Author: Steve Boren

Your tax dollars buy TV talking head

MIT economist Jonathan Gruber has no qualms about speaking his mind on ObamaCare. He’s been one of the most outspoken independent voices defending the healthcare proposals.

But there’s a catch. He’s not independent at all. As it turns out, the Department of Health and Human Services paid him nearly $400,000 to provide "technical assistance" in evaluating the healthcare proposals.

Funny how he forgot to mention this blatant conflict of interest on the many TV shows in which he’s touted the plan, or in the newspaper articles where he’s been quoted.

He even wrote an Op-Ed piece on health reform in the Washington Post, and again declined to mention that he’s getting paid put a positive spin on the plan.

Yup — just one more elite who takes your money to tell you what’s good for you.

For the record, Gruber says it’s all fine because he told anyone who asked, and anyway he was paid to advise the administration — not for his media appearances.

To paraphrase an old saying about ducks: If it speaks like a shill and it’s paid like a shill…it’s a shill.

Counting the days until the midterm elections,

William Campbell Douglass II, M.D.

P.S. And if you still need more proof that they just won’t play fair, take a look at this video. On at least eight occasions, President Obama promised to put the health care negotiations on C-SPAN for all to see. Guess what you won’t find on C-SPAN? That’s right…those negotiations. The most significant piece of legislation in modern history is going to be hammered out behind closed doors…as usual. What happened to change we can believe in?

02.05.10 09:16 PM

A Bubble in Search of a Pin
Unemployment Numbers: A Mixed Bag
A Bubble in Search of a Pin
And Speaking of Bubbles
Help in Europe, California, and Tampa, and Becoming our Parents

Should Greenspan and Bernanke have seen the bubble in housing and other assets and acted, or should we accept their defense that you can't know whether there is a bubble until after the fact? We will look at research that suggests they should have known, and, at the least, policy makers should no longer be allowed to say, “How could I have known?”

Of course, the employment numbers came out this morning, and the results are mixed; but that is better than they have been for the past two years. We dig into the numbers to see what they are really saying. And finally, we examine why the markets are so volatile. Is it just Greece, or is there more? There's a lot of very interesting, and important, material to cover.

But first, and quickly, as I wrote in Outside the Box a few weeks ago, I am starting to very selectively buy biotech stocks, and mostly, though not exclusively, companies associated with the regenerative genetic revolution that is coming our way. I am convinced that this is going to be a decade of the most amazing medical breakthroughs, which will literally change (and in many cases extend) our lives, as therapies to treat all sorts of diseases become available.

This is the last time I am going to mention it, but here is the link to that OTB, which analyzes why we may see a bubble in biotech stocks before the end of the decade. The OTB was written by my friend Pat Cox, who covers these stocks and other technological marvels in his newsletter, Breakthrough Technology Alert. I have been following Pat for some time now, have talked extensively with him, and think he is one of those guys who have a handle on what by all accounts is going to be an amazing decade of breakthroughs.

I have asked his publisher to offer my readers a very discounted subscription price for one more week. (Ignore the deadline of February 5.) And yes, the promotional piece is a little over the top, as it is for most subscription newsletters (I am lucky mine is free – I don't have to do that). But I think his letter has a lot of substance. The link to the site is in the Outside the Box. Don't procrastinate. Join me, because for once in my life, dear God, I want to be in at the beginning of a bubble. And now to our letter.

Unemployment Numbers: A Mixed Bag

January employment numbers are characteristically volatile, as the birth/death ratio numbers are typically the largest of the year. This month the birth/death model subtracted (rather than added) 427,000 jobs (yes, I wrote that correctly). This is a very large “adjustment” month, and the volatility gets smoothed over in the seasonal adjustments. It is part and parcel of the process, as making estimates about how many new businesses are formed or die is extraordinarily difficult at turning points in the economy.

As an acknowledgment of that, the employment level for March 2009 was revised down by 930,000 jobs, and by December it was a total of almost 1.4 million extra jobs lost. That means that the Bureau of Labor Statistics overestimated the number of new jobs significantly. December's job loss was really 150,000, not the 85,000 originally reported. How would the markets have reacted to a number that large?

January saw a slightly larger than estimated loss of 22,000 jobs, which would have been 53,000 without new federal employees, 9,000 of whom were hired to perform the census. (By the way, federal employment is absolutely exploding!)

Now, the somewhat good news. I have been writing about how the household survey has been much weaker for almost two years than the establishment survey. For instance, the total number of unemployed rose by 589,000 in December, while the number of people not classified as looking for work rose by 843,000. No matter how you spin it, those were very ugly numbers.

This month the household survey showed the largest one-month turnaround that I could find. As The Liscio Report noted:

“Adjusting for the changes in the population controls, total household employment rose by 784,000 – and when further adjusted to match the payroll concept, employment was up 841,000. Moves of this magnitude (regardless of sign) are unusual, but not unknown – and frequently undone in subsequent months. The less volatile ratios were also up, with the participation rate up 0.1 point, and the employment/population ratio rose a nice 0.2 point, its first increase since last April. While it's too early to say whether this strength in the household survey is a harbinger of an upturn that will soon show up in payrolls, it's something to be filed under 'tentatively encouraging.'”

The work-week hours rose slightly. Income growth was better than it has been. Temporary workers rose, which is typically a harbinger of an increase in full-time employment. The number of people working part-time for economic reasons plummeted by 849,000.

And finally, the unemployment rate fell 0.3% to 9.7%. This of course means that more people are dropping out of the labor pool, and it also means they will at some point come back.

On the negative side, a loss of 22,000 jobs is nowhere close to the 100,000 new jobs that are needed just to hold unemployment steady. 41% of those unemployed have been so for over 6 months.

And quoting David Rosenberg:

“While there will be many economists touting today's report as some inflection point, and it could well be argued that we are entering some sort of healing phase in the jobs market just by mere virtue of inertia, the reality is that the level of employment today, at 129.5 million, is the exact same level it was in 1999. And, during this 11-year span of Japanese-like labour market stagnation, the working-age population has risen 29 million. Contemplate that for a moment; fully 29 million people competing for the same number of jobs that existed more than a decade ago. That sounds like pretty deflationary stuff from our standpoint.

“Not only that, but consideration must be taken that in 2009, we had a zero policy rate, a $2.2 trillion Fed balance sheet and an epic 10% deficit-to-GDP ratio. You could not have asked for more government stimulus. Yet employment tumbled nearly 5 million in 2009.”

Finally, a very sad chart, courtesy of David. Those in the 25-54 year-old male category have seen their total number of jobs fall back to the level it was in 1996. Fourteen years later, and the “breadwinners” who are supposedly in their prime have seen an almost 10% drop in employment.

As noted above, January employment numbers are very volatile, and are likely to be adjusted either up or down by a lot in coming months. But this report was not the disaster of December. It still shows a very weak economy that certainly does not need a large tax hike next year. I hope we start seeing some positive numbers soon, but I am not optimistic that we are going to see the 200,000-plus new jobs per month we need to really start denting the unemployment numbers, for some time. Not when the National Federation of Independent Business says 71% of small businesses do not plan to hire this year.

The Fed is taking away quantitative easing. Stimulus spending is exiting in the last half of the year. States and communities are having to either raise taxes or cut spending by $350 billion! I heard on the radio coming back from the gym (I think it was my friend Steve Liesman on CNBC) that there are now 55,000 fewer teachers than a few years ago.

And again from the NFIB, small businesses see very tight credit conditions, which makes it hard for them to expand (see chart below). The headlines this week from the Fed banking survey said that banks were prone to be less tight, but the NFIB writers went deep into the report. What they found is that very large banks are willing to be less tight in their lending standards. Smaller banks were in fact not as easy. Loan demand is falling. Consumer credit actually declined slightly in December, after plunging in November. If you can't count on Americans to buy during Christmas, the world is in fact moving to the New Frugal.

All this is not the stuff that robust recoveries are made of. We drift back into Muddle Through the last half of the year, I think. And if Congress does not act to postpone or mitigate the enormous tax increases due in 2011, we slip back into recession. It will be a policy error of major magnitude to raise taxes with 10% unemployment and a weak economy.

A Bubble in Search of a Pin

We are going to once again return to the book highlighted the last few weeks, This Time Is Different, by Carmen M. Reinhart and Kenneth Rogoff. This is a book you should buy and read, especially the last 4-5 chapters, and try to get your Congressman to read it as well, so he or she can see what happens to countries that run up their debt. It makes no difference if it is small or large, the end result is the same.

Last week we looked at the role of confidence in allowing governments to borrow money. This week we ask whether Greenspan and Bernanke, along with the entire Fed, should have been able to determine whether a bubble was building in the US economy and lean against it, preventing the debacle we are now in. Reinhart and Rogoff gently come down on the side of those who think they should have, and that we need to implement changes in our institutions. Others, as we will see, are not so gentle. Let's look at a few selected paragraphs I pulled off my Kindle (all emphasis mine).

“As we will show, the outsized U.S. borrowing from abroad that occurred prior to the crisis (manifested in a sequence of gaping current account and trade balance deficits) was hardly the only warning signal. In fact, the U.S. economy, at the epicenter of the crisis, showed many other signs of being on the brink of a deep financial crisis. Other measures such as asset price inflation, most notably in the real estate sector, rising household leverage, and the slowing output – standard leading indicators of financial crises – all revealed worrisome symptoms. Indeed, from a purely quantitative perspective, the run-up to the U.S. financial crisis showed all the signs of an accident waiting to happen. Of course, the United States was hardly alone in showing classic warning signs of a financial crisis, with Great Britain, Spain, and Ireland, among other countries, experiencing many of the same symptoms.

“… On the one hand, the Federal Reserve's logic for ignoring housing prices was grounded in the perfectly sensible proposition that the private sector can judge equilibrium housing prices (or equity prices) at least as well as any government bureaucrat. On the other hand, it might have paid more attention to the fact that the rise in asset prices was being fueled by a relentless increase in the ratio of household debt to GDP, against a backdrop of record lows in the personal saving rate. This ratio, which had been roughly stable at close to 80 percent of personal income until 1993, had risen to 120 percent in 2003 and to nearly 130 percent by mid-2006. Empirical work by Bordo and Jeanne and the Bank for International Settlements suggested that when housing booms are accompanied by sharp rises in debt, the risk of a crisis is significantly elevated. Although this work was not necessarily definitive, it certainly raised questions about the Federal Reserve's policy of benign neglect.

“The U.S. conceit that its financial and regulatory system could withstand massive capital inflows on a sustained basis without any problems arguably laid the foundations for the global financial crisis of the late 2000s. The thinking that “this time is different” – because this time the U.S. had a superior system – once again proved false. Outsized financial market returns were in fact greatly exaggerated by capital inflows, just as would be the case in emerging markets. What could in retrospect be recognized as huge regulatory mistakes, including the deregulation of the subprime mortgage market and the 2004 decision of the Securities and Exchange Commission to allow investment banks to triple their leverage ratios (that is, the ratio measuring the amount of risk to capital), appeared benign at the time. Capital inflows pushed up borrowing and asset prices while reducing spreads on all sorts of risky assets, leading the International Monetary Fund to conclude in April 2007, in its twice-annual World Economic Outlook, that risks to the global economy had become extremely low and that, for the moment, there were no great worries. When the international agency charged with being the global watchdog declares that there are no risks, there is no surer sign that this time is different. [By that they mean that the attitude of the market in general and central bankers in particular was that “this time is different” and so we did not need to worry about the warning signs. The entire point of the book is that it is never different. We just somehow believe we are in a special situation.]

“… We have focused on macroeconomic issues, but many problems were hidden in the 'plumbing' of the financial markets, as has become painfully evident since the beginning of the crisis. Some of these problems might have taken years to address. Above all, the huge run-up in housing prices – over 100 percent nationally over five years – should have been an alarm, especially fueled as it was by rising leverage. At the beginning of 2008, the total value of mortgages in the United States was approximately 90 percent of GDP. Policy makers should have decided several years prior to the crisis to deliberately take some steam out of the system. Unfortunately, efforts to maintain growth and prevent significant sharp stock market declines had the effect of taking the safety valve off the pressure cooker.

“… The signals approach (or most alternative methods) will not pinpoint the exact date on which a bubble will burst or provide an obvious indication of the severity of the looming crisis. What this systematic exercise can deliver is valuable information as to whether an economy is showing one or more of the classic symptoms that emerge before a severe financial illness develops. The most significant hurdle in establishing an effective and credible early warning system, however, is not the design of a systematic framework that is capable of producing relatively reliable signals of distress from the various indicators in a timely manner. The greatest barrier to success is the well-entrenched tendency of policy makers and market participants to treat the signals as irrelevant archaic residuals of an outdated framework, assuming that old rules of valuation no longer apply. If the past we have studied in this book is any guide, these signals will be dismissed more often that not. That is why we also need to think about improving institutions.

“… Second, policy makers must recognize that banking crises tend to be protracted affairs. Some crisis episodes (such as those of Japan in 1992 and Spain in 1977) were stretched out even longer by the authorities by a lengthy period of denial.”

The evidence is there. So why did the Fed miss it?

A more pointed critique is leveled at the Fed and Greenspan, and at Bernanke in particular, by Andrew Smithers in his powerful book (now updated) Wall Street Revalued: Imperfect Markets and Inept Central Bankers. The foreword is by one of my favorite analysts, Jeremy Grantham. This is on the top of my reading list for the coming week. I am loving the first part, which ties nicely into the themes explored by Reinhart and Rogoff.

The book is a withering critique of the Efficient Market Hypothesis (EMH), among other economic theories. Smithers argues that because the tenets of EMH are so ingrained, Greenspan and Bernanke could not recognize the bubble, because they believed in the efficiency of markets. “Dismissing financial crisis on the grounds that bubbles and busts cannot take place because that would imply irrationality is to ignore a condition for the sake of theory.” Which they did.

As Grantham wrote in the foreword: “My own favorite illustration of their views was Bernanke's comment in late 2006 at the height of a 3-sigma (100-year) event in a US housing market that had no prior housing bubbles: 'The US housing market merely reflects a strong US economy.” He was surrounded by statisticians and yet could not see the data… His profound faith in market efficiency, and therefore a world where bubbles could not exist, made it impossible for him to see what was in front of his own eyes.”

Reinhart and Rogoff show time and time again that bubbles always end in tears. Markets and investors are in fact irrational. What kind of Fed governor would it have taken to suggest that housing was in a bubble and we were going to have to take steps to slow it down – raising rates, analyzing securitization and ratings? It would have taken one tough hombre. In fact, we had Greenspan, who encouraged the unchecked expansion of the securitized derivatives market. And a Congress that would not allow proper supervision of Fannie and Freddie (which is going to cost US taxpayers on the order of $400 billion). The list is long.

And Speaking of Bubbles

This week the turmoil that is Greece continues. One of my favorite quotes comes from Donald Morris, writing in June of 1993 (hat tip to Dennis Gartman):

“If all of the Greek islands were merged with the mainland, it would be about the size of Alabama; there are 10 million Greeks – and perhaps another 4 million living throughout the world, who still think of themselves as Greek. They are, thanks to their history, magnificent patriots and nationalists – and abominable citizens, who deeply mistrust every government they've ever had. Essentially they are fierce individualists, who mistrust not so much whatever government happens to be in power as the very idea of government. The have almost no sense of civic responsibility – Pericles complained about this at length – and History has never given them much of a chance to work out a stable system of government. Democracy, yes (the Greeks invented it!!), but stability, no.”

Have things changed? From here it does not seem so. Greece apparently hid about 40 billion euros of debt from the public and EU governing bodies. (If the government can hide that much, is it any wonder that individual Greeks themselves can hide their income and pay so little in actual taxes? They have made it an art form!) In response to just the initial phase of belt tightening, unions are launching strikes and protests. What will happen when it gets serious? Stratfor estimates that Greek deficits may actually run as high as 15% of GDP rather than “just” the 10% or so publicly revealed. That will require far more than a little belt tightening.

Let's look at the record. Greece has been in default for 105 years out of the last 200. They have never had a balanced budget, at least not willingly.

The EU is backed into a corner. They have this treaty that says governments will act in certain ways. Greece is flaunting that treaty. Everyone acts as if Greece defaulting on its debt would be the end of the EU. Will the EU force Greece to withdraw if they do not control their budget? Upon reflection, I am not so sure.

Let's take that proposition to the US. What if Illinois defaulted on its debt? Would we kick them out of the Union? Hardly. A default would mean a severe loss of credit, a forced retrenching, and a severe economic crisis in Illinois. The losses would be serious for banks and investors. There would be negotiations on how to deal with the debt, who gets a haircut on their bonds, what pension assets and expenses would be cut, and so on. A crisis? Yes. End of the world? No.

So what if Greece does default? The banks and those who lent them the money would take a loss of some amount. The cost of borrowing for Greece would rise dramatically, if they could even get into the debt market. If they actually cut their budgets enough to deal with the deficit in a responsible way, it would mean, at best, a severe and prolonged recession. If Stratfor is right about deficits reaching 15% of GDP, it could mean a depression. They have no good choices.

It is doubtful that German and French voters will be happy with any bailout using their tax money that does not impose serious cuts in Greek budgets, with realistic controls as a condition for the bailout. Can Greece live with that? We'll see.

(I am sure I have hundreds of Greek readers. I would love to hear from you as to your views, from the inside.)

But is it so unthinkable that Greece could simply default and then be forced by the market to get realistic about its deficits? The same market forces that work in Illinois can work in Greece.

But if the EU does bail out Greece, what then of Ireland, which is making the tough choices? Will Portugal be next? If Greece is allowed to fail, or better, actually shows some fiscal discipline, that bodes well for the EU in the long run. It will be a lesson that each nation is responsible to maintain its own house.

The data presented by Reinhart and Rogoff show clearly that adding yet more suffocating debt to a bloated debt crisis is not the solution. It simply puts off the inevitable. Greece is an intractable problem. From here it looks like default or a very serious recession, with large unemployment numbers.

But in the meantime the Greek situation is adding volatility to risk markets of all types. I have written before of the connection between what is called the euro-yen cross and risk markets all over the world. Right now, you can borrow money very cheaply in dollars and yen (the so-called carry trade). When investors want to reduce risk, they pay back those loans, which has the result of increasing the value of the dollar and the yen.

That is what is happening with the euro-yen cross as of this morning. It is in the process of falling out of bed. And so are risk markets. Markets do not like uncertainty. And Greece and Portugal and Spain are uncertainty in spades. If Greece defaults, who owns the debt? Which banks? My bank? Will they call my loan? This happened in 2008 a lot! Can it happen again? We still have banks all over the world that are too big too fail. Credit default swaps are not on an exchange (because to do that would make them less profitable for the investment banks that sell them, and thus the lobbyists have convinced Congress to ignore them).

Are we at the place where we can think the unthinkable? That sovereign nations can in fact default? I think we see a de facto default by Japan this decade.

Do not assume that we have weathered the storm. We may just be getting ready for the next one.

Help in Europe, California, and Tampa, and Becoming our Parents

Tiffani wanted me to ask some of you for help with our vacation. I am taking all seven kids, four spouses, and three grandkids to France and then to Italy in June. We could use some suggestions, especially for how to accommodate 14 people. We will spend most of the time in Italy, after stopping at Bill Bonner's French chateau for a few days. I am checking out the International Living website for ideas. I really enjoy each issue, as I dream about having a retreat in some less hectic locale. You should check it out if you have that dream as well. It is inexpensive inspiration.

Tomorrow Tiffani, Ryan, and I head for a last-minute important meeting in LA. This will be interesting, as we are taking 2-month-old granddaughter Lively and the nanny as well. “Dad, I am just not prepared to leave my baby yet. I have to have more notice to get used to the idea.” The bonus is that I get to have dinner with Rob and Marina Arnott on Sunday before we head back Monday morning.

And then next week is the NBA All-Star Game, which most of my kids will be attending with me. What a fun day!

And the following weekend I am off to meet with Jeff Saut, the chief investment officer of Raymond James. But we may slip in a little fun on his boat in the bay in Tampa. It's going to be a good, good month.

It seems that more than a few times lately that Tiffani has turned to me and said, “Dad, don't you remember telling me that just a few days ago?” It is almost a running joke. Then as I was drifting off the other night, I remembered telling my Dad the same thing – only when he was a lot older than I am now! I am becoming my Dad. Sigh. And I would give a great deal to still be able to chide him on his failing memory.

Have a great week!

Your going to eat Greek food this weekend (but no ouzo) analyst,

John Mauldin

http://feedproxy.google.com/~r/Thoug…-of-a-pin.aspx

02.04.10 10:54 AM

Sometimes when I read a newspaper article, it strikes me as a “He said, she said” game. If I'm going to make an informed decision, I need analysis – not opinions from two sides, each with their own motive. You can find quotes from “experts” anywhere, but they usually don't offer much insight, except into the agenda of the person quoted. For deeper insight, I turn to my friend George Friedman at STRATFOR. STRATFOR publishes intelligence, not news. No journalists, no politicians – just analysts.

I'm sending you a peek at the type of intelligence they provide for decision-makers like you and me. Enjoy the read, notice the difference and visit their site to sign up to get your own free articles.

John Mauldin, Editor
Outside the Box

A Defensive Buildup in the Gulf

By George Friedman

This weekend's newspapers were filled with stories about how the United States is providing ballistic missile defense (BMD) to four countries on the Arabian Peninsula. The New York Times carried a front-page story on the United States providing anti-missile defenses to Kuwait, the United Arab Emirates, Qatar and Oman, as well as stationing BMD-capable, Aegis-equipped warships in the Persian Gulf. Meanwhile, the front page of The Washington Post carried a story saying that “the Obama administration is quietly working with Saudi Arabia and other Persian Gulf allies to speed up arms sales and rapidly upgrade defenses for oil terminals and other key infrastructure in a bid to thwart future attacks by Iran, according to former and current U.S. and Middle Eastern government officials.”

Obviously, the work is no longer “quiet.” In fact, Washington has been publicly engaged in upgrading defensive systems in the area for some time. Central Command head Gen. David Petraeus recently said the four countries named by the Times were receiving BMD-capable Patriot Advanced Capability-3 (PAC-3) batteries, and at the end of October the United States carried out its largest-ever military exercises with Israel, known as Juniper Cobra.

More interesting than the stories themselves was the Obama administration's decision to launch a major public relations campaign this weekend regarding these moves. And the most intriguing question out of all this is why the administration decided to call everyone's attention to these defensive measures while not mentioning any offensive options.

The Iranian Nuclear Question

U.S. President Barack Obama spent little time on foreign policy in his Jan. 27 State of the Union message, though he did make a short, sharp reference to Iran. He promised a strong response to Tehran if it continued its present course; though this could have been pro forma, it seemed quite pointed. Early in his administration, Obama had said he would give the Iranians until the end of 2009 to change their policy on nuclear weapons development. But the end of 2009 came, and the Iranians continued their policy.

All along, Obama has focused on diplomacy on the Iran question. To be more precise, he has focused on bringing together a coalition prepared to impose “crippling sanctions” on the Iranians. The most crippling sanction would be stopping Iran's gasoline imports, as Tehran imports about 35 percent of its gasoline. Such sanctions are now unlikely, as China has made clear that it is not prepared to participate — and that was before the most recent round of U.S. weapon sales to Taiwan. Similarly, while the Russians have indicated that their participation in sanctions is not completely out of the question, they also have made clear that time for sanctions is not near. We suspect that the Russian time frame for sanctions will keep getting pushed back.

Therefore, the diplomatic option appears to have dissolved. The Israelis have said they regard February as the decisive month for sanctions, which they have indicated is based on an agreement with the United States. While previous deadlines of various sorts regarding Iran have come and gone, there is really no room after February. If no progress is made on sanctions and no action follows, then the decision has been made by default that a nuclear-armed Iran is acceptable.

The Americans and the Israelis have somewhat different views of this based on different geopolitical realities. The Americans have seen a number of apparently extreme and dangerous countries develop nuclear weapons. The most important example was Maoist China. Mao Zedong had argued that a nuclear war was not particularly dangerous to China, as it could lose several hundred million people and still win the war. But once China developed nuclear weapons, the wild talk subsided and China behaved quite cautiously. From this experience, the United States developed a two-stage strategy.

First, the United States believed that while the spread of nuclear weapons is a danger, countries tend to be circumspect after acquiring nuclear weapons. Therefore, overreaction by United States to the acquisition of nuclear weapons by other countries is unnecessary and unwise.

Second, since the United States is a big country with widely dispersed population and a massive nuclear arsenal, a reckless country that launched some weapons at the United States would do minimal harm to the United States while the other country would face annihilation. And the United States has emphasized BMD to further mitigate — if not eliminate — the threat of such a limited strike to the United States.

Israel's geography forces it to see things differently. Iranian President Mahmoud Ahmadinejad has said Israel should be wiped off the face of the Earth while simultaneously working to attain nuclear weapons. While the Americans take comfort in the view that the acquisition of nuclear weapons has a sobering effect on a new nuclear power, the Israelis don't think the Chinese case necessarily can be generalized. Moreover, the United States is outside the range of the Iranians' current ballistic missile arsenal while Israel is not. And a nuclear strike would have a particularly devastating effect on Israel. Unlike the United States, Israel is small country with a highly concentrated population. A strike with just one or two weapons could destroy Israel.

Therefore, Israel has a very different threshold for risk as far as Iran is concerned. For Israel, a nuclear strike from Iran is improbable, but would be catastrophic if it happened. For the United States, the risk of an Iranian strike is far more remote, and would be painful but not catastrophic if it happened. The two countries thus approach the situation very differently.

How close the Iranians are to having a deliverable nuclear weapon is, of course, a significant consideration in all this. Iran has not yet achieved a testable nuclear device. Logic tells us they are quite far from a deliverable nuclear weapon. But the ability to trust logic varies as the risk grows. The United States (and this is true for both the Bush and Obama administrations) has been much more willing to play for time than Israel can afford to be. For Israel, all intelligence must be read in the context of worst-case scenarios.

Diverging Interests and Grand Strategy

It is also important to remember that Israel is much less dependent on the United States than it was in 1973. Though U.S. aid to Israel continues, it is now a much smaller percentage of Israeli gross domestic product. Moreover, the threat of sudden conventional attack by Israel's immediate neighbors has disappeared. Egypt is at peace with Israel, and in any case, its military is too weak to mount an attack. Jordan is effectively an Israeli ally. Only Syria is hostile, but it presents no conventional military threat. Israel previously has relied on guarantees that the United States would rush aid to Israel in the event of war. But it has been a generation since this has been a major consideration for Israel. In the minds of many, the Israeli-U.S. relationship is stuck in the past. Israel is not critical to American interests the way it was during the Cold War. And Israel does not need the United States the way it did during the Cold War. While there is intelligence cooperation in the struggle against jihadists, even here American and Israeli interests diverge.

And this means that the United States no longer has Israeli national security as an overriding consideration — and that the United States cannot compel Israel to pursue policies Israel regards as dangerous.

Given all of this, the Obama administration's decision to launch a public relations campaign on defensive measures just before February makes perfect sense. If Iran develops a nuclear capability, a defensive capability might shift Iran's calculus of the risks and rewards of the military option.

Assume, for example, that the Iranians decided to launch a nuclear missile at Israel or Iran's Arab neighbors with which its relations are not the best. Iran would have only a handful of missiles, and perhaps just one. Launching that one missile only to have it shot down would represent the worst-case scenario for Iran. Tehran would have lost a valuable military asset, it would not have achieved its goal and it would have invited a devastating counterstrike. Anything the United States can do to increase the likelihood of an Iranian failure therefore decreases the likelihood that Iran would strike until they have more delivery systems and more fissile material for manufacturing more weapons.

The U.S. announcement of the defensive measures therefore has three audiences: Iran, Israel and the American public. Israel and Iran obviously know all about American efforts, meaning the key audience is the American public. The administration is trying to deflect American concerns about Iran generated both by reality and Israel by showing that effective steps are being taken.

There are two key weapon systems being deployed, the PAC-3 and the Aegis/Standard Missile-3 (SM-3). The original Patriot, primarily an anti-aircraft system, had a poor record — especially as a BMD system — during the first Gulf War. But that was almost 20 years ago. The new system is regarded as much more effective as a terminal-phase BMD system, such as the medium-range ballistic missiles (MRBMs) developed by Iran, and performed much more impressively in this role during the opening of Operation Iraqi Freedom in March 2003. In addition, Juniper Cobra served to further integrate a series of American and Israeli BMD interceptors and sensors, building a more redundant and layered system. This operation also included the SM-3, which is deployed aboard specially modified Aegis-equipped guided missile cruisers and destroyers. The SM-3 is one of the most successful BMD technologies currently in the field and successfully brought down a wayward U.S. spy satellite in 2008.

Nevertheless, a series of Iranian Shahab-3s is a different threat than a few Iraqi Scuds, and the PAC-3 and SM-3 have yet to be proven in combat against such MRBMs — something the Israelis are no doubt aware of. War planners must calculate the incalculable; that is what makes good generals pessimists.

The Obama administration does not want to mount an offensive action against Iran. Such an operation would not be a single strike like the 1981 Osirak attack in Iraq. Iran has multiple nuclear sites buried deep and surrounded by air defenses. And assessing the effectiveness of airstrikes would be a nightmare. Many days of combat at a minimum probably would be required, and like the effectiveness of defensive weapons systems, the quality of intelligence about which locations to hit cannot be known until after the battle.

A defensive posture therefore makes perfect sense for the United States. Washington can simply defend its allies, letting them absorb the risk and then the first strike before the United States counterstrikes rather than rely on its intelligence and offensive forces in a pre-emptive strike. This defensive posture on Iran fits American grand strategy, which is always to shift such risk to partners in exchange for technology and long-term guarantees.

The Arabian states can live with this, albeit nervously, since they are not the likely targets. But Israel finds its assigned role in U.S. grand strategy far more difficult to stomach. In the unlikely event that Iran actually does develop a weapon and does strike, Israel is the likely target. If the defensive measures do not convince Iran to abandon its program and if the Patriots allow a missile to leak through, Israel has a national catastrophe. It faces an unlikely event with unacceptable consequences.

Israel's Options

It has options, although a long-range conventional airstrike against Iran is really not one of them. Carrying out a multiday or even multiweek air campaign with Israel's available force is too likely to be insufficient and too likely to fail. Israel's most effective option for taking out Iran's nuclear activities is itself nuclear. Israel could strike Iran from submarines if it genuinely intended to stop Iran's program.

The problem with this is that much of the Iranian nuclear program is sited near large cities, including Tehran. Depending on the nuclear weapons used and their precision, any Israeli strikes could thus turn into city-killers. Israel is not able to live in a region where nuclear weapons are used in counterpopulation strikes (regardless of the actual intent behind launching). Mounting such a strike could unravel the careful balance of power Israel has created and threaten relationships it needs. And while Israel may not be as dependent on the United States as it once was, it does not want the United States completely distancing itself from Israel, as Washington doubtless would after an Israeli nuclear strike.

The Israelis want Iran's nuclear program destroyed, but they do not want to be the ones to try to do it. Only the United States has the force needed to carry out the strike conventionally. But like the Bush administration, the Obama administration is not confident in its ability to remove the Iranian program surgically. Washington is concerned that any air campaign would have an indeterminate outcome and would require extremely difficult ground operations to determine the strikes' success or failure. Perhaps even more complicated is the U.S. ability to manage the consequences, such as a potential attempt by Iran to close the Strait of Hormuz and Iranian meddling in already extremely delicate situations in Iraq and Afghanistan. As Iran does not threaten the United States, the United States therefore is in no hurry to initiate combat. And so the United States has launched a public relations campaign about defensive measures, hoping to affect Iranian calculations while remaining content to let the game play itself out.

Israel's option is to respond to the United States with its intent to go nuclear, something Washington does not want in a region where U.S. troops are fighting in countries on either side of Iran. Israel might calculate that its announcement would force the United States to pre-empt an Israeli nuclear strike with conventional strikes. But the American response to Israel cannot be predicted. It is therefore dangerous for a small regional power to try to corner a global power.

With the adoption of a defensive posture, we have now seen the U.S. response to the February deadline. This response closes off no U.S. options (the United States can always shift its strategy when intelligence indicates), it increases the Arabian Peninsula's dependence on the United States, and it possibly causes Iran to recalculate its position. Israel, meanwhile, finds itself in a box, because the United States calculates that Israel will not chance a conventional strike and fears a nuclear strike on Iran as much as the United States does.

In the end, Obama has followed the Bush strategy on Iran — make vague threats, try to build a coalition, hold Israel off with vague promises, protect the Arabian Peninsula, and wait — to the letter. But along with this announcement, we would expect to begin to see a series of articles on the offensive deployment of U.S. forces, as good defensive posture requires a strong offensive option.

http://feedproxy.google.com/~r/John_…-the-gulf.aspx

Senate Budget Committee slows down speed-camera idea
Gov. Arnold Schwarzenegger’s plan to install cameras that automatically ticket speeding drivers hit a roadblock Wednesday. Several members of the Senate budget committee expressed serious concerns about the idea despite a positive recommendation from the nonpartisan Legislative Analyst’s Office. Under Schwarzenegger’s plan, cities and counties would install automatic speed cameras at intersections, generally where red-light cameras are already in place. Violations would result in total fines of $225 for driving up to 15 mph over the limit and $325 for driving faster than 15 mph over it. Sacramento Bee

Los Angeles Police Foundation announces a three-year $300,000 grant
OneWest Foundation has made a three-year commitment of $100,000 annually to the Juvenile Impact Program (JIP) in the LAPD’s Central and 77th Areas. JIP is a police program that works with at-risk youth between the ages of 9 and 15, immersing them in a boot camp style program that helps them resist gangs while improving their school attendance and performance, their relationships with their families and their self-respect. A unique feature of the program is that the parents must also participate in parenting classes. Press Release

LAPPL newsletter

Gooey Caramel-Chocolate Bars

Who doesn’t love gooey chocolate and caramel all wrapped up in a quick-to-make bar cookie.

Prep Time: 25 min
Total Time: 3 hours 0 min
Makes: 48 bars

Crust1box Betty Crocker® SuperMoist® chocolate fudge cake mix
1/2cup butter or margarine, softened3eggs1cup semisweet chocolate chipsFilling1bag (14 oz) caramels, unwrapped1/4cup butter or margarine1can (14 oz) sweetened condensed milk (not evaporated)
Topping

1/2cup reserved cake mix

1/2cup quick-cooking oats

3tablespoons butter or margarine, softened

1. Heat oven to 350°F (or 325°F for dark or nonstick pan). Reserve 1/2 cup cake mix for topping. In large bowl, beat remaining cake mix, 1/2 cup butter and the eggs with electric mixer on medium speed until dough forms. Stir in chocolate chips. Spread in ungreased 13×9-inch pan. Bake 14 to 18 minutes or until set.

2. Meanwhile, in 2-quart saucepan, heat caramels, 1/4 cup butter and the milk over medium heat about 8 minutes, stirring frequently, until caramels are melted and mixture is smooth.

3. Spread caramel filling evenly over partially baked crust. In small bowl, mix reserved 1/2 cup cake mix, the oats and 3 tablespoons butter with fork until crumbly. Sprinkle over caramel filling.

4. Bake 18 to 22 minutes longer or until top is set. Cool completely, about 2 hours. Run knife around sides of pan to loosen bars. For bars, cut into 8 rows by 6 rows.High Altitude (3500-6500 ft): In step 1, bake 16 to 20 minutes.

Kitchen Tips

Get your kids involved in making these bars by letting them unwrap the caramels. Just make sure the caramels don’t disappear!Be sure to purchase sweetened condensed milk, not evaporated milk. They are used very differently in recipes.

Nutrition Information:
1 Bar: Calories 160 (Calories from Fat 60); Total Fat 7g (Saturated Fat 4g, Trans Fat 0g); Cholesterol 25mg; Sodium 150mg; Total Carbohydrate 22g (Dietary Fiber 0g, Sugars 15g); Protein 2g Percent Daily Value*: Vitamin A 4%; Vitamin C 0%; Calcium 4%; Iron 4% Exchanges: 1/2 Starch; 1 Other Carbohydrate; 0 Vegetable; 1 1/2 Fat Carbohydrate Choices: 1 1/2
*Percent Daily Values are based on a 2,000 calorie diet.

SONGWRITER’S SEMINAR with

Steve Dorff
9 #1 Film Songs
15 Top Ten Hits
40 BMI Awards
6 Emmy Award Nominations
2 Grammy Award Nominations
People’s Choice Award
CMA Award
NSAI Songwriter of the Year
Songwriter of the Year Award POPULAR DEMAND!!!

Through the Years (Kenny Rogers)
Miracle (Celine Dion)
Higher Ground (Barbars Strisand)
I Just Fall In Love Again(Ann Murray) and many more!
Songwriter of the Year Award POPULAR DEMAND!!!

Composer, Hit Song Writer (George Strait "Cross My Heart", Celine Dion "Miracle", Barbara Strisand "Higher Ground" and more), Music Publisher, Record Producer and Arranger
Music Director, Current TV Hit “The SingingBee

BACK BY POPULAR DEMAND!!!

With Hit Songwriter, Bobby Tomberlin and other friends. Spend a delightful afternoon and learn how to navigate the multi-faceted music business, with “inside” stories and humorous experiences, a question and answer period and live performances of some of his many hits. Get the latest scoop on his projects currently making their way to Broadway- “Pure Country” and “Josephine”, the Josephine Baker Story,

Saturday February 27 at 4:00 PM
Admission: $40 Donation includes intermission refreshments
For Reservations : (818) 998 0185
Avenue Act 1 – Homepage
Big Oak Theatre address: 22200 Chatsworth St., Chatsworth, Ca. 91311
Reservations: [email protected] or (818) 998 0185

China still trying to poison our kids

Want to protect your children? Don’t just keep them off the meds — keep the little tykes far, far away from anything with "Made in China" on the label.

I know — that’s pretty much everything. But the lead-toy scandal is about to have a sequel as the Chinese junk peddlers turn to a different heavy metal for their shoddy children’s jewelry items.

An Associated Press investigation finds that some toy jewelry is loaded with cadmium, a heavy metal that — like lead — has been linked to brain development problems. It’s also known to cause cancer.

Some of these charms are so packed with cadmium that they may as well be carved out of it. One set of charms sold in Wal-Mart stores contained between 84 and 86 percent cadmium. Other items tested were up to 91 percent cadmium.

In all, 12 of the 103 items tested by the AP contained at least 10 percent cadmium, including products with popular characters on them like a Disney princess and Rudolph the Red-Nosed Reindeer.

But the biggest outrage isn’t the fact that the Chinese are loading up boats with this junk and aiming them at our kids…it’s that this known toxin is a perfectly legal ingredient in children’s jewelry.

They could use 100 percent cadmium…and break no laws.

Thank your local congressmen — when they passed "tough" new laws after the lead scandal, they left a loophole big enough to sail a barge full of tainted toys through. The law restricts cadmium in painted toys…but it’s completely silent on children’s jewelry.

And the Chinese are taking full advantage of that.

Send ’em a message: Stop buying this garbage. From toys to food to drywall, keep Chinese-made junk out of your home.

Stores are already pulling some of these products from their shelves, but without standards and tests it’s impossible to tell which ones are safe and which ones aren’t.

And if they do pass new laws…rest assured, comrades: The Chinese junk lords will find some other cheap toxin to use instead.

Pointing out the bull in this China shop,

William Campbell Douglass II, M.D.

Toddlers given dangerous mood meds

What ever happened to keeping drugs AWAY from kids?

Now, pediatric pushers are shoving dangerous antipsychotic meds at an alarming rate on small children — even toddlers — for bogus diagnoses like attention deficit hyperactivity disorder and disruptive behavior disorder.

You can see this outrage for yourself in the pages of the Journal of the American Academy of Child & Adolescent Psychiatry. The chilling details: between 1999 and 2001, around one in 650 5-year-olds in the United States were being given these meds.

That’s way too much already. But that’s nothing — because by 2007, that number had doubled to one in 329.

And these powerful brain drugs — meds used to treat schizophrenia and bipolar disorder in adults — are also on the rise in toddlers between the ages of 2 and 4.

Some of these kids are autistic, and some docs — mistakenly — think these powerful meds can help with irritability in autistic kids. But too many other kids are already being saddled with that made-up ADHD label before they can even speak in sentences.

This should be criminal behavior — instead, it’s called "off-label."

These meds aren’t approved for little kids in most cases — but docs are free to prescribe them whenever they want, for whatever they want. Makes it sounds like the docs are making decisions, but don’t kid yourself — if they’re prescribing antipsychotics to kids, it’s because they got the idea from their friendly Big Pharma sales rep.

They certainly can’t be doing it based on the evidence — because there isn’t any. We don’t even know all the side effects of these drugs on kids that little — and I hope we never do, because a clinical trial of antipsychotic drugs on two-year-olds is quite possibly the most immoral drug experiment I can think of.

I don’t care how moody, frustrating or energetic your 2- year-old is. They call it the "terrible twos" for a reason — they can be hard to take. They fuss, fidget and don’t pay attention — and guess what? They’re designed that way.

The answer isn’t a drug — it’s better parenting.

That’s not the only threat to our kids…keep reading for the latest garbage being shipped here from China.

William Campbell Douglass II, M.D.

Grim Reaper ends cancer drug study

If you think approved drugs are bad, you should see the junk that never makes it to the pharmacy.

In the latest outrage, Pfizer was forced to cut short a clinical trial on a lung cancer drug called figitumumab. Officially, it’s because they decided the med wouldn’t improve survival among lung cancer patients.

Unofficially, it’s because the test patients were dropping like flies.

Seems like a good reason to ditch this experimental drug and start from square one. But not Pfizer! Despite the disastrous results of the lung cancer trial, Pfizer is continuing to test this drug on patients with breast and prostate cancer.

I wonder if their blatant disregard for the lives of their test subjects has anything to do with this little tidbit I read in The Wall Street Journal: Analysts estimate that if the drug is approved, it could bring in $1 billion in sales by 2015.

Pfizer has one billion reasons to press on with their dangerous experiments — so who cares if a handful of people die in the process?

I can’t help but wonder why people are willing to be Big Pharma’s guinea pigs in the first place. I imagine it’s because they think they’ve run out of options — especially if they’ve been diagnosed with cancer. But if that’s the case, then they’ve bought into the lie.

No matter what mainstream medicine tells you, there are real alternatives out there that don’t involve subjecting yourself to chemotherapy or experimental drugs.

If you’re worried about cancer, do yourself a favor and take a look at my special report, "Deadly Cancer Myths – and the Truth That Will Save Your Life."

You’ll be stunned at what the mainstream is keeping from you.

Busting mainstream myths,

William Campbell Douglass II, M.D.

Airports to begin strip-searching passengers

You might want to take a minute to say goodbye to your personal liberties. They’re flying right out the window — and, as usual, it’s all in the name of "protecting the public."

You knew this was coming…After the failed terror attempt on Christmas day, the federal Transportation Security Agency (TSA) has decided to step up its security screenings. Their solution? Strip-search every passenger. It’s not by hand, mind you, but it may as well be.

The TSA plans to begin using full-body X-ray scanners that would essentially strip passengers of their clothing — and their dignity. With these new scanners, no details would be left to the imagination — which is just how the feds like it.

Yup, Big Brother is a big perv.

But I’m not sure which is worse: The threat to your privacy or the threat to your health.

Like X-rays, the new machines use radiation to create these indecent exposures. The experts claim that the low dose of radiation is perfectly safe — even for children and pregnant women.

Baloney.

Exposing pregnant women to radiation can lead to grossly disfigured babies or can even cause women to miscarry. It’s no coincidence that five female security guards had miscarriages after working with these supposedly safe machines.

And it’s not much safer for adults. Radiation can damage DNA and cause structural damage to your cells — both of which can lead to cancer. In fact, Dr. John Gofman, Professor Emeritus of Molecular and Cell Biology at the University of California, Berkeley, believes that 50 percent of all cancers are caused by the radiation from medical tests — the same ones meant to "protect" you by detecting cancer early!

Bottom line: If you don’t want to be fried with ionizing radiation every time you fly — and if you’d rather not have airport workers paid to be peeping toms…you won’t stand for this outright invasion of your rights.

When it comes to these full-body X-rays, I don’t care how low the dose is. There is no safe level of ionizing radiation. Period.

William Campbell Douglass II, M.D.

02.02.10 07:45 AM

I wrote about Greece in last week's letter. Then I ran across this column in the Financial Times by my friend Mohammed El-Erian, chief executive of Pimco, and someone who qualifies to be introduced as one of the smartest men on the planet. It is short and to the point. (www.pimco.com)

Then, somehow my London partner, Niels Jensen of Absolute Return Partners found the time to write a letter while we were running around Europe. As we had a lot of conversations with some very key players, and a lot of debate, the letter reflects a lot of what we learned, as well as further documents the serious straits that European nations face in the coming years due to their debt and deficits. It is not just a US or Japanese problem. I have worked closely with Niels for years and have found him to be one of the more savvy observers of the markets I know. You can see more of his work at www.arpllp.com and contact them at [email protected].

And finally, many of you are probably familiar with TED Talks. If you are not, you should be. They basically get very smart, creative people to come in and do short talks Tiffani just sent me one of their latest videos. 13 minutes. It blew me away. The world of Minority Report is here, 40 years ahead of schedule. All I could do was just say “Wow!” Its young men like this that should make us all optimists that somehow we will figure out how to get through all this. http://www.ted.com/talks/view/id/685

John Mauldin, Editor
Outside the Box

Greece part of unfolding sovereign debt story

By Mohamed El-Erian

Global investors worldwide are starting to pay more attention to what is unfolding in Greece. Yet most still think of Greece as an isolated case, just as they did for Dubai a few months ago.

With time, they will see Greece as part of a much larger investment theme that is a direct outcome of the global financial crisis: the 2008-09 ballooning of sovereign balance sheets in advanced economies is consequential and is becoming an important influence on valuations in many markets around the world.

As realisation spreads of this key sovereign investment theme, it is important to be clear about what Greece is, and what it is not.

At the simplest level, think of Greece as Europe's big game of chicken, with the operational question for markets being two-fold: who will blink first, the Greek authorities, donors or both; and will they blink in time to avoid truly disorderly debt and market dynamics that also entail significant contagion risk.

Let us start with Greece where, under any realistic scenario, a meaningful internal adjustment is needed.

There is no solution to the country's debt issues without a deep and sustained policy effort. Yet, given the initial conditions (including the size and maturity profile of its debt) and the existing policy framework (anchored on adherence to a fixed exchange rate via the euro), such adjustment is difficult and not sufficient.

If unaccompanied by extraordinary external assistance, it would entail such contractionary fiscal measures as to raise legitimate socio-political problems.

External assistance is needed to support the meaningful implementation of internal policies. And it has to be consequential in scale and durability, as well as timely and well-targeted.

Understandably, such assistance faces headwinds on account of donors' moral hazard concerns (vis-à-vis Greece and beyond); of donors' understanding that a Greek bail-out would not be a one-shot deal; and of donors' own domestic budgetary considerations.

Because of this, I suspect that at least three of the following four conditions are needed to force the hand of European donors, and that is assuming that Greece provides them at least with the fig leaf of commitment to meaningful internal policy actions.

• First, evidence that Greek markets are being severely impacted by funding concerns. With the recent surge in borrowing costs and the disruptions in the normal functioning of government and corporate markets, this condition is clearly already met.
• Second, evidence that other peripherals in Europe – such as Ireland, Italy, Portugal and Spain – are also being impacted. This is happening, as signalled by the gradual widening in market risk spreads.
• Third, evidence that other providers of capital are sharing the burden of financing Greece. Tuesday's €8bn bond issuance to private creditors is consistent with this.
• Fourth, evidence that the Greek financial disruptions are starting to undermine core European countries. Evidence here is limited to the weakening of the euro, which, as yet, cannot be viewed as disruptive (indeed, some view it as helpful for Europe).

Notwithstanding this last condition, we are much closer today to the point where donors' hands will be forced. Yet investors should remain wary, as this would offer, at best, only a short-term tactical opportunity. Greater clarity as to what Greece can deliver in internal adjustment should remain the primary driver for long-term investment opportunities.

Investors should also remember that “market technicals” remain tricky and now constitute a meaningful marginal price setter. The shift in the investment characterisation of Greece, from being primarily an interest rate exposure to a credit exposure, has happened in such a way as to allow for little orderly repositioning. Many investors are trapped and the phenomenon has been accentuated by the recent evaporation of market liquidity.

Where does all this leave us?

Over the next few days, we are likely to get some combination of Greek and European donor announcements aimed at calming markets, reducing volatility, and reducing contagion risk. But the impact on markets is unlikely to be sustained as both sides face multi-round, protracted challenges which contain all the elements of complex game dynamics.

No matter how you view it, markets in Greece will remain volatile and more global investors will be paying attention. In the process, this will accelerate the more general recognition that sovereign balance sheets in many advanced economies are now in play when it comes to broad portfolio positioning considerations.

And now to Niels Jensen's piece.

If PIIGS Could Fly

By Niels Jensen

The Absolute Return Letter – February 2010

“A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy…”

Alexander Fraser Tytler, Scottish lawyer and writer, 1770

Travelling with John Mauldin

It was always naïve to believe that a crisis so deep and profound was going to go away with a whimper; however, an increase of more than 50% in global equity prices can be very seductive, and nine months of virtually uninterrupted gains have led many to believe that the problems of 2008-09 are now largely behind us.

Well, not quite everybody. Friend and business partner John Mauldin remains a sceptic. I have had the pleasure of travelling across Europe with John over the past week or so and, as the week progressed, my mood swung decisively towards a state where Prozac would probably be the most appropriate remedy.

Now, John and I do not agree on absolutely everything. For example, I believe – and have believed for a while – that he is too bearish on equities. But, before we go there, allow me to share with you the essence of John's views which can be summed up quite nicely by two charts, courtesy of BCA Research.

In John's opinion – and I do not disagree – we are still only in the second or third innings of the de-leveraging process (chart 1). Years of excessive debt accumulation cannot be reversed in 18 months, and it will take at least another 5-6 years to play out, possibly longer.

The other part of John's argument – and again it is hard to disagree – is that it remains an open question how much de-leveraging has in fact taken place. As you can see from chart 2, US sovereign debt has risen as fast as private debt has declined (and the picture is similar in many other countries), providing support for the argument that all we have achieved so far is to move liabilities from private to public balance sheets, effectively burdening tomorrow's taxpayer.

The basket case named Greece

In the last few days, developments in Greece have totally overshadowed other events. As I write these lines, the 10-year Greek government bond trades a shade under 7%, now yielding a whopping 370 basis points more than the corresponding Bunds. At the same time, and not at all surprisingly, Greek credit default swaps – measuring the cost of insurance against a Greek sovereign default – have exploded (chart 3).

When I was in Zurich with John last week, I bumped into the famous Swiss investor, Felix Zulauf, who pointed out to me that Greece has in fact been in default in 105 of the last 200 years, so never say never. Having said that, Greece cannot be allowed to default, as the implications would be catastrophic. Bond investors would immediately pick apart the next country in line, and it is almost certainly going to be one of the other PIIGS – Portugal, Italy, Ireland or Spain. Bailing out Greece is just about manageable, but having to save all of them would overwhelm the EU. Swift action must therefore be taken, moral hazard or not.

Back in early January, the research team at Danske Bank in Copenhagen produced a most interesting research paper[1], revealing how desperate the fiscal outlook is for many EU members. Table 1 illustrates the path of debt-to-GDP between now and 2020, assuming no change to current policy.

Now, we all know what cannot happen, will not happen. There is a reason the EU, via its stability pact, set the debt-to-GDP ceiling at 60% for its euro zone members. Obviously, with the low interest rates we currently enjoy, one could argue that a higher debt-to-GDP ratio could be sustained, and that is essentially correct as long as interest rates remain low; however, you leave yourself seriously exposed, should rates rise which they almost certainly will as sovereign debt increasingly becomes junk. .

Danske Bank then went one step further in its analysis. In order to illustrate the magnitude of the problem, they calculated how aggressive the fiscal tightening would have to be in order for the euro zone member states to comply with the stability pact by 2020. Table 2 below indicates how much the deficit must be reduced every year for the next five years in order to bring debt-to-GDP to 60% by 2020. Greece, being in the most precarious position, would need to shave 4% off its budget every year. We all know that is not going to happen because that would spell depression.

In the short term, Greece needs to find over €50 billion before the end of the year to refinance debt which is about to mature. The question is not so much whether it will fail in its endeavour but what price it will have to pay. An already fragile Greek fiscal situation could be further undermined, if Greece is forced to pay 7% going forward which it can hardly afford.

Is Spain next?

Towards the end of last week it became apparent that there might be some appetite for rescuing Greece, although few details are currently available. However, I am not convinced that there is a strong consensus in favour of a rescue package. Most of the positive vibes have come from Spain, whereas Germany and France have been decidedly less forthcoming. It is perhaps not surprising that it is the Spanish who seem most eager to bail Greece out, considering that they could very well be the next victim of the bond market's invisible hand.

In the last few days, Spain has gone out of its way to demonstrate its commitment to greater fiscal discipline in general and to the stability pact in particular. The government has just proposed for the retirement age to be increased from 65 to 67 (to be introduced gradually from 2013), and a fiscal programme designed to reduce the annual deficit to 3% of GDP by 2013 has been presented. The problem for Spain is that words are cheap. Few commentators believe that 3% is a realistic target given the depth of Spain's problems at the moment. Don't hold your breath.

The outlook is very grim

The outlook goes from murky to unbelievably grim, if one includes off-balance sheet items such as social security, pension and health liabilities, which have been promised to us over the years by well meaning but financially inept governments (see chart 4). As Societe Generale's Dylan Grice puts it:

“I don't see how our governments can pay these liabilities. EU and US net liabilities add up to around $135 trillion alone. That is four times the capitalization of Datastream's World equity index of about $36 trillion, and forty times the cost of the 2008 financial crisis.”[2].

I also note that Greece, not included in the chart, stands at 875% debt-to-GDP when including off-balance sheet items!

The bond market will ultimately determine when enough is enough. As President Clinton's campaign strategist James Carville once put it:

“I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.”

It can play out in a couple of different ways. Either bond investors will go on strike until they feel that they are being sufficiently rewarded for the higher risk associated with sovereign debt following the credit crunch or governments will implement budget curtailments designed to bring the debt escalation under control again, but that will be detrimental to economic growth. My bet is that the latter outcome will ultimately prevail but not until the bond market forces the hand of our governments.

The end game for Japan?

The first country to really feel the pinch could very well be Japan; in the bigger context, Greece is just the appetizer. Japan's debt-to-GDP ratio has grown from 65% in the early 1990s when their crisis began in earnest to over 200% now. Fortunately for Japan, the high savings rate has allowed shifting governments to finance the deficit internally with about 93% of all JGBs held domestically[3]. This is the key reason why Japan gets away with paying only 1.3% on their 10-year bonds when other large OECD countries must pay 3-4% to attract investors.

Now, predicting the demise of Japan has cost many a career over the years. Despite the ever rising debt, and contrary to many expert opinions, the yen has been rock solid and bond yields have remained comparatively low. I often hear the argument from the bulls that the Japanese situation is sustainable because they, unlike us, are a nation of savers. Wrong. They were a nation of savers.

Looking at chart 5, it is evident that the demographic tsunami has finally hit Japan. The savings rate is in a structural decline and the Ministry of Finance in Tokyo may soon be forced to go to international capital markets to fund their deficits. I very much doubt that non-Japanese investors will be as forgiving as the Japanese, and that could force bond yields in Japan in line with US and German yields. Herein lies the challenge. Japan already spends 35% of its pre-bond issuance revenues on servicing its debt. If the Japanese were forced to fund themselves at 3.5% instead of 1.3%, the game would soon be up.

Why stock markets go up

Despite the grim outlook, the world's stock markets have produced brilliant returns over the past nine months. This has provoked some of the best and brightest in our industry (most recently Mohamed El-Erian, CEO of Pimco[4]) to declare that there is a dis-connect between the economic reality and the picture painted by Wall Street.

I am not convinced. Firstly, global equities reached extremely depressed levels back in February 2009, and the recovery, however muted it may ultimately turn out to be, has stopped the bleeding in most large companies, giving investors an excuse to accumulate stocks again (smaller companies is a different story altogether, but that is a story for another day). What matters to the likes of Coca Cola, Rolls Royce and Volkswagen is not so much how the domestic economy performs, because the leading lights of industry today are becoming increasingly detached from the domestic economy. Ever more important to those companies is the global stage, and the global outlook is considerably more upbeat than, say, the US, UK or German growth prospects.

Secondly, equities usually do very well in the very late stages of recession and early stages of recovery. I refer to our July 2006 Absolute Return Letter for an in-depth analysis of this, which you can find here.

Thirdly, valuations are not prohibitively high. Many bears refer to the stock market (whether European or US) as being very expensive at current levels, but that is plainly untrue. Based on 2010 projected earnings, most OECD markets are either in line with or 10-20% below historical averages (see table 3). Only in emerging markets can you reasonably argue that current P/E levels are not cheap relative to the long term average.

In 2009 there have been massive flows of capital towards emerging markets – and towards Asia in particular – and valuations have been driven up as a result. It is hard to argue that those markets are yet in bubble territory, if one uses the valuations in table 3 as a benchmark; however, by pegging their currencies to the US dollar, Asian countries have effectively adopted a monetary policy which is entirely unsuitable for economies growing as fast as they do. That is how bubbles have been created in the past and why Asian equity markets should be monitored closely for signs of overheating in the months to come.

Conclusion

Summing it all up, the fate of global equity markets is very much in the hands of bond investors. Under normal circumstances, this is the best time to be in equities. But these times are not normal, so do not expect that the outstanding performance of 2009 will be repeated in 2010. If international bond markets calm down again – and that may happen, at least temporarily – equities can probably post further (but modest) gains in 2010; however, the end game is approaching. If bond investors do not revolt in 2010, they probably will in 2011, so playing the economic recovery through equities is a dangerous game.

As far as the bond market is concerned, as often pointed out by Martin Barnes at BCA Research, if you want to know where the next crisis will be, then look at where the leverage is being created today. And nowhere is there more leverage being created at the moment than on sovereign balance sheets. What is happening is an experiment never undertaken before. As John Mauldin puts it, we are operating on the patient without anaesthesia.

The big challenge will be to get the timing right. These situations can run for longer than most people imagine. Japan's crisis has been widely predicted for almost a decade now, and the ship appears to be as steady as ever. As I suggested earlier, the key to predicting the timing of Japan's demise – because there will be one – may very well be embedded in the savings rate, which could quite possibly turn negative in the next few years.

The Dubai crisis taught us that markets are in a forgiving mode at the moment and, before long, Greece could very well find some respite from its current problems. But then again, ultimately, governments will find – just like millions of households have found over the years – that you cannot spend more then you earn in perpetuity. The enormous debt levels being created at the moment will haunt us for many years to come and we may have to wait a long time to see the PIIGS fly again.

Footnotes:

[1] 'Debt on a dangerous path', 4th January, 2010, by Danske Bank. You can find the entire report here.

[2] 'Popular Delusions', Societe Generale, 12th November, 2009

[3] Source: http://econompicdata.blogspot.com/20…p-edition.html

[4] Source: http://www.investmentpostcards.com/2…-slow-economy/

http://feedproxy.google.com/~r/John_…could-fly.aspx

IN THIS ISSUE:

1. 4Q GDP Was Stronger Than Expected
2. The Worst of the Housing Slump is Not Over
3. New Home Sales Continue to Fall Overall
4. Sales of Existing Homes Continue to Plunge
5. Home Foreclosures Continue to Mount
6. When Will Housing Prices Recover?

Introduction

Last week I discussed why many economists and market analysts are downgrading their forecasts for economic growth in 2010. While it seems that the worst of the Great Recession is behind us, there is no consensus regarding when, or if, consumer spending is going to rebound to pre-recession levels.

In the economic world, there is widespread agreement that consumer spending accounts for 65-70% of Gross Domestic Product. As I will point out below, however, consumer spending that normally increases by 2-4% each year actually fell in the last half of 2008 and the first half of 2009.

One of the main reasons that consumer spending has softened is the continuing housing slump. It's a classic “catch 22” in that the more home prices fall, the less people have to spend, and millions of housing related jobs have been lost as well. While some analysts believe we have seen the worst of the housing debacle, most agree that it will take years for home prices to recover to where they were at the peak in late 2007.

In the pages that follow, we will look at some detailed housing numbers to see where we are in the down cycle. But before we go there, let's quickly review last Friday's “advance” GDP report for the 4Q of last year.

4Q GDP Was Stronger Than Expected

The Commerce Department reported on Friday that 4Q GDP rose 5.7% (annual rate), which was above most pre-report estimates. Not surprisingly, the growth in the economy in the 4Q was fueled primarily by inventory rebuilding. This was the first of three reports on 4Q GDP, so it will be revised later this month and again in March. It remains to be seen if the advance GDP report will be revised significantly lower as was the case with the 3Q advance report.

The Commerce Department noted in the report that 4Q growth was primarily the result of positive contributions from private inventory investment, exports, personal consumption expenditures (PCE), and a drop in imports – in that order.

Consumer spending increased 2.0% in the 4Q compared with 2.8% in the 3Q. Government spending in the 4Q increased only 0.1% compared with 8.0% in the 3Q. These numbers confirm that the increase in the 4Q was largely the result of inventory rebuilding which was long overdue. The significant increase in real private inventories added 3.4% to the 4Q change in real GDP compared to only 0.7% in the 3Q.

The price index for gross domestic purchases, which measures prices paid by US residents, increased 2.1% in the 4Q compared with an increase of 1.3% in the 3Q. Excluding food and energy prices, the price index for gross domestic purchases increased 1.2% in the 4Q compared with an increase of 0.3% in the 3Q.

The question that still remains is when, or if, US consumers will return to pre-recession spending levels. Below are the quarterly consumer spending changes since the recession began:

These numbers confirm that the worst of the recession occurred in the last half of 2008 and the first half of 2009. They also confirm that even though consumer spending has risen over the last two quarters, it has not recovered to pre-recession levels.

Following last Friday's GDP report, The Wall Street Journal responded as follows:

“Even if this [5.7%] growth rate were to be sustained for 3 years we would still not create enough jobs to climb out of the hole caused by this recession. Worse, this growth will not be sustained. This quarter's growth was driven largely by a restocking of business inventories that will not be repeated in coming quarters.”

“Also note that much of the inventory improvement was limited to non-durable goods and the auto industry, the latter of which is building inventories with questionable short term sales prospects. This inventory-driven GDP number also calls into question the sustainability of this type of growth–there's no reason to anticipate that inventories will continue to build aggressively with consumer spending remaining somewhat stagnant.”

It is impossible to know if consumer spending will rebound this year, but I think it is safe to say that it will not return to pre-recession levels for some time to come, primarily because home prices continue to fall across much of the country. Given that, let's take a close look at what is happening in the housing markets.

The Worst of the Housing Slump is Not Over

There is little disagreement in economic circles that the housing slump led us into the worst recession since the Great Depression. Never mind that the Clinton administration and the Bush administration exacerbated the housing bubble by encouraging Fannie Mae, Freddie Mac and the big banks to make home loans to millions of Americans that could not afford them. But that is a discussion for another time.

The point is, the housing slump is still not over. New home sales fell 7.6% in December from November to a seasonally adjusted annual rate of 342,000 units. This was well below the consensus estimate of a 366,000 annual rate and even 8.6% below the year ago rate of 374,000. The December decline followed a 9.3% plunge in November.

New home sales for all of 2009 dropped sharply by 22.9% to 374,000 units, down from 485,000 units in 2008. In good economic times, new home sales typically average one million units or more per year. Yet the latest new home sales for December are only slightly above the record low set back in January 2009 when we hit a 329,000 rate.

You can see the magnitude of the housing plunge in the chart below from http://www.calculatedriskblog.com/.

Some analysts cited the unusually cold weather in December as one reason for the unexpectedly low December sales number. Others said the December drop-off was worse because the government tax credit for new home buyers stopped at the end of November.

Congress extended the home buyer tax credit and expanded it to more potential buyers, which home builders hope will spur more sales this year. But the weak numbers at the end of last year reinforce some economists' fears that the housing market will stumble yet again when the home-buyer tax credit expires later this year and/or if interest rates rise.

New Home Sales Continue to Fall Overall

Regionally, the data was all over the place. The Northeast was by far the strongest region, with December sales rising 42.9% over November and up 33.3% year over year. The problem is that the Northeast accounted for only 11.7% of total sales in December and is often less than 10% of total sales.

By comparison, the Midwest got slammed with a 41.1% monthly decline in sales in December and down 27.1% from a year ago. The moves in the other two regions were more muted, with sales in the West rising by 5.2% for the month but down 12.0% year over year, and in the South sales were down 7.3% for the month and down 7.8% year over year. The South accounts for over 50% of total new home sales around the country.

The good news is the absolute level of inventories continues to decline, falling to 231,000 units from 235,000 in November, and down 34.0% from the 350,000 level a year ago. Absolute inventory levels have declined for 12 straight months now. However, with the slower sales rate, the months of supply (inventory of unsold homes) rose back up to 8.1 months in December. That is up from 7.6 months in November and an interim low of 7.1 months is October, but it is significantly better than the 12.4 month peak in January 2009, or the year-ago level of 11.2 months.

For the market to stage a healthy recovery, the unsold inventory of new homes needs to fall at least to the six months inventory level. During the housing bubble the inventory shrank to only a four months supply.

The other bright spot in the latest housing report was that there was a big month-to-month pick-up in both the median and the average sales price, with the median increasing by 5.2% in December to $221,300 while the average was up 7.6% to $290,600. However, a year ago the median sales price was $229,600, so it is down 3.6% year over year.

New Home Sales Crucial to the Economy

Most economists agree that the level of new home sales is more important to the overall economy than is the level of existing home sales. New home construction stimulates lots of economic activity, from the various building materials that are used to the workers who build the homes. Existing home sales simply transfer existing assets from one set of hands to another.

Think about it in relation to auto sales. Every month people closely watch to see how many new cars the major automakers are selling, but rarely do we hear about the level of used cars being sold. The point is, the decline in new home sales is very bad news.

Look back at the chart above to see the relationship between new home sales and the various blue-shaded periods indicating recessions. New home sales tend to decline going into recessions and tend to reverse higher near the end of recessions. Obviously, that hasn't happened yet, which is another indicator that this recession is not completely over.

The major consolation is that the new home sales numbers for December might be revised upwards next month, but of course there is no certainty about that, and they might even be revised lower. If the current numbers stand, this is one of the more negative economic reports we have gotten in a while now.

Keep in mind that the low level of new home sales is happening during a time when there is massive government support for the housing market in the form of the home buyer tax credit, and very low mortgage rates engineered by the Fed through its extraordinarily low interest rate regime and the buying up of apprx. $1.25 trillion of mortgage-backed securities. Who knows where home sales would be without this artificial stimulus.

What Needs to Happen

For new home sales to really get back on track, we need for the employment situation to improve. The construction industry has been one of the hardest hit in terms of job losses in this downturn, with at least 1.8 million jobs lost since the peak in January 2007, an overall decline of 23.6%. That is a big chunk of the total jobs lost in this downturn, especially if you factor in the manufacturing jobs that are tied to the making of construction materials, and the multiplier effects of those jobs. It is going to be very hard to get the employment situation resolved if new home construction does not pick up.

Home construction historically has been a source of relatively good paying jobs, often for people with relatively little formal education, but with other skill sets. Ideally, these laid-off workers would try to get new jobs where they can use those skills. Some have suggested that the government should create even more incentives for people to buy new homes, while others believe such added incentives – on top of the generous home buyer tax credit – could lead to another housing bubble.

With large inventories (at least relative to sales) of both new and existing homes, it does not make a lot of sense to be building lots of new homes on several levels. What we really need is for household formation to pick up. The best way to stimulate household formation, and thus real demand for housing, is through more and better paying jobs. But generating those jobs without a significant increase in residential investment is going to be difficult.

Sales of Existing Homes Continue to Plunge

Sales of previously owned homes took their biggest tumble in at least 40 years last month as the impact of a buying spree spurred by a tax credit for first-time buyers waned. Existing home sales plunged 16.7% in December despite the extension of the home buyer tax credit to April 30. That was a bigger drop than analysts had expected and the lowest sales rate since August. It was also the biggest monthly decrease on records that date back to 1968, according to the National Association of Realtors.

Those who rushed to meet the original November deadline to take advantage of the $8,000 tax credit for first-time home buyers caused a surge in sales earlier in 2009, but left the market wobbly by the end of the year. First-time buyers, who made up more than 50% of sales earlier last year, represented just 43% of the market in December. The shift also resulted in fewer sales of lower-cost homes, which first-time buyers typically seek.

As this is written, there is some optimism that existing home sales will increase this spring, but that remains to be seen. As noted above, Congress extended the home buyer tax credit until April 30 and expanded it to more potential buyers, raising hopes among some analysts that sales will pick up in the next few months. But the surprisingly large drop in December raises questions about the strength of any housing recovery once the revamped tax-credit program expires.

The weak sales come as a Federal Reserve program that has kept interest rates near historic lows is set to expire on March 31. If mortgage rates rise this year, along with the end of the tax credits, that could also make a home purchase too expensive for many buyers. The bottom line is that as long as unemployment remains at 10% or above, many potential home buyers are simply not in the mood and/or are not financially able to purchase a home.

Home Foreclosures Continue to Mount

The weakened housing market may get considerably worse before it gets better according to housing-industry professionals who expect foreclosures and home-price declines to continue pressuring the sector through at least the first half of 2010. The biggest problem will likely be a flood of inventory hitting the market from rising foreclosures, says Bob Curran, a managing director at Fitch Ratings.

With a mountain of specialized adjustable-rate mortgages (option ARMs and certain Alt-A mortgages, etc.) slated to reset over the next 12 to 18 months and unemployment projected to go as high as 10.5% this year, the number of homeowners defaulting on their mortgages is expected to surge. At least $64 billion in option ARMs will reset in 2010 and another $68 billion in 2011, according to First American CoreLogic, a real estate and mortgage-data company.

At the same time, the government's loan-modification program has been disappointing. The default rate on loans modified after the 3Q of 2008 was 61%, according to a report issued in December by the Office of the Comptroller of the Currency and the Office of Thrift Supervision. All of this is expected to trigger another wave of potential home foreclosures in 2010 and could cause home prices to fall another 5% to 10% or more before the market stabilizes.

A record three million homes received foreclosure notices in 2009, according to the National Association of Realtors. Most real estate analysts believe that home foreclosures will be even higher in 2010. Foreclosure notices include default notices, auction-sale letters and bank-repossession notices.

One reason for the expected jump in foreclosures is that in 2009 many lenders were under pressure from the Obama administration to postpone repossessions until loan modifications could be made. However, many banks didn't have the staff to assess all their defaulted loans at the time, and many of those loans are likely to go into foreclosure in 2010.

When Will Housing Prices Recover?

Home prices have fallen 30% on average since reaching their peak in 2007, and many economists think they will take another tumble this year as more foreclosures pile on the market. Moody's Economy.com has forecast an additional 10% decline in home prices this year, while Barclays expects prices to fall 8% by early 2011; Wells Fargo is more optimistic as it expects home values to drop just 3% more this year.

For all of 2009, the median existing-home price fell to $173,500, down 12.4% from $198,100 in 2008. As noted above, sales for all homes plunged almost 23% in 2009. While more losses are expected this year, most analysts believe that the housing market will hit a bottom sometime in 2010, most likely in the second half of the year.

Assuming that happens, the pace of recovery will vary significantly throughout the country, with homes in the most battered markets taking the longest to regain value. Meanwhile, millions of homeowners who are “underwater” – meaning they owe more on their mortgages than their homes are worth – face years of negative equity that puts them at a higher risk of foreclosure.

First American CoreLogic estimates that apprx. 25% of homeowners owe more than their home is worth. In that case, it could take up to a decade for many homeowners to regain equity in their homes, while some people in the hardest-hit regions of the country may not see a recovery during their lifetimes.

While it has historically taken five to 10 years for home prices to regain losses after a major downturn, it is likely to take much longer this time, particularly in parts of the country that have seen the steepest declines.

“In California, Florida, in the ground-zero zones, it could take 15 years to fully recover,” predicted Lawrence Yun, chief economist for the National Association of Realtors. In regions marked by rampant speculative home purchases, such as Naples, FL, Las Vegas and parts of southern California, it could take even longer, noted Mark Zandi, chief economist for Moody's Economy.com.

“Historical comparisons are likely moot, given the unprecedented nature of this housing downturn,” said Thomas Lawler, a housing consultant and economist. Most housing-market collapses have been regional, not national like this one, he said, and many have not included the steep price declines experienced this time around.

“If the question is how long will it take for prices to recover to the peak, it will be longer than before simply because prices fell by more, and in some parts of the country, the answer may be never, Lawler said.

Conclusions – It's “Catch 22”

As referenced throughout this article, the worst of the housing slump is not yet over in many parts of the country. In fact, if home foreclosures hit another new record this year, as is predicted, many areas could see home prices fall another 5-10% or even more this year.

We can analyze and dissect the data all we want, but the fact is that consumer spending has not rebounded to pre-recession levels, and it is not likely to do so anytime soon. While we got a nice bounce in the economy in the 4Q due to inventory rebuilding, the next few quarters are likely to see much more mundane economic growth.

In many ways, we are in a classic “Catch 22”: we need home prices to rebound to increase consumer spending, but we need consumer spending to rebound to boost the housing market. And neither may happen just ahead.

Finally, I must admit that when I began doing the research for this letter, I did not expect the news to be so overwhelmingly negative. We've been fortunate here in Austin as home prices have held up fairly well over the last couple of years, and some areas have actually seen home values rise modestly. Austin is a very popular place to live, and thousands relocate here every month. Unfortunately, this is not true in most parts of the country.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

Still Hunting for a Bottom in Housing Prices
http://www.time.com/time/printout/0,…952132,00.html

New home sales fell unexpectedly in December
http://www.reuters.com/article/idUSTRE60O3ES20100128

5.7% GDP growth is not nearly as good as it looks
http://www.realclearmarkets.com/arti…ers_97617.html

More…

Clueless Brits miss the point on pleasure

If the mysterious female sex button known as the G-spot exists, believe me — the last people who’ll find it will be a group of British scientists.

Proving once again that sex researchers can’t find their way around a bedroom, these scientific virgins have declared the G-spot to be a myth — based on a bizarre survey of twins.

I’ll spare you the sordid details…but apparently they’ve decided that a G-spot, if it exists, should be genetic. And if one twin has found it, they think the other twin shouldv’e found hers too.

But the survey of 1,804 British women aged 23-83, all twins, about the absence or presence of their G-spots found no such connection, according to the study published in the Journal of Sexual Medicine.

So what? Does that mean it doesn’t exist? No. It barely means anything all.

If you’ve found — or think you’ve found — yours, good for you. If not, don’t worry about it. Great sex isn’t about finding a secret button any more than swallowing a magic pill.

It’s about getting plenty of practice with someone you love.

Always spot-on with my sex advice,

William Campbell Douglass II, M.D.

New study finds calorie counts wildly off

I stopped believing long ago any claims made by the food industry fat cats…so I wasn’t surprised in the least by a new study that finds calorie information on menus and food labels to be flat-out false.

In most cases, you’re eating more than you’ve been told, whether you’re dining out or heating up a frozen dinner.

Sometimes a lot more.

Makes sense to me — they shovel out more meals if calorie- counting customers think they’re shoveling in less, right?

Tufts University researchers found that big chain restaurants underestimated their already-bloated calorie counts by an average of 18 percent — and as much as 200 percent. Frozen meals — the tasteless, nutrition-free heat-and-serve "dinners" you can buy in the supermarket — were off by an average of 8 percent, according to the study in the Journal of the American Dietician Association.

Of course, all this is perfectly legal. In its never-ending quest to protect big business and keep American consumers completely in the dark, the FDA actually allows for discrepancies of up to 20 percent for packaged foods.

Outrageous? You bet!

But that’s not even the REAL crime here — that’s just a distraction. Try reading the ingredients instead of the calorie count. If you’re eating meal-in-a-can or frozen dinners every night, or indulging in food from chain restaurants, you’ve got much bigger problems than counting calories.

These so-called foods are packed with the worst carbs, soy, preservatives, meat byproducts that shouldn’t even be called meat, and more. Just last week I told you about the pink slime invading American hamburger. Click here to read that — if you can stomach it.

I don’t care how many calories you’re eating — if you’re swallowing that junk, you’re heading for an early grave, plain and simple…especially if you’re eating those nasty and completely ineffective frozen diet meals.

Want to know the best way to read a food label? Read it, and put it back on the shelf. Better yet, skip every aisle in the supermarket and buy the fresh foods on the perimeter — the ones that usually don’t have any label beyond weight and price.

Focus on grass-fed beef, free-range chicken, pork and fish. Add a variety of fresh vegetables (French fries don’t count). Avoid vegetable oils, fake butter and anything with sugar or artificial sweeteners.

You’ll lose weight, keep it off, stay healthy — and never need to count a calorie again.

And keep reading for a disgusting new reason to avoid soda!

Soda fountains spew fecal filth

I’ve been fond of using an unprintable word to describe soda. Let’s just say it has the same number of letters as "poop" and means the same thing.

Well, it turns out that may be more than just a colorful description, because a nauseating new study finds that fast food soda fountains are crawling with fecal bacteria.

You read that right — in one end, out the other…and right back in again.

A study on 30 soda machines in Virginia’s Roanoke Valley revealed coliform bacteria — an indicator of fecal contamination — in nearly half of the samples. And 70 percent of the beverages tested had some form of bacteria present — including E. coli and species of Klebsiella, Staphylococcus, Stenotrophomonas, Candida, and Serratia.

I’m not going to quiz you on the names — trust me, they’re all sickening germs and you don’t want them anywhere near your mouth.

I’m not done yet — it gets worse. Researchers tested 11 kinds of antibiotics on these bacteria, and found most of them were resistant to at least one, according to the study published in the International Journal of Food Microbiology.

The researchers suggest eliminating self-service soda fountains — as if low-wage fast-food workers are any cleaner than Joe Public. In fact, one of the researchers says workers may be contaminating the machines — get this — when they take them apart for "cleaning."

So what else do they suggest? More cleanings! If these things are being contaminated during rinsing to begin with, won’t more cleanings make them even worse? Trust me, the kid at Taco Heaven who didn’t wash his hands yesterday isn’t going to change his filthy habits tomorrow.

Here’s an obvious solution: Stop drinking soda. Period. There are plenty of reasons to skip this garbage, and this is just the newest — and by far most disgusting — one. The sugar alone is enough to rot your brain and body…and the fake sugars in the diet drinks are even worse.

And that’s only the beginning.

Coke and other sodas contain phosphoric acid. You used to be able to watch it eat paint right off a car. You can’t do that anymore — not because the soda has gotten better, but because auto paint has gotten stronger.

But if it can do that to an old car, imagine what it does to your stomach, guts and bones.

You want to keep putting that junk inside you, be my guest. Just don’t say I didn’t warn you.

Bottoms up,

William Campbell Douglass II, M.D.

Feds inch forward on Clean Water update

We’ve been drowning in drug residue and toxic chemicals flowing from the faucets in our own homes. Now, the feds say they’re getting serious about cleaning up your water… but don’t start sipping from the tap just yet.

The Environmental Protection Agency may update its dangerously outdated list of regulated water contaminants by adding 13 drugs — mostly hormone meds that turn every sip and shower into a potential gender-bending experiment. They’re also considering 104 chemicals and 12 microbial contaminants for possible regulation.

It’s a start. But there are hundreds — maybe even thousands — of other dangerous contaminants in our water, and millions upon millions of people drink it every single day. Tests on U.S. drinking water routinely find the residue of legal and illegal drugs, poisons, chemicals and even rocket fuel.

One recent study showed that 62 million Americans drink substandard water. That’s bad enough — but since many of the chemicals, drugs (including those sex hormones) and toxins are unregulated, millions more drink dangerous water that actually meet U.S. government standards.

The feds are finally being dragged kicking and screaming into action only after repeated investigations and exposés — including my own work. But like everything else that comes from Beltway boneheads, you can bet these changes will be shallow and slipshod, miss the point and protect any big-money interests that feel the need to treat U.S. watersheds as their own corporate dumping grounds.

The FDA doesn’t make it easier — they actually recommend flushing as a disposal method for some two dozen meds, including Percocet, Demerol, Methadone and Oxycontin. Apparently, these meds are so dangerous they want to make extra sure no one else can take them after you’ve had your fill.

But if they’re that harmful…why even prescribe them at all?

New York State recently discovered two hospitals and three nursing homes disposing of meds like painkillers, antibiotics, antidepressants and hormones in toilets and sinks. These drugs ended up in the water supply used by 9 million people.

The problem isn’t that this happens occasionally…but that it’s actually routine.

Don’t wait for the feds to get their act together — a reverse-osmosis water filter can remove just about all the pharmaceuticals and most of the other contaminants that may be in your water. Just don’t put it under the kitchen sink. Install it where the water enters your home, so every tap in your house is safe.

But those aren’t the only chemicals in your home you need to worry about. Keep reading…

Surrounded by secret chemicals

They’re not just in the water…chemicals are everywhere, indoors and out.

Some of you sharper minds might think you have an idea of how dangerous these toxins are. Buddy, you don’t know the half of it. Not even most of the so-called experts have a clue. None of us do…because many of these chemicals are trade secrets!

A recent report in the Washington Post shows how laws designed to help the chemical industry remain competitive have actually helped them remain highly secretive…and once again, the rest of us get the short end of this poison wand.

The newspaper told of one nurse who fell ill after treating a worker injured in a chemical spill. When her doctors called the company to find out what she had been exposed her, they wouldn’t say.

Because they didn’t have to.

Nice guys, right?

Chemical manufacturers get to hide behind the misleadingly named Toxic Substances Control Act. Rather than help control toxic substances, the 1976 law actually helps companies keep their chemicals secret.

What’d you expect from our Corporate Congress, where lobbyists get the write the laws?

This particular law requires that companies disclose the ingredients in all their chemicals to the government. But it also protects any chemical that the company thinks is important to its bottom line.

Lately, that’s all of them — in recent years, 95 percent of all notices for new chemicals — some 700 of these are filed each year — have contained secrecy requests, according to the Post.

How can you avoid this garbage? You can’t. It’s in everything, even your clothing and furniture if they’ve been treated to be flame-retardant.

But you can wake up and realize that your government isn’t working for you — it’s working for America’s biggest companies. The solution can be found at the ballot box — if you can find a clean politician.

Good luck with that.

Spilling secrets,

William Campbell Douglass II, M.D.

IN THIS ISSUE:

1. 4Q GDP to Rise – But by How Much?
2. Retail Sales – Worst Drop on Record in 2009
3. Uncertainty and the Slow Recovery
4. Political Implications & How to Move Forward
5. Conclusions: Expect the Economy to Disappoint
6. P.S. Pelosi & Reid Plot Secret Plan for ObamaCare

Introduction

All eyes will be on this Friday's Gross Domestic Product report for the 4Q of last year. Pre-report estimates suggest the 4Q GDP number will come in around 4.5% (annual rate), as compared to 2.2% in the 3Q. There are a number of widely-followed analysts that believe the 4Q GDP number could surprise on the upside in the 5-6% range, but that remains to be seen.

Yet even if the GDP number comes in at or above expectations on Friday, there are increasing fears that the economy will fall short of earlier forecasts for the first half of 2010. Reasons for such concerns vary but the December retail sales report sent shivers down the optimists' spines. As I will discus below, retail sales for all of 2009 fell by the largest percentage decline on record, following a disappointing performance in 2008.

With consumer spending accounting for apprx. 70% of GDP, many economists are downgrading their 2010 forecasts. Previous forecasts of 5-6% growth in the first half of 2010 are being scaled back to 2-3% in many cases, and even that could be optimistic. This is consistent with what I have been suggesting for the last several months.

An excellent article appeared in the Wall Street Journal earlier this month that sums up our economic and financial dilemma as well as any I have seen. It is co-authored by three University of Chicago economists. If you want to understand why we likely face a year of anemic economic growth in 2010 – as opposed to 5-6% growth that some analysts predicted late last year – I suggest you read this article very closely; it is reprinted later on in this E-Letter.

Finally, there is word that Nancy Pelosi and Harry Reid are plotting a backdoor way to pass the Senate healthcare reform plan, even though the Senate no longer has the 60 votes to override a filibuster. If this is true, it is disgusting! I have included a link to this story as a P.S. at the end of this E-Letter. If you think healthcare reform is now dead, you need to read this.

4Q GDP to Rise – But by How Much?

The Commerce Department reported late last year that 3Q GDP rose by 3.5%, but later revised that number down to only 2.2% (annual rate). Even with the downward revisions, most economists proclaimed that the positive growth in the 3Q of last year marked the end of the worst recession since the Great Depression.

Here are the quarterly GDP reports for 2008 and 2009 (through the 3Q) as reported by the Bureau of Economic Analysis within the Commerce Department:

The Commerce Department noted that 3Q economic growth was fueled primarily by consumer spending, exports, private inventory rebuilding and federal government spending. Most analysts believe that these four areas of growth continued in the 4Q as well. However, as we will discuss later on, there are some reasons to question whether consumer spending continued to rebound in the 4Q – but I'm getting ahead of myself.

The government's first “advance” estimate of 4Q GDP will be released this Friday. As this is written, the pre-report consensus is for a rise of 4.5% in the 4Q. But some respected analysts believe that 4Q GDP likely rose by 5-6%, mainly due to inventory rebuilding. That remains to be seen. And don't forget that the “advance” GDP report this Friday, whatever it is, could be revised significantly lower (or higher) over the next couple of months, as was the case with the 3Q GDP report.

Retail Sales – Worst Drop on Record in 2009

Every year we hear conflicting reports during the holiday season as to how retail sales are going. Inevitably, some reports suggest that sales are running above expectations, while others indicate just the opposite. The real facts don't become clear until the following January when we get the official retail sales report for December.

The latest retail sales report for December was quite the negative surprise, marking the largest annual percentage decline on record. Retail sales fell in December as demand for autos, clothing, appliances, electronics, etc. all slipped more than expected to finish an already disappointing year.

The Commerce Department reported earlier this month that retail sales declined 0.3% in December compared with November. This was much weaker than the 0.5% rise that economists had been expecting. For all of 2009, retail sales fell 6.2%, the biggest decline on record, and it comes on the heels of a modest decline in 2008.

While a record decline in retail sales last year is bad enough, we must put it in a broader perspective. Retail sales typically increase every year, even during recessions, if only modestly. In fact, retail sales have risen every year since such records have been kept with the exception of 2008 when annual sales fell a modest 0.5%, and then fell again in 2009 as noted above.

The 0.3 percent decline in December was the first setback since September when sales fell 2%. Sales posted strong gains of 1.2% in October and 1.8% in November, raising hopes that the consumer is starting to mount a comeback. Yet for the year, retail sales fell by the largest amount since records have been kept.

The December drop in sales was a surprise given that the country's largest retailers reported better-than-expected sales during the last week before Christmas. But even with the late rebound reported by the nation's biggest chains, these retailers suffered their worst annual decline ever.

The weakness over the year reflected the battering that consumers have taken from the worst recession since the Great Depression, a downturn that has cost over 7 million jobs and left households trying to rebuild savings depleted by losses on Wall Street and a crash in housing prices.

Economists are worried about consumer spending in the months ahead given their forecasts that unemployment, currently at 10%, will keep rising until perhaps midyear. The growing worry is that GDP will slow significantly in at least the first half of 2010 unless consumers continue to spend at 3Q and 4Q levels, which is looking increasingly doubtful.

The trends in personal consumption spending are considered critical to any sustained economic revival, since consumer spending accounts for apprx. 70% of total economic activity (GDP). This explains why many forecasters are downgrading their predictions for 2010.

The Struggling Economy – Putting It All in Perspective

A big part of my job as a writer has always been to try and make complicated matters understandable for my clients and readers. I was advised many years ago to try and keep things simple, and that advice has served me well.

But occasionally I run across articles and research papers that do a much better job than I when it comes to handicapping our economic and financial situation and putting it all in perspective. Such is the case with the article below, which was published earlier this month in the Wall Street Journal by three noted University of Chicago economists.

If you want to truly understand the economic and financial pickle we are in, I suggest you read this article carefully.

QUOTE:

Uncertainty and the Slow Recovery
A recession is a terrible time to make major changes in the economic rules of the game.

by Gary S. Becker, Steven J. Davis and Kevin M. Murphy

In terms of U.S. output contractions, the so-called Great Recession was not much more severe than the recessions in 1973-75 and 1981-82. Yet recovery from the latest recession has started out much more slowly. For example, real GDP expanded by 7.7% in 1983 after unemployment peaked at 10.8% in December 1982, whereas GDP grew at an unimpressive annual rate of 2.2% in the third quarter of 2009. Although the fourth quarter is likely to show better numbers—probably much better—there are no signs of an explosive take off from the recession.

We believe two factors are behind this rather tepid rebound. An obvious one is the severe financial crisis that precipitated this recession, with many major financial institutions receiving large bailouts from the federal government. The confidence of bankers and venture capitalists has been shattered, at least for a while, and it will take time for them to recover from the financial turmoil of the past couple of years. The household sector also faces a difficult period of financial retrenchment in the wake of a major collapse in home prices, overextended debt positions for many, and high unemployment.

The second factor is less obvious, but possibly also of great importance. Liberal Democrats won a major victory in the 2008 elections, winning the presidency and large majorities in both the House and Senate. They interpreted this as evidence that a large majority of Americans want major reforms in the economy, health-care and many other areas. So in addition to continuing and extending the Bush-initiated bailout of banks, AIG, General Motors, Chrysler and other companies, Congress and President Obama signaled their intentions to introduce major changes in taxes, government spending and regulations—changes that could radically transform the American economy.

The efforts to transform the economy began with a fiscal stimulus package of nearly $800 billion. While some elements served the package's stated purpose and helped to soften the recession's impact, the overall package was not well designed to foster a speedy recovery or set the stage for long-term growth. Instead, the “stimulus” was oriented to sectors that liberal Democrats believe are deserving of much greater federal help. This explains why much of the stimulus money is going toward education, health, energy conservation, and other activities that would do little to soak up unemployed resources and stimulate the economy.

In terms of discouraging a rapid recovery, other government proposals created greater uncertainty and risk for businesses and investors. These include plans to increase greatly marginal tax rates for higher incomes. In addition, discussions at the Copenhagen conference and by the president to impose high taxes on carbon dioxide emissions must surely discourage investments in refineries, power plants, factories and other businesses that are big emitters of greenhouse gases.

Congressional “reforms” of the American health delivery system have gone through dozens of versions. The separate bills passed by the House and Senate worry small businesses, in particular. They fear their labor costs will increase because of mandates to spend much more on health insurance for their employees. The resulting reluctance of small businesses to invest, expand and hire harms households as well, because it slows the creation of new jobs and the growth of labor incomes.

The administration also indicated early on that it would take a different approach to antitrust policy, reversing a 30-year trend toward more consumer-based interpretations of antitrust laws. Likewise, the installation of a pay “czar” in Washington is scary, even though his activities are so far confined to companies that received substantial bailout assistance from the Treasury. Perhaps as a next step, Congress will decide that executive pay is too high generally and levy special taxes on bonuses, or impose other controls over executive compensation—as the British and French have done. Congress is also considering major new regulations on consumer financial products.

In its efforts to combat the financial crisis and recession, the Fed created over $1 trillion of excess reserves at banks through various bailout programs and open market operations. When banks draw on these reserves for loans to businesses and households, there is a potential for the money supply to grow rapidly, possibly producing a substantial inflation. How hard the Fed will fight inflationary pressures through open market sales and other actions that raise interest rates is a significant source of uncertainty about future inflation and about the potential for monetary policy tightening to choke off the recovery.

The uncertainty about monetary policy has important political dimensions as well. The Fed now faces greater political pressures than at any other time in the past quarter century, as seen from the grilling the Senate Banking committee gave to Fed Chairman Ben Bernanke in deciding whether to approve his reappointment. These pressures may intensify greatly if, and when, future Fed actions to restrain inflation conflict with politicians' desires to prop up housing and the major government enterprises enmeshed in housing finance.

Even though some of the proposed antibusiness policies might never be implemented, they generate considerable uncertainty for businesses and households. Faced with a highly uncertain policy environment, the prudent course is to set aside or delay costly commitments that are hard to reverse. The result is reluctance by banks to increase lending—despite their huge excess reserves—reluctance by businesses to undertake new capital expenditures or expand work forces, and decisions by households to postpone major purchases. [Emphasis added, GDH.]

Several pieces of evidence point to extreme caution by businesses and households. A regular survey by the National Federation of Independent Businesses (NFIB) shows that recent capital expenditures and near-term plans for new capital investments remain stuck at 35-year lows. The same survey reveals that only 7% of small businesses see the next few months as a good time to expand. Only 8% of small businesses report job openings, as compared to 14%-24% in 2008, depending on month, and 19%-26% in 2007.

The weak economy is far and away the most prevalent reason given for why the next few months is “not a good time” to expand, but “political climate” is the next most frequently cited reason, well ahead of borrowing costs and financing availability. The authors of the NFIB December 2009 report on Small Business Economic Trends state: “the other major concern is the level of uncertainty being created by government, the usually [sic] source of uncertainty for the economy. The ‘turbulence' created when Congress is in session is often debilitating, this year being one of the worst. . . . There is not much to look forward to here.”

Government statistics tell a similar story. Business investment in the third quarter of 2009 is down 20% from the low levels a year earlier. Job openings are at the lowest level since the government began measuring the concept in 2000. The pace of new job creation by expanding businesses is slower than at any time in the past two decades and, though older data are not as reliable, likely slower than at any time in the past half-century. While layoffs and new claims for unemployment benefits have declined in recent months, job prospects for unemployed workers have continued to deteriorate. The exit rate from unemployment is lower now than any time on record, dating back to 1967.

According to the Michigan Survey of Consumers, 37% of households plan to postpone purchases because of uncertainty about jobs and income, a figure that has not budged since the second quarter of 2009, and one that remains higher than any previous year back to 1960.

These facts suggest that it was a serious economic mistake to press for a hasty, major transformation of the U.S. economy on the heels of the worst financial crisis in decades. A more effective approach would have been to concentrate first on fighting the recession and laying solid foundations for growth.

They should have put plans to re-engineer the economy on the backburner, and kept them there until the economy emerged fully from the recession and returned to robust growth. By failing to adopt a measured approach to economic policy, Congress and the president may be slowing the economic recovery, and thereby prolonging the distress from the recession. [Emphasis added, GDH.]

END QUOTE

Political Implications & How to Move Forward

You may or may not agree with the analysis and conclusions offered by the three economists above. Obviously, I think they hit the nail squarely on the head, or I would not have reprinted the article. But whether you agree or disagree, one thing is very clear:

President Obama and his administration made a conscious decision to pursue the most aggressive and politically charged elements of their agenda – healthcare reform, cap-and-trade and card check (pro-unions) – in the first year of his presidency. And they decided to enact the $787 billion stimulus package in ways that did not create a lot of near-term job growth.

We can argue about why this was the path they chose, but one reason has to be that they knew these policies would be unpopular, and thus they needed to pass them as quickly as possible before the president's enormous popularity faded (as it always does).

Now that Obama's key initiatives (namely healthcare and cap-and-trade) have failed to pass, at least for now, and now that the Democrats have lost their filibuster-proof 60-vote super majority in the Senate, it remains to be seen how the president will move forward. I would not even venture a guess at this point.

Obama's senior adviser, David Axelrod, said last week that the president intends to move full-speed-ahead with his agenda, despite what happened last week in Massachusetts. But that remains to be seen, and in my opinion, is quite doubtful. Without admitting as much, I expect President Obama will quietly move to the center, as so many presidents have done before him.

Of course, there are others who believe what Axelrod said last week – that the president will continue to press ahead with his controversial agenda, precisely with the goal of labeling the Republicans as “obstructionists” going into the November mid-term elections. Whatever the president decides, it will be very interesting to watch it all unfold.

Conclusions: Expect the Economy to Disappoint

Whichever political path the president decides to take just ahead, the US economy is likely to disappoint in at least the first half of this year. As noted above, many economists are now scaling back their estimates for growth in the first half of this year.

Consumer spending is not likely to rebound to pre-recession levels anytime soon. As a result, we may be lucky to see GDP growth of 2-3% for the first half of this year, with much of that the result of debt-financed government spending.

Oddly, I am seeing few, if any, suggestions for what growth may be in the second half of this year. That is partly because no one knows when the employment trend is going to pick up. As a result, consumers remain pessimistic and this mood could persist even in the second half of the year. The same may be true for businesses and plans for new capital spending later this year.

All of this does not bode well for a continued rise in the stock markets, which rose meteorically in 2009 after the March lows. The S&P 500 Index (see chart below) is approaching major overhead resistance at 1200 and above. With economic forecasts being revised lower, we could see stocks come under pressure just ahead, or simply move into a broad trading range. In my view, the easy money in stocks is behind us.

Given all the uncertainties and challenges facing us, I would suggest that this is a good time to consider some of the “actively managed” investment programs I recommend (and where I have most of my own money). Most importantly, these professionally managed programs include the flexibility to move to the safety of cash (money market) or hedge long positions should the market trends turn lower once again.

The primary objective of these actively managed programs is to minimize losses during down periods in the stock markets, while also participating in market gains during upward trending periods. The equity programs I recommend fared much better in 2008 than the S&P 500 Index, and some even made money in the bear market. (Past results are no guarantee of future results.)

For investors who held onto their equity positions through the nasty 2008 bear market, the stock market recovery last year served to improve their portfolios; however, buy-and-hold investors are nowhere near where they were at the peak of the bull market in late 2007.

If you'd like to learn more about the professionally managed investment programs I recommend, please feel free to give one of our Halbert Wealth Management Investment Consultants a call at 800-348-3601. You can also send us an e-mail at [email protected], or obtain more information on our HWM website at www.halbertwealth.com. We look forward to hearing from you.

Wishing you profits,

Gary D. Halbert

P.S. Healthcare reform is now dead, right? With the latest election of Republican Scott Brown to the US Senate in Massachusetts, most political pundits have concluded that healthcare reform is dead, at least for now. However, Dick Morris, political commentator (and former senior adviser to President Bill Clinton), says that Nancy Pelosi and Harry Reid are quietly crafting a plan to ram through the Senate healthcare plan, despite widespread public disapproval. Whether you like or loathe Dick Morris, you may want to read his latest warning on healthcare reform moving secretly ahead, despite the loss of the 60-vote super majority in the Senate. Here's the link:

Pelosi & Reid Plot Secret Plan for ObamaCare
http://www.dickmorris.com/blog/2010/…for-obamacare/

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http://www.nytimes.com/2010/01/24/business/24fund.html

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01.25.10 09:02 AM

I have been writing for a very long time about the coming debacle that the commercial real estate problem is going to be. This week's Outside the Box is an interview that my good friend David Galland did with Andy Miller, a man on the inside of the coming commercial real estate crisis. I thought it was very revealing, as there are so many nuances to the problem. For instance, in some cases, if you default and walk away from the loan you may trigger huge taxes as the loan loss to the bank is now considered income to you. Ouch! So many strings to unravel as you figure this one out.

I asked David if I could use this as an Outside the Box, and he agreed. This was from Casey Research, a very good source for non-mainstream investment ideas. You can learn more or subscribe at a discount at here.

I really think you will find this a very easy and informative read. Have a great week.

Your writing from Monaco on my way to Zurich analyst,

John Mauldin, Editor
Outside the Box

An Insider's View of the Real Estate Train Wreck

By David Galland, The Casey Report

The first time I spoke with real estate entrepreneur Andy Miller was in late 2007, when I asked him to serve on the faculty of a Casey Research Summit. As John Mauldin, a former faculty member himself, knows, we're very selective with our speakers. And there was no one in the nation I wanted more than Andy to address the critical topic of real estate.

My interest in Andy was due to the fact that he has been singularly successful in pretty much all aspects of the real estate market, including financing and developing large projects – such as shopping centers, apartment communities, office buildings, and warehouses – from one end of the country to the other. His expertise has also allowed him to build an impressive business providing assistance to large financial institutions that need help in dealing with problem commercial real estate loans. As you might suspect, business is booming.

Back in 2007, however, what most intrigued me about Andy was that he had been almost alone among his peer group in foreseeing the coming end of the real estate bubble, and in liquidating essentially all of his considerable portfolio of projects near the top. There are people that think they know what's going on, and those who actually know – Andy very much belongs in the latter category.

In fact, he initially refused to speak at our event, only agreeing very reluctantly after I had hounded him for several months. The reason for his refusal, I later found out, was that he had spoken at several industry events before the real estate collapse and had been all but booed off the stage for his dire outlook.

The happy ending of this story is that Andy's speech at our Summit was a rousing success, and he enjoyed it so much that he has now spoken at several, and has kindly agreed to sit for periodic interviews to keep our readers up to date on the latest developments in this critical sector. So far, Andy's real estate forecasts continue to come true.

As you'll read in the following excerpt from my latest interview with Andy, who now spends considerable time each day helping the nation's biggest banks cope with growing stacks of problem loans, he remains deeply concerned about the outlook for real estate.

David Galland

No one has been more right on the housing market in recent years. So, what's coming next? Some of the housing numbers in the last few months look a little less ugly. Could housing be getting ready to get well?

MILLER: I don't think so.

For all intents and purposes, the United States home mortgage market has been nationalized without anybody noticing. Last September, reportedly over 95% of all new loans for single-family homes in the U.S. were made with federal assistance, either through Fannie Mae and the implied guarantee, or Freddie Mac, or through the FHA.

If it's true that most of the financing in the single-family home market is being facilitated by government guarantees, that should make everybody very, very concerned. If government support goes away, and it will go away, where will that leave the home market? It leaves you with a catastrophe, because private lenders for single-family homes are nervous. Lenders that are still lending are reverting to 75% to 80% loan to value. But that doesn't help a homeowner whose property is worth less than the mortgage. So when the supply of government-facilitated loans dries up, it's going to put the home market in a very, very bad place.

Why am I so certain that the federal government will have to cut back on its lending? Because most of the financing is done via the bond market, through Ginnie Mae or other government agencies. And the numbers are so big that eventually the bond market is going to gag on the government-sponsored paper.

The public doesn't have any idea of the scale of the guarantees the government is taking on through Fannie, Freddie, and FHA. It's huge. If people understood what the federal government has done and subjected the taxpayers to, there would be a public outrage. But you can't get people to focus on it, and it's very esoteric, it's very hard to understand. But it's not something the bond market won't notice. The government can't keep doing what it has been doing to support mortgage lending without pushing interest rates way up.

Refinancings of single-family homes are very interest-rate sensitive. Consumers have their backs against the wall. They have too much debt. Refinancing their maturing mortgages or their adjustable-rate mortgages is very problematic if rates go up, but that's exactly where they're headed. So anyone who's comforted by current statistics on single-family homes should look beyond the data and into the dynamics of the market. What they'll find is very alarming.

On that topic, recent data I saw was that something like 24% of the loans FHA backed in 2007 are now in default, and for those generated in 2008, 20% are in default, and the FHA is out of money.

MILLER: Fannie Mae had a $19 billion loss for the third quarter of 2009, and they are now drawing on their facility with the U.S. Treasury. We have all forgotten that Fannie and Freddie are still being operated under a federal conservatorship. On Christmas Eve, the agency announced that they were going to remove all the caps on the agencies.

So what about commercial real estate?

MILLER: When I saw what was happening in the housing market, I liquidated all my multifamily apartments, shopping centers, and office buildings. I liquidated all my loan portfolios, and I'm happy I did.

Then it occurred to me in 2005 and 2006 that the commercial world had to follow suit. Why? Because it's a normal progression. Obviously, when single-family homes decline in value, multifamily apartments decline in value. And when consumers hit the wall with spending and debt, that's going to have an impact on retailers that pay for commercial space.

Furthermore, the financing for retail properties had gotten ludicrous. The conduits were making loans that they advertised as 80% of property value when they originated them, but in reality the loan-to-value ratios were well over 100%. And I say that to you with absolute, categorical certainty, because I was a seller and nobody knew the value of the properties that I was selling better than I did. I had operated some of them for 20 years, so I knew exactly what they were bringing in. I knew what the operating expenses were, and I knew what the cap rates were. And, you know, the underwriting on the loan side and the purchasing side of these assets was completely insane. It was ludicrous. It did not reflect at all what the conduits thought they were doing. They were valuing the properties way too aggressively.

I became very bearish about the commercial business starting in late '05. In fact, I think I was in Argentina with Doug Casey, sitting on a veranda at one of the estancias, and he and I were lamenting what was going on in the real estate business, and I said there was going to be a huge adjustment in the commercial market.

Beyond the obvious, that the real estate market has taken pretty significant hits and some banks have been dragged under by their bad loans, what has really changed in real estate since the crash?

MILLER: I think the first thing that changed was that people learned that prices don't go up forever. Lenders also saw that underwriting guidelines for commercial real estate loans, especially in the securitization markets, were erroneous. They realized that some of their properties had been financed too aggressively, but still, I don't think even at the fall of Lehman, anybody was predicting a wholesale collapse in commercial real estate.

But they did see they should be more circumspect with loan underwritings. In fact, after the fall of Lehman, they completely stopped lending. I think they realized we had been living in fantasy land for 10 years. And that was the first change – a mental adjustment from Alice in Wonderland to reality.

Today it's clear that commercial properties are not performing and that values have gone down, although I've got to tell you, the denial is still widespread, particularly in the United States and on the part of lenders sitting on and servicing all these real estate portfolios. People still do not understand how grave this is.

Right now there are an awful lot of banks that do an awful lot of commercial real estate lending, and for about a year now you've been telling me that you saw the first and second quarter of 2010 as being particularly risky for commercial real estate. Why this year, and what do you see happening with these loans and the banks holding them?

MILLER: It's an educated guess, and it hasn't changed. I still think that it's second quarter 2010.

The current volume of defaults is already alarming. And the volume of commercial real estate defaults is growing every month. That can only keep going for so long, and then you hit a breaking point, which I believe will come sometime in 2010. When you hit that breaking point, unless there's some alternative in place, it's going to be a very hideous picture for the bond market and the banking system.

The reason I say second quarter 2010 is a guess is that the Treasury Department, the Federal Reserve, and the FDIC can influence how fast the crisis unfolds. I think they can have an impact on the severity of the crisis as well – not making it less severe but making it more severe. I will get to that in a minute. But they can influence the speed with which it all unfolds, and I'll give you an example.

In November, the FDIC circulated new guidelines for bank regulators to streamline and standardize the way banks are examined. One standout feature is that as long as a bank has evaluated the borrower and the asset behind a loan, if they are convinced the borrower can repay the loan, even if they go into a workout with the borrower, the bank does not have to reserve for the loan. The bank doesn't have to take any hit against its capital, so if the collateral all of a sudden sinks to 50% of the loan balance, the bank still does not have to take any sort of write-down. That obviously allows banks to just sit on weak assets instead of liquidating them or trying to raise more capital.

That's very significant. It means the FDIC and the Treasury Department have decided that rather than see 1,000 or 2,000 banks go under and then create another RTC to sift through all the bad assets, they'll let the banking system warehouse the bad assets. Their plan is to leave the assets in place, and then, when the market changes, let the banks deal with them. Now, that's horribly destructive.

Just to be clear on this, let's say I own an apartment building and I've been making my payments, but I'm having trouble and the value of the property has fallen by half. I go to the bank and say, “Look, I've got a problem,” and the bank says, “Okay, let's work something out, and instead of you paying $10,000 a month, you pay us $5,000 a month and we'll shake hands and smile.” Then, even though the property's value has dropped, as long as we keep smiling and I'm still making payments, then the bank won't have to reserve anything against the risk that I'll give the building back and it will be worth a whole lot less than the mortgage.

MILLER: I think what you just described is accurate. And it's exactly a Japanese-style solution. This is what Japan did in '89 and '90 because they didn't want their banking system to implode, so they made it easier for their banks to sit on bad assets without owning up to the losses.

And what's the result? Well, it leaves the status quo in place. The real problem with this is twofold. One is that it prolongs the problem – if a bank is allowed to sit on bad assets for three to five years, it's not going to sell them.

Why is that bad? Well, the money tied up in the loans the bank is sitting on is idle. It is not being used for anything productive.

Wouldn't banks know that ultimately the piper must be paid, and so they'd be trying to build cash – trying to build capital to deal with the problem when it comes home to roost?

MILLER: The more intelligent banks are doing exactly that, hoping they can weather the storm by building enough reserves, so when they do ultimately have to take the loss, it's digestible. But in commercial real estate generally, the longer you delay realizing a loss, the more severe it's going to be. I can tell you that because I'm out there servicing real estate all day long. Not facing the problems, and not writing down the values, and not allowing purchasers to come in and take these assets at discounted prices – all the foot-dragging allows the fundamental problem to get worse.

In the apartment business, people are under water, particularly if they got their loan through a conduit. When maintenance is required, a borrower with a property worth less than the loan is very reluctant to reach into his pocket. If you have a $10 million loan on a property now worth $5 million, you're clearly not making any cash flow. So what do you do when you need new roofs? Are you going to dig into your pocket and spend $600,000 on roofing? Not likely. Why would you do that?

Or a borrower who is sitting on a suburban office property – he's got two years left on the loan. He knows he has a loan-to-value problem. Well, a new tenant wants to lease from him, but it would cost $30 a square foot to put the tenant in. Is the borrower going to put the tenant in? I don't think so. So the problems get bigger.

Why would the owner bother going through a workout with the bank if he knows he's so deep underwater he's below snorkel depth?

MILLER: It's always in your interest to delay an inevitable default. For example, the minute you give the property back to the bank, you trigger a huge taxable gain. All of a sudden the forgiveness of debt on your loan becomes taxable income to you. Another reason is that many of these loans are either full recourse or part recourse. If you're a borrower who's guaranteed a loan, why would you want to hasten the call on your guarantee? You want to delay as long as possible because there's always a little hope that values will turn around. So there is no reason to hurry into a default. None.

So that's from the borrower's standpoint. But wouldn't the banks want to clear these loans off their balance sheets?

MILLER: No. The banks have a lot of incentive to delay the realization of the problem because if they liquidate the asset and the loss is realized, then they have to reserve the loss against their capital immediately. If they keep extending the loan under the rules present today, then they can delay a write-down and hope for better days. Remember, you suffer if the bank succumbs and turns around and liquidates that asset, then you really do have to take a write-down because then your capital is gone.

So here we are, we've got the federal government again, through its agencies and the FDIC, ready to support the commercial real estate market. They've taken one step, in allowing banks to use a very loose standard for loss reserves. What else can they do?

MILLER: Well, obviously nobody knows, but I can guess at what's coming by extrapolating from what the federal government has already done. I believe that the Treasury and the Federal Reserve now see that commercial real estate is a huge problem.

I think they're going to contrive something to help assist commercial real estate so that it doesn't hurt the banks that lent on commercial real estate. It'll resemble what they did with housing.

They created a nearly perfect political formula in dealing with housing, and they are going to follow that formula. The entire U.S. residential mortgage market has in effect been nationalized, but there wasn't any act of Congress, no screaming and shouting, no headlines in the Wall Street Journal or the New York Times about “Should we nationalize the home loan market in America.” No. It happened right under our noses and with no hue and cry. That's a template for what they could do with the commercial loan market.

And how can they do that? By using federal guarantees much in the way they used federal guarantees for the FHA. FHA issues Ginnie Mae securities, which are sold to the public. Those proceeds are used to make the loans.

But it won't really be a solution. In fact, it will make the problems much more intense.

Don't these properties have to be allowed to go to their intrinsic value before the market can start working again?

MILLER: Yes. Of course, very few people agree with that, because if you let it all go today, there would be enormous losses and a tremendous amount of pain. We're going to have some really terrible, terrible years ahead of us because letting it all go is the only way to be done with the problem.

Do you think the U.S. will come out of this crisis? I mean, do you think the country, the institutions, the government, or the banking sector are going to look anything like they do today when this thing is over?

MILLER: I know this is going to make you laugh, but I'm actually an optimist about this. I'm not optimistic about the short run, and I'm not optimistic about the severity of the problem, but I'm totally optimistic as it relates to the United States of America.

This is a very resilient place. We have very resilient people. There is nothing like the American spirit. There is nothing like American ingenuity anywhere on Planet Earth, and while I certainly believe that we are headed for a catastrophe and a crisis, I also believe that ultimately we are going to come out better.

Andy Miller is the co-founder of the Miller Frishman Group (www.millerfrishman.com), which includes three companies serving different sectors of the real estate market – from mortgage brokerage and banking, to the building, management, and marketing of commercial real estate across the United States. His firm is currently deeply involved in the distressed real estate business, assisting lenders across the nation with their growing portfolios of non-performing loans.

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