Mid-Year 2009 Checkup

Here’s Karl Denninger’s mid-year review of his new year predictions, and thoughts on 2009 part 2.

Mid-Year 2009 Checkup

Courtesy of Karl at The Market Ticker

It doesn’t seem possible that six months have passed under the bridge of time in 2009 yet, does it?  Yet they have.

Let’s take a look at the scorecard first from my 2009 Prediction Ticker, remembering of course that I have six months left!

1. The economy will not recover in 2009.  No sign of it yet, "green shooters" be damned.  I predicted that U3 would reach 8% by the end of the year, it has exceeded that wildly, and is now 9.5%.  U-6 also has exceeded my predicted value already.
2. Deflation, not inflation, will become evident well beyond housing.  Already has.  CPI and PPI have come in with negative prints as has capital goods pricing.
3. Housing prices will continue to decline.  Yep.
4. The Fed’s attempt to "pump liquidity" will be shown to be an abject failure.  I’ll leave this one on the table for now; I believe the evidence is in, but I’m in the minority.  Score this one as a "no result" as of yet.
5. GDP will post a 12-month negative number.  12 months aren’t up yet, but we’re working on it!
6. The Stock Market has not bottomed.  Remember, this was made with the market around the 900 level.  Major check; we declined to 666.  My secondary prediction was a 50% trading range and a 5xx low; we missed that by 67 points, but I still have six months left.  I’m sticking with this one.
7. Precious metals will not be a safe haven.  Oh Jim Sinclair!  Where’s my $1,600+ gold price?  (Or for some, their $5,000+ gold price?)  Missing, that’s where.  I know, I know, its all manipulation (instead of debt deflation.)  Check.
8. The Dollar will not collapse.  Hasn’t yet.
9. The pound or euro will be where the FX dislocation originates if it occurs.  I predicted Par for both being a possibility, not happening yet.  We’ll see what the next six months bring.
10. The US Consumer will go from a negative savings rate to a seriously-positive one.  I’m predicting 4% but it could go as high as 10%.  Major double-check!  We’re up close to 7% now.  That’s a home run in any book.
11. Commercial Real Estate will effectively collapse.  The REITs have not yet imploded but the pricing and occupancy look like something that came out of the back end of a horse.  Anyone got a finger to lend to push this pile over?
12. Along with the above, expect 10% of retail stores to close.  We’re getting there.
13. Several states will get in serious financial trouble and outright default of one or more is possible.  California anyone?  Major check.
14. Mortgages are not done.  Yep.  Prime, OptionARMs, ALT-A.
15. If you want to refinance you may get one brief shot at it with long rates around 4%.  Check again.  Hope you took it.
16. Those who have said that the corporate bond market is being "unreasonable" in its expectation for defaults will start to look like the jackasses they are.  Ding!  Check CDS spreads the last few weeks?  They’re widening again.  Even worse, the actual corporate default rates are getting rather nasty.  This trend continues.
17. Calls for "more lending" to consumers and businesses will go exactly nowhere.  Major check.  The drunk who is passed out from intoxication can’t lift the bottle.  Nice try guys.
18. General Motors and Chrysler will wind up in bankruptcy.  DING!
19. Protectionism and currency manipulation will rear their ugly heads.  This has started but there’s much more to come.  Watch out; this has the possibility of igniting wars.
20. Commodities will appear to be headed for a new bull market but this will turn out to be a false hope.  Attempts to manage oil output to prop up the price will fail.  Crude just rolled over, in fact, and major agri commodities were lock-limit down on one day last week.  Ding.
21. Sovereign debt defaults will number at least three.  Not yet.
22. China will have its first large-scale rumbling of civil unrest.  Maybe.  Scattered reports, but nothing confirmed.  Let’s call this a "not yet."
23. Foreign uptake of Treasuries will be choked off.  DING DING DING DING DING DING DING DING DING!  Treasury changes the definition of "indirect bid" and then under the NEW definition demand appears to have (just recently) collapsed.  This, by the way, is double-plus ungood.
24. "The City" will be recognized as getting it worse than we are.  No kidding? :)
25. Things will get "revolting" in a number of nations.  Not yet on any meaningful scale, unless of course you count Honduras and Iran.  I’ll call it a "not yet" for now, as those weren’t the areas I was thinking of and I don’t believe in "curve fitting."

So let’s see – I have 25 predictions and of them I can score 13 "confirms", half the year is over, and no busts as of yet (although there is one, the Euro/Pound prediction, that is looking shaky.)

That’s not bad, and we have six months left.  I’ll take it.

Now let’s talk about what’s going on.

First, I want to focus on housing, because, well, everyone else is, even though the housing mess is a symptom, not the cause of the problem.  But the WSJ’s "opinion" page has an interesting article up this morning:

The analysis indicates that, by far, the most important factor related to foreclosures is the extent to which the homeowner now has or ever had positive equity in a home. The accompanying figure shows how important negative equity or a low Loan-To-Value ratio is in explaining foreclosures (homes in foreclosure during December of 2008 generally entered foreclosure in the second half of 2008). A simple statistic can help make the point: although only 12% of homes had negative equity, they comprised 47% of all foreclosures.

Stan then waxes on about the necessity of "real" down payment amounts, something I’ve harped on for more than two years.  In fact, on April 6th 2007 I said this:

You should have put down 20% of the purchase price as a down payment. The down payment serves two purposes – it insures you have "skin" in the game, and more importantly, it demonstrates conclusively that you have the discipline to amass a decent chunk of cash and sequester – rather than spend – that money. Historically, this money had to be "seasoned" – that is, it could not have come from some other form of loan (e.g. a personal loan) or gift (e.g. your parents give you $20,000); the source of the down payment has historically had to be disclosed and proven.

The reason for this, by the way, is not "simply" (as is often claimed) to provide positive equity.  In fact, that’s a side effect that happens to be very beneficial.

What Stan misses (as do the others) is that down payments are an inverse to leverage, and it is leverage throughout the system that got us in trouble in the first place.

Unfortunately neither the government nor columnists such as Stan "get it" in this regard.  Stan claims this is "New Evidence" in the title of his piece; it is, in fact, not new at all.  I’ve been yelling about this since literally the founding of The Market Ticker, and with good cause – it is the reason we are in this mess.

The market is a cruel enforcer of reality in this regard - when Fannie, Freddie, AIG, Lehman and Bear blew up all had leverage ratios in excess of 30:1 – that is, less than a 3% decline in asset value caused them to detonate.

This is the bottom line in the housing and indeed all other markets.  Values fluctuate in the marketplace and the only way you can avoid those fluctuations becoming a bankruptcy trigger is by leaving yourself sufficient cushion by keeping leverage to reasonable levels.

This same principle applies to banks, it applies to homeowners and it applies to businesses.  The concept of "too little skin in the game" is really a matter of leverage ratios, and how far an asset can depreciate in value before the holder owes more than the asset is worth.  Once that occurs the so-called "asset" becomes a liability, and in short order it will sink you economically.

The underlying foolishness among our so-called "experts" in industry and government is that nobody is talking about or addressing this.

Why?

Because doing so means that we must:

• WITHDRAW the "excess stimulus" that made this idiocy possible in the first place, and is attempting to continue it.
• ACCEPT that asset prices will FALL until they reach equilibrium with income, and will appreciate only in concert with real income from production, not from leverage and debt.
• DEFAULT the existing bad debt that cannot be serviced under the above two points, forcing those institutions and individuals who are over-leveraged to go bankrupt.
• DEAL WITH the inevitable contraction in GDP that will come from this, even though it will be painful and unpleasant.

The last three points sound awful, and they are.

The problem is that they’re more awful today than they were two years ago when I started yelling about this in the current economic malaise, and are much more awful than they were in 2000, when we should have done it, but refused due to the idiocy of Alan Greenspan and our elected government officials at the time.

The longer we wait the worse the damage will get, and you need no more evidence than what has recently come out of the auto industry.

The last couple of years of the bubble featured 14 million unit sales rates.  This has now collapsed, of course, along with GM and Chrysler.

Their own people, along with the government, now predict that "stability" will come when we return to a roughly 10 million sales rate for new vehicles. 

THAT IS A TWENTY-NINE PERCENT DECLINE!

Folks, do you realize what we’re talking about here?  If you look at the 2009 "Year In Review" Ticker (linked above) you will find that I discuss (again) the fact that in 2000 the Internet fraud had created an "excess" 10% GDP that had to be taken down to restore balance.  It wasn’t – and instead of 10%, now we are faced with 25%.

But the automakers are telling us that the real number in terms of capital goods might be closer to thirty percent.

It is happening here and now whether the pundits like it or not.  We have gone from a -3% savings rate (roughly) to a +6.9% one.  This is a 10% swing and with the consumer being 70% of the economy that’s an immediate hit of somewhere between 4.83% and 7% of GDP (depending on whether you "count" the negative as an additive force, and you probably should.)

The problem is that it doesn’t stop there: The government calls this a "savings rate" but it isn’t.  It counts debt repayments as "savings" among other distortions, meaning that trying to use the "savings rate" as an indicator of future capital formation is a lost cause.  In point of fact there is no capital formation going on – people are cutting back on their voluntary 401k and IRA contributions because they don’t have any money to put in – they are furiously paying down debt as fast as they’re able in an attempt to avoid foreclosure and bankruptcy.

That of course means that spending drops which in turn means that employers need fewer people to work.  Capacity utilization is in the toilet and average hours worked has fallen to never-before-recorded numbers in the history of the data being collected.  This in turn feeds more layoffs which begets more people without income to spend on discretionary purchases (and in some cases non-discretionary ones!)

There is no avoiding the necessary contraction in GDP to bring the system back into balance, and the longer we continue to allow our government and media to LIE about what has happened, who is responsible, and what has to happen before the economy can clear and recover the worse off we will be.

Two years ago I began beating the drum on the prescription for a solution.  It involved pulling the rug – intentionally – on housing price supports, and allowing them to collapse to sustainable numbers, all at once.

This would have resulted in a lot of people losing their homes.  But by now, they’d be starting to buy them back at half or less of their former prices – and at sustainable payments under a 30 year fixed mortgage.  They would have been able to save the 20% down payment too.

We would have seen myriad banks, including most of the big ones, go under.  So what?  The FDIC would have consumed the "bailout funds" in paying off depositors, which is bad, but the debt would be out of the system.  Instead we have gotten exactly nothing out of more than $2 trillion now borrowed and spent by government – the debt is still there, it is still toxic, and it is still preventing recovery.

This story is by no means finished.  The government has spent $2 trillion it does not have and has committed to nearly $6 trillion more in either guarantees or outright payments, and yet capacity utilization continues to drop, employees continue to be laid off, consumption continues to fall and frantic attempts to pay down debt and avoid default continue to rise.

In response the economy has continued to shrink and tax revenues have sunk through the floor, skyrocketing the deficit.  Treasury apparently detected a reluctance among foreigners to continue buying our used toilet paper and changed the rules on reporting of "indirect" sales – which then, even after the change to intentionally overstate foreign interest, have precipitously declined anyway.  It is fair to say that foreign interest in Treasuries is all-but-exhausted and barring a collapse in equity prices to recreate a "fear" environment for holding government bonds, there is going to be an increasing problem with funding the insane "prop up the game" money flood policy of The Fed and Treasury.

California is just the beginning of this unraveling; they are now issuing IOUs.  Most other states will find themselves in similar circumstances and be forced to dramatically curtail spending along with raising taxes.  The public labor unions (state and federal) are currently able to prevent their overly-fat pension and benefit programs from being brought in line with private industry, but this will not last forever, and when that wall cracks it will come with ferocious intensity.  The "death spiral" of higher taxes leading people to erect their middle finger and either cocoon, go underground with their earnings, or depart has begun in California and will spread – count on it.

At some point reality must be faced, and we may as well do it now while we still have civil order.  Those politicians, numbering nearly all of them from both parties, who argue that this can be "avoided" or that we can "support housing (and/or asset) prices" need to be run out of town on a rail.

There is no way to prevent the unwinding of leverage when the carrying costs exceed income and the more debt we as a society take on in trying to do so the worse things will get in the end, as we are simply adding to the pile of defaults that must occur.

I am quickly running out of possible scenarios to prevent a severe deflationary depression from taking place.  By "severe" I mean 20%+ U3 unemployment, GDP contraction of at least 25%, and a possible loss of federal funding capacity leading to the immediate destruction of Medicare, Medicaid and Social Security, a 50% reduction of defense spending and near-complete-elimination of all other Federal Programs due to a "sudden stop" in the ability to fund Treasury issuance.  Yes, it could get that bad, and it could happen a lot faster than you think.

I wish there was good news – "green shoots" – that I could honestly find and report.  There are not.  There is only more obfuscation and fraud, which I have and will continue to chronicle here in The Ticker, not so much in the belief that government gives a damn, but rather so that historians have it available later and, if the collapse I believe is possible does materialize, the angry proletariat with pitchfork and torch will know where to properly direct their wrath.

Government needs to lock up the psychopaths that have run the asylum for the last 20 years and let adults into the room to rationally discuss the inevitable and how to best deal with it.  They’re refusing now, just as they did when Bush was President.  This is not a partisan debate – even having lost badly in November the Republicans are wasting time with the same old canards about "Tax and Spend" instead of attacking the problem at the root: fraudulent credit issuance, much of which they championed and enabled themselves.

Happy Independence Day!