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A Long Economic Winter ^ | 05-Feb-2003 | Richard Benson

Posted on 02/05/2003 11:10:57 AM PST by sourcery

Richard Benson is president of Specialty Finance Group, LLC , offering diversified investment banking services. This article was originally published Oct. 15, 2002 on his website. The recent AOL writedown appears to provide an example of the vaporizing "Fictional Equity" mentioned below.

Simple arithmetic, knowledge of how the world works, and common sense, are all that are needed to see that a long Real Recession lies ahead. The pillars of the U.S. economy: Business, Real Estate, Financial Markets, the Consumer, and, the Government, are still pointing down. In order to meet demand, businesses still have too many workers, too many plants, and too much capital. The $8 Trillion drop in equity values will force companies to write off at least another Trillion in corporate “Goodwill” from their balance sheets. Companies that acquired other companies for stock during the bubble, clearly overpaid. That “Fiction” was booked as Equity in the form of Goodwill. Now that the “Fictional Equity is vaporizing, it is leaving companies with new problems meeting debt to equity covenants with their banks and bond holders. In addition, the drop in equity values has “ripped up” company pension funds. The S&P 500 pension funds alone are suddenly $280 billion under-funded, and major corporations that keep an assumption of an annual 9 - 10% return on their investments are long past the “Laugh Test” for credibility. Corporate revenues are not “Snapping Back”. Indeed, corporations have far too much debt to service, and corporate credit spreads are at record levels. The junk bond market is rapidly expanding because of “Fallen Angles”, and in the next year or two we will certainly see many “household” names of major firms go bankrupt like United Air, Household, and Ford. United Can’t afford to pay its airline pilots up to $300,000 a year; Household can’t keep making credit card loans to people who will lose their job; Ford can’t fund its pension fund and sell cars to people with bad credit, at no profit and at zero interest. The Federal Reserve has tried adding massive amounts of liquidity, and the credit markets are finally waking up to the reality that liquidity doesn’t make “Bad Loans Good”, it makes “Bad Loans Bigger”. Companies can no longer borrow their way to meeting cash-flow needs. Companies are forced to cut new investment and slash employment. If there is any need for new investment, it will certainly be in China, where labor cost 10% of what it does in the U.S. When history is re-written in order to match the actual acts, much of the recent U.S. “Productivity Boom” is nothing more than a strong dollar, importing parts made with “cheap Asian labor”, and final assembly in the U.S. Business is going to continue to be a big negative for the economy and the job market.

Commercial Real Estate is already rotting, and single family real estate has peaked and started a very long slide. Commercial buildings are still being finished for tenants that no longer exist. Commercial vacancy rates are way up, but do not reflect the large amount of “sub-lease” space that is on the market.

The owners of commercial properties with mortgages on the buildings don’t want to look at what will happen when primary leases come up for renewal, and the major tenant decides to reduce the space they are willing to pay for back to what they actually need. The smart property owners are selling now while there is still an impression that Real Estate is better than the stock market. Major corporations, like Citicorp, are selling their corporate headquarters because they need the money. More firms like K-Mart will file bankruptcy and significantly cut the number of locations they lease. New construction for commercial properties has to collapse. Who needs them? Single Family housing foreclosures just hit a 30-year high. This fact undermines the durability of the “Housing Price Bubble” and record cash-out mortgage re-financings.

Housing has helped to hold up the economy but winter is coming. The re-financing binge is running its course and will be ending by the first quarter of next year. The real damage to the housing market has yet to come. New housing construction and record low interest rates have pulled consumers out of multi-family rental units, pushing rents and commercial property prices down. This has encouraged the consumers to greatly overpay for their homes. When this individual loses their job, they will lose their house to the bank. Their new home will become the old apartment they used to rent.

Banks and the GSEs are acting as if housing prices can only go up, and have lent to very marginal borrowers. The good news is that home ownership is at record levels for the population. The bad news is that the records for homeownership will be replaced by new records for housing foreclosures. Look forward to a very long winter for housing and commercial real estate.

The financial markets are still signaling “Major Bubbles”. While the stock markets have started to correct, and have wiped out $8 Trillion in the U.S and at least $20 Trillion worldwide, the major bubble in the debt and credit markets is just stating to unwind. The Federal Reserve created the bubbles and has been desperately trying to protect them with massive injections of liquidity, and encouragement of credit creation. However, the credit markets are beginning to catch on: adding liquidity to markets doesn’t make “Bad Credits Good”; it makes “Bad Loans Bigger”. Too many credits are already too big. Argentina has defaulted. Brazil will default. Turkey will default. United Airlines and Conseco will file bankruptcy. There is a huge list of companies and countries that cannot pay back what they have already borrowed. Lending them more money will change the date of default and increase the amount. The credit markets are saying that you just can’t find anybody that wants to be the “New Lender” to help “Bailout the old Lender.” The problem for the financial markets is that one firm’s debt is a financial institution’s asset. As loans default, they destroy real equity capital in banks, insurance companies, hedge funds, CDO’s, etc.

The capital markets and financial institutions depend on leverage. As equity is destroyed, their ability to leverage and lend is destroyed. Downgrades of a bank like JP Morgan Chase make it harder for them to take on risk. They already have over $20 trillion of derivative exposure. If JP Morgan Chase’s derivative book for interest rate swaps, credit derivatives, structured equity notes and other market bets were put back on balance sheet, they would make the balance sheet of Long Term Capital look quite conservative.

In the financial system there are over $100 Trillion of derivatives. Most of these were booked based on pricing models that assumed that markets do not move more than three standard deviations from long-term trends or averages. We now live in a world where many markets have easily moved four or five standard deviations from the norm. Major financial institutions have tremendous losses that have not jet been realized. The only steady source of earnings for the financial sector is funding long term Treasury notes and mortgage assets with short term CP or Fed Funds. If you think an economy is healthy if it offers a return on a 10-Year Treasury Note of 3.60%, it means you don’t think.

The “Bond Bubble”, based on low and lower short term interest rates, is a catastrophe waiting for the first time the Fed raises interest rates. If the Fed is true to form, it will cut short term interest rates to make this Bond and Agency Security Bubble as big as possible. The financial markets do not offer a quick fix or a long term solution to our current economic problems. Indeed, the financial markets are the problem. Only “de-levering” the financial markets will restore them to health. However, de-levering means less debt, less borrowing, more saving, and much less spending. Less spending means less economic activity.

Will the consumer spend us back to prosperity? The answer is with what? The consumer has been conditioned by the stock market bubble. Since the stock market would take care of his retirement, there was no need to save. Indeed, the consumer could spend every dollar he earned and every dollar he could borrow. This leads us to a world where 1.6 million consumers are now filing for bankruptcy every year. This year the U.S. Treasury will collect $180 billion less in taxes from individuals than last year. That means that $600 billion of income and capital gains has gone missing. This year single family mortgage debt will be up $600 Billion. Borrowing helps keep spending alive. But at some point, decreasing incomes and increased borrowing just don’t add up, particularly when pension funds and 401K’s have been nuked by the Bear Market. Borrowing to spend means that you are spending other people’s money. It’s wonderful; it's fun; Unless, of course, you are the lender. With low incomes, no bonus, job loss, no new jobs, record bankruptcies, and record home foreclosures, we are starting to see consumer spending sag, and slowed down lending to people who can’t pay. The consumer pull-back will trigger the Long Economic Winter.

With Congress approving going to war, you would think that the boost in Federal spending needed for the war effort would boost the economy. The government is not doing enough. While the Federal budget is going into deficit, more of the deficit is coming from a drop in tax revenue than new spending. Moreover, state and local governments are headed for $80 Billion in deficits; except, these governmental entities are not supposed to run deficits. While state and local borrowing is rising, so will taxes and cuts in programs and employment. Because of the November elections, needed fiscal policy will be postponed until next year.

Without massive, immediate fiscal stimulus to offset the major negative forces from business, real estate, the consumer, and financial markets, common sense and arithmetic add up to a very Long Economic Winter.

TOPICS: Business/Economy
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1 posted on 02/05/2003 11:10:57 AM PST by sourcery
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To: sourcery
What - a website called is pushing the most radically bearish views? Amazing! (And quite a marvel of objectivity).

Note to the prognosticating Mr. Benson: If you actually published this on February 5th, why are you predicting two banruptcies that happened two months ago?

2 posted on 02/05/2003 11:21:56 AM PST by wideawake
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To: sourcery

I've been saying we are entering a serious depression. But this article says it far better than I am able.

3 posted on 02/05/2003 11:26:10 AM PST by ThePythonicCow (Mooo !!!!)
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To: wideawake
Because he published it in October 2002, as noted at the top of this posting.
4 posted on 02/05/2003 11:27:27 AM PST by ThePythonicCow (Mooo !!!!)
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To: ThePythonicCow
Still unimpressive. UAL and Conseco were threatening to file way before October.
5 posted on 02/05/2003 11:29:18 AM PST by wideawake
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To: wideawake
Ah - so he "predicted" one thing that in your humble opinion was obvious at the time.

That makes the entire article unimpressive.

You set a pretty high bar there -- have you found an analyst with whom you are impressed -- I'd like to read them.

6 posted on 02/05/2003 11:31:30 AM PST by ThePythonicCow (Mooo !!!!)
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To: ThePythonicCow
Irrational moroseness is the flipside of irrational exuberance.

Everyone who bought the dotcom snakeoil was gullible, but everyone who buys the economic doomsday scenarios these guys are peddling are just as gullible.

For 50 years our tax system has encouraged borrowing and spending and penalized saving and investment. The Washington bureaucrats are beginning to realize that.

7 posted on 02/05/2003 11:33:10 AM PST by wideawake
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To: ThePythonicCow
have you found an analyst with whom you are impressed -- I'd like to read them.

I recommend Grant's Interest Rate Observer.

Here's a sample:

8 posted on 02/05/2003 11:44:07 AM PST by wideawake
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To: wideawake
The gullible ones in the boom were not those who observed a huge runup in tech stocks and such; the gullible ones were those who saw a "new era" in which such a boom would continue unending. There was a runup, a big one. One of the biggest bubbles in recorded financial history. It just didn't last. They never do.

The analog would be predicting not that we are entering into a Depression, but predicting that it will last forever. I'd agree with you that anyone so predicting is a fool.

Neither the boom nor the bust was nor will be forever. It went up, it's going down. You've seen one. You will be seeing the other, when you depart the low state of denial in which you are currently trapping yourself.

Let me know when you finally exclaim "oh s**t - this really is a serious Depression!" For on that day I will know that we are one more investor closer to hitting bottom and starting back up again.

9 posted on 02/05/2003 11:45:15 AM PST by ThePythonicCow (Mooo !!!!)
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To: wideawake
This author is a hopeless optimist.

In fact, we are at the start of a terminal depression that will lead to a global war unlike anything ever seen. Most of the world's infrastructure will be destroyed and the earth's population reduced by 70% or more.

The survivors will be left to struggle through a dark age of plague and famine that will last for centuries.

Nothing irritates me like a pessimist without an imagination.
10 posted on 02/05/2003 11:50:45 AM PST by the
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To: ThePythonicCow
I'm not in a state of denial. There are real problems. There are also excellent businesses that are undervalued at the moment.

When I talk about dotcom mania I talk about the people who thought Akamai at $330 (that's right) was as good an idea as Cisco at $80. In 2000 I thought they were both far too expensive and I didn't buy them. I think that Cisco is cheap today at $13 and that Akamai is still too expensive at $1.25.

Two or three years from now there will be a return to economic stability, and it will driven by the Ciscos of the world.

Are you familiar with the Austrian theory of the business cycle?

11 posted on 02/05/2003 11:54:32 AM PST by wideawake
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To: the
Cool - it's a pleasure to read a prediction more pessimistic than mine. Bring it on.
12 posted on 02/05/2003 12:05:31 PM PST by ThePythonicCow (Mooo !!!!)
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To: sourcery
While the Federal budget is going into deficit, more of the deficit is coming from a drop in tax revenue than new spending. Moreover, state and local governments are headed for $80 Billion in deficits; except, these governmental entities are not supposed to run deficits.

It's good to see that there is a non-Kudlow financial prognisticator who doesn't buy into the Dumbya Administration's nonsense about how their tax cuts caused "only" 40% of the deficit. Anybody who buys a stock in today's market based upon confidence in the Dumbya Administration is a sure loser.

13 posted on 02/05/2003 1:12:50 PM PST by MurryMom
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To: wideawake
Thanks for the link to Grant's Interest Rate Observer . I hadn't really paid attention to it before. He's rather bearish himself, though he focuses on different aspects of the overall economy and financial markets.

In looking into this Grants site a little bit, I stumbled on an excellent list of bearish newsletters and analysts, which includes Grants, and my current favorite three, Stack, Dines and Prechter (Elliott Wave). Check out the site for the page Great Bear Advice. It lists:

14 posted on 02/05/2003 1:18:53 PM PST by ThePythonicCow (Mooo !!!!)
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To: MurryMom
He's not saying that the drop in tax revenue came from taxcuts - at least I hope not. Most of the drop came from reduced income - lower corporate income, more unemployed not paying taxes, and much reduced capital gains to be taxed with the falling stock market.

What tax cut has happened so far is minor in comparison.

You are misreading this, blinded by your disrespect for a darn good President.

15 posted on 02/05/2003 1:22:25 PM PST by ThePythonicCow (Mooo !!!!)
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To: ThePythonicCow
Neither the boom nor the bust was nor will be forever.

The Roman Empire will be glad to hear that!

16 posted on 02/05/2003 1:25:07 PM PST by The Duke
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To: sourcery; AdamSelene235; JohnHuang2; Nick Danger; RJayneJ
It might be worth noting (if you actually want to consider all of the evidence prior to making a "conclusion") that the U.S. economy GREW during the year and Quarter in which this article was written.

We've got record high worker productivity, reasonably low unemployment (~~ 6%), very low interest rates, and inflation is dead.

We've got a great infrastructure, university educational system, and superior research and development in this nation.

Our population is increasing and our average salaries are rising.

This is not data that warns of an impending doom in our economy.

Crying that the "sky is falling" simply because some techies have to learn new careers and that it's just so awful that our state and federal government(s) is/are getting less tax income hardly seems like a mature, manly response to the rational information at hand.

Let's not all be feminized by Leftist gloom and political correctness.

Buck up, gentlemen! We are at war!

17 posted on 02/05/2003 1:41:23 PM PST by Southack (Media bias means that Castro won't be punished for Cuban war crimes against Black Angolans in Africa)
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To: The Duke
The world came back after the Roman Empire collapsed. It's just not called the Roman Empire anymore.
18 posted on 02/05/2003 1:43:42 PM PST by ThePythonicCow (Mooo !!!!)
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To: Southack
Southack - you shouldn't take financial forecasts as necessarilyl having political implications. Both liberals and conservatives can predict both boom and bust. And both will be right, sometimes.

A huge boom in Clinton's reign doesn't make him good, nor does a major depression in Bush's term make him bad. Major economic cycles are bigger than one man - whether he be the President or the head of the Fed.

Don't fall for the leftist trap of responding to their cries that the economic sky is falling by claiming that it isn't falling. If the sky falls anyway, you're cornered, no fault necessarily of yourself nor of Bush.

Forecasts of doom (or boom) don't spin left, but leftist spinners can sure forecast. Don't go there with them.

19 posted on 02/05/2003 1:53:06 PM PST by ThePythonicCow (Mooo !!!!)
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To: ThePythonicCow
"A huge boom in Clinton's reign doesn't make him good"

Klintoon had the GREAT FORTUNE to be contemporary to Gates, Grove and Greenspan.....Nothing more than that!

20 posted on 02/05/2003 2:01:13 PM PST by litehaus
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