Friday, August 31, 2007


One of my favorite economists is the guest host on Squawk Box this morning. He is on the money! This morning, he said that a very powerful combination event is about to happen. The President will announce assistance for sub prime borrowers this morning and Ben Bernanke will basically hold firm against inflation. Brian points out that the hedge fund players who have shorted the sub prime loan securities, using 20 to 1 leverage, could take a serious hit when many of these loans are suddenly worth 100 cents on the dollar.

Doing the right thing! It is an understatement to say that George Bush is not a very popular President. Still, Bush is once again "doing the right thing." A number of TV talking heads have said that the sub prime mess was caused by lending money to "people who did not deserve to own a home." My belief is that every American should be given the opportunity to own a home. Before the announcement that Bush will propose new rules that allow sub prime lenders to refinance, I correctly maintained that more than 85% of all those "poor credits" who were allowed to buy a home with no money down would continue to pay their loans. With the additional help, the number will be significantly higher than 85%. Given a poor person a helping hand is not a bad thing.

It is not like anyone is agreeing to pay the mortgage for the homeowner. Many times every day business loans are "restructured." Corporate CFO's have the experience to know that if a company has a short term financial problem that a deal should be struck to redo the terms of outstanding loans. There is often a long term cost or penalty but help is often available.

As Bernanke mentioned the other day, there are many creative ways possible to help those stuck in loans that have onerous terms. If a loan started out as an interest only loan and is about to be reset with a $500 per month principle payment, the terms could be modified to reduce the principle payment. No one would be hurt. The bank does not need $500 per month in principle to make the loan a profitable loan. Sure, if the principle payment becomes a graduated amount, for a few years, the loan would look like a 50 year mortgage but the graduated principle payment could increase a certain percent each year and continue to increase even after the $500 per month principle payment is reached.

Employment and wage growth are strong. A person who has successfully paid an interest only loan for the past three years might easily afford a $100 per month increase in his home payment this year and another $120 per month next year and so forth. The proposals to be made by Bush today will be along these lines. He will use executive authority for the government to guarantee the refinancing of 80,000 of these loans. This is the right thing to do. He will make other proposals, some of which will require the passage of congressional bills.


Those who have sold these mortgages short are suddenly being hammered. Short selling anything is risky business. One of the smart moves that was made recently was to eliminate the short sale up tick rule. Yes, once again a smart move has been severely criticized as an idiotic move. The removal of this rule has been blamed for the "extreme volatility" of the recent markets. What a joke!? To begin with, this market has not been "extremely volatile" and second of all the removal of the rule has the effect of reducing volatility not adding to it. This is just one more area where a lot of very smart people have "joined in group think" to get things upside down and backwards. Last night, John Brown repeated the oft repeated mantra that Ben Bernanke is between a rock and a hard place because if he cuts interest rates the dollar will fall. John and those criticizing the removal of the short sale rule are looking at one end of an elephant and concluding that it is a snake. Use the water level in a lake as an analogy, if one only looked at how much water was flowing over the dam, without ever knowing the level of the lake, one might conclude that the lake level is going down on a day when the over flow is very heavy. The truth is that if much water is over flowing the dam, there must have been heavy rains upstream and the lake is probably full to the brim.

Under the old rule, an artificial rule said you cannot sell short unless water is over flowing the dam. You were not permitted an exception because you had checked upstream to know that the "rains are coming".

There are a number of children's board games that demonstrate the point well. In many of these games, players will often attempt to "corner a market." In a "business game" they might consistently bid high on a certain resource in order to be the only one able to sell certain goods. The problem they discover is that they pay so much for the resource that their profit margins are low. The game of Risk is another game where one cannot win by being overly aggressive. The more you attack your neighbors, the weaker you become, leaving an opening for another player to put you out of the game.

In the same way that investors can buy all they want on the way up, they should be able to sell all they want on the way down. Think about it this way; how low can speculators drive the price of a stock? Even if they committed conspiracy and as a group shorted 200% of all the shares outstanding, would they drive the company out of business because the price of the stock was down to a very low price? No, a profitable business in this situation could declare a dividend and the short sellers as a group would owe 200% of the total dividend!

Certainly most investors understand that when they buy a share of stock on the market, they are not investing in the sense of giving the company money. When the shares were originally sold by the company, it got money. If you buy a few shares or sell a few shares it does not effect the balance sheet of the company one iota.


The point of the above paragraphs about short selling is that the pundits have found just one more thing to rant and rave about when they should be pounding the table saying BUY, BUY, BUY! In the old days, recessions were common at the mid cycle juncture. Certainly, the rollover has and will cause a little pain. The GNP numbers posted yesterday tell the story well. For the second quarter, the US economy grew at a real rate of 4%. The rants of those who say inflation is out of control must remember that this 4% has been adjusted downward to account for inflation. The problems in the housing market reduced this number by about 75 basis points. Therefore, if there had not been a problem in housing, the real economy would have grown by 4.75%!

Yes, the growth in the economy will be reduced by the recent "freezing-up" in the credit markets. Will there be a recession? It's not likely. Besides, a mild recession would not be a big deal. Recessions are announced after the fact and the stock market typically jumps up big time right in the middle of a recession. What happens during a recession is that the price of money goes down enough to increase the profit margins of companies. What has happened the past two months? The price of money has come down!


Smooth, smooth, smooth! The water in the big lake is smooth. Pundits have focused on a 250 point drop in the Dow on one day and a 250 point jump the next day and screamed VOLATILITY! This correction got to about 10% before reversing quickly. It is now less than 5%. In 1987, the correction was 23% in one day! Big Ben is proving his metal quickly.

Sure, those who believe $100 oil is just around the corner are screaming that Ben should lower rates. Those who have profited by prior wild swings in the market are ready for Ben to capitulate. Ben is about to disappoint these players. Under the current circumstances, Ben will probably lower rates a little. However, he is not going to stop fighting inflation. His move to lower the discount rate without lowering the Fed Funds rate was a master stroke. It was filled with common sense but it was a master stroke because it went against the grain of conventional wisdom. Many said that it was only a confidence building move but in reality it had teeth. A few days later, when all the big and strong banks took down chunks of money, the pundits said again this was just a confidence building move but it was much more than that. Slowly the numbers will be revealed. The banks that were in trouble did not go to the discount window directly but got "pass through" - loans from the money center banks. Liquidity was restored where needed without causing a run on the banks that needed the help. Had a regional bank jumped at the discount window, they would have been shooting themselves in the foot. They would have seen millions of dollars of withdrawals from their frightened depositors. The system is sound; fear in the eyes of pundits is going away and Ben will not need to lower short rates much. Smooth sailing ahead!


Early this morning, one of the Asian airlines announced profit growth of better than 25%!

What is a mid cycle turn? Before the turn, there is generally enough capacity to produce all the goods needed throughout the world. Sales are much stronger than they were during the previous recession but demand is generally satisfied without building new plants. By the time of the turn, the gradual growth of the population and the additional growth in standards of living means that production capacity is short. By the time of the turn, there is a need for more and more and more major capital projects. You have to have the plants plus the energy to run them. This is the reason that China has no less than 40 nuclear power plants on the drawing boards.

Capital projects consume huge quantities of resources. For example, Saudi Arabia and Kuwait each have a number of development projects on the drawing board. Indeed, they each have a single project that will cost over $9 billion dollars to develop. Specifically, the development of the Khurais field in Saudi Arabia is expected to increase total production from Saudi Arabia by 1.2 million barrels per day. This is an increase of about 10% by the worlds biggest producer. Several thousand workers will be required to build-out this field but once it's built only a few hundred will be required to operate it.

Business construction already requires more capital and more workers than were required by the housing market when it was at its peak a couple of years ago. Look at it this way, each one of these $9 billion projects are the equivalent of building cities of 45,000 $200,000 homes. I can't remember the average cost of the nuclear plants in China. I recall that the latest designs are smaller. $5 billion each is probably in the ball park for a total of $200 billion. The electricity from these plants will support many times the number of production facilities. We are talking about trillions of dollars of construction over the next several years.

It is only natural for the demand for money for major capital projects to squeeze out home construction. When the average Joe finds that money is available to buy a house, he goes for it. When money gets tight, he stays where he is. On the other hand, when a company is selling all the products it can make, it does not let the cost of money get in the way of expanding. When the "prosperity" phase of the business cycle is here, the FOMC has to hold tight. It has to lean against the wind. It has to keep short term interest rates up so that a bidding war does not develop. If five companies selling the same products are all selling out of goods, the one that can complete the next plant the quickest is the one that will reap the benefits of having goods for sale that are in short supply. Ben's job at this point is to focus on inflation even though the housing market is weak.

The constant argument that the consumer is the engine of the economy is a good argument for a different time. The new locomotive is the business locomotive. The consumer will come along for the ride. We simply should not worry so much about the consumer during these times. Most Americans spend the income they receive. This is the reason that payroll deduction works to build a retirement nest egg, even though, the person who will make regular deposits to a stock account will grow much more wealthy. The person who routinely saves to an an aggressive investment account is a rare individual.

Of the people I help, only a few of them make regular additions to their accounts. Most wait until the account has moved up strong and then they add chunks of money. It is too much to expect them to lean against the wind as they should and add chunks of money while the market is down. Therefore, regular monthly deposits are a rare blessing. Big irregular deposits make my job very difficult but I accept the challenge freely. The main point is that during the "prosperity phase" jobs will remain plentiful and wages will increase. Consumers will not be as apt to refinance their homes but they will have steady income and they will spend it. The year over year growth in personal income is currently running at about 300 million dollars!

Yesterday, I said that Big Ben is about to shoot the starters pistol. He is, but the actions to be announced by President Bush will address the "sub prime crisis" more specifically than a Fed Funds rate cut can do. Cutting the Fed Funds to solve the sub prime crisis is a bit like going deer hunting with bird shot. As a result of "help" in the mortgage market, the need for Ben to cut will be much reduced. This may cause great disappointment by those screaming FIRE but holding firm against the wind is the right thing to do. I expect a minor cut of 25 basis points at the September 18 meeting and not much more later in the year. More importantly, the second half of the business cycle is underway without a severe crunch at the "turn".

Consumers who are paying 50 cents less per gallon of gas are buying electronic toys. New toys are on the way. The new toys are typically connected to one another. Kids are playing games with other kids from around the world on their cell phones. Business people are able to "get things done" quicker than ever before. The build out of this new system is not even half way done.

The energy/electricity investments must always come first and indeed they are in the works. I do not believe there has ever been as much energy/electricity under development. The poorest of the poor are starting to feel the effects; oil projects in Africa are starting to enrich millions of people. The newest OPEC member, Angola, will add about 200,000 barrels of production per day this year. The good news is that this is just the start. It takes time to develop an oil field but there are hundreds under development.

Production from China has been held back by the scarcity of electricity. This scarcity is in the process of being filled. The 15% growth rate of China is unsustainable because the law of large numbers will be in the way but billions of dollars of new production will continue to hold the lid on inflation as long as Big Ben will keep one foot on the brakes.

You will know that the world has hit hit 4th gear when products begin to hit the market that take advantage of super highway broadband wireless networks. These networks will allow more to be done at lower costs.