, the average yield for equity REITs is still over 9%. Yields are well in excess (600bps+) of the 10-year Treasury
• 3) If commercial real estate fundamentals do not fall off a cliff and follow residential into the abyss, then there could be some attractive long-term buys

In this environment, we like well-capitalized companies that have adequate liquidity to fund debt through at least 2009. One name we still have Buys on is Avalon Bay (AVB), an apartment REIT with low debt and assets in infill markets where little new supply will be coming on board. Fannie and Freddie are still heavy lenders for apartments, which gives the sector access to relatively cheap capital.

In addition, we like Vornado (VNO), another company with low comparative debt, lots of cash and class-A office assets in some good long-term, heavily supply-constrained areas.

The credit freeze will have a good effect on these sectors down the road; new office and apartment construction has almost come to a halt, which should benefit these companies in the next couple of years. In fact, a handful of companies has ceased all new development starts in 2009.

These are long-term buys -- headline risk will cause continued volatility in the entire sector. Buy REITs for the yield, and expect share prices to be choppy until there is some evidence that some of the hundreds of billions of dollars the government is printing will help the country come out of the recession.

WEAKNESSES

• 1) REITs still depend on access to debt to fund growth, and with the credit markets still frozen, it will be difficult for companies to raise cheap debt
• 2) Going forward, many REITs will raise capital through property level debt and dividend reductions. Property level debt will be harder to obtain as commercial real estate prices continue to plummet, which decreases the amount that a company can borrow and increases LTVs [loan-to-value ratios]. Dividend reductions make the sector less attractive to income-oriented investors
• 3) REITs will be dependent on asset sales to raise cash. Overall commercial sales volumes decreased in 2008, and going forward it will be difficult to unload assets. Buyers simply cannot get financing
• 4) Commercial real estate delinquencies are ticking up at a fast pace, which makes lenders nervous about exposure to the CRE sector. Many companies in our coverage universe have cut dividends or decided to pay a large portion of dividend in stock in an effort to keep as much cash as possible. We are negative on stock dividends; companies want to keep cash and give investors cheap shares which dilutes all holders
• 5) Equity issuance at this time would be dilutive since many companies are trading at depressed prices

Overall, REITs are still down 30% so far in 2009, well behind the S&P and Dow. The March mini-rally is nothing to get excited about and the sector could continue to sell off.

OPPORTUNITIES

That said, there are still some positives:   

• 1) Most REITs are trading at large discounts to NAV [net asset value], a good buy signal. Historically, over the past 7 or so years, REITs have traded near or in excess of NAV    
• 2) Even with dividend cuts, the average yield for equity REITs is still over 9%. Yields are well in excess (600bps+) of the 10-year Treasury    
• 3) If commercial real estate fundamentals do not fall off a cliff and follow residential into the abyss, then there could be some attractive long-term buys

In this environment, we like well-capitalized companies that have adequate liquidity to fund debt through at least 2009. One name we still have Buys on is Avalon Bay Communities, Inc. (AVB), an apartment REIT with low debt and assets in infill markets where little new supply will be coming on board. Fannie and Freddie are still heavy lenders for apartments, which gives the sector access to relatively cheap capital.

In addition, we like Vornado Realty Trust (VNO), another company with low comparative debt, lots of cash and class-A office assets in some good long-term, heavily supply-constrained areas.

The credit freeze will have a good effect on these sectors down the road; new office and apartment construction has almost come to a halt, which should benefit these companies in the next couple of years. In fact, a handful of companies has ceased all new development starts in 2009.

These are long-term buys -- headline risk will cause continued volatility in the entire sector. Buy REITs for the yield, and expect share prices to be choppy until there is some evidence that some of the hundreds of billions of dollars the government is printing will help the country come out of the recession.

WEAKNESSES

On the other hand:   

• 1) REITs still depend on access to debt to fund growth, and with the credit markets still frozen, it will be difficult for companies to raise cheap debt    
• 2) Going forward, many REITs will raise capital through property level debt and dividend reductions. Property level debt will be harder to obtain as commercial real estate prices continue to plummet, which decreases the amount that a company can borrow and increases LTVs [loan-to-value ratios]. Dividend reductions make the sector less attractive to income-oriented investors    
• 3) REITs will be dependent on asset sales to raise cash. Overall commercial sales volumes decreased in 2008, and going forward it will be difficult to unload assets. Buyers simply cannot get financing    
• 4) Commercial real estate delinquencies are ticking up at a fast pace, which makes lenders nervous about exposure to the CRE sector. Many companies in our coverage universe have cut dividends or decided to pay a large portion of dividend in stock in an effort to keep as much cash as possible. We are negative on stock dividends; companies want to keep cash and give investors cheap shares which dilutes all holders    
• 5) Equity issuance at this time would be dilutive since many companies are trading at depressed prices

Equity REITs posted somewhat of a comeback last week after a rough 1st quarter. So far in March, REITs have rebounded 7% (total return FTSE NAREIT Index). All sectors are up in March; the best performing sectors were apartments (16% return), industrial (16%), and lodging (15%).

Overall, REITs are still down 30% so far in 2009, well behind the S&P and Dow. The March mini-rally is nothing to get excited about, and the sector could continue to sell off. Here's why:   

• 1) REITs still depend on access to debt to fund growth, and with the credit markets still frozen, it will be difficult for companies to raise cheap debt    
• 2) Going forward, many REITs will raise capital through property level debt and dividend reductions. Property level debt will be harder to obtain as commercial real estate prices continue to plummet, which decreases the amount that a company can borrow and increases LTVs [loan-to-value ratios]. Dividend reductions make the sector less attractive to income-oriented investors    
• 3) REITs will be dependent on asset sales to raise cash. Overall commercial sales volumes decreased in 2008, and going forward it will be difficult to unload assets. Buyers simply cannot get financing    
• 4) Commercial real estate delinquencies are ticking up at a fast pace, which makes lenders nervous about exposure to the CRE sector. Many companies in our coverage universe have cut dividends or decided to pay a large portion of dividend in stock in an effort to keep as much cash as possible. We are negative on stock dividends; companies want to keep cash and give investors cheap shares which dilutes all holders    
• 5) Equity issuance at this time would be dilutive since many companies are trading at depressed prices

• 1) Most REITs are trading at large discounts to NAV [net asset value], a good buy signal. Historically, over the past 7 or so years, REITs have traded near or in excess of NAV    
• 2) Even with dividend cuts, the average yield for equity REITs is still over 9%. Yields are well in excess (600bps+) of the 10-year Treasury    
• 3) If commercial real estate fundamentals do not fall off a cliff and follow residential into the abyss, then there could be some attractive long-term buys

In this environment, we like well-capitalized companies that have adequate liquidity to fund debt through at least 2009. One name we still have Buys on is Avalon Bay (AVB), an apartment REIT with low debt and assets in infill markets where little new supply will be coming on board. Fannie and Freddie are still heavy lenders for apartments, which gives the sector access to relatively cheap capital.

In addition, we like Vornado (VNO), another company with low comparative debt, lots of cash and class-A office assets in some good long-term, heavily supply-constrained areas.

The credit freeze will have a good effect on these sectors down the road; new office and apartment construction has almost come to a halt, which should benefit these companies in the next couple of years. In fact, a handful of companies has ceased all new development starts in 2009.

These are long-term buys -- headline risk will cause continued volatility in the entire sector. Buy REITs for the yield, and expect share prices to be choppy until there is some evidence that some of the hundreds of billions of dollars the government is printing will help the country come out of the recession.

It remains to be seen whether these steps and others like them in other countries will be sufficient to restore confidence in the financial system and increase lending.

In the meantime, lower lending activity will continue to hurt the margins though the low interest rate environment should be beneficial to the banks with a liability sensitive balance sheet.

It still remains a bit too early to begin building a position in bank stocks. We have yet to see any positive momentum from the initiatives so far as shareholders appear to be getting more dilution rather than less. We anticipate further consolidation in the banking space, as the weaker players fail and the stronger players seek to build up their positions, and may be assisted by the regulators in doing so.

Therefore, we suggest investors wait for signs of stabilization in the credit and stock markets. At that point, we suggest interested investors build small positions using dollar cost averaging.

U.S. Winners and Losers

As many of the bigger lending institutions continue work through their issues once again it should be the smaller regional players with local connections and the ability to view opportunities within their own markets that will first benefit from economic growth. In addition, we would expect to see a reemergence of the consolidation theme that ran at a frenetic pace during the 1990s over the next couple of years, albeit as a potentially slower pace.

We like the banks which have:

1. Solid capital levels (more so the Tangible Common Equity level)
2. Less exposure to housing (and or did not diluted their reasonable credit standards) and other related risky assets than their peers
3. Derive a significant portion of their revenues from non-interest income (not loan-based)

Among, the bigger banks, we expect Goldman Sachs Group (GS), JPMorgan Chase (JPM) and Morgan Stanley (MS) to emerge as winners.

Out of the banks that we cover, we like WestAmerica Bancorp (WABC), Commerce Bancshares (CBSH), Hudson City Bancorp (HCBK), BOK Financial Corporation (BOKF), and Texas Capital Bancshares (TCBI).

At this time, we advise the investors totally avoid the bigger zombie banks, which are perfect candidates for capital infusion by the government after the stress tests, like Bank of America (BAC), Citigroup (C), U.S. Bancorp (USB) and PNC Financial Services Group (PNC).

Non-U.S. Winners and Losers

As to non-US banks, we believe that banks in stable emerging economies, such as Chile, Brazil or India, may be more attractive investments, similar to what we expect for certain regional banks in the US. To be sure, banks in emerging economies will face asset quality issues; however, they are not confronted with other significant problems that many of the larger banks in Europe and the United Kingdom are, such as toxic securities, dilution from being forced to raise additional capital, and dividend cuts/omissions.

Moreover, they generally tend to be well capitalized, aren't as heavily exposed to the property markets, and have significant and generally growing sources of noninterest income.

One caveat, investment in non-US ADR bank stocks entails foreign currency risk. Currently, the USdollar is appreciating against many foreign currencies, which tends to depress US$ share performance. On the other hand, when this turns and the US$ starts falling against other foreign currencies, this will accelerate gains in US dollar.

Investors may wish to look at HDFC Bank Limited (HDB), one of the largest banks in India; Banco Itau Holding Financeira S.A. (ITU) in Brazil, the largest bank in Brazil following the February 2009 merger of Uniao de Bancos Brasileiros S.A. and Banco Itau Holding Financeira S.A. (or Itau); or Banco Santander-Chile (SAN), the largest private bank in Chile.

Topics For Consideration

U.S. Banks To See More Asset Deterioration

For the last few quarters, banks have mainly suffered due to the losses in the mortgages and CRE (residential construction loans). We are hopeful about the Obama's "Homeowner" plan, but do not expect the housing markets to turn around any time soon and anticipate continued losses in the housing and related portfolios. Further, deterioration in other commercial real estate loans has started of late and the downturn in this class is also likely to be very challenging.

With the deterioration in the overall economic environment and rising job losses, we anticipate the losses will increase in all the other asset classes as well, especially in the consumer related loans. (It was recently reported that U.S. credit card delinquencies rose to a record high in January. They will likely rise further).

We also expect the deterioration in asset quality to continue at least through the end of 2009. Further, the banks will also continue to take mark-downs in the investment portfolios, further hurting the bottom-line.

We continue to remain a bit concerned with the lack of lending the banks. Not loans that may be placed through the Government Sponsored Enterprises, but rather those that are made by banks. A number of mortgage consolidator websites show what could appear to be non-realistic points and fee structures. While rate including fees and points are at historic low, what some may deem, "The cost of doing business," many others could deem "vulture pricing" or an attempt not do lend. Until this current practice is rectified, the positives from the stimulus program may not gain all the traction possible.

Foreign Banks Face A Daunting Outlook

Many countries have already adopted recapitalization plans.

For example, the British government already purchased large stakes in Lloyds Banking Group PLC (LYG) and Royal Bank of Scotland Group (RBS). Britain also completely nationalized other banks, such as Northern Rock.

When these efforts failed to stabilize the credit markets, an Asset Protection Scheme (APS) was adopted. Under this plan, the government insures the bank against losses on its most toxic assets (e.g., mortgage-backed securities and property loans) for more in return for a small fee and an obligation by the bank to increase lending to consumers and businesses. The bank absorbs the first 10% of the losses, with the British government assuming responsibility for the remaining 90%.

Though Britain and many other countries are trying to restore confidence, it is uncertain as to whether the current measures will be enough.

Consumer job losses and sluggish business conditions are increasing worldwide, which will tend to dampen demand for credit, even assuming banks are capable of lending more. Moreover, these factors will also hurt asset quality and increase losses on the existing "good" loan portfolios, even apart from considerations of toxic assets. Combined with top line pressure due to weakening economic conditions, non-U.S. banks face a daunting outlook.

Bank Nationalization

There is a lot of confusion about what would classify as "Nationalization" as evidenced by the very divergent opinions on the issue.

Some experts view any government ownership as a form of nationalization. Others feel that government ownership above 51% would be termed so. Technically, if the government owns 80% or more of a company's shares, then accounting rules require the company to be put on the government's balance sheet. (This is why the U.S. government decided to take control of 79.9% of the shares in Fannie and Freddie).

Both Treasury Secretary Geithner and Fed Chairman Ben Bernanke have spoken against nationalization, but the fact is that the U.S. government already has a substantial stake in the financial system of the country. With the latest round of bailouts, U.S. taxpayers will own about 78% equity in AIG and 36% in Citigroup. Instead of these piecemeal efforts at the banks, we think it would make perfect sense for the government to take control of such banks for a short period of time, and then split them and sell them to private parties or even relist them through initial public offerings.

Further, we suspect that the government will end acquiring substantial stake in all banks required to raise additional capital after stress tests are applied. This will be a necessity as these "losers" will find extreme difficulty with accessing private capital. As of now, stress tests are mandatory only for the large banks but may be expanded later to cover other banks as well.

In any case, whether it is nationalization or substantial ownership by a government, the investors of such banks will suffer badly or be wiped out. (This is what happened with Northern Rock shareholders.) Nationalization has been around for many years. In the U.S, nationalization was used effectively by the FDIC to take over 16 banks this year so far. Any government assistance accepted is a nationalization of the entity. While the Resolution Trust Corporation (RTC) did work to digest the volumes of assets seized in the last real estate bubble, it took multiple years to resolve, with benefit really only exhibited after the first 3 years and final resolution about 15 years later.

We think that it is important for all parties to remain as fiscally responsible as possible.

In the U.S., the current housing plan calls for mortgages to be reworked if the borrower misses a few payments or can demonstrate really need to intervention to remain in the home. This approach only rewards borrowers that have not been responsible. We believe that aid should be made available but not just given without any reasonable strings attached (accountability remains paramount).

If financial institutions were required to rework loans with reasonable terms and conditions(e.g. changing Alt-A and Option ARMs into more traditional loans), the results would be less foreclosures over the next several years from the pool of 10 million potential loans coming due.

Candidate Explanations

In particular, when one examines the mixture of policies and events that have led us to the brink of possibly the deepest and most persistent downturn since the Great Depression, one can see several suspects listed.

• Fannie and Freddie
• Community Reinvestment Act
• CDO's and CDS's
• Global saving glut
• Monetary policy
• Deregulation
• Criminal activity and regulatory disarmament
• Tax cuts and fiscal profligacy
• Tax policy

Red Herrings

I've already dealt with the first two "betes noire" -- favorite villains in the fevered commentary of certain noneconomists -- in this post, so we can dispense with these as key drivers (Jim attributes some blame, here, although I don't think he attributes central blame here either). I don't think CDO's and CDS's in and of themselves caused the crisis, although they certainly obscured the primary problem of overleveraging (CDO's) and lack of transparency (CDS's). And the saving glut -- well, the saving glut was a worldwide phenomenon, but I think it safe to say the countries that did and didn't borrow from the Chinese have suffered in the current crisis (here is my critique from 2005; CFR report [pdf]).

Synergy

So what I want to think about is the toxic mixture of the last five items, which interacted in a synergistic manner to place us in the situation we are now in.

First, monetary policy. While there seems to be a widespread consensus that it was too lax in 2002-04, this is a viewpoint made with the benefit of hindsight. As Orphanides and Wieland (2007) [pdf] have pointed out, according to the Greenbook forecasts, monetary policy was not -- according to a Taylor rule framework -- overly lax.

Second, deregulation. On this front, I think it's important to not indict all deregulation (eliminating the Glass-Steagall barriers makes sense to me, while the Phil Gramm-sponsored Commodity Futures Modernization Act exemption of regulation of CDS's does not). I outline some empirical research on what factors were important in this crisis in this post.

Third, regulatory disarmament/nonenforcement and "criminal activity". I would have discounted this item in the absence of clear evidence, but now that we know about how the OTS "helped out" IndyMac [2] [3], I think we can be reasonably confident that we'll hear a lot more about how deregulatory zeal [4] [5] metastatized over into criminal activities on the part of regulators and the regulated.

Fourth, fiscal profligacy via tax cuts. I think it's important to focus on profligacy (because it pushed the economy more into a boom exactly at a time when not needed) and on tax cuts (because it made people feel like they had more discretionary income than reasonable), thereby pushing the asset boom.

Fifth, tax policy. In particular, I have been thinking about the tax deductibility on second homes, a provision dating back to 1997 [6] [7] [8]. (I've been thinking about this in part because mortgage deductibility on a second home never made sense to me, let alone on a first home). Capital Games and Gains has pointed out this provision, citing a NYT article. But even this last article doesn't locate primary blame here; rather it's cited as a contributing factor. I suspect that on its own, this provision wouldn't had a big impact, but in combination, it might have. My caveat here is that I haven't found much empirical work backing a big role for this factor.

Typically, in my academic work, I would think of these factors adding up in a linear fashion, so that each of the impulses would sum to the total effect. But (departing from a model, and with no econometric work to back up the hypothesis interactive effects), I think it's worthwhile to think about lax monetary policy, deregulatory zeal and criminal activity/regulatory disarmament, and tax cuts and tax policy changes, all combining to lead to the "bubble" (in a nontechnical sense) we've witnessed, the deflation of which has been associated with the ongoing financial crisis.

Consider one example of a pernicious synergy: the 2001 and 2003 tax cuts were aimed at higher income households, while the second home mortgage deductibility benefited mostly higher income households [7]; with regulatory oversight absent, and low interest rates, well the stage was set.

Prescient, or Not

To sum up, I won't claim to have foreseen the full enormity of the crisis we're now undergoing. As I indicated when I posted my first blogpost some three years ago, I thought the sheer irresponsibility of the fiscal policy being pursued, against a backdrop of overconfidence in largely nontraded derivatives, would lead to grief in the form of a "sudden stop" of net capital flows to the US. In this respect, I was wrong -- what we've achieved instead is a sort of "global sudden stop" where the process of deleveraging proceeded in a discrete (and "disorderly") fashion. So, unlike some, I was only partially -- not completely -- blindsided. (And, I'm sure Akerlof and Romer were completely aware of what was coming...)

I believe history will look critically on the Bush Administration's economic stewardship, in particular how the policies propelled an unsustainable bubble, and tied our hands in the use of fiscal policy tools. In sum, I think Kevin (Dow 36,000) Hassett's view "Bush's Legacy May End Up Better Than You Think" will not prove true.

Technorati Tags: financial crisis, recession, subprime, regulation, Bush Administration, Office of Thrift Supervision, Fannie Mae, and Freddie Mac.

From the conclusion to M.K. Brunnermeier, "Deciphering the Liquidity and Credit Crunch 2007-08," forthcoming Journal of Economic Perspectives, 2009, 23(1):

An increase in mortgage delinquencies due to a nationwide decline in housing prices was the trigger for a full-blown liquidity crisis that emerged in 2007 and might well drag on over the next years. While each crisis has its own specificities, the current one has been surprisingly close to a -- classical banking crisis. What is new about this crisis is the extent of securitization, which led to an opaque web of interconnected obligations. This paper outlined several amplification mechanisms that help explain the causes of the financial turmoil. These mechanisms also form a natural point from which to start thinking about a new financial architecture. For example, fire-sale externalities and network effects suggest that financial institutions have an individual incentive to take on too much leverage, to have excessive mismatch in asset-liability maturities, and to be too 36 interconnected. Brunnermeier (2008b) discusses the possible direction of future financial regulation using measures of risk that take these domino effects into account.

(As an aside, I'll observe that in this paper, Fannie and Freddie do not make appearances as "causes" of the crisis. I wonder who has an interest in pushing the view of Fannie and Freddie as betes noire. For more recent critiques of the "F&F caused it" meme, see [1], [2] (h/t DeLong).)

Technorati Tags: financial crisis, credit spreads, subprime, liquidity, Libor, OIS, Treasurys, and externalities.</P

“We shouldn’t worry about the deficit next year or even the year after,” the U.S. president-elect Barack Obama said on 60 Minutes over the weekend.

We were afraid that Barack’s message of “change you can believe in” was going to make it harder to take issue with politics as usual in Washington. But now we see he already drank the Kool-Aid and we…

- But W. didn’t stop there. Apart from wanting governments to be “smarter” (who doesn’t?), he called for called for leaders to recognize that “government intervention is not a cure-all” for economic problems. So what was Fannie and Freddie all about? Or Hank Paulson’s Troubled Assets Relief Program. Or the bailout of AIG? If government is not a cure-all,…

- But W. didn’t stop there. Apart from wanting governments to be “smarter” (who doesn’t?), he called for called for leaders to recognize that “government intervention is not a cure-all” for economic problems. So what was Fannie and Freddie all about? Or Hank Paulson’s Troubled Assets Relief Program. Or the bailout of AIG? If government is not a cure-all,…

- Here’s the breakdown, from CreditSights, a research firm in New York and London, as reported in Forbes magazine.

The Fed

• $1 trillion in overnight or short-term loans since March to primary dealers through its emergency discount window*
• $1.8 trillion in loans to primary dealers through the Fed’s term auction facility since in January*
• $29 billion in Bear Stearns debt
• $60 billion of credit available to American International Group
• $22.5 billion to set up…

Oy. “The $700 billion financial bailout program,” the New York Times sums up Treasury Secretary Paulson’s speech this morning, “will not be used to buy troubled mortgage-backed assets, as originally intended. Instead, capital would be provided directly to nonbank companies, as well as banks and financial institutions, and that more would be done to prevent home foreclosures.”

Is it any wonder 83% of Americans think the U.S.…

Oy. “The $700 billion financial bailout program,” the New York Times sums up Treasury Secretary Paulson’s speech this morning, “will not be used to buy troubled mortgage-backed assets, as originally intended. Instead, capital would be provided directly to nonbank companies, as well as banks and financial institutions, and that more would be done to prevent home foreclosures.”

Is it any wonder 83% of Americans think the U.S.…

This from The Rude Awakening:

The American people voted for change…and now they’re going to get it. But the change they get may not be the change they expect Obama to deliver. Something more sinister may be coming our way.

After an historic election and inauguration, president-elect Obama will enter office with a huge list of challenges. These challenges — from a contracting economy to large-scale corporate bankruptcies to soaring national indebtedness — will…

This from The Daily Reckoning Australia

Now to the big subject of the day: Inflation. You’d think evidence of even bigger deficits in the U.S. is clearly inflationary. But not everyone thinks so. The new prophet of doom, Dr. Nouriel Roubini, says at least four factors are setting up what he calls “Stag Deflation” (as opposed to the stagflation of the 1970s, where you had no growth and rising prices).

Roubini’s four…

Quotable
“Historically, economists have evaluated the economy’s overall leverage in terms of nonfinancial debt. The theory for this is that the financial sector takes on debt in order to make loans for the nonfinancial sector; thus, to include financial debt would result in double counting. The logic of that approach is not valid in the current situation. The leverage in the financial system, including the financial intermediaries and government sponsored entities like Fannie and Freddie, is clearly excessive and the source of much distress in the economy. When viewed on this more comprehensive basis, total leverage of the U.S. economy surged to an all time peak for the past 92 years that records have been kept. Total U.S. debt in the second quarter jumped to 357% of GDP, up from an average of 195% from 1916 to the present. In less than five years, the total debt to GDP ratio jumped more than 50%.


 
“As the chart indicates, 300% was the 1933 high of the total debt to GDP ratio. The current peak, however, was reached due to a surge in debt, while the 1933 peak reflected a dramatic fall of nominal GDP, the denominator of the ratio. The new record level of debt in the second quarter reflected the worsening situation among corporations, both financial and nonfinancial. Clearly the magnitude of the debt problem is unprecedented and years, not months or quarters, will be required to bring debt into some reasonable relationship with economic activity. As long as this situation persists, the U.S. faces a difficult economic environment. This is due to the fact that over the past four decades every additional dollar of debt created 86 cents worth of GDP, and with debt shrinking, GDP will struggle to generate positive growth.”

Hoisington Management Third Quarter Review&Outlook

FX Trading – Risk aversion ebbs this morning…Comdol time?

Gold is sharply higher this morning…up $20 bucks.  Stocks globally are doing well and premarket SPU is bidding a bit higher.  Oil is trying to turn higher. 

Ebb in risk aversion means a flow of risk appetite by definition.  And risk appetite may mean it’s time for commodities, which have been body slammed, to make a decent correction; maybe of the multi-week variety.  Thus, maybe it’s time to own some Comdols again i.e. commodity dollars, fist three letters of each word,  for those not yet super-fx-trader slang literate. 

The chart above is a 240-min chart of oil, gold, and Aussie.  All have broken above their nasty down trends of late on this near-term basis.

Regards,
Jack & JR

Quotable
“Historically, economists have evaluated the economy’s overall leverage in terms of nonfinancial debt. The theory for this is that the financial sector takes on debt in order to make loans for the nonfinancial sector; thus, to include financial debt would result in double counting. The logic of that approach is not valid in the current situation. The leverage in the financial system, including the financial intermediaries and government sponsored entities like Fannie and Freddie, is clearly excessive and the source of much distress in the economy. When viewed on this more comprehensive basis, total leverage of the U.S. economy surged to an all time peak for the past 92 years that records have been kept. Total U.S. debt in the second quarter jumped to 357% of GDP, up from an average of 195% from 1916 to the present. In less than five years, the total debt to GDP ratio jumped more than 50%.


 
“As the chart indicates, 300% was the 1933 high of the total debt to GDP ratio. The current peak, however, was reached due to a surge in debt, while the 1933 peak reflected a dramatic fall of nominal GDP, the denominator of the ratio. The new record level of debt in the second quarter reflected the worsening situation among corporations, both financial and nonfinancial. Clearly the magnitude of the debt problem is unprecedented and years, not months or quarters, will be required to bring debt into some reasonable relationship with economic activity. As long as this situation persists, the U.S. faces a difficult economic environment. This is due to the fact that over the past four decades every additional dollar of debt created 86 cents worth of GDP, and with debt shrinking, GDP will struggle to generate positive growth.”

Hoisington Management Third Quarter Review&Outlook

FX Trading – Risk aversion ebbs this morning…Comdol time?

Gold is sharply higher this morning…up $20 bucks.  Stocks globally are doing well and premarket SPU is bidding a bit higher.  Oil is trying to turn higher. 

Ebb in risk aversion means a flow of risk appetite by definition.  And risk appetite may mean it’s time for commodities, which have been body slammed, to make a decent correction; maybe of the multi-week variety.  Thus, maybe it’s time to own some Comdols again i.e. commodity dollars, fist three letters of each word,  for those not yet super-fx-trader slang literate. 

The chart above is a 240-min chart of oil, gold, and Aussie.  All have broken above their nasty down trends of late on this near-term basis.

Regards,
Jack & JR

This from the Daily Reckoning:

You’ll recall that the credit crisis began in the summer of ’07. Before that the ‘war’ between inflation and deflation had been an even match. But then, sub-prime debt came upon the battlefield like a new tank. In a matter of days, deflation seized the high ground and has been winning ever since.

Of course, you have to give the feds credit. They’ve fought a…

The U.S. dollar fell by its largest percentage in 13 years yesterday.

Et voila, the trend we believe is your friend returned with some impressive steam:

The Reuters/Jefferies CRB Index popped 5.9% — diddly squat compared with equity moves lately, but still the biggest daily gain for the index since its inception, in 1956.

Alas, despite the rise, the CRB is still down 24% this year.

Still, the Fed…

More from Investor’s Daily Edge:

Equities aren’t the only markets acting strangely these days. The bond markets are acting even stranger.

For both bond and equity markets the cause of this strange behavior is the same: Piecemeal government actions in the U.S., Europe and Asia culminating in massive intervention.

The U.S. government is trying to nurse the economy back to health. And like a doctor who has…

The essence of the Fed's balance sheet used to be quite simple. The Fed's primary operations would consist of either buying outstanding Treasury securities or issuing loans to banks through its discount window. It paid for these transactions by creating credits in accounts that banks hold with the Federal Reserve, known as reserve deposits. Banks can turn those reserves into green cash any time they desire, so the process is sometimes loosely summarized as saying that the Fed pays for the Treasury bills it buys or loans it extends by "printing money". Before the excitement began, the Fed's assets consisted primarily of the Treasury securities it had acquired over time (about $800 billion as of August 2007) plus its discount loans (an insignificant number at that time). Its liabilities consisted primarily of cash held by the public (about $800 billion a year ago) plus the reserve deposits held by banks (which again used to be a very small number).

Bernanke's overriding goal since then has been to extend a huge volume of short-term loans to financial institutions. If he'd done that in the usual way, just creating new reserve deposits with each new loan, the supply of cash would have ballooned, bringing worries of inflation. The Fed didn't want to do that, and in fact there was no shortage of funds available for overnight interbank lending. The fed funds rate, an average overnight lending rate between banks, is already quite low, and further reductions seem unlikely to accomplish much. But longer term interbank lending rates remain quite high relative to the overnight rate.

Bernanke's first approach to this challenge was to "sterilize" the new loans from the Fed, basically selling off the Fed's Treasury holdings at the same time that it extended the new loans. When a counterparty buys the Treasury security from the Fed, the Fed debits the bank's account with the Fed, and these debits net out the credits that would be created as a consequence of the Fed's new loans. Reserves go up with the loans, down with the sale of Treasuries, so the net result is an increase in loans from the Fed but no change in reserve deposits. These new Federal Reserve assets came in many colors and flavors, including the Term Auction Facility, the Primary Dealer Credit Facility, currency swaps (which I presume is the biggest single item in the burgeoning "other F.R. assets" category), and the seriously non-acronymizable Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility.

But $800 billion-- the total stock of Treasuries that Bernanke originally had available for this purpose when he started down this path over a year ago-- only goes so far these days, particularly when you remember that a quarter trillion of those securities are now being used in the Term Securities Lending Facility, which the Fed records as an off-balance-sheet transaction. To enable it to extend more than $800 billion in loans without "printing more money," the Fed asked the Treasury to implement a Supplementary Financing Program in which the Treasury would sell securities directly to the public but simply keep the funds in an account with the Fed. The payments by the public for these securities then initiate a flow of reserves out of private banks, the same as if the Fed itself had sold Treasuries to the public out of its own holdings, so the SFP enables the Fed to sterilize a greater volume of loans than it could if it had to rely solely on its original holdings of Treasury securities. The Treasury supplementary account as of last week has provided the Fed with an additional $559 billion to play with. It appears from the latest balance sheet that the Fed has now asked the Treasury to do the same sort of thing with the Treasury's "general account" with the Fed. Historically, that account was just used to facilitate daily Treasury transactions, and was usually held to about $5 billion. Last week, it's up to $56 billion.

It's clear that the Fed is now also using yet another tool to balloon its balance sheet, namely, deliberately encouraging banks to sit on their excess reserve deposits. When these started to shoot up at the end of September, I initially attributed this to frictions in the interbank lending market. But with the announcement on October 6 that the Fed would begin to pay interest on those deposits, and the further announcement on October 22 that the Fed is now raising that interest rate to within 35 basis points of the target for the fed funds rate itself, it is clear that the Fed has now settled on a deliberate policy of encouraging banks to just sit on the reserves it creates, giving it another device with which to expand its balance sheet without increasing the quantity of cash held by the public. That's provided another quarter trillion for the alphabet soup of new facilities.

I had a call from a reporter this week asking me to explain why the Fed raised the interest rate paid on reserves. I think she was expecting a 30-second sound bite, but instead we went back and forth for about 15 minutes and I'm not sure even then that I succeeded in getting the basic idea across. At that point she asked me, "Do you see it as an encouraging development that the Fed has taken this step to address the credit crunch?" My immediate answer was no. It's not an encouraging development because it means that the heroic efforts that the Fed has taken previously weren't enough. The Fed's first $100 billion didn't do it. The Fed's first $1 trillion didn't do it. Having the Treasury take over the $5 trillion in debts and guarantees of Fannie and Freddie didn't do it. The Treasury's $3/4 trillion rescue/bailout package didn't do it. And another quarter trillion will?

If the spread between overnight and 3-month interbank lending rates indeed results from pure illiquidity of the latter market, it seems to me it shouldn't have required too much grease to get that market lubricated. But if, as argued by John Taylor and John Williams, the spread instead represents compensation for counterparty risk, it doesn't matter how much term lending the Fed does. Its actions would only move that spread to the extent they reduce the counterparty risk itself. The primary consequence of the actions would not be to change the spreads but instead would just shift the risk onto the Federal Reserve's balance sheet.

There was another juicy morsel in the latest H.4.1. The latest report acknowledges that the Fed has taken some losses on some of these unconventional assets. The Fed last week wrote off $2.7 billion in losses on the loans to "Maiden Lane LLC," an entity created through the Bear Stearns package. The assets of Maiden Lane consisted of claims on certain troubled securities, and the liabilities consisted of a loan from the Federal Reserve. The Fed now admits that Maiden Lane won't be repaying all of the loan, so it had to reduce its claimed assets by $2.7 billion. This also required a corresponding imputed $2.7 B reduction in the "other" category on the liabilities side of the Fed's balance sheet, presumably in large part coming from debits to the "surplus" and "other capital accounts" entries in the Statement of Condition of the Federal Reserve Bank of New York, though I haven't traced through the details of exactly how that was implemented.

Regardless of the accounting, here's how those losses will show up in practice. When the Treasury auctioned the T-bills for the increase in its supplementary and general accounts with the Fed, and when the Fed sold off its existing holdings of Treasuries, the Treasury started making interest payments to the public. The Fed is also receiving interest on the loans it made, and returns that interest to the Treasury. As long as the loans are performing, it is a wash to the Treasury. But if some of the Fed's loans go bad, it means the Treasury is on the hook for the extra interest costs with no offsetting receipts. In other words, any losses by the Federal Reserve are equivalent to a fiscal expenditure financed by Treasury borrowing.

The notes to the H.4.1. seem to imply that the Fed's intention is to update its assessment of the "fair value" of its Maiden Lane holdings as of the end of each quarter, which would mean no new markdowns until January.

But that doesn't mean that the remaining $1,839 B in Fed assets will all continue to bring in their hoped-for receipts for the Treasury between now and then.

Technorati Tags: macroeconomics, economics, Federal Reserve, interest rates, term auction facility, TSLF, TAF, term securities lending facility, credit crunch

From David Goldstein and Kevin G. Hall, "Private sector loans, not Fannie or Freddie, triggered crisis":

Federal Reserve Board data show that:

• More than 84 percent of the subprime mortgages in 2006 were issued by private lending institutions.
• Private firms made nearly 83 percent of the subprime loans to low- and moderate-income borrowers that year.
• Only one of the top 25 subprime lenders in 2006 was directly subject to the housing law that's being lambasted by conservative critics.

From David Goldstein and Kevin G. Hall, "Private sector loans, not Fannie or Freddie, triggered crisis," McClatchy Papers (October 12, 2008).

The article continues:

What's more, only commercial banks and thrifts must follow CRA rules. The investment banks don't, nor did the now-bankrupt non-bank lenders such as New Century Financial Corp. and Ameriquest that underwrote most of the subprime loans.

These private non-bank lenders enjoyed a regulatory gap, allowing them to be regulated by 50 different state banking supervisors instead of the federal government. And mortgage brokers, who also weren't subject to federal regulation or the CRA, originated most of the subprime loans.

In a speech last March, Janet Yellen, the president of the Federal Reserve Bank of San Francisco, debunked the notion that the push for affordable housing created today's problems.

"Most of the loans made by depository institutions examined under the CRA have not been higher-priced loans," she said. "The CRA has increased the volume of responsible lending to low- and moderate-income households."

In a book on the sub-prime lending collapse published in June 2007, the late Federal Reserve Governor Ed Gramlich wrote that only one-third of all CRA loans had interest rates high enough to be considered sub-prime and that to the pleasant surprise of commercial banks there were low default rates. Banks that participated in CRA lending had found, he wrote, "that this new lending is good business."

One point the article does not touch on is why the states did not regulate more rigorously the banks most involved in subprime lending. The answer is, in part, explained by this item (which I've cited in the past) from the NYT:

The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

What about the charge that Fannie and Freddie "made" the market so that all these subprime loans could be securitized? There's a grain of truth in there, but I think keeping in mind which loans are going bad is useful, when reading this excerpt.

This much is true. In an effort to promote affordable home ownership for minorities and rural whites, the Department of Housing and Urban Development set targets for Fannie and Freddie in 1992 to purchase low-income loans for sale into the secondary market that eventually reached this number: 52 percent of loans given to low-to moderate-income families.

To be sure, encouraging lower-income Americans to become homeowners gave unsophisticated borrowers and unscrupulous lenders and mortgage brokers more chances to turn dreams of homeownership in nightmares.

But these loans, and those to low- and moderate-income families represent a small portion of overall lending. And at the height of the housing boom in 2005 and 2006, Republicans and their party's standard bearer, President Bush, didn't criticize any sort of lending, frequently boasting that they were presiding over the highest-ever rates of U.S. homeownership.

Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication. One reason is that Fannie and Freddie were subject to tougher standards than many of the unregulated players in the private sector who weakened lending standards, most of whom have gone bankrupt or are now in deep trouble.

During those same explosive three years, private investment banks -- not Fannie and Freddie -- dominated the mortgage loans that were packaged and sold into the secondary mortgage market. In 2005 and 2006, the private sector securitized almost two thirds of all U.S. mortgages, supplanting Fannie and Freddie, according to a number of specialty publications that track this data. [Emphasis added -- mdc]

Now, again, consider which subprime loans, in the graph below, went bad...

Notice that the delinquency rate is highest in the years after Fannie and Freddie are constrained in terms of their subprime holdings. So, more regulation of F&F was a good thing, I'll say, with the benefit of hindsight.

Now, there are more sophisticated, game-theoretic based arguments. In particular, Jim has observed that the mere existence of GSEs with substantial portfolios of MBS's meant that the government -- by insuring Fannie and Freddie -- would implicitly insure the private firms as they expanded their operations, supplanting F&F's market share:

what forces caused the explosion of private participation in a much more reckless replication of the GSE game? A year ago, I suggested one possible answer-- private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off.

This is by far the most intelligent and plausible interpretations of how F&F could have contributed in a significant way to the current housing crisis (as separate from the overall crisis, which would have been triggered by some other market given the mixture of securitization, credit default swaps and high leverage [2]). In fact, Mike Dooley and I have made similar arguments about the expansion of contingent liabilities, in the run-up to the East Asian crises [3]. The challenge here is how to test this hypothesis against others; we need to measure the implicit insurance that these private firms felt they had directlyfrom the Fed's intent keep the monetary policy sufficiently expansionary to keep housing prices going up, separate from the insurance committed directly by the Treasury to prevent individual banks from going under. (By the way, this is a separate issue from whether F&F made sense economically in their circa 2006 form; see the analysis by Frame and White. I tend to think the answer is no.)

Interestingly, one of the corollaries of this argument is that it would be hard to disentangle the balance of blame of F&F and the "Greenspan put".

One question I do (or will) have is the following: if the credit card or auto loan securitized markets blow up [4], who are the equivalents to the GSE's?

I think all of this leads to a more nuanced view of the role of CRA and the two GSE's in the crisis. If I had to identify the central factors, I wouldn't point to F&F alone, or CRA alone (if at all). Rather, I'd look to (i) monetary policy (including whether it was lax, and the implications of the "Greenspan put"), (ii) what drove down the returns at the long end of the maturity spectrum ("the conundrum") thus inducing the desperate search for yield, (iii) securitization in the absence of countervailing regulation and (iv) the development of a completely non-transparent and unregulated over-the-counter credit default swap market.

Breitbart reports:

The US Senate Saturday approved 25 billion dollars in loan guarantees for the financially strapped US auto industry, intended to spark a wave of automotive innovation. The loan guarantees were included in a continuing resolution that included funding for the US government and the wars in Iraq and Afghanistan. President George W. Bush has indicated that he intends to sign the bill....

The bill, which was approved by the House of Representatives on Wednesday, are the first loan guarantees for U.S. carmakers since Congress approved a similar 675 million dollar measure for Chrysler Corp. in 1980. Chrysler Chairman Robert Nardelli, however, said this week the loan guarantees should not be considered a rescue package for struggling carmakers. "This is not a bailout," he said.

Well, if the loans are repaid, you might argue that it's not a bailout because no federal outlays were involved. And you might argue the same for the $1.7 trillion in Fannie and Freddie's debt that the U.S. Treasury now seems to be guaranteeing, and for the $3.1 trillion in guarantees on agency MBS, and for the $600 billion or so in loans that the Federal Reserve seems to have extended. Not to mention the $700 billion Treasury plan still under debate.

Now, there may be a wee bit of a correlation among those sundry and staggeringly large exposures-- the state of the world in which the auto loans don't get repaid is likely the same state of the world in which significant chunks of the other items also turn in to a bill due for Uncle Sam.

On the other hand, what's another measly $25 billion among friends?

Technorati Tags: macroeconomics, autos, auto bailout

Breitbart reports:

The US Senate Saturday approved 25 billion dollars in loan guarantees for the financially strapped US auto industry, intended to spark a wave of automotive innovation. The loan guarantees were included in a continuing resolution that included funding for the US government and the wars in Iraq and Afghanistan. President George W. Bush has indicated that he intends to sign the bill....

The bill, which was approved by the House of Representatives on Wednesday, are the first loan guarantees for U.S. carmakers since Congress approved a similar 675 million dollar measure for Chrysler Corp. in 1980. Chrysler Chairman Robert Nardelli, however, said this week the loan guarantees should not be considered a rescue package for struggling carmakers. "This is not a bailout," he said.

Well, if the loans are repaid, you might argue that it's not a bailout because no federal outlays were involved. And you might argue the same for the $1.7 trillion in Fannie and Freddie's debt that the U.S. Treasury now seems to be guaranteeing, and for the $3.1 trillion in guarantees on agency MBS, and for the $600 billion or so in loans that the Federal Reserve seems to have extended. Not to mention the $700 billion Treasury plan still under debate.

Now, there may be a wee bit of a correlation among those sundry and staggeringly large exposures-- the state of the world in which the auto loans don't get repaid is likely the same state of the world in which significant chunks of the other items also turn in to a bill due for Uncle Sam.

On the other hand, what's another measly $25 billion among friends?

Technorati Tags: macroeconomics, autos, auto bailout

The ink had hardly dried on the U.S. Treasury’s socialization of Fannie (NYSE:FNM) and Freddie (NYSE:FRE), and thus half of the U.S. mortgage market, when it realized it would have to reconvene over whether Lehman (NYSE:LEH) was too big to fail the following weekend. Apparently, it was not, and so began the filing of the largest bankruptcy in U.S. history.

Then the dominoes really began to fall. Merrill Lynch was taken out, and then speculation turned on AIG, Goldman (NYSE:GS), Morgan Stanley (NYSE:MS) and many others. The Treasury ended up taking control of AIG, but not before giving rise to fears about the exposure of “safe” assets, like money market funds, to Lehman or AIG or whatever failing counterparty might be guaranteeing this or that in your portfolio.

The events reminded investors that there is nowhere to hide, except, perhaps, in the one asset that is “no one else’s liability” — gold. The government is grabbing at straws. The Federal Reserve’s balance sheet is wearing so thin that the Treasury is raising money for it on Wall Street now. Talk about wash trades. It is not just the U.S. markets. Loan markets are stressed all over the world. Russian markets froze. The Chinese central bank cut rates and its government kicked off a plan to start buying stocks for its sovereign wealth fund to stem the bearish tide.

~~~~~~~~~~~~~Special~~~~~~~~~~~~~

“Brace Yourself for the Next Five Super-Shocks of the COMING STOCK MARKET APOCALYPSE”

“I called every market expert I could think of into the room. We closed the doors. And then we came to only one possible conclusion...”

“Over the next 12 months...and despite all the bank write-downs, market bombs and ‘bailout’ talk already...there are at least FIVE MORE DEVASTATING NEW FINANCIAL SHOCKS ahead.”

Click here to grab the seven financial survival steps you need to protect yourself…

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Despite fluctuations in expectations, the fundamentals have remained bullish for gold. The events have generally confirmed gold bulls’ warnings, and all but guarantee future inflation.

Evidence of soaring demand in the physical space has been oft reported throughout the correction.

The amount of contracts closed on futures exchanges dwarfs the real ounces liquidated by the bullion trusts in this time. On the COMEX alone the amount of contracts outstanding shrank by 10 million oz, compared with just two million ounces for the streetTracks GLD bullion trust.

Stay the Course

This move in gold does not look like a bear market rally. It looks real. In fact, it suggests that the decline through $850 last month was a mistake…that the market was wrong, as we suspected. That is, the market was wrong to think the bust was over, that central banks were capable of any kind of “tightening” or that the problems for the dollar have passed.

My general suggestion is to buy the dips and corrections. Don’t chase the breakouts. The reason is that it is not yet a slam-dunk that the Fed will inflate. We have to adopt a wait-and-see attitude.

Source: Bear Patrol

Prior to the establishment of the Federal Reserve in 1913, the United States would periodically experience events that are often referred to as "financial panics." Rick Mishkin noted that these usually occurred after a recession began and a major financial institution had failed, and were characterized by a sharp increase in the spread between the interest rate paid by higher risk versus lower risk borrowers.

The graph below plots the difference between the interest rate on 3-month certificates of deposit and 3-month treasury bills. The alarming behavior of this spread began in August 2007, when it spiked up to 243 basis points, higher than anything seen in the previous 20 years. Aggressive responses from the U.S. Federal Reserve and other central banks last August succeeded in bringing banks' borrowing costs back down, though we saw subsequent comparable spikes in December 2007 and March 2008.

Gap between interest rates on 3-month certificates of deposit and 3-month treasury bills, from Federal Reserve Statistical Release H.15.

But those events would barely be noticed when compared with what happened last week. Following the bankruptcy of Lehman Brothers, the spread reached 527 basis points on Thursday.

Financial intermediaries, who earn their profit by lending at a modest markup over their borrowing cost, simply can not be expected to function in this kind of an environment. Lending institutions that had been solvent before this week would not remain so for long if this situation were to persist. Only the safest customers could be expected to obtain loans, and only after paying very high interest rates.

To respond to this situation, Treasury Secretary Paulson has proposed a plan whose key feature is the authorization to spend $700 billion to purchase troubled assets from financial institutions.

By my count, the Federal Reserve has already extended something on the order of $455 billion in loans collateralized by some of these same troubled assets, namely $125 billion in repos, $150 billion in the term auction facility, $50 billion in "other loans", $30 billion from the Bear Stearns deal, and $100 billion in "other Federal Reserve assets". That $455 billion total does not include this week's $85 billion loan to AIG, nor the $180 billion in reciprocal currency swap lines.

My primary criticism of these previous unconventional actions by the Fed is that they are better characterized as fiscal policy rather than monetary policy. They unquestionably represent an implicit potential commitment of Treasury dollars. If the latest $700 billion Treasury proposal were to take these assets off the books of the Federal Reserve and put them onto the Treasury's balance sheet, and have Paulson rather than Bernanke be the guy who makes these calls of when and where to put the taxpayers at risk, I would be all for it.

But I gather that instead the $700 billion is construed to be in addition to the comparable sum that's already been committed by the Federal Reserve. And it seems to be in addition to the $1.7 trillion in debts from Fannie and Freddie that the U.S. Treasury has now apparently assumed, and is in addition to the guarantees on $3.1 trillion in agency MBS for which the Treasury has again apparently assumed responsibility.

And do you think that this week's $700 billion is going to be the last such request?

Granted, these numbers I've been adding up represent loans or guarantees, which are something very different from outright expenditures. Actual losses should only amount to a small fraction of this sum. But even a small fraction of $6 trillion is still a huge number.

Before we can solve these problems, we need to agree on what caused them. In a narrow mechanical sense, that seems straightforward to answer. Reckless underwriting standards and excessively low interest rates contributed to bidding up house prices to unsustainable levels. Real estate price declines have now engendered current and prospective future default rates that translate into large capital losses for institutions holding assets based on those loans. This erosion of capital makes creditors wary of extending any new funds to these institutions.

But there is also a deeper question here that is harder to answer. How did the financial system come to be susceptible to such a profound degree of miscalculation and inappropriate leveraging of risk in the first place? My answer would be that the core problem was financial arrangements in which the gains went to one group but the downside risk was borne by somebody else. The loan originators offered unsound loans, but still made big profits because they sold those bad loans off to the loan aggregators. Fannie and Freddie earned themselves nice income while the loans were performing, but the taxpayers absorbed the loss when the loans went bad. CEOs and fund managers earned huge bonuses while the boom went on, leaving stockholders and investors holding the bag when things went sour.

And I agree with the Financial Stability Forum that the key changes we need to make to avoid such problems are more transparency in accounting and stronger capital requirements. Transparency is vital so that that creditors, shareholders, fund investors, and regulators can better perceive the risks to which they are exposed. Stronger capital requirements are necessary to ensure that the principal actors are risking their own capital and not just somebody else's.

How you get from our current situation to one where financial institutions are adequately capitalized is of course one of the key challenges of the moment. We can't just impose tougher requirements and expect everybody to extricate themselves from the mess they're in without some federal contributions. But I do not see that a clear vision of exactly what is expected and required, in the way of modified capital standards and risk management procedures, for any institution that receives federal assistance is a key part of any of the proposals. And it should be.

Transparency strikes me as something that ought to be easier to achieve. I would start with a centralized clearing house for reporting all derivative contracts and collateral pledged for them, and requiring financial statements such as annual reports to communicate clearly the specific exposures that those entail. Perhaps there's a fear that if we had a clear communication of exactly who is holding the bag, that could exacerbate the kinds of destabilizing capital flights with which we've been fighting. But I think the uncertainty itself may be even more destabilizing.

Before the taxpayers are asked to commit such sums, we are owed a coherent and compelling explanation of why this kind of problem is never going to occur again.

There's lots of other good analysis out there in the 'sphere. Brad DeLong has a nice exposition of the conditions in which a government intervention could be successful and desirable, and when it could fail. Calculated Risk offers details of how he would run the bailout. Yves Smith and Paul Krugman [1], [2] express their reservations about the Paulson plan. Representative Barney Frank (D-MA) wants to see a cap on executive compensation be part of any bailout. For some comic relief (and heaven knows we could use some at the moment), see the Washington Post (hat tip: Greg Mankiw).

And your thoughts, dear readers?

Technorati Tags: macroeconomics, economics, Federal Reserve, interest rates, credit crunch, Bernanke, financial crisis

Both the bondholders and the stockholders of Lehman Brothers (LEH) were effectively wiped out. This led to the original money market fund, a fund with $63 billion in it, breaking the buck and suspending redemptions for a week. This is only the second time a money market fund has broken the buck, and the last time it was a very small fund that it happened to.

Fear rules the Street, and banks are afraid to lend to anyone, even each other. In a bid to find a safe place to park money, the interest rate on the three month T-Bill actually went negative briefly. I guess it is hard to find a mattress big enough to hold billions of dollars, but effectively that is what a zero rate on a T-Bill is. That is the first time that has ever happened -- the closest parallel was in January of 1940. Think about it, this is a bigger flight to safety than before the U.S. had engaged in World War II!

If that's not enough, Merrill Lynch (MER) was forced into a shotgun wedding with Bank of America (BAC), a $50 billion deal (all stock and based on the prices at the announcement) that was reached with as much due diligence as most people use when buying some candy at the checkout lane at the grocery store.

Three of the top five investment banks at the start of the year are either gone or
subsumed by large commercial banks, and it looks like the remaining two, Goldman Sachs (GS) and Morgan Stanley (MS), are desperately looking for dance partners. Meanwhile, the largest S&L, Washington Mutual (WM), is hanging by a thread. If (when) it goes under, it will use up most of the existing FDIC insurance fund. Either Congress of the Fed will have to replenish it, most likely to the tune of over $100 billion.

By any honest accounting of the moves already taken, the budget deficit is rapidly approaching the $1 trillion (with a "t") mark. Whoever wins the White House is going to face a mess on his hands greater than any faced by an incoming president since FDR. Oh, and in the middle of it all, Hurricane Ike shut down 20% of the nations refining capacity for a few weeks and left millions with out electricity for at least as long. Talk about taking a few shocks to the system.

But heck, things could have been much, much worse; if Bush and McCain had had their way a few years back, a big chunk of Social Security would have been in the hands of Lehman Brothers and Bear Sterns. The New Deal programs were put in place for a reason in response to the Great Depression, as ways of preventing its reoccurrence. We have spent much of the past decade dismantling those programs, but some of them still survive and should help to slow the decline.

But the damage from the unraveling of the FDR-era reforms has been great. The primary cause of this mess is a lack of regulation. The first great step in this direction was the unwinding of Glass Stiegel in 1999. To what I am sure is his great shame Bill Clinton signed this legislation (although given the margins it passed through the GOP-controlled Congress it would not mattered if he had vetoed it or not). The main provision of Glass Stiegel was the separation of Commercial Banks from Investment Banks. This helped insulate the Commercial Banks from the volatility of Wall Street.

That egg can no longer be unscrambled, as each move to shore up this teetering financial system has moved us farther and farther away from it. J.P. Morgan (JPM) has bought Bear Stearns, Bank of America is buying Merrill Lynch and quite probably by the time this is published Morgan Stanley and Wachovia (WB) will be married. Barclays of England (BCS) picked up the carcass of Lehman Brothers. Citigroup (C), of course, long ago picked up Smith Barney.

We are in the middle of a massive deleveraging, in effect those bad or close-to-worst-case-scenarios I have been writing about for the last few months are coming to pass. By and large Bernanke and Paulson are trying to do the right things, and has shown incredible creativity in fighting this fire. I have to say on legal and constitutional grounds I am not all that crazy about the appropriation and spending of hundreds of billions of dollars without Congressional approval, but this is a real emergency and I suspect that Congress will approve of it ex post facto.

A massive deleveraging means that lots and lots of dollars are going to money heaven. The Fed is trying to offset that by creating as much money as it can as fast as it can. The metaphorical printing presses are working overtime in an attempt to keep up. The Fed is using a fire hose of liquidity to try to put out this fire, but more and more it is not looking like a simple house fire, but a raging wildfire driven by hot winds and heading right for an Oil refinery. It is a seven-alarm fire and other fire departments like the European Central Bank, the Bank of England, the Bank of Japan, etc. have been called in to help out.

Once upon a time, many moons ago (actually, about six) the Federal Reserve would only lend to Commercial Banks, which were under its direct supervision, in its role as lender of last resort. It would only take Treasury paper as collateral. Then along came the Bear Sterns situation and they started to open the window to Primary Dealers, also known as the big Wall Street Investment Banks, and started to take Agency paper (i.e. Fannie and Freddie debt) as collateral.

With its latest moves, the Fed will take any "investment grade" debt and even equities as collateral. We know the rating agencies have been right on top of things with their determinations of who is investment grade, right? Seriously, the collateral at the pawn shop on the wrong side of the tracks is now better than what the Fed is taking onto its balance sheet. That balance sheet is what backs all those "Federal Reserve Notes" in your wallet. Now the window is so wide open I don't think it is fair to call it a window anymore. A window implied something that can be open and shut, with some sort of cashier sitting at it. This is not a window, it is a gaping hole in the side of a building.

I still do not think this is the time to try to bottom-fish in the financials. Yes, there may be tradable rally's as governments force short sellers to cover and directly inject liquidity into these firms, but for many of them the question is not liquidity, it is solvency.

Do not be tempted to by firms like Citigroup, Wachovia, Bank of America or Morgan Stanley. If you have to be in the market, look for either stable demand firms with rock solid balance sheets -- along the lines of Proctor and Gamble (PG) or PepsiCo (PEP) or some of the Energy names that have been beaten down with the recent decline in oil prices. Offshore drillers like Transocean (RIG) and Diamond Offshore (DO) look particularly attractive to me in here. Big Integrated Oils like Exxon (XOM), Conoco (COP) and Chevron (CVX) all have fortress balance sheets and are a very good place to hide.

Read the analyst note on FRE

Read the analyst note on AIG

Read the analyst note on WM

Read the analyst note on JPM

Read the analyst note on WB

Read the analyst note on BCS

Read the analyst note on PG

Read the analyst note on PEP

Read the analyst note on RIG

Read the analyst note on DO

Read the analyst note on XOM

Read the analyst note on COP

Read the analyst note on CVX

In terms of sector performance, the general rank ordering is similar. Energy is expected to far out perform all other sectors with growth of 33.3%. Then there is a tight grouping of Industrials, Health Care and Tech between 10.3% and 11.8% growth. Financials (-10.4%) and Consumer Discretionary (-1.5%) are once again expected to be the weakest performers.

This week, we also provide our first peak at the expected growth rates for the fourth quarter. Here the overall picture looks much stronger than the third quarter, with an expected median growth rate of 11.8%. This is mostly a function of extremely easy comparisons in the Financial sector. Recall that in the fourth quarter of last year the sector as a whole was bleeding red ink. Given those super easy comps it is surprising that the sector is only in fourth place for fourth quarter growth at 12.2%, trailing Energy (+34.7%), Health Care (+14.5%) and Industrials (+13.4%).

Some of the factors which should help median EPS growth are share repurchases, which though have slowed in recent months, will still reflect what happened last year. The share repurchase totals have not been released yet for the second quarter, but in the first quarter, S&P 500 firms bought back $113.9 billion, following $141.7 billion in the fourth quarter.

For a sense of scale, total reported earnings (not the same as the operating earnings before non-recurring items that we track) for the S&P 500 were $135.2 billion in the first quarter and $68.5 billion in the second quarter. The repurchase numbers are gross, not net of share issuance, and in recent quarters many firms, particularly in the Financial sector have been issuing stock to bolster their balance sheets. Oddly, increased share counts will also help boost EPS among the Financials. Since the ones that have increased their share counts the most (by going hat in had to the sovereign wealth funds looking for new capital) are also the ones that are likely to reports losses, so the loss per share will be less.

In addition, to the extent that firms have large operations overseas, they should benefit from the currency translation effects of the weak dollar. The weak dollar has also boosted those companies that export a substantial portion of their sales. With the recent rebound in the dollar, that effect will fade somewhat, particularly the currency translation effect. The revenue effect of U.S. firms being less competitive overseas due to the dollar rebound is more likely to affect the fourth quarter than the third.

Keep in mind that median growth rates are inherently equally weighted, so the growth rate for Cabot Oil and Gas (COG) is just as significant to the results for the Energy sector as the growth rate for Exxon (XOM).

Third Quarter Scorecard (Reported)
Sector	Q3 08 Median Growth Rep.	Q4 08 Median Proj. Growth.	2007 Median Rep. Growth	2008 Median Proj. Growth	% Reported	Median % Surprise	# Pos Surprise	# Neg Surprise	# Match
Tech	13.79%	2.94%	-19.15%	22.38%	1.41%	-2.94%	0	1	0
S&P 500	13.79%	2.94%	-19.15%	22.38%	0.20%	-2.94%	0	1	0

Third Quarter Yet-to-Report
Sector	Q3 08 Proj. Growth	Q4 08 Proj. Growth	2007 Rep. Growth	2008 Proj. Growth	2009 Proj. Growth
Energy	33.33%	34.69%	12.83%	28.70%	19.68%
Tech	11.76%	11.71%	17.91%	14.69%	15.25%
Healthcare	10.99%	14.47%	16.98%	13.42%	12.76%
Industrial	10.34%	13.38%	15.29%	13.88%	11.09%
Cons. Stap.	7.53%	9.97%	12.03%	10.10%	9.76%
Utilities	5.79%	5.88%	9.09%	5.85%	7.88%
Telecom	4.00%	1.22%	-2.94%	8.22%	5.85%
Materials	3.71%	8.91%	12.94%	6.67%	13.36%
Cons. Disc.	-1.54%	6.72%	7.97%	2.11%	9.27%
Financial	-10.41%	12.15%	3.70%	-5.10%	7.29%
S&P 500	6.23%	11.78%	12.15%	9.28%	10.73%

Total Net Income Growth

In regards to the third quarter, it looks like we will have another down quarter, but not anywhere near as ugly as the last 3 have been. Currently a 2.98% decline is expected. At a similar point before the second quarter earnings season, the expected decline was 9.7%, rather than the 21.0% decline we actually experienced. While I expect a better (less worse) earnings season for the third quarter than we had in the second, I don’t think the improvement will be that dramatic.

All of the improvement (such as it is) is expected to come from two sources.

The Financials are expected to suck just a little bit less (don’t count on that happening) with a decline of 49.8% from a year ago. While that is ugly, it represents a significant improvement over any of the last 3 quarters where the declines ranged from -78.4% to -119.8%. However, many will have to write off their holdings in Fannie and Freddie preferred, and who knows how much damage will have to be recognized due to Lehman Brothers. Given the continuing estimate cuts for the sector, that sort of improvement seems optimistic.

To a lesser extent, there is also a less severe decline expected for the Consumer Discretionary sector, with only a 32.8% drop, rather than the 66.8% year over year drop it suffered in the second quarter. However, Financials are a far larger sector and thus will have a much more significant effect.

Energy is expected to post eye popping growth of 49.5%, which will be a very tall order indeed, especially with oil prices slipping in recent weeks. Note below that estimate revisions for the Energy sector have now turned negative. Materials are expected to post the second largest increase in net income at 14.5%, but that is a fairly small sector. Anemic low- to mid-single digit growth is expected for all other sectors.

On the plus side, that does not seem like that big a hurdle. We may be setting up for many positive surprises in the third quarter.

Total Net Income Growth (Reported)
Sector	Q1 08 Rep. Growth	Q2 08 Rep. Growth	Q3 08 Rep. Growth	Q4 08 Proj. Growth	2007 Rep. Growth	2008 Proj. Growth	2009 Proj. Growth
Technology	-2.67%	-4.44%	-3.61%	-11.21%	-16.31%	22.88%	9.66%
S&P	-2.67%	-4.44%	-3.61%	-11.21%	-16.31%	22.88%	9.66%

Total Reported
Sector	Q3 08 Income	Q3 07 Income	Q3 % Growth	Q2 08 Income	Q2 07 Income	Q2 % Growth
Technology	$80	$83	-3.61%	$86	$90	-4.44%
S&P	$80	$83	-3.61%	$86	$90	-4.44%

Total Earnings Growth: Yet-to-Report
Sector	Q1 08 Rep. Growth	Q2 08 Rep. Growth	Q3 08 Proj. Growth	Q4 08 Proj. Growth	2007 Rep. Growth	2008 Proj. Growth	2009 Proj. Growth
Energy	25.75%	17.33%	49.45%	30.52%	5.95%	38.18%	12.82%
Materials	16.43%	4.78%	14.50%	48.92%	12.45%	13.54%	14.25%
Technology	12.57%	13.07%	6.26%	4.04%	20.31%	16.58%	16.53%
Cons. Stap.	11.45%	3.45%	5.58%	17.65%	12.20%	11.70%	10.07%
Industrials	5.58%	5.45%	2.06%	5.18%	10.17%	9.08%	11.16%
Health Care	3.25%	8.27%	1.51%	5.89%	18.70%	9.08%	10.10%
Utilities	8.90%	3.79%	0.51%	3.44%	10.40%	6.84%	10.32%
Telecom	1.41%	-1.11%	-6.48%	-5.71%	17.66%	0.88%	8.75%
Cons. Disc.	-18.97%