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The Daily Reckoning | Tuesday, June 8, 2010 Stock market upheaval continues...just as it ought to, The next chapter in the great American mortgage market meltdown, Plus, Bill Bonner on Geithner's discontent, building an economy from the ground up and the case of the missing clunkers... Gravity Defying Economics The misguided optimism of modern day economists Joel Bowman Reporting from Taipei, Taiwan... The world economy is airing its dirty laundry...and America is the "least dirty shirt" in the pile. That's how Bill Gross, manager of the world's largest bond fund, sees the state of world's largest economy. Mr. Gross is being polite. We'd say the US looks more like the least dirty pair of undergarments...after a very scary opening scene of a very long horror movie. Moreover, as reckoners who have children will surely attest, it's much harder to clean dirty cloths than it is to dirty clean ones. That truism is especially so when the kids wearing the clothes enjoy playing in the mud, as kids tend to do. Unfortunately for the voting (and non-voting) citizens of the world, their elected (and unelected) officials like nothing more than a little roll in the dirt before recess. Mr. Gross' comments came after a Bloomberg survey concluded that America is now the preferred capital destination for worldwide investors. According to the study, almost 4 in 10 investors surveyed believed the United States would yield the greatest opportunities over the coming year, double the percentage from only 6 months ago. Those same investors rated Brazil as the second most promising market (29%), with China and India rounding out the top four, respectively. The story makes for some enticing headline fodder...but it's not all "whiter whites and brighter colors." The same survey also found that "Forty-two percent of investors now believe the world economy is deteriorating, double the 21 percent who thought so in January. US investors were the most pessimistic about the global economy, with 58 percent saying it is getting worse versus 31 percent of Europeans and 35 percent of Asians. Europeans were the most pessimistic about their own region, with 40 percent viewing it as deteriorating; 21 percent of US investors viewed their home region negatively, while 9 percent in Asia felt that way." But wait a minute! Aren't the Europeans rioting in the streets? How can they be more optimistic than their American comrades? Aren't the Greeks torching buildings? Aren't the Spaniards up in arms? Didn't the Hungarian government just reveal that the economy there was in a "very grave situation"? Didn't David Cameron, the new British PM, just announce that the problems in Ol' Blighty were "worse than we thought"? And that's to say nothing of the Italians and the Irish, the Slovenians, Romanians and Portuguese. And these folk are almost twice as positive as the Americans? Where's their spirit of doom and gloom? Could it be that American investors are simply better informed than those across the pond? Or could it be that people simply don't know what they're talking about? Your editor has no clue. Many an overconfident man was knocked out in the first round...and sentiments don't pay the bills. We do know, however, that nobody can spend his or her way to prosperity, whether they are an individual investor, a Fortune 500 company or a sovereign state with a Keynesian enthusiast at the helm. Debts must eventually be repaid...or defaulted on. It's a case of "what goes up..." But no matter how solid the laws of gravity may be, there will always be men who try to subvert them. Skydivers refer to such men as "casualties." Politicians refer to them as modern day "economists." Ben Bernanke is one such man. When asked yesterday whether the US economy would likely suffer a "double dip recession" Bernanke replied, "My best guess is we'll have a continued recovery [but] it won't feel terrific." As near as we can tell, Mr. Bernanke has missed the point entirely. He assumes that the economy is recovering. It is not. He sees a renewed enthusiasm among consumers (which is, in itself, dubious at best and waning at worst) as bricks on the road to the Land of Milk and Honey. "So far [this year] the news is pretty good," he said. "We've seen consumers coming back." But consumers are not coming back, at least not in any kind of sustainable manner. Wages are going down. Hours are being cut. Credit is contracting. And even if they were coming back, what on earth are they spending? They have no money! Secondly, the private debts of yore have not been repaid; they have merely been collectivized and dumped on to the public books. They are still the same debts as they always were, only now they are much bigger, threatening to drag entire nations asunder instead of poorly managed private institutions. This trend of debt-collectivization has driven spendthrift central governments to what Anthony Crescenzi, an investor at Bill Gross' Pacific Investment Management Co., refers to as the "Keynesian endpoint." "Time, devaluations, and debt restructurings might be the only way out for many nations," Crescenzi wrote in an e-mailed note titled "Keynesian Endpoint." Debt-fueled spending programs aimed at combating the global financial crisis of 2008 are among policy tools now "being seen as a magic elixir that has morphed into poison." As our Reckoner-in-Chief, Bill Bonner, tirelessly reminds readers, we are in the throes of the Great Correction. There is not a shade of recovery in the mix. Firstly, the jobs situation is worsening, as is evident to anyone who bothers taking more than a cursory glance at Friday's woeful employment report, on which Bill has more thoughts below. Secondly, the non-recovery in housing is about to get a whole lot more non-recovering. Whitney Tilson, founder and Managing Partner of T2 Partners LLC and the Tilson Mutual Fund, provides the details in today's guest column... The Daily Reckoning Presents The Housing Non-Recovery Whitney Tilson Ed. Note: This is an excerpt from Whitney Tilson's presentation to the Value Investing Congress in Pasadena, California on May 5, 2010. Whitney Tilson is the founder and Managing Partner of T2 Partners LLC and the Tilson Mutual Funds. Two years ago, we stood up here on this exact stage and delivered a very downbeat presentation on the US housing market. We return today to provide an update...and a new forecast. In early May of 2008 housing prices had already been declining for two years. The Bear Stearns hedge funds had blown up a year earlier. NovaStar and New Century Financial had also blown up a year earlier. The subprime crisis was well upon us. And many, many people thought that this was going to be contained to subprime. But we announced that the data led us to believe the contrary and we delivered our analysis in a presentation entitled, "Why We're Still in the Early Innings of the Bursting Housing and Credit Bubbles." We concluded that things were terrible and that there was no sign of a bottom. Obviously, that forecast was on target. So where are we today? Two thirds of American homes have mortgages - 56 million mortgages outstanding. A little over half are owned or guaranteed by government entities. 35% are held on the balance sheets of banks and thrifts, and 15% are so-called private label securities that went to Wall Street. This last piece was the sub-prime stuff that was some of the very worst mortgage debt ever written. It's very easy to get complacent about the mortgage market, as housing prices have stabilized and foreclosures have stabilized, you know, 'we don't have to worry about that anymore.' But I'd argue to the contrary, let me show you why. Fourteen percent of America's 56 million mortgages are already delinquent or in foreclosure. So if you multiply 56 million by 14%, that means that 7.8 million people right now are not paying their mortgages. 7.8 million homeowners have been delinquent for 30, 60 or 90 days...or are in foreclosure already. 91% of the people who are currently not paying are never going to get back to current, according to recent statistics. So that means that of 7.8 million people not paying their mortgage, 7.2 million are never going to get back. So that's a problem. 7.2 million homes. 7.2 million mortgages will go into foreclosure...eventually. And the real story is even worse than the nearby chart suggests. Because of loan modification programs, the government, banks and servicers have dramatically slowed down the foreclosure process. The banks have been modifying everybody, slowing down the foreclosure pipeline and not taking properties onto their books. So what this means is that the rate of NON-foreclosure on delinquent borrowers is climbing sharply. As the nearby chart illustrates, 24% of the people who have not made a mortgage payment during the last two years have still not been foreclosed on. That's how clogged the foreclosure pipeline is. So what's going on? Well, there are a lot of modifications going on the past year. But modifications don't really work very well. It turns out that even when you cut someone's mortgage payment by 50% or more, half of them still default within 12 months. The re-default rate is astronomical...even when you cut the monthly payments dramatically. So why is that? Because the real driver is people being under water, people who have no 'skin in the game.' Basically what we did in this crisis is we gave American homeowners a $2 trillion "call option" on home price appreciation. But when the value of their properties fell below their debt levels, they handed the keys to the lender; that's what people do. And that's what American homeowners have done. To some extent American homeowners are now minimizing the human toll of losing homes and so forth. Purely as a group, on an economic basis, they're the only rational players in this bubble. They've pocketed $2 trillion in cash and now, when the value of the property falls below their debt, they're walking away. As it turns out, the unemployment rate isn't really much of a driver of default rates. Instead, it's all about home equity...or the lack thereof. So what does the future hold? Foreclosures are starting to spike back up as the trial 'mods' are failing and moving into foreclosure. If we're very lucky, home prices will stabilize here. But if interest rates go up, and if we don't properly deal with those 7.85 million people who aren't paying their mortgages and those delinquent mortgages turn into foreclosures, look out below! Today about 17.2% of homeowners are underwater. But if home prices drop 10% from here, 27% of homeowners would go underwater. In other words, a 10% drop in home prices would cause a 56% increase in the number of people underwater...which would almost certainly lead to another surge in defaults. So I really think the housing market is on a precipice right now, where we need some very strong intervention by the government, by the banks and the servicers to offset what, in the absence of strong action, would be a resurgence of foreclosures, which would lead to a fresh drop in home prices, which will lead to even more defaults... And you can get into the vicious cycle that we were in back in '07 through '08. One big problem in all of this is second liens. You have $842 billion in second liens outstanding and the majority of them are owned by the Big 4 banks. And you have this bizarre situation where American consumers are not making the $1,200 monthly payment on their first lien, but maybe just to prevent harassing phone calls from debt lenders, they are paying the $150 second lien. Well, that means that the banks are looking at this and they're holding all of these second liens at par, even if the first lien has already gone bad. This situation makes the banks very reluctant to approve a short sale, since that would completely wipe out the second lien. Because if you write down the first lien, the second lien is a zero. Of course, banks just don't want to do that because it's a huge amount of money that would wipe out the equity of these Big 4 banks, if they were to mark these second liens to zero. This is a big problem. Then there's commercial real estate. The majority of commercial real estate loans that are coming due, nothing is happening on them. They don't get refinanced, but they don't get foreclosed on either. It's "extend and pretend" or "delay and pray." That's what's going on with commercial real estate. Net-net, there's more pain to come in the real estate market. Whitney Tilson, for The Daily Reckoning Bill Bonner Government Spending Won't Stave of a Correction Bill Bonner Reckoning from Baltimore, Maryland... I like to work, I'm rolling all the time... I can pop my initials on a mule's behind... - Jimmy Rogers The Dow dropped another 115 points yesterday. Gold moved up to near an all-time high. This past weekend, we worked on a barn roof...just like we did 30 years ago. But come Monday morning we didn't feel 30 years old. Our legs still ached from the weekend's work. We always liked physical labor. Outside in the fresh air. Our feet on the ground...our muscles straining... Concentrating our whole mind on a problem that we can solve! Such as how to get a piece of tin on top of a barn without it taking off in the breeze, like a kite. Or how to get the blades off a bush hog, so they can be sharpened. Or how to set up scaffold on a hill so it doesn't fall down. Simple? Yes...and satisfying. Man spent millions of years solving practical problems. He needed shelter. He needed food. He needed to fend off predators...or he'd be food! His mind evolved as a problem-solving machine. Tying things together...cutting...throwing...carrying. He was a mathematician without numbers...a climatologist without a thermometer...a geographer without a map. He was a practical man who needed to solve practical problems. His life depended on it. And that's why he's so good at it. He can build trains that go 400 kilometers per hour and pyramids that stand stock still. Maybe that's why we like working with our hands. We were made for it. But never in 10 million years has any creature solved the problem of a funky, junky economy. It is only in the last 100 years that man has dared to try. Yes, dear reader, now our leaders are called upon to solve problems that they are not equipped to solve. They are not prepared for the challenge. They cannot do it. Even the best minds in the world are stumped. The latest important news came out on Friday. Eighteen months. Two trillion dollars. And now this: the number of unemployed people is still going up! The unemployment rate is creeping back towards 10%. But that only counts the people who have looked for a job in the last year. Trouble is, more and more people have given up looking. The number of people who have been unemployed for 6 months or more has doubled from 3.2 million to 6.7 million. There are now more than 8 million people officially unemployed. And there are millions more unofficially unemployed - 17% of the population all together. And even those who have jobs are losing income. That's right. With so many people jobless, it doesn't make sense to raise wages; instead, wages are going down. Supply up, prices down. All of these facts are consistent with a Great Correction. They are what we expected. They are merely things happening they way they ought to happen. But these events are not compatible with the pretensions of the economic world improvers. Tim Geithner, for example. The poor man is frustrated by his European counterparts. While he and his colleagues in the US continue to stimulate the economy in order to make the world a better place...the Europeans have decided to get their financial houses in order. And that means cutbacks in public spending. To give you just a hint of what is going on, here's a Bloomberg report: Cameron Prepares UK for Cuts Hurting 'Every Single Person' June 7 (Bloomberg) - UK Prime Minister David Cameron, preparing voters for the deepest spending cuts in a generation, said the previous Labour government left the public finances in a weaker state than he anticipated. "The overall scale of the problem is even worse than we thought," Cameron said in a speech today in Milton Keynes, 50 miles (80 kilometers) north of London. "The decisions we make will affect every single person in our country. And the effects of those decisions will stay with us for years, perhaps decades to come. "Today we spend more on debt interest than we do on running schools in England," Cameron said. "Raising taxes and cutting spending is socially painful. But what's the alternative, keeping generous budget policies?" Nouriel Roubini, the New York University economist who predicted the financial crisis, said in an interview with Le Monde. "The markets have already sounded the alarm that continuing that way would lead to bankruptcy," he said. "Austerity isn't optional." What has happened in Britain is little different from what has happened everywhere else in the developed world. "Forty years ago," said an Englishman on the phone yesterday, "Britain had 8 million people in manufacturing, making things, and 3 million people on the public payroll, consuming them. Now, those numbers have almost completely reversed. And it gets worse. Every day, 126 people are added to government employment in Britain, while 1440 private sector jobs are eliminated." Germany is promising cuts to government spending too. Bloomberg again: "Merkel's cabinet backs decisive cuts..." The way we look at it here at The Daily Reckoning is this: the world improvers have made a massive mistake. They've spent too much money...and put too much of the economy under control of the government. Now, the markets - and economic reality - are forcing a correction. But many economists see no mistake and think austerity IS optional. Paul Krugman, for example. Like Mr. Geithner, The New York Times columnist thinks it's just a matter of better management. He thinks the government should increase spending in a downturn - even if the government hasn't got any money: "The right thing, overwhelmingly, is to do things that will reduce spending and/or raise revenue after the economy has recovered - specifically, wait until after the economy is strong enough that monetary policy can offset the contractionary effects of fiscal austerity. But no: the deficit hawks want their cuts while unemployment rates are still at near-record highs and monetary policy is still hard up against the zero bound." In other words, Krugman believes that overspending on government-led consumption is not the problem. Instead, the problem is the correction itself. Once the correction is stopped - by more government spending! - then, the feds can cut back. The important thing about putting on roofing is that you have to work from the bottom up. The upper pieces have to overlap the bottom pieces so that water runs off the roof. Probably neither Geithner nor Krugman has ever put on a roof. If they had, maybe they'd have a greater appreciation for the practical side of things. Deficit hawks do not put the roofing on from the bottom up just because they are grumpy and have low levels of sugar in their blood. They do it because it is the practical, sensible solution to the problem of credit quality. If you want people to lend you money, you have to be able to pay your bills. Krugman's solution is deeply impractical, to the point of absurdity. He proposes that the feds spend money they don't have to cure the problems caused by spending money they didn't have. It's like starting the roofing at the peak of the roof. It will look like a roof. It just won't shed water. And more thoughts: And here's poor George W. Bush...back in the news...admitting a crime... The Huffington Post: George W. Bush's casual acknowledgment Wednesday that he had Khalid Sheikh Mohammed waterboarded - and would do it again - has horrified some former military and intelligence officials who argue that the former president doesn't seem to understand the gravity of what he is admitting. Waterboarding, a form of controlled drowning, is "unequivocably torture", said retired Brigadier General David R. Irvine, a former strategic intelligence officer who taught prisoner of war interrogation and military law for 18 years. "As a nation, we have historically prosecuted it as such, going back to the time of the Spanish-American War," Irvine said. "Moreover, it cannot be demonstrated that any use of waterboarding by US personnel in recent years has saved a single American life." [N.B. The USG prosecuted Japanese Military for waterboarding OUR soldiers after WW2. Bush's travel outside of the US now entails real risks of arrest and prosecution. ] Irvine told The Huffington Post that Bush doesn't appreciate how much harm his countenancing of torture has done to his country. "Yeah, we waterboarded Khalid Sheikh Mohammed," Bush told a Grand Rapids audience Wednesday, of the self-professed 9/11 mastermind. "I'd do it again to save lives." Advice to GWB: put your passport away. And keep quiet. *** "You could have bought that car for $2,000 less two years ago." We went to a used car dealer over the weekend. One of the children needed an automobile. We looked on the Internet. And then, on the recommendation of a friend, we went to a used car dealer. We were looking for a clunker. Trouble was, there weren't any clunkers. "How come you don't have anything for less than $5,000," we asked the dealer. "Because the bottom of the market disappeared. Remember that 'Cash for Clunkers' program? Well, normally we would have bought those clunkers ourselves. We would have invested a few hundred dollars in them and put them back on the market. But the clunkers were taken out of the market all together. They were destroyed by government decree. "There is a whole class of people who depended on those old cars for transportation. Now, they don't exist. It's hard to find a decent car for a couple thousand. I feel sorry for people who are unemployed, for example. "And I saw a figure in Automotive News that each of those clunkers cost the federal government $24,000. Your government at work. And now these clowns are going to run national health care." Regards, Bill Bonner, for The Daily Reckoning ------------------------------------------------------- Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor at joel@dailyreckoning.com The Specious Reasoning of Census Employment The census takers illustrate our point. Government spending – including government jobs – do not really make us richer. They make us poorer. If you could make people better off by hiring them to count each other, why not count them twice? Or three times? The trouble is, no matter how often you do it...or how well you do it...counting people doesn’t add to our wealth; it takes away from it. Honohan, Meet Havenstain Why BP Should Just Deny Everything and Brace for Impact Inflation Corroded Copper Coins Junior Mogambo Ranger (JMR) Phil S. sent an article from the Globe and Mail where I learned that inflation in Canada has been so persistently corrosive over the years that, like in America, “it now costs the Royal Canadian Mint more than a penny to make a penny, and because of penny ‘hoarding’ by Canadians, the mint has to keep making more.” Hahaha! “Hoarding”? Hahahaha! Re-Animating a Debt Dog Government Desperate. Gold Tax Imminent? Could Gov’t Workers be Fastest-Growing Set of US Millionaires This recent Forbes article is of the sort that should be taken with a grain of salt... tales of everyday police officers, firefighters, and teachers becoming millionaires due to lavish public pensions – even in these days of government excess – still sounds a bit unrealistic. Yet, even with a grain of salty flavoring... there’s probably also a grain of truth. What’s Worse Than Joblessness? When it’s Combined With Frozen and Shrinking Wages ENSCO PLC (NYSE:ESV) — How the BP Leak Affects This Offshore Driller