For years we have talked about deflation - the prospect of a shrinking economy, marked by lower prices, less credit, and falling income.  A deflationary period is marked by what is called the “vicious cycle,” where falling purchases by consumers leads businesses to lower prices for goods, which leads to less revenue for companies, which leads them to lower wages that are paid to workers, which leads the workers to buy less stuff, thereby causing prices to fall again, thereby completing and continuing the cycle.  This is the opposite of the “virtuous cycle,” which goes the other direction, where higher sales lead to growth at the company and higher wages, which lead to higher sales, and so on.

We have discussed the falling prices in our current economy, with housing being the most obvious, but sales at retail stores and cuts in prices for services also being noticeable.  The huge swaths of layoffs and flat out firings are apparent in the unemployment numbers, but what we have been missing is some sort of data on what is happening when people are re-hired.  It is not true that everyone who gets fired cannot find a job.  Many recently unemployed are finding work.  The question is, ”Are they making the same, more, or less than their old job?”  Our forecast has been that the falling economy will indeed lead to lower wages, thereby cementing the vicious cycle.  Unfortunately it appears we are correct.

The NYT ran an article today with some crude, preliminary data on this subject. Several groups, including the Hamilton Project, the Center for American Progress, and the National Employment Law Project weighed in from different angles, but the outcome is the same.  The high end workers (graduate degrees, jobs requiring high degrees of skill) are somewhat insulated, the bottom rung remains at the bottom but is facing mass unemployment, and those in the middle jobs (some college, median income) are falling to the lower rungs of work and pay, displacing those who used to be in those spots.  Essentially, middle income workers are losing their jobs and when they find other employment it is well below their previous work.

This development adds more fuel to the deflationary fire, as those workers will now show up as “employed,” so it looks good on paper, but they will not show up as high spending consumers, which will confound bureaucrats who will not be able to figure out why the employment numbers have stabilized but the economic picture continues to weaken. 

In the Bizzaro Superman world we live in where things mean their opposite, we shave almost a full percentage point off of the estimate of Q2 GDP growth and markets like it.  The estimate had been a revision even lower, 1.2%-1.5%, so this print of 1.6% looks “positive.”  For some reason, I prefer the real world, where our efforts at reviving the economy are failing spectacularly, having spent almost $4 trillion extra (stimulus, bailouts, and deficits) and all we have to show for it is a lousy, shrinking GDP. 

I have been patient with policymakers, but that time has past.  There must be recognition that the issues we face cannot be solved with more debt.  An asset bubble must deflate, and will deflate.  The question is, will we manage it lower the best we can, or hold on to a false hope of propping up the bubble only to watch it fail in a much bigger, more devatstating way down the road? 

Look for Q2 GDP to be revised again next month, most likely close to 1.0%, or even lower. 

The next big thing is Unemployment, coming next Friday (Sept 3rd).  The estimate is for a loss of jobs of 60k-70k, however that includes the US government releasing 110k of census workers, so the net would be a gain of jobs of 40k-50k.   If we are anywhere near negative 60k or less, the markets would most likely rally, because we live in Bizarro world.  We need at least 100k of jobs created every month just to absorb the new workers entering the workforce.  Anything less than 100k new jobs created will do nothing to start alleviating the pain of unemployment for roughly 15mm Americans.

The WSJ ran an article today on commercial real estate owners playing hardball with their lenders.  In essence, the property owners are telling the lenders that they can either restructure the loans - which is code for write-off some of the principal I owe you - or they can take the building back.  Their example in the article is Taubman Centers, Inc., run by Mr. Robert Taubman, which stoppped paying interest on its $135 million loan outstanding on a property in Atlantic City, NJ.  Taubman Centers, Inc. estimates the property is only worth $52 million.

The catch is, this company has the money to make the payments. The implication of the article is that many businesses are in the same situation, they own property that is underwater to a point where there is no realistic expectation of making any profit on the property.  So what to do?  Obviously, you default.

By the way, the article quotes Trepp, LLC as estimating that of the $1.4 trillion in commercial loans coming due in the next 4 years, over half of them are on properties that are underwater.

Now, this is a fabulous way for an individual company to rid itself of a burdensome load in an effort to find greener pastures.  But what about the people who made the loans? Those would be bondholders and banks.  Those people, who tend to be regional banks and then corporate bond investors such as pension funds and endowments, are stuck with the properties, which they in turn try to sell and of course realize quite a loss.  So these lenders take a hit that the business, such as Robert Taubman, did not want to take.  Why do people like Taubman do this?   Because they can.  Their business loans are non-recourse, meaning the lenders cannot go after them personally.  Which is the difference between corporate owners and residential homeowners.

Very few states in the US have non-recourse mortgages.  California does, for the most part, but they still have a way of going after the most egregious “strategic defaulters,” those people that could easily pay their mortgages but choose not to because they think it’s a bad deal.

However, just because businesses that are in strong financial shape can pay their mortgages, does that mean they should?  If I am an investor in a company that bought a property that has turned into a drag, I might want the company to unload it any way it could.  However, if I’m a stockholder in a bank or an stakeholder in a pension fund or endowment  that has lent that company the money, I’m sure I’d see it differently.  No matter which side you fall on, it seems obvious that there will be repercussions from these decisions for many years.  Who will lend to businesses to buy buildings if they can and do choose to walk on loans when times get tough?  I would think twice about it.

At the beginning of the summer we were forecasting 2nd quarter GDP to be in the 1.5%-2.0% range.  We used information from Consumer Metrics (www.consumerindexes.com) and other places to arrive at that modest number.  July 30th, the Friday of the month, was more or less D-Day for us because that was the day that the advance estimate of 2nd Quarter GDP was to be announced.  As the day approached, the consensus estimate was around 3.0-3.5%.  However, our view was that the economy was slowing down even further, so we were concerned that our range of 1.5%-2.0% was high. 

The number came in at 2.4%, which surprised us (too high, we thought) and surprised many mainstream economists on CNBC (they thought it was too low).  The markets shrugged off the news.

Now the revisions are coming.  The first numbers I heard were from JPMorgan and Goldman, where the new estimate of 2nd Quarter GDP was 1.5%-1.7%, which is in line with our views.  Now, as we are seeing durable goods and other measures like the Philly Index get crushed, the estimates of 2nd Quarter GDP are going lower, 1.0%-1.5%.  This Friday we will get the revised estimate of 2nd Quarter GDP, and it looks like it will come in a full 1% lower than the advance estimate just four weeks ago.  I cannot imagine that this will be good for the markets, but I think we are already seeing the larger players become more defensive ahead of the announcement, pulling this market down.

After this Friday’s GDP number, we all get to wait in anticipation of next Friday’s Unemployment report.  What a way to end the summer!

My lack of regard for GM is obvious, as I remain opposed to the way the situation was handled and continues to be handled.  However, the facts on the ground are exactly that - facts.  GM rec’d a bailout of $50 billion plus. Secured bondholders were passed over.  Unsecured creditors in the form of Union Pension Healthcare Trusts were put at the front of the line.  Pensioners, existing and prospective, were NOT required to move to the PBGC and begin receiving the PBGC schedule of benefits as required by law, instead these groups were allowed to retain their exceptionally generous benefits.

Now GM is going public and current estimates put a value on the company of $60-70 billion, and show net profits of $12 billion per year over the next several years.  That’s a good thing, because the company will need it.

According to a GAO report from April, GM continues to use “credits” for past contributions to fulfill its current year pension funding obligations, and anticipates using these “credits” next year.  These credits are a hall pass that the company receives because of past contributions.  However, the pension funding at GM, the new and improved debt-free GM, is a negative $26 billion.  While 2009 helped out a little bit because of gains, the liabilities continue to grow while the company is contributing “credits.”  The GAO estimates that in the years 2013 and 2014 GM will have to contribute over $12 billion. 

I fully expect the IPO to go well.  I presume demand will be strong domestically and internationally.  But that doesn’t make the company a good deal.  Caveat Emptor.

General Motors filed an S-1, which is the form required for a company to “go public.” This is odd in itself, as GM still IS public, or at least what is called the “old” GM, the one with all those pesky losses in it and the plants that no one wants still trades.  But meet the NEW GM, the one that had all debts forgiven, was cleansed of any burden from the past, given a fresh start by reneging on all of its debts except those deemed important by the US govt.  This new GM, in filing to sell shares of itself to the public, is embarking on one of the hallmark activities of capitalism.  This filing comes only 18 short months after receiving the largest federal bailout in the history of the country in which capitalism was utterly destroyed, where private investors with a legal claim to assets were told to pound sand in favor those the government appointees deemed more worthy.

The government has chosen banks - yes, those it also bailed out and guaranteed - to participate in the underwriting of the shares, thereby guaranteeing another profit, and has launched a feel good campaign to encourage prospective stock buyers to line up at the trough.  And who wouldn’t?  The situation couldn’t be more favorable.  A badly run company goes billions into debt and can’t possibly survive, but it is propped up by the government in the name of, well, something I’m sure.  With a fresh start the company claims operating profits almost immediately.  It’s a miracle!  This company should mint money going forward, right?  Right. 

There will most likely be some gains to be had, especially given that S&P and Dow Jones won’t be able to ignore the new company.  Shortly after it’s IPO, look for the new GM to be added to the two large cap indices, thereby guaranteeing a buying spree, goosing the shares.

If you look under the hood, the facts aren’t so attractive.  None of the money raised for stock will be used to do anything useful.  It will simply be funneled to existing owners - the US govt, the unions, and a pittance for old bond holders.  What does this do for the new GM?  Nothing. No money for operations, no nothing.  The company claims it will throw off the shackles of government control, freeing the company to make bolder, quicker decisions.  That didn’t work out so well last time, and that pesky government control came w/ $50 billion and a get-out- of-jail-free card.  Not bad.

The real meat is in the preferreds.  GM will sell shares of a preferred class that will pay interest.  Anyone with synapses firing should consider these interest bearing certificates as good as US government paper, since the company will still be 50% owned by the government, and the feds have shown a willingness to support the company in the past.  I’d imagine these securities will run up in value dramatically, capturing a hefty profit for whoever owns them.  Oh, that’s right, the securities will most likely be owned  by the same banks that we bailed out, guaranteed, and then gave business to.  Expect the banks to take down the preferreds for their own accounts and the accounts of selected clients, and then mark them up dramatically.

It’s time to sell the Suburban.

An article I wrote was picked up by Morningstar and appears on the front page  today, 8/17 -  Life In The Great Recession. 

I know the numbers about food stamps…40.8 million Americans, roughly 13% of our population, are now on assistance.  That number to me is two-dimensional, it’s a number.  People can use a subsidy to purchase necessary food.  I imagine it happens in my neighborhood (or at least near it), but I can’t pinpoint anyone in particular.  I hear about WIC, and we all hear about unemployment (1.4 million unemployed for more than 99 weeks, or almost two years, and  6.5 million unemployed for over 27 weeks).  This one is a little easier to spot.  You get the emails from old friends, acquaintances, and even people you met in passing, that are general calls for any leads on a job in a specific field or at a certain level.  That’s a little closer to home of course, but I can imagine this being worked out over time.

What took me by surprise was an article in the WSJ over the weekend regarding applications for Section 8 housing subsidies in a town in GA.  30,000 people lined up to wait for 455 vouchers to cover part of their rent.  30,000.  That’s the population of many small towns in America.  Some camped out for days in what has been a horrific heat wave.  There were fights, there were medical emergencies.  When 30,000 people show up for 455 vouchers representing rental assistance, I must believe there was also dispair.  This is going to be a very difficult decade.

Bloomberg reported that FHA is now the business of financing luxury condos in NYC.  Apparently the little agency that has grown so dramatically since traditional banks fled the mortgage market has also extended its reach to the Big Apple, where you can put down 3.5% on a condo that cost 700k+.  Previously, having a government agency involved in the financing was looked down upon, but now if a building is approved to have FHA-guaranteed loans on its units this piece of information becomes a sharp sales tool. 

Obviously, after we safeguarded the employment and income of those in the banking business by first rescuing their sinking ships and then providing them with an explicit/implicit guarantee (first we did it outright, but now the taxpayers are just the rich uncle standing off-stage, ready to help when and if needed) that requires almost nothing in terms of a change of business practice, we should now assist in the purchase of luxury goods by extending loans that no self-respecting, um, well, banker, would ever extend.  Who in their right mind would risk the capital of their firm by lending 96.5% of the cost of buying a condo today?  Any takers?  I think the banker that originated such a loan would be fired.  Unless, of course, he worked for us, the US taxpayers.  Apparently we are jumping at the chance to make such loans. 

I can’t get past the irony that a NYC banker whose job we saved through the bailout, and who’s bonus we guaranteed through our perceived backing which allows those banks to get funding at ridiculously cheap levels today, won’t extend mortgage financing to (potentially) himself on such fabulous terms, so we do it.   

All dripping sarcasm aside, the point of what the FHA is doing is to create liquidity through government intervention, and a US govt guarantee on a 96.5% loan on real estate definitely qualifies as intervention.  But is that the role of our government, to create liquidity in such markets where a perfectly functioning private market exists?  Others might argue that there is no liquidity, but that is not true.  Apparently if you come to the table with 30-40% down, there is no problem obtaining a loan.  The issue arises because there are not enough buyers with enough capital to satisfy newly restrictive lending standards.  I believe the new lending standards to be a much better idea than what passed for lending standards in 2005, and it seems a poor use of taxpayer dollars (yes, I know these are guarantees, not monies spent, but a rising percentage of them do default, which costs us money) to provide this backing.  Certainly we can do better.

In what is surely the oddest turn of the “no more conspicuous consumption” race, Stuart Vevers has come out with a new handbag that is designed to look, well, ordinary.  It’s a replica of a brown paper bag like you would get in a grocery store (at least you would before the evil plastic bags), but it’s made out of leather.  The cost?  A mere $1,045.  The attraction?  I have no idea.

OK, that’s not entirely true.  I presume the attraction to be for the not-so-closet conspicuous consumer, the one who wants to draw less attention than a studded padlock bag would draw, but still wants others, or at least others “in the know,” to know that the bag is a status symbol.  That’s a lot of work to show other people you have money.  I guess people could just tape cash on themselves, but that would be crass.