Pushing a String

Once again I must bring you John Mauldin's "Thoughts from the Frontline Weekly Newsletter. 
I truly hope you all go to www.frontlinethoughts.com/learnmore and sign up for your own copy, you will look forward to reading it every Saturday morning as much as I do

by John Mauldin
September 24, 2010

   This week the Fed altered their end-of-meeting statement by just a few words, but those words have a lot of meaning. It seems they are paving the way to a new round of quantitative easing (QE2), if in their opinion the situation warrants it. A trillion dollars of new money could soon be injected into the system. Tonight we explore some of the implications of a new round of QE. Let's put our speculation hats on, gentle reader, as we are moving into uncharted territory. There are no maps, just theories, and they don't all agree

     Let's Shift the Focus
   The Fed issued the usual statement at the end of their meeting this week, and Fed watchers poured over the words, looking carefully for any sign of change in Fed policy. The consensus seems to be that the most important change was the statement concerning inflation, the first such change in over a year.
   "Measures of inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability."
   The next (and only other real) change was:
   "The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate." (my emphasis)
   Translation: inflation may be getting too low, but don't worry, we are on the job.
   One of my laugh lines in my speeches (I don't have that many) is: "When you are appointed to the Federal Reserve they take you into a back room and do a DNA change on you. After that, you are viscerally and genetically opposed to deflation."
   Bernanke made his famous helicopter speech about not allowing deflation to happen back in 2002. He happily assured us that the Fed has many tools to fight deflation and that it won't happen here. Of course, he also told us the subprime problem would be contained, but I am sure that we have to give him a bit of slack - we all miss a few, including your humble analyst. (Well, I didn't miss the subprime thingie. Nailed that one.)
   Anyway, the Fed seems to be setting us up for another round of quantitative easing. That is Fed speak for buying a few trillion or so dollars of government debt and injecting said cash into the economy.
   Before we get into the wisdom of such a move, let's look at what might prompt them to do so. This is where we get into speculation.
   Recessions are by definition deflationary, but if we go into recession when inflation is already as low as it is, the Fed will be behind the curve. But telling us they are going to start easing because they are worried about a recession is not a good recipe for a positive market reaction.
   So? Why not just say that they are worried about the lack of inflation, "at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability." That way they are not fighting a weak economy but rather something that everyone understands, i.e., deflation.
   I agree with David Greenlaw from Morgan Stanley. He writes:
   "Growth data still take precedence. The change in the inflation language, while important, does not, in our view, signal an elevated emphasis on the incoming inflation data itself as a possible trigger for asset purchases. To be sure, the inflation data do matter, but the growth indicators matter more because, from the Fed's perspective, the pace of growth in economic activity is a leading indicator of inflation. Here is a key excerpt from Bernanke's Jackson Hole speech that helps explain the perceived link between growth and inflation:
   " '...the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.' " (emphasis added)
   The key driver for whether the Fed enters into another round of quantitative easing, likely to be in the trillions, is the growth in the US economy. If we are above 1.5-2%, I think they will hesitate, for reasons I go into below. If we drop below 1% and it looks like we are getting weaker, then they are likely to act. A slide into recession would bring about deflation. As noted, they are viscerally opposed to deflation.
  
     An Invitation to an Inflation Party
   The question in my mind is whether a few trillion dollars spent purchasing government debt would do the trick. What if they sent out invitations to an inflation party and nobody came? Let's look at some data points.
   The Fed purchased $1.25 trillion in mortgage assets last year. The theory was that injecting money into the economy would cause banks to take that money and lend it, jump-starting the economy and bringing us back into a normal recovery. Let's see how the lending part went. Here are a few graphs from the St. Louis Fed FRED database.
   The first is "Bank Credit of All Commercial Banks." Please note that the straight upward line in the middle of 2010 is an accounting change. Without that the trend would still be down.

 
   Then we have "Total Consumer Credit Outstanding." That had been growing steadily for 65 years until this last recession.



   Next we have "Commercial and Industrial Loans at All Commercial Banks."



      We could look at total residential mortgages (down); credit card debt (down); and commercial mortgages (down). The list goes on.

   Sidebar from Greg Weldon:
   "Also, the value of Commercial Property Loans classified as Special Servicing (restructured and-or- extended) rose to a NEW HIGH, pegged at 11.74% of all CMBS, as evidenced in the chart below."


   No wonder commercial mortgages are down.
   So, what happened to the trillion-plus dollars? It doesn't look like it went into bank lending. As it turns out, it went back onto the balance sheet of the Federal Reserve. Banks put it back into the Fed. There are several ways you can measure this with the FRED database, but one way is to look at "Reserve Balances with Federal Reserve Banks, Not Adjusted for Changes in Reserve Requirements."



   If banks are not lending now, with what seems like lots of reserves, then what is to make us think that another $2 trillion in QE will make them feel like they have too much money in their vaults?
   If it is because they don't have enough capital, then adding liquidity to the system will not help that. If it is because they don't feel they have creditworthy customers, do we really want banks to lower their standards? Isn't that what got us into trouble last time? If it is because businesses don't want to borrow all that much because of the uncertain times, will easy money make that any better? As someone said, "I don't need more credit, I just need more customers."
   How much of an impact would $2 trillion in QE give us? Not much, according to former Fed governor Larry Meyer, who, according to Morgan Stanley, "...maintains a large-scale macro-econometric model of the US economy that is widely used in the private sector and in public policy-making circles. These types of models are good for running 'what if?' simulations. Meyer estimates that a $2 trillion asset purchase program would: 1) lower Treasury yields by 50bp; 2) increase GDP growth by 0.3pp in 2011 and 0.4pp in 2012; and 3) lower the unemployment rate by 0.3pp by the end of 2011 and 0.5pp by the end of 2012. However, Meyer admits that these may be 'high-end estimates'.
   "Some probability of a resumption of asset purchases is already priced in, and thus a full 50bp response in Treasuries is unlikely. Moreover, a model such as Meyer's is based on normal historical relationships and therefore assumes that the typical transmission mechanisms are working. For example, a drop in Treasury yields would lower borrowing costs for consumers and businesses, helping to stimulate consumption, business investment and housing. But there is good reason to believe that the transmission mechanism is at least partially broken at present, and thus the pass-through benefit to the economy associated with a small decline in Treasury yields (relative to current levels) would likely be infinitesimal." (Morgan Stanley)
   That is not much bang for the buck, so to speak, but it would be pointing a gun with a very big bang at the valuation of the dollar. If QE were attempted on that scale, it would not be good for the dollar. My call for the pound and the euro to go to parity with the dollar would be out the window for some time, and maybe for good.
   Now, if the strategy is to lower the dollar, then QE might make some sense; but of course no one would admit to that, not when we are accusing other countries of manipulating their currencies (as in China). No, we would just be fighting deflation. The fact that the dollar dropped would just be a coincidence, a necessary but sad thing in the important fight against deflation. (Please note tongue firmly in cheek. Not you, of course, but some other readers sometimes miss my sarcasm.)
   Of course, not all agree that a lower dollar would necessarily be a bad thing. Ambrose Evans-Pritchard, writing in the London Telegraph, concludes a column in where he notes that there is a lot of opposition to QE2 from some fairly significant economic luminaries, and that:
   "Dr Bernanke said in November 2002 that Japan had the economic instruments to pull itself out of malaise but failed to do so. 'Political deadlock' and a cacophony of views over the right policy had prevented action. He insisted that a central bank had 'most definitely' not run out of ammo once rates were zero, and retained 'considerable power to expand economic activity'.
   "Yet eight years later, the US is in such 'deadlock'. Worse, Fed officials now say 'the ball is in the fiscal court', arguing that budget policy should do more to 'complement' the Fed's existing stimulus. Oh no!
   "This is the worst possible prescription. What is needed is fiscal austerity (slowly) before debt spirals out of control, offset by easy money or real QE for as long as it takes. This formula rescued Britain from disaster in 1931-1933 and 1992-1994.
   "Damn the rest of the world if they object. They have been free-loading off US demand for too long. A weaker dollar will force the mercantilists to face some hard truths. So keep those helicopters well-oiled and on standby."
   Hmmmm. If everyone else wants to devalue their currency, should we play along? Can you say buy some more gold?
   But back to the inflation party invitation. If the economy is recovering, QE is not needed. Note that the US economy in the current quarter may be doing better than last. And if you looked at the bank lending charts I presented above, an optimist could note that it looks like we might be seeing a bottom forming and even some increase in lending. Perhaps we have turned the corner. Again, the banks have plenty of reserves, so another $2 trillion is not needed.
   But what if they went ahead and threw $1-2 trillion against the wall? If it showed up back at the Federal Reserve, it would only serve to show that the Fed does not have the tools it needs, or would have to be really willing to monetize debt. It would be Keynes' "liquidity trap" or what Fisher called debt deflation. Neither are good.
   That's called pushing on a string. If the markets sensed that, it would not be pretty.
   The Fed has been buying government debt for several months, taking the money from the mortgages that are being amortized and buying the debt. Let's maybe see how that works out before we bring out the big guns. Just a thought.
   I agree with Allan Meltzer, a historian of the US central bank:
   " 'We don't have a monetary problem, we have 1 trillion or more in excess reserves, so it's literally stupid to say we're going to add another trillion to that,' Meltzer, a professor at Carnegie Mellon University in Pittsburgh, said today in an interview on Bloomberg Television's 'InBusiness With Margaret Brennan.'
   " 'One of the major mistakes that the Fed makes all the time is too much concentration on the short-term,' said Meltzer, author of a history of the Fed. 'Aiming at that is just a fool's game.' " (Business Week)
   That being said, we live in a world where we need to act in terms of what will be rather than what should be. And if the economy continues to weaken, I think it is likely the Fed will act preemptively and start QE2. So the next few months of economic data are very important.
   And even more important is whether Congress will extend the Bush tax cuts at least until the economy is growing respectably, when they come back for the lame duck session in November. Not extending them would be a policy mistake bigger than QE2, and might force even more precipitous action. We do live in interesting times.
   Your ready to be in his own bed for a week analyst,

     John Mauldin
         John@FrontLineThoughts.com

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With Certainty

It is only certain that uncertainty rules . . .

It really doesn't make a whole lot of difference if we are in the first part of a double dip recession or close to the bottom of a single dip; the US economic recovery will be very, VERY slow compared to what the country has been used to after past recessions.

   The recovery won't really get under way until the real estate market gets back on track. Today, the estimate is that we have more than a year’s supply of homes on the market. That is, a year's supply of what used to be a year's supply in the good (read, "of course the beanstalk grows to the moon, stupid") old days. In today's market it is two or three times that amount. Then there is the shadow inventory (those are the houses that the banks will wind up owning when this all shakes out, and which they will then dump on the market.) that will be, at least, another 12 months added. So you see, in real terms it may be 4, 5, 6 or even seven years before things get back to some semblance of "normal" in the residential real estate market. Oh yes, we are just now beginning to feel the slump in the commercial real estate market. That bit of bad news has yet to be figured into the sound bites of the Political Wonks.
   The American Consumer is not as stupid as most political and financial pundits are. Those of us who live in the real world, that is East of Riverside, CA, and west of the Hudson River, excluding that part of the heartland which lies inside "Beltway"; have a much better understanding where the economy is, and where it is going than those inside the Beltway, on Wall Street, or the nuts of the West.
   Consumers have become Savers and are saving all they can, at least those who have a job are. Job or no job, there are few who are spending on anything which isn't necessary, so retail sales aren't going to pull us out of the doldrums. Small businesses, the major creators of jobs, aren't going to do anything that uses cash because they don't know what "money grabbing/money costing" Sisyphean Load Washington will pile on their backs next.
   Maybe the Tea Partiers and their associated groups will get Washington's attention and stop the ridiculous taxing and spending spree before it is too late. The only certainties are these:

• Unless things turn around, the U.S. will be relegated to Third World Status by the time my Grandson graduates from collage and has to go to India or China to find a job.
• Until entrepreneurs are free to carry on business without fear of retribution from Washington, we will continue with 10% plus unemployment.
• Without reducing the exponentially increasing size and cost of government, that’s all governments, Federal, State and Local, to somewhere under 5 % of GDP, we will continue to be a debtor nation.

   Maybe it wouldn’t be so bad. I wonder how Mexico would treat US illegals streaming into their country looking for a job?

My Take
Dave Skibowski

Another Bailout ? ! ? ! ?

   Gonna Print More Money

   "Main Street may be about to get its own gigantic bailout. Rumors are running wild from Washington to Wall Street that the Obama administration is about to order government-controlled lenders Fannie Mae and Freddie Mac to forgive a portion of the mortgage debt of millions of Americans who owe more than what their homes are worth. An estimated 15 million U.S. mortgages - one in five - are underwater with negative equity of some $800 billion. Recall that on Christmas Eve 2009, the Treasury Department waived a $400 billion limit on financial assistance to Fannie and Freddie, pledging unlimited help. The actual vehicle for the bailout could be the Bush-era Home Affordable Refinance Program, or HARP, a sister program to Obama's loan-modification effort. HARP was just extended through June 30, 2011.    "The move, if it happens, would be a stunning political and economic bombshell, less than 100 days before a midterm election in which Democrats are currently expected to suffer massive, if not historic losses. The key date to watch is August 17, when the Treasury Department holds a much-hyped meeting on the future of Fannie and Freddie."

   Rumors are just that. But James Pethokoukis is a serious journalist with a solid pedigree and a long list of inside contacts, which you can see at the link below.

   I hope this is just a rumor. Seriously. You want to tax everyone including renters (about 35% of us) to help pay for mortgages for people who entered knowingly into a business transaction that sadly did not end well? I truly feel sorry for them. I have several very good (and responsible) friends who are in trouble, and I understand the issues. They just bought at the wrong time. But what about my investment in a start-up that failed? People who are behind on credit cards? If you bought a new car, you are underwater the moment you drive the car off the lot. Help for those? Where does it end? Hundreds of billions of debt that our children will have to pay?

   You can read the whole blog if you have adult beverages or blood-pressure medicine nearby.
http://blogs.reuters.com/james-pethokoukis/2010/08/05/an-august-surprise-from-obama/

Wealth in America was in our homes

We won't be well till we get it back

     Whose Got A Centrifuge?
   The “Fair Weather-All Is Well” prognosticators are spin, spin, spinning away like a mama orb spider in a new location. In fact, if they get much more bad news to spin into good, they may need a centrifuge. The 2nd Quarter advance GDP report came out this morning only 0.10% lower than projected. However, the revised data for earlier periods presents some real cause for alarm. 1st Quarter GDP numbers were adjusted upward a full 1%. That made the 1st Quarter look pretty good. But boy, that switched the 2nd Quarter numbers from OK to bad, if not dismal. To add to the turmoil, the 2009 GDP was dropped from a -2.4% to a 2.6% loss, the 2008 was lowered from +0.4% to unchanged, and the 2007 was dropped 0.2%. All worse than we were told.

What this means is the economy has not been growing as fast (I use that term with trepidation) as claimed, and we are not in nearly as good shape as the Administration pundits claim. I question whether even this poor news will be enough to wake up the markets, and make the “rah, Rah, RAHers” understand that until the housing market quits bouncing along on the bottom (if it is even at the bottom) and the consumers leave the sidelines and start to spend, the economy is going nowhere. We need businesses to start creating jobs, but no businessperson in there right mind would go on a hiring binge, or even think about it with a future so clouded by tax increases, healthcare uncertainties, and banks that won’t lend. Why wont the banks lend? Because they don’t know what sucker punch the administration will throw at them next.

     The Gains Are Not Sustainable
   The gains the equity markets have been enjoying have been fueled by positive corporate earnings. Problem is those earnings have been predicated on massive cost cutting by companies. They’re reducing costs and slicing R & D budgets, preparing for the draconian increase in regulatory costs that will start hitting next year. 2010 hasn’t been fun, but 2011 just may be horrendous. Even Bernanke is pushing full recovery off till 2015 or 2016

     How Long Till Recovery?
   The last two years have seen America’s wealth peeled away like the skin of an onion. The constant flow of double-talk and even lies from inside the Beltway has both businesses and the consumer confused. Wealth in America was in our homes. This fact seems to have come as a surprise to the Beltway insiders and even the geniuses on Wall Street. It is going to take several years to recover from the excesses of the past few, and the government is doing everything in it’s power to push the date of full recovery farther down the time line.

That's My Take.
Dave Skibowski

Running through a minefield, backwards

The U.S. is upside down, but in reality, the E.U. is worse. Here is another article Via John Mauldin’s Outside the Box newsletter at InvestorsInsight.com to give you some more perspective on the worlds economy.

John's intro . . .
   Now, I offer you a very intriguing essay by those friendly guys from Bedlam Asset Management in London. They argue that Belgium's sovereign debt should be suspect, and is the country that could be a "sleeper" problem. This is a very interesting read, with a lot of history. It is not too long and very interesting. Enjoy. (www.bedlamplc.com)
   Your thinking sovereign debt is the biggest bubble of all analyst,
   John Mauldin

Farewell Flanonia?
   The last issue concentrated on sure sovereign default by Greece, Spain and Portugal - partly due to hopeless economic numbers but more because of various 'soft' issues. For, just as the numbers in a company's balance sheet theoretically provide all that is required to understand and value it, the reality is that squishy issues, such as the quality of management, staff morale or even simple luck can make a mockery of these numbers. Part I also emphasised the futility of gnawing at the bone of the de facto bankruptcy of these three countries. Backward looking investment never makes money; better surely to recognise the sovereign default cycle has further to go, and so spend time identifying the next unexpected candidate.
   On the numbers alone, the most likely casualties are the UK and US in that order, but both have good odds of escaping. Many hard issues help. In America, one such is the dollar's currently irreplaceable role as the world's reserve currency. In the UK, the relatively excellent debt duration (i.e. it is spread over many years rather than near-term) is a plus. Each also has good soft issues: the market likes the new British government's tax and slash policies so is a willing buyer of UK debt, whilst the Asian central banks have so many US bonds they simply self destruct if they refuse to keep buying.
   The standout surprise candidate for sovereign default by end-2012 is Belgium. A decent country; civilised, at peace, wealthy and globally competitive in several areas. Moreover, first glance at the numbers gives no particular reason to expect Belgium to default. Its potential financial problems have been on the radar screen for so long that we have grown used to them, rather like those many parents who fail to recognise the repulsiveness of their offspring. With net government debt of €400bn, it is hardly a huge world borrower in absolute terms. Yet default could occur almost entirely by accident and the ripples be far greater than its size warrants, because of its position as the de facto federal capital of the EU. Belgium's hastening car crash is not in current bond prices or exchange rates.
   The glue has dissolved There are five reasons why Belgium has hung together for the last 180 years: Britain, God, the King, fear and most importantly, money. Before addressing these, it is necessary to understand why Belgium exists at all. When in 1815 Britain was the Big Beluga after the battle of Waterloo, it wanted a buffer state to contain France. The easy solution was to give the area now known as Belgium to one of its staunchest allies, Holland. Unfortunately, King William I of the now-renamed United Netherlands was not, even according to Dutch history books, the smartest primate in the zoo, and he suffered from the diplomatic skills of a water buffalo. Holland (or the Kingdom of the Netherlands to give it its official name) had a long history of Calvinism. This was unpopular with the newly acquired Dutch and French Catholic subjects alike. Moreover, by deliberately ensuring the French were under-represented in all parts of government, yet overtaxed, the embers of resentment smouldered. These grew hotter in 1823 after an attempt to make Dutch the official language for the whole population. Surprisingly, full rebellion was ignited by the staging of a sentimental patriotic opera in Brussels in 1830. The crowds poured out of the theatre and went on the rampage. As Britain still wanted a buffer state, and was still the world superpower, it quickly moved to ensure the creation of a new country called Belgium, uniting Flanders and Wallonia (hence Flanonia might have been more appropriate).
   The people, having suddenly been rebranded, opted for a French king. Britain growled, ever mindful of France's latent imperial ambitions, thus a minor German duke's second son was chosen instead. After nine years' skirmishing, as Holland held onto a few strong points, and a minor invasion by France, Holland withdrew to sulk.
   The Dutch king's alienation of his many Dutch speaking but Catholic subjects in Belgium united them with their French counterparts, providing a powerful glue to hold society together well into the late twentieth century. Now, like most of Western Europe, society has rapidly turned secular. In 1967, 43% of the population attended Catholic mass every Sunday. By 1998 (the last year in which the Roman Catholic Church produced data) this was down to 11%. It is estimated to have fallen by 0.5% p.a. ever since, possibly accelerating given the latest sex-scandal investigations. (The Bishop of Bruges confessed to an unpleasant 20-year history and resigned; the police then raided and sealed off the Archbishop's palace, also the national catholic HQ on similar charges. The investigation continues.)
   In line with this trend, reverence for the monarchy has also waned, although most of the country's kings have done a good job given they have forever walked the high wire over ferocious political and linguistic divisions. Little needs to be said of the fear quotient. Belgium has suffered from three highly aggressive neighbours: Germany, France and the Netherlands. It was a popular sport for each to routinely stomp all over the area. They have all changed their ways. Leaving aside a lack of clout, the British are now wholly ignorant of how or why they created Belgium at all.
   The language chasm Belgium is a federation of three states: Flanders in the North, where Dutch (Flemish) is spoken by the native Flemings; Wallonia in the South where the official language is French; and thirdly the all-important region of Brussels. This is surrounded by Flanders although the majority of the region speaks French. The linguistic divide is well-known, but this is not of the Mandarin vs. Cantonese or Castilian vs. Catalan spat variety. It is aggressive. Ten metres either side of the official linguistic border, the other language does not exist. Municipalities can and often do insist official documents and meetings only take place in their local language. This draconian legal divide was foolishly legislated into place in 1980 and has become more intolerant every since. Belgian politics are so culturally divided that all 12 of the major parties break down on linguistic lines and cannot stand in the other language area.
   A shifting balance of power Post-independence the balance of power shifted to the French speakers. The richer Flemish Belgians were highly dependent on Holland's colonial trade and capital. Post independence, this stagnated and so they concentrated on successfully out-breeding the French over the next 150 years. Meanwhile the French speaking south boomed. The development of iron, steel, coal and heavy industry - funded by French, and to a lesser extent German, capital and supplied by the major mineral deposits nearby - put all the financial and industrial power into Walloon hands. Like their previous masters in Holland, this was gradually abused. Almost all higher education was in French; plump political posts always went to French-speakers.
   Meanwhile, the Flemish-speakers developed into a distinct but majority underclass. By the early 1970s, the wheel had again turned. Today, 75% of GDP is accounted for by the service sector as industry withers. The majority Flemings now sit in the financial chairs and have not hesitated to embark on a little light payback, such as splitting up key universities into Flemish and French speaking sections from 1968 onwards. The relative wealth of the Flemings is simply overwhelming. Their income per head is 118% of the EU average - the French-speakers 85%. Per capita productivity is 20% higher. They make up over 70% of the skilled labour force. French unemployment is twice that of the Flemish speakers.
   Per capita, subsidies for French speakers are 50% more than for the Flemish. In short, Flanders funds and props up Wallonia.
   This has not been lost on the ever chaotic voting system. Recent headlines have screamed that the independence parties have taken over. A slight exaggeration. True, the Flemish speaking, free market and pro-independence Vlaams Belang (VB) party won the most seats in the 150- member lower house, with an increase from 17 to 27 (in line with the wealth divide, the second largest party with 26 seats is the French-speaking Socialist "welfare" party). But this does not ensure separation, even though in those areas where it was allowed to stand, VB and its sympathisers won over 40% of the votes. Belgian law requires that at least four of the 12 "major" parties (seven Flemish and five French) form a government with at least one from each state. Hence, once again various caretakers are manning the desk. There is no elected government.
   The most heated and longest debates in parliament concern two issues: language superiority and the French speakers demanding, and to date getting, an ever greater and disproportionate share of the welfare pie. Up north, not surprisingly this is unpopular. The result is net government borrowing equal to 100% of GDP. Not quite as bad as Greece and a few other miscreants, but add a budget deficit of 6% of GDP and a too-high a structural deficit, and Belgium is in the top fifth of over-borrowed nations globally, a position it has steadfastly maintained for the last 30 years. It has even been worse. Throughout most of the late 1980s and 1990s net government debt averaged 114% of GDP.
   As with several Mediterranean countries, Belgium was a huge beneficiary of joining the euro (it was the first to do so) because the implicit German guarantee allowed heavy borrowing at much lower interest rates. Before joining the euro zone, general government net interest payments in 1992 absorbed a whopping 10.3% of GDP. In 2009, even after the collapse and necessary bailing out of its banks, especially the big two of Fortis and Dexia, interest payments were only 3.6%.
   Follow the money High debt and gradual linguistic separation have been a constant for 30 years. The recent elections confirm the trend of accelerating separatism. Yet these are likely to morph faster than expected into a financial problem because of Brussels.
   Much to the dislike of most politicians across Europe, Brussels is the de facto Federal Capital. A small city; and only 1.1m people live within the "Brussels region". It is wealthy, with income per head 233% above the EU average. Moreover, despite being only a tenth of the Belgian population, it accounts for over a fifth of GDP. The reasons are well-known. Since the early 1950s treaties presaging the European Union, money has poured into Brussels. The EU Commission alone employs 25,000 people, the EU parliament another 7,000. There are over 10,000 registered lobbyists and more diplomats and countries represented in Brussels than in Washington. Then there are 1,200 accredited journalists (which may explain why expenditure on expenses accounts alone was €800m in Brussels in 2009). Just for direct running costs (i.e. rentals and electricity), the EU pumps $1bn into Brussels every year. Yet this money fountain is not only the EU. 40% of the population comes from outside Belgium, as it is headquarters to a range of other organisations which have developed into an administrative cluster. The better known includes groups like NATO, where Brussels is the European HQ with 5,000 employees. The range includes the weird, such as the heavily funded, big employing World Customs Organisation or EURATOM.
   All these foreigners, usually funded by their overseas governments, are amongst the very highest earners in Europe, creating a major multiplier effect on schools, restaurants, cleaners, auto sales or house building. Originally majority Flemish-speaking, now most locally born Brussels residents speak French, the result of policies introduced when they were at the top of the economic tree. Yet Flemings - residents and commuters - still dominate the better paid and skilled jobs, hence Brussels is the only part of Belgium where both languages must co-exist by law. Some local French speaking politicians have been muttering darkly about doing to Flanders what Flanders wants to do to Wallonia, i.e. spin out of Flanders or even Belgium itself. This is because the money spigot is about to jam.
   Turning off the taps As the third richest region in Europe (after Luxembourg and London) it could in theory exist as a wealthy city-state cum federal capital, but such a dream is a chimera. Derided eurocrats live a life apart. Even Brussels-born residents who benefit from their largesse often complain that the many organisations have created rich ghettos from which they are excluded. That these eurocrats are out of touch has been demonstrated both by pay and expenses enough to make a third world dictator blink, and recent demands for pay rises.
   There is a commonsense test to apply to the financial future of Brussels. Most European countries are net recipients of aid from the EU. Of the minority putting money in, Germany dominates. Other small contributors such as Scandinavia or the UK are co-joined triplets with Germany. Forced to slash their own capital, social, and welfare budgets following the financial crash, they will not put more into Brussels. It is a matter of time before each country decides to reduce its net or gross cheques written out to various Brussels organisations; hence the second most important engine of Belgium's economy (after the wider economy of Flanders) suffers its first ever post-war squeeze. This means it has less largesse to spread around - particularly in Wallonia
   Moreover, Brussels is no longer so logical a geographic centre for a federal capital since the EU expanded eastwards. This has not been lost on the Germans (Brussels' most significant honey provider). Its press and politicians have suggested for example that NATO be moved from a largely neutral country with minimal military capability to one with a little more vim, such as Germany. France would murder to get its hands on more EU institutions. Even the UK, ever-equivocal about what it really wants form the EU, and outside the euro zone, would like a few pointless but foreign funded pork barrels like EURATOM. Such major political changes will take time. Turning off the money spigot is easier and will happen sooner.
   How it plays out? What is evolving in Belgium is old news. The problem now, as for divorcing couples, is how to divide up the assets, or more precisely in Belgium's case, its sovereign debt. It is noteworthy that the government is chary in producing full data on how much Brussels and Flanders subsidise the minority Walloons, but roughly speaking the national debt should probably be split about 35:65 Dutch:French. Yet relatively poor Wallonia simply could not service nearly €260bn of national debt (€175,000 per person in employment). Meanwhile, wealthy Flanders would emerge with a budget surplus, a minute structural deficit and debt to GDP the lower than any EU nation outside of Scandinavia. The imperative for Flanders, along with the scope for argument, is clear.
   There is a growing risk of a faster than expected dissolution of Belgium which will result in sovereign default; this is based on a belief in the inability of the individual nations within the euro zone, let alone the EU institutions themselves, to realise that as nations unravel, speed is of the essence. To repeat, the net €400bn national debt is chicken feed - less than half the loss racked up by America's AIG in 2007-8. And in wealthier times, the dream then shared by most of its members, of a politically united Europe would have ensured a quick bailout led by Germany. Mrs Merkel has already discovered that small cash subsidies to the profligate, such as Greece, are very expensive electorally. So foot dragging and evasion are sure to be the political order of the day. As the divorce commences, little is gained in double guessing the next phase. Whether Flanders goes alone as a fabulously rich small state or joins up with Holland (now the religious issue is moribund) is a moot point. Equally, whether France chooses to absorb Wallonia into greater France (Sarkozy's wild card to escape likely electoral defenestration?) or to subsidise Wallonia as a client state again, is also an unknown. On every topic, there is no agreement on how these regions should evolve, nor who is responsible for the debts, further ensuring delay.
   Investment conclusions If markets have re-learned one lesson recently, it is that small events have disproportionate results. Belgium ranks as the world's 20th economy by size, accounting for 0.8% of world GDP. Greece before the fall was No. 28, with 0.6%; its problems continue to shake markets, both because they were unexpected and because of the risk of a domino effect. So too would be the problem with Belgium. It is yet another reason why government bonds are toxic and why at some stage their yields will blow out, thus capital values fall.
   Obviously, not holding Belgian shares on a medium term basis is sensible unless valuation work has fully taken account of these unexpected risks (clients have zero exposure). Once again the euro would fall and the German export machine boom. Equity markets would rattle around for a while but then absorb the key lesson. For Belgium is yet another example, as if one was needed, that the supply of government bonds over coming years will continue to soar to unprecedented levels even. All commodity prices tumble when the supply is perceived as infinite. Meanwhile, equities would benefit.


      Regards 
      Bedlam Asset Management plc

HIGHER TAXES RESPONSIBLE FOR EUROPE'S LOWER PRODUCTIVITY

   We won't be out of this recession until we start creating jobs, and we won't get the jobs engine kickstarted until we remove the threat of higher taxes from individuals, small and medium sized businesses. If you look around the world, you will find wonderful proofs. Re, the following article:
   Dave

James K. Glassman, Commentary Magazine, July/August 2010.

   In 2004, the year he won the Nobel Prize, Edward Prescott, an economist at the Federal Reserve Bank of Minneapolis, published a paper titled "Why Do Americans Work So Much More than Europeans?" The data were stunning, says James K. Glassman, former undersecretary of state for public diplomacy and public affairs and the current executive director of the George W. Bush Institute in Dallas. 
   Prescott found that the average output per adult between 1993 and 1996 in the United States was 75 percent greater than in Italy, 49 percent greater than in the United Kingdom, and 35 percent greater than in France and Germany. "Most of the differences in output," he wrote, were "accounted for by differences in hours worked per person and not by differences in productivity."
   In other words, Americans don't work any more efficiently than Germans; we just work a lot more. Not only do we work longer hours each week and take fewer vacations; we also work more years of our lives, and a higher proportion of our adults are working:

• In 2007, for example, American men, on average, retired at age 64.6, while Frenchmen retired at just 58.7 and Austrians at 58.9.
• That same year, 72 percent of Americans, aged 15 to 64, were in the workforce, compared with 59 percent of Italians and 64 percent of French.

   The result is that Americans produce and earn considerably more than Europeans:

• In the United States we make $47,000, compared with $36,000 in Germany and the United Kingdom, and $34,000 in France.
• In fact, as the Michigan State economist Mark Perry points out on his blog, Carpe Diem, citizens of America's poorest state, Mississippi, have a higher GDP per capita than Italians, and Alabamans surpass Germans, French and Belgians.

   Prescott fingered the culprit: high taxes. Taxation rates on the next euro of income became so high that people were discouraged from working -- especially with the enticements of early retirement.
   But why are taxes so high in Europe? Certainly not to maintain a strong defense but rather to pour money into a welfare state that provides lavish support to retirees, perennial students, and others who aren't working. In other words, Europeans have chosen to have workers support nonworkers in their leisure, explains Glassman.

http://www.commentarymagazine.com/viewarticle.cfm/notes-on-europe-s-economic-decadence-15465

Home Ownership Outlook . . .

   Those inside the Beltway are proud to boast that 75% of American’s own their own home. What they don’t know, or won’t admit, is that there are somewhere in the neighborhood of 8 million who are not presently making mortgage payments, and probably 6+ million of them will be foreclosed upon on the next two years. What the loss of these homes will mean is that less than 62% of Americans will own their own home, and number that harkens back to the early ‘90s. AND, recent studies suggest that about 5% of all households, or roughly 5 million people have no equity in their homes. This leaves only 56%, or so who do have equity. I don’t know about you, but I believe many of these people who have no, or negative equity will choose a strategic default, and give their homes back to the lender.

   John Burns, CEO at John Burns Real Estate Consulting, and the author of “The U.S. Building Market Intelligence” newsletter brings us the following information:
     Factors Pushing Homeownership Up
• Aging Demographics - If we built a fence around the U.S. and did not let immigrants in, homeownership would go up due mostly to the fact that homeownership rises as you age.
• New Households - Every year, millions of young people reach the age where they leave their parents and go out on their own. This far exceeds the households lost to death. The actual numbers cycle with the economy, however, as they won't leave if they can't find a job or can't afford housing.
• Great Affordability - Approximately 58% of homeowners can afford the median priced home vs. 45% historically (assuming a 31% front-end DTI ratio and a 95% LTV). Affordable housing and generous mortgage terms impact housing greatly.
• Social Policy - Elected officials seem to be very much in favor of high homeownership because it builds equity and provides neighborhood stability. While that's correct in theory, they need to balance that goal with the fiscal reality that not everyone is financially responsible enough to save some money for a down payment and to make their mortgage payment every month!
     Factors Pushing Homeownership Down
• Immigration - Immigrants tend to rent first before buying. A rule of thumb is that immigrants average 7 years as a renter before becoming a buyer. The higher the immigration, the lower the homeownership rate.
• Lending Policies Tightening - Fannie Mae, Freddie Mac and FHA have tightened standards, but it is still much easier than usual to get a mortgage. For most of the last 50 years, 20% down payments or 10% down payments with mortgage insurance, 32% front-end and 40% back-end debt to income ratios were the norms. Fannie and Freddie will still buy loans in some states over $700,000. Fifteen years ago, the maximum was only $203,000. Thanks to government mandates to get more aggressive, mortgages have become much easier to obtain, with default risks borne by the taxpayer.
• Defaults - As mentioned above, 8 million homeowners are not paying their mortgage, and this number grows every day. The loan modifications have little prayer of helping, primarily because so many of these consumers have too much additional debt. As an example, the homeowners who have received permanent modification pay more than 30% of their income to service debt that is not their mortgage.

   As we said at the beginning, the official homeownership rate stands at 67%. (75% less 8% who are not paying their mortgage) That’s a level consistent with the turn of the millennium. Now that the economy has sagged lower than expected, many people who may have been potential homebuyers have gone underground and pulled the hole in after them. It is really a shame, because today we have a very large supply of exceptionally affordable homes. Mortgage rates are better than they have been in 60 years. But not many are even shopping for a home. Jobs are too scarce or too tenuous. There are just far to few people who have the income to take advantage of the situation. Until jobs return the real estate market with its housing glut will continue its morbidly sluggish pace.

Europe: The State of the Banking System

More words of wisdom Via John Mauldin’s Outside the Box @ InvestorsInsight.com

July 1, 2010 
     Summary
   In the last six months, the eurozone has faced its biggest economic challenge to date — one sparked by the Greek debt crisis which has migrated to the rest of the monetary union. But well before the sovereign debt crisis, Europe was facing a full-blown banking crisis that did not seem any closer to being resolved than when it began in late 2008. With investors and markets focused on European governments' debt problems, the banking issues have largely been ignored. However, the sovereign debt crisis and banking crisis have become intertwined and could feed off each other in the near future.
     Analysis
   July 1 is a milestone for eurozone banks , with 442 billion euros ($541 billion) worth of European Central Bank (ECB) loans coming due. The loans were part of the ECB's one-year liquidity offering made in 2009, which was intended to help stabilize the banking system.
   However, one year after the ECB provision was initially offered, the eurozone's banks are still struggling, and now Europe's banks must collectively come up with the cash roughly equivalent to Poland's gross domestic product (GDP). 
   Fears regarding the potentially adverse consequences of removing ECB liquidity are gripping many European banks and, by extension, investors who were already panicked by the sovereign debt crisis in the Club Med countries (Greece, Portugal, Spain and Italy). These concerns are as much a testament to the severity of the eurozone's ongoing banking crisis as to the lack of resolve that has characterized Europe's handling of the underlying problems.
     Origins of Europe's Banking Problems
   Europe's banking problems precede the eurozone's ongoing sovereign debt crisis and even exposure to the U.S. subprime mortgage imbroglio. The European banking crisis has its origins in two fundamental factors: euro adoption in 1999 and the general global credit expansion that began in the early 2000s. The combination of the two created an environment that inflated credit bubbles across the Continent, which were then grafted onto the European banking sector's structural problems.
   In terms of specific pre-2008 problems we can point to five major factors. Not all the factors affected European economies uniformly, but all contributed to the overall weakness of the Continent's banking sector.
     1. Euro Adoption and Europe's Local Subprime Bubble

   The adoption of the euro — in fact, the very process of preparing to adopt the euro that began in the early 1990s with the signing of the Maastricht Treaty — effectively created a credit bubble in the eurozone. As the adjacent graph indicates, the cost of borrowing in peripheral European countries (Spain, Portugal, Italy and Greece in particular) was greatly reduced due, in part, to the implied guarantee that once they joined the eurozone their debt would be as solid as Germany's government debt.

   In essence, euro adoption allowed countries like Spain access to credit at lower rates than their economies could ever justify based on their own fundamentals. This eventually created a number of housing bubbles across Europe, but particularly in Spain and Ireland (the two eurozone economies currently boasting the relatively highest levels of private-sector indebtedness). As an example, in 2006 there were more than 700,000 new homes built in Spain — more than the total new homes built in Germany, France and the United Kingdom combined, even though the United Kingdom was experiencing a housing bubble of its own at the time.
   It could be argued that the Spanish case was particularly egregious because Madrid attempted to use access to cheap housing as a way to integrate its large pool of first-generation Latin American migrant workers into Spanish society. However, the very fact that Spain felt confident enough to attempt such wide-scale social engineering indicates just how far peripheral European countries felt they could stretch their use of cheap euro loans. Spain is today feeling the pain of a collapsed construction sector, with unemployment approaching 20 percent and with the Spanish cajas (regional savings banks) reeling from their holdings of 58.9 percent of the country's mortgage market. The real estate and construction sectors' outstanding debt is equal to roughly 45 percent of the country's GDP.
     2. Europe's 'Carry Trade'
   "Carry trade" usually refers to the practice in which loans are taken in a low interest rate country with a stable currency and "carried" for investment in the government debt of a high interest rate economy. The European practice, which extended the concept to consumer and mortgage loans, was championed by the Austrian banks that had experience with the method due to their proximity to the traditionally low interest rate economy of Switzerland.
   In the carry trade, the loans extended to consumers and businesses are linked to the currency of the country where the low interest loan originates. Because of this, Swiss francs and euros served as the basis for most of such lending across Europe. Loans in these currencies were then extended as low interest rate mortgages and other consumer and corporate loans in higher interest rate economies in Central and Eastern Europe. Since loans were denominated in foreign currency, when their local currency depreciated against the Swiss franc or euro, the real financial burden of the loan increased.
   This created conditions for a potential economic maelstrom at the onset of the financial crisis in 2008 when consumers in Central and Eastern Europe saw their monthly mortgage payments grow as investors pulled out from emerging markets in order to "flee to safety," leading these countries' domestic currencies to fall. The problem was particularly dire for Central and Eastern European countries with a great amount of exposure to such foreign currency lending (see adjacent table).

     3. Crisis in Central/Eastern Europe
   The carry trade led Europe's banks to be overexposed to Central and Eastern European economies. As the European Union enlarged into the former Communist sphere in Central Europe, and as security and political uncertainties in the Balkans subsided in the early 2000s, European banks sought new markets where they could make use of their expanded access to credit provided by euro adoption. Banking institutions in mid-level financial powers such as Sweden, Austria, Italy and even Greece sought to capitalize on the carry trade by going into markets that their larger French, German, British and Swiss rivals largely shunned.
   This, however, created problems for the banking systems that became overexposed to Central and Eastern Europe. The International Monetary Fund and the European Union ended up having to bail out several countries in the region, including Romania, Hungary, Latvia and Serbia. And before the eurozone ever contemplated a Greek or eurozone bailout, it was discussing a potential 150 billion-euro rescue fund for Central and Eastern Europe at the urging of the Austrian and Italian governments.
     4. Exposure to 'Toxic Assets'
   The exposure to various credit bubbles ultimately left Europe vulnerable to the financial crisis, which peaked with the collapse of Lehman Brothers in September 2008. But the outright exposure to various financial derivatives, including the U.S. subprime market, was by itself considerable.
   While the Swedish, Italian, Austrian and Greek banking systems expanded into the new markets in Central and Eastern Europe, the established financial centers of France, Germany, Switzerland, the Netherlands and the United Kingdom dabbled in various derivatives markets. This was particularly the case for the German banking system, where the Landesbanken — banks with strong ties to regional governments — faced chronically low profit margins caused by a fragmented banking system of more than 2,000 banks and a tepid domestic retail banking market. The Landesbanken on their own face between 350 billion and 500 billion euros worth of toxic assets — a considerable figure for the 2.5 trillion-euro German economy — and could be responsible for nearly half of all outstanding toxic assets in Europe.
     5. Demographic Decline
   Another problem for Europe is that its long-term outlook for consumption, particularly in the housing sector, is dampened by the underlying demographic factors. Europe's birth rate is at 1.53, well below the population "replacement rate" of 2.1. Exacerbating the demographic imbalance is the increasing life expectancy across the region, which results in an older population. The average European age is already 40.9, and is expected to hit 44.5 by 2030.
   An older population does not purchase starter homes or appliances to outfit those homes. And if older citizens do make such purchases, they are less likely to depend as much on bank lending as first-time homebuyers. That means not just less demand, but that any demand will depend less upon banks, which means less profitability for financial institutions. Generally speaking, an older population will also increase the burden on taxpayers in Europe to support social welfare systems, dampening consumption further.
   In this environment, housing prices will continue to decline (barring another credit bubble, which would of course exacerbate problems). This will further restrict lending activities because banks will be wary of granting loans for assets that they know will become less valuable over time. At the very least, banks will demand much higher interest rates for these loans, but that too will further dampen the demand.
     The Geopolitics of Europe's Banking System
   Given these challenges, the European banking system was less than rock-solid even before the onset of the global recession in 2008. However, Europe's response as a Continent to the crisis so far has been muted, with essentially every country looking to fend for itself. Therefore, at the heart of Europe's banking problems lie geopolitics and "capital nationalism."
   Europe's geography encourages both political stratification and unity in trade and communications. The numerous peninsulas, mountain chains and large islands all allow political entities to persist against stronger rivals and continental unification efforts, giving Europe the highest global ratio of independent nations to area. Meanwhile, the navigable rivers, inland seas (Black, Mediterranean and Baltic), Atlantic Ocean and the North European Plain facilitate the exchange of ideas, trade and technologies among the disparate political actors.
   This has, over time, incubated a continent full of sovereign nations that intimately interact with one another but are impossible to unite politically. Furthermore, in terms of capital flows, European geography has engendered a stratification of capital centers. Each capital center essentially dominates a particular river valley where it can use its access to a key transportation route to accumulate capital. These capital centers are then mobilized by the proximate political powers for the purposes of supporting national geopolitical imperatives, so Viennese bankers fund the Austro-Hungarian Empire, for example, while Rhineland bankers fund the German Empire. With no political unity, the stratification of capital centers becomes more solidified over time.

   The European Union's common market rules stipulate the free movement of capital across the borders of its 27 member states. Theoretically, with barriers to capital movement removed, the disparate nature of Europe's capital centers should wane; French banks should be active in Germany, and German banks should be active in Spain. However, control of financial institutions is one of the most jealously guarded privileges of national sovereignty in Europe.
   One reason for this "capital nationalism" is that Europe's corporations and businesses are far less dependent on the stock and bond market for funding than their U.S. counterparts, relying primarily on banks. This comes from close links between Europe's state champions in industry and finance (for example, the close historical links between German industrial heavyweights and Deutsche Bank). Such links, largely frowned upon in the United States for most of its history, were seen as necessary by Europe's nation-states in the late 19th and early 20th centuries because of the need to compete with industries in neighboring states. European states in fact encouraged — in some ways even mandated — banks and corporations to work together for political and social purposes of competing with other European states and providing employment. This also goes for Europe's medium-sized businesses — Germany's mid-sized businesses are a prime example — which often rely on regional banks they have political and personal relationships with.
   Regional banks are an issue unto themselves. Many European economies have a special banking sector dedicated to regional banks owned or backed by regional governments, such as the German Landesbanken or the Spanish cajas which in many ways are used as captive firms to serve the needs of both the local governments (at best) and local politicians (at worst). Many Landesbanken actually have regional politicians sitting on their boards while the Spanish cajas have a mandate to reinvest around half of their annual profits in local social projects, tempting local politicians to control how and when funds are used.
   Europe's banking architecture was therefore wholly unprepared to deal with the severe financial crisis that hit in September 2008. With each banking system tightly integrated into the political economy of each EU member state, an EU-wide "solution" to Europe's banking problems — let alone the structural issues, of which the banking problems are merely symptomatic — has largely evaded the Continent. While the European Union has made progress in enhancing EU-wide regulatory mechanisms by drawing up legislation to set up micro- and macro-prudential institutions (with the latest proposal still in the implementation stages), the fact remains that outside of the ECB's response of providing unlimited liquidity to the eurozone system, there has been no meaningful attempt to deal with the underlying structural issues on the political level.
   EU member states have, therefore, had to deal with banking problems largely on a case-by-case (and often ad hoc) basis, as each government has taken extra care to specifically tailor its financial assistance packages to support the most and upset the fewest constituents. In contrast, the United States — which took an immediate hit in late 2008 — bought up massive amounts of the toxic assets from the banks, swiftly transferring the burden onto the state.
     ECB to the 'Rescue'
   Europe's banking system obviously has problems, but exacerbating the problems is the fact that Europe's banks know that they and their peers are in trouble. This is causing the interbank market to seize up and thus forcing Europe's banks to rely on the ECB for funding.
   The interbank market refers to the wholesale money market that only the largest financial institutions are able to participate in. In this market, the participating banks are able to borrow from one another for short periods of time to ensure that they have enough cash to maintain normal operations. Normally, the interbank market essentially regulates itself. Banks with surplus liquidity want to put their idle cash to work, and banks with a liquidity deficit need to borrow in order to meet the reserve requirements at the end of the day, for example. Without an interbank market there is no banking "system" because each individual bank would be required to supply all of its own capital all the time.
   In the current environment in Europe, many banks are simply unwilling to lend money to each other, as they do not trust their peers' creditworthiness, even at very high interest rates. When this happened in the United States in 2008, the Federal Reserve and Federal Deposit Insurance Corporation stepped in and bolstered the interbank market directly and indirectly by both providing loans to interested banks and guaranteeing the safety of the loans banks were willing to grant each other. Within a few months, the U.S. crisis mitigation efforts allowed confidence to return and this liquidity support was able to be withdrawn.
   The ECB originally did something similar, providing an unlimited volume of loans to any bank that could offer qualifying collateral, while national governments offered their own guarantees on newly issued debt. But unlike in the United States, confidence never fully returned to the banking sector due to the reasons listed above, and these provisions were never canceled. In fact, this program was expanded to serve a second purpose: stabilizing European governments.
   With economic growth in 2009 weak, many EU governments found it difficult to maintain government spending programs in the face of dropping tax receipts. They resorted to deficit spending, and the ECB (indirectly) provided the means to fund that spending. Banks could purchase government bonds, deposit them with the ECB as collateral and walk away with a fresh liquidity loan (which they could use, if they so chose, to buy yet more government debt).
   The ECB's liquidity provisions were ostensibly a temporary measure that would eventually be withdrawn as soon as it was no longer necessary. So on July 1, 2009, the ECB offered the first of what was intended to be its three "final" batches of 12-month loans as part of a return to a more normal policy. On that day 1,121 banks took out a record total of 442 billion euros in liquidity loans (followed by another 75 billion euros taken out in September and 96 billion euros in December). The 442 billion euro operation has come due July 1. The day before, banks tapped the ECB's shorter-term liquidity facilities to gain access to 294.8 billion euros to help them bridge the gap.
   Europe now faces three problems. First, global growth has not picked up sufficiently in the last year, so European banks have not had a chance to grow out of their problems. This would have been difficult to accomplish on such a short timeframe. Second, the lack of a unified European banking regulator — although the European Union is trying to set one up — means that there has not yet been any pan-European effort to fix the banking problems. And even the regulation that is being discussed at the EU-level is more about being able to foresee a future crisis than resolving the current one. So banks still need the emergency liquidity provisions now as they did a year ago (to some degree the ECB saw this coming and has issued additional "final" batches of long-term liquidity loans). In fact, banks remain so unwilling to lend to one another that they have deposited nearly the equivalent amount of credit obtained from ECB's liquidity facilities back into its deposit facility instead of lending it out to consumers or other banks.

   Third, there is now a new crisis brewing that not only is likely to dwarf the banking crisis, but could make solving the banking crisis impossible. The ECB's decision to facilitate the purchase of state bonds has greatly delayed European governments' efforts to tame their budget deficits. There is now nearly 3 trillion euros of outstanding state debt just in the Club Med economies — vast portions of which are held by European banks — illustrating that the two issues have become as mammoth as they are inseparable.
   There is no easy way out of this imbroglio. Reducing government debts and budget deficits means less government spending, which means less growth because public spending accounts for a relatively large portion of overall output in most European countries. Simply put, the belt-tightening that Germany and the markets are forcing upon European governments likely will lead to lower growth in the short term (although in the long term, if austerity measures prove credible, it should reassure investors of the credibility of the eurozone's economies). And economic growth — and the business it generates for banks — is one of the few proven methods of emerging from a banking crisis. One cannot solve one problem without first solving the other, and each problem prevents the other from being approached, much less solved.
   There is, however, a silver lining. Investor uncertainty about the European Union's ability to solve its debt and banking problems is making the euro ever weaker, which ironically will support European exporters in the coming quarters. This not only helps maintain employment (and with it social stability), but it also boosts government tax receipts and banking activity — precisely the sort of activity necessary to begin addressing the banking and debt crises. But while this might allow Europe to avoid a return to economic recession in 2010, it alone will not resolve the European banking system's underlying problems.
   For Europe's banks, this means that not only will they have to write down remaining toxic assets (the old problem), but they now also have to account for dampened growth prospects as a result of budget cuts and lower asset values on their balance sheets due to sovereign bonds losing value.
   Ironically, with public consumption down as a result of budget cuts, the only way to boost growth would be for private consumption to increase, which is going to be difficult with banks wary of lending.
     The Way Forward?
   So long as the ECB continues to provide funding to the banks — and STRATFOR does not foresee any meaningful change in the ECB's posture in the near term or even long term — Europe's banks should be able to avoid a liquidity crisis. However, there is a difference between being well-capitalized but sitting on the cash due to uncertainty and being well-capitalized and willing to lend. Europe's banks are clearly in the former state, with lending to both consumers and corporations still tepid.
   In light of Europe's ongoing sovereign debt crisis and the attempts to alleviate that crisis by cutting down deficits and debt levels, European countries are going to need growth, pure and simple, to get out of the crisis. Without meaningful economic growth, European governments will find it increasingly difficult — if not impossible — to service or reduce their ever-larger debt burdens. But for growth to be engendered, the Europeans are going to need their banks, currently spooked into sitting on liquidity, to perform the vital function that banks normally do: finance the wider economy.
   As long as Europe faces both austerity measures and reticent banks, it will have little chance of producing the GDP growth needed to reduce its budget deficits. If its export-driven growth becomes threatened by decreasing demand in China or the United States, it could also face a very real possibility of another recession which, combined with austerity measures, could precipitate considerable political, social and economic fallout.

John Mauldin
John@FrontLineThoughts.com
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What are your foreclosure choices?

   Are you behind on your mortgage? Almost half the mortgagees in Michigan are. Do you owe more than your home's worth? Have you decided trying to keep up is not worth the struggle, you're going to let your home go?
   Most people just wait for foreclosure and in Michigan more than a year can pass before the hammer falls. Is there a better way? What are your choices? Foreclosure, deed in lieu of foreclosure, short sale, what's the difference?
   Foreclosure will find you. If you don't do something, the sheriff will show up, post a notice on your front door, and your house will be auctioned off; probably for something less than the mortgage. You'll have to move and whoever purchased the house gets to sell it and pocket the profit.
   What about the "deficiency," the difference between the amount you owed and the amount of the sale? In a foreclosure you are responsible for the deficiency. You may get a Forgiveness of Debt Form 1099C for the amount of the deficiency and may owe the IRS the tax on that "phantom income" (although there currently is a moratorium through 2012).
   If you don't get the dreaded 1099C, there may come a time when a collection company contacts you looking for the deficiency, plus interest. Right now, lenders and collection companies are holding off such collections, but companies are buying up those deficiency contacts and will be coming after people to collect, and they have ten years or more to do it!
   Deed in Lieu of Foreclosure, or DIL, is giving your house back to the mortgage holder without going through the court/sheriff's sale procedure. In most states the lender can still pursue you for a mortgage deficiency after a foreclosure sale. They can sue you and maybe get a garnishment, levy against other assets or get a court order that would put you in contempt of court if you did not come up with the money.
   With a DIL, the disposition of deficiencies is negotiated prior to you giving your house keys back to the bank. DIL is much preferable to foreclosure and looks better on your credit report, but almost all lenders will require you to try to do a short sale prior to accepting a Deed in Lieu of Foreclosure.
   A short sale is the sale of property in which the proceeds are less than the mortgage balance. Short sale agreements come after negotiation between the parties with regard to the disposition of the deficiencies remaining after the short sale. Short sales significantly reduce the hefty legal fees expended in foreclosure, and improves credit report outcomes for the borrower. The agreement also will set forth the disposition of any deficiency which may be required to be paid back.
   In all cases a short sale is the best option. Find a reputable short sale specialist firm, they will not charge up-front fees, will be paid by the lender, and will negotiate the most advantageous deficiency repayment contract.

The worst of both worlds . . .

The Economy, apprehension because there’s indecision or indecision because of apprehension.


   Everyone can agree that we need jobs so we can earn our way out of the recession. Jobs in the government, any governmental jobs, don’t do anything to help the situation, they just suck up the tax dollars which are paid by the people who have “real” jobs, those which add to the Gross Domestic Product. Only the private sector creates such jobs, and small business is the component of that sector that produces the majority of all private sector jobs
   A Small Business Administration, Business FAQ, sets forth the following:
• Small businesses represent 99.7 percent of all employer firms.
• Over the past decade, small business net job creation fluctuated between 60 and 80 percent.
• Small businesses generate more than 50 percent of the nonfarm private gross domestic product (GDP).
• Two-thirds of new employer establishments survive at least two years after start-up, and 44 percent survive at least four years.
• Small businesses employ half of all private sector employees.
• Very small firms with fewer than 20 employees spend 45 percent more per employee than the largest firms to comply with federal regulations.
• Minorities own 4.1 million firms that generate $694.1 billion in revenues and employ 4.8 million workers.
• Women own 6.5 million businesses that generate $950.6 billion in revenues, and employ 7.2 million workers.
   These facts, and common sense, should lead one to the conclusion that we should be doing everything possible to encourage small business. So, what’s happening?
     Apprehension
   Small business owners are very apprehensive about the business outlook. For small business to expand, there needs to be a reasonably stable economic outlook, or at least one that is fathomable. No one is willing to expand their business if there is a reasonable suspicion that they will not be able to meet the additional expenses, to say nothing about making a profit. There is little doubt that Small Business will be hit by significantly higher taxes and fees in 2011 and beyond, as the Obama Administration struggles under the oppressive weight of the newly expanded Budget Deficit which is greatly adding to the girth of the, morbidly obese, American Debt.
     Indecision
   The malaise of indecision hangs over the American economy like the cloud from the Eyjafjallajökull volcano hung over Europe. No one knowing how bad it would get and no one, seemingly, able to do anything about it. The only body with the potential ability to lift the gloom hanging over the American economy is the U. S. Congress. They have the power, but obviously not the will to set the economy back on the track and get it moving again toward prosperity. There is no drive, and in reality, no ability in the members of today’s legislature to act in any bipartisan manner; no matter the dire straights of our once great Republic. A simple act, such as reinstating the Bush Administration’s business tax cuts might be all that is needed to kick start the economic engine. There are other simple actions which could be taken, but they won’t happen as long as those inside the Beltway continue derailing any and all things which might keep the economic train rolling down the track.
   Until apprehension turns to enthusiasm and indecision becomes decisiveness, the light at the end of the tunnel is the Chinese Economic Express screaming directly at US.