The Economy

Presidents and the Economy

I need a break from writing about the mortgage mess so...

With this being an election year I have tried to not discuss politics at all but I would like to discuss the economy and suggest that political rhetoric serves little purpose regarding the economy.

Politicians find out what concerns folks and then suggest that they have solutions regarding those concerns. One thing folks are concerned about is the economy so it is natural that Presidential candidates address that issue.

The problem is that the President of the United States has virtually no significant effect on the economy. The only person who is part of the Federal apparatus who can significantly affect the economy is the Chairman of the Federal Reserve. The fact is that the President is affected by the economy to a vastly greater extent that the economy is affected by him.

Presidents do not create significant numbers of jobs. Jobs are created by a coming together of businesses, labor and capital. We have a gigantic system in place which does this. Folks see opportunities for profit and create and expand businesses and create jobs in the process. This also has the annoying effect of creating business cycles which go with those opportunities. It works like this: opportunity knocks, people see a situation where a product or service can be provided at a profit, business expands, jobs are created, at some point supply exceeds demand and a downturn occurs. This is what happened in the dot-com thing and this is what is happening in the present housing cycle.

To be fair there are marginal cases when political intervention does effect the economy. Tax cuts spur short-term economic growth. The recent stimulus package will provide some economic growth. But these are aberrations not the normative methods for job creation.

In short, when any of the Presidential candidates describe how they will create jobs pay no attention to them. They cannot create jobs and their ability to help business and workers create jobs is rather limited.

All that said, this has to be one of the strangest Presidential elections I have witnessed. There are three people still contending and they are all fairly liberal so the conservative agenda is not exactly having a good year. At present this is all about Obama. It is amazing that someone with so little political experience can be doing so well. It is not merely about Obama-mania or his being a sort of cult hero. The stark political fact is that he has made all the right moves while the experienced Clinton machine has made all the wrong moves.

He certainly has engaged the youth of American and that is a good thing. Getting young people involved in politics and interested in finding out what the government does is good. It is too easy to dismiss young folks saying that they are so inexperienced that it is easy for them to be swayed by someone such as Obama merely because of his speaking ability and his appeal to the liberal notions common to youth. There is more here than that. This guy really has engaged people. Folks feel a lot closer to him than they do the other candidates and certainly closer than they do to anyone who has been President in a long time. That by no means certifies that he will be nominated or elected but this is one darn interesting election.

In my view one effect of the potential nomination or election of Obama would be the perception that foreigners would have of what the U.S. is and what opportunities exist here. This is a guy with one black parent, one white parent and a Muslim name. Foreigners will conclude 1) that this is really a land of opportunity where a guy with mixed race and a Muslim name can get elected 2) we are totally insane and this is just a sort of extension of American Idol or 3) both 1) and 2) are true.

In no way do I suggest that we tailor our vote to what pleases foreigners. That makes little sense.

No matter what - whoever is elected will have little effect on the economy.

Data vs. Opinions

aThe news of the day is BofA's acquisition of Countrywide (CWF). This is an interesting story. It could be a 1) good money after bad story 2) a bargain because BofA has an incredible ability to offer retail banking products (credit cards) to all those CWF customers 3) a really, really bad disaster if the costs of the litigation losses from the lending practices of CWF prove gigantic rather that large.

This is my perspective: BofA is deadly serious about increasing its retail mortgage profile. One of the core beliefs of BofA's present management is that mortgage loan customers can be cross-sold other banking products such as credit cards and can, consequently, become profit centers.

So what BofA is getting is CWF's servicing portfolio and the database of clients and what they are risking is the potential of some gigantic losses associated with the litigation which will result from potential class action lawsuits regarding CWF's lending practices.

The losers are the folks who created CWF and worked to make it the great company which it was. They made the one mistake of getting heavily into subprime because it was short-term profitable. In a sense the story of CWF is a capsule of the mortgage disaster. The winners are litigation attorneys. Litigation law firms now have BofA to pay the cost of potential litigation rather than suing a bankrupt CWF and counterparties.

The mortgage business is still in a state of chaos. The most important thing is getting credit insurance for Jumbos. It does not appear to me as is anyone is really addressing this issue but rather papering it over.

Let's go bank and examine what insurance is. Insurance is the exchange of a relatively small loss (the principle payment) in place of the possibility of a potential large loss. Looked at over time one can personalize this by regarding it as a payment plan for disasters. In essence whet we get out is equal to what we put in, It's just that we put it in in small amounts and take it out in large amounts.

In short there is no mystery. Credit default insurance must be built into the cost of the loan - either up front or in the cash stream or both. In the subprime disaster the money to cover the credit insurance is not there because the risk was, as Mr. Bush would say, misunderestimated.

The present credit insurers are - how to put this? - uhh, bleeped. The alternatives are 1) have the lenders pump more money into them so that the insurance can be paid 2) have the debt issuers take the loss because the insurers fold 3) let 2 happen and create new credit insurers.

V) Data and Analysis

Last December I was at a meeting with a bioscientist (this is something which I will write about in a future newsletter). One topic we were discussing was how a scientist deals with the large amount of research published in his field. He picked up a journal which had been sitting on his desk and made an insightful comment. He said, essentially, "The thing to do is read these articles and just look at the data and pay no attention to the conclusions drawn by the researchers."

His notion was that anyone reading any such publication was just as capable of drawing his own conclusions from the data than the authors were.

Of course with science there may be cases where profound conclusions are drawn but they are, in fact, rare.

We live in a media-rich era. Economic data is treated like yesterday's sports scores - not really important. The savants and the people who play fantasy baseball want to guess what is going to happen tomorrow or, at bare minimum, draw conclusions from yesterday's data.

A few weeks ago I commented that I found it strange that the NYT defined Christmas Retail Sales gains of +3.6% as "weak." To me, a gain of +3.6% in face of the mortgage crisis was indicative of strength. The NYT points out that sales grew 6.6 percent in 2006 and 8.7 percent in 2005 so, yes, the rate of growth was smaller in 2007 than in the pervious two year but the 3.6% growth in 2007 was compounded on the growth of the previous two years. In short, Retail Christmas Sales are 120.04% of what they were three years ago.

The point here is that the data is the data and while the New York Times and Dick Lepre may have varying opinions about what the data implies you should look at the data and draw your own conclusions. What I mean is that markets may work best if individuals look at the data, draw their own conclusions and make market decisions accordingly.

At the opposite end of the spectrum one has things such as the CIA. These are folks who amass large amounts of data, draw conclusions, and then only share the conclusions with the public not the data. Perhaps it is more accurate to say that they only share that part of the data which supports the conclusions.

I am in no way suggesting that the CIA should share everything of even anything. I am simply stating that the process of presenting the conclusions without presenting data may well be flawed simply because the data is much more important than the conclusions.

My belief here is in keeping with the fact that I value the technical interest rate forecasts. The technicals do not really draw any conclusions except for the thesis that it is that data that drives the data. The stochastic seeks no rationalization of what happened or what is going to happen. It is a notion that markets have cycles and it seeks to quantify those cycles. It does not forecast economic fundamentals.

Markets

Another issue is that markets tend to trade based not on data but on guesses about data. The typical scenario is that a company announces its quarterly and the earnings and sales are great and the stock gets hammered because the data was presumed.

So we have an unfortunate paradox. It is the data that is important to the economy but it is the opinions about what the data will be and the difference between the forecast and the actual data that moves markets.

---

Dick Lepre

The Invisible Hand of the Free Market Is Rewriting the Guidelines

The mortgage industry has suffered a severe liquidity problem. It is not as if there is not a lot of money out there it is that there is an enormous amount of doubt about the true value of mortgage backed securities. Lowering the Discount Rate may have helped perception but it has not reestablished liquidity for Jumbo mortgages.

The problem has an easy solution - going forward. I proposed it last week.

1) No loans to folks with bad credit (<640 credit score) without full documentation that they at least have the potential to make the payment.

2) stated income A-paper (good credit) should be bumped up about 0.625% in RATE above full doc.

I am going to add a third point. The GSE's (FHLMC & FNMA) must be more adequately capitalized and the Federal government should clarify whether or not it is standing behind FHLMC/FNMA debt. It literally is not but everyone acts as if it it. That make absolutely no sense.

Adequately capitalized GSE's need to up their loan limits and securitized jumbo mortgages.

That is it. The bump in rate for stated may be a bit excessive but what we need is liquidity. Corrections can be made later.

This problem was cause by irresponsible lending. It is not the result of exogenous forces.

Q: But Shouldn't the Fed Solve the Problem by Lowering Rates?

A: This gets confusing. Today, the Fed lowered the discount rate which is the rate at which bank can borrow money directly from the Fed. That is largely symbolic because because very few people borrow money directly from the Fed window because there is a stigma associated with it. Banks believe that it is a great way to get scrutinized. In addition the Discount rate is evey now higher than the Fed Funds rate.

What is much more important is the Fed funds rate. That is an open market rate at which banks lend money to one another for 1 day. The Fed sets a target and intervenes with open market operations to keep that target. The most important thing the Fed did today was not to lower the discount rate but to indicate that they will start lowering the target for the Fed funds rate. Check out this language: "Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth,'' the Federal Open Market Committee said today. ``The committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects."

In English "prepared to act as needed" means lower the Fed Funds target at the next FOMC meeting. At least that is what I think.

Is the Fed bailing the mortgage industry out? No. Fed bailouts are not appropriate to undercapitalized companies which take undue risks. A Fed bailout sends the wrong message and only encourages risk in the future. As William Poole of the Fed says, "everyone knows that a policy of bailouts will increase their number."

The Fed also injects money with repurchase agreements whereby short term cash is loaned in exchange for securities which are then repurchased by the borrower. What is of paramount importance is banking liquidity and the Fed will provide that as necessary by injecting massive amounts of cash into the system with repos and outright purchases.

How Did All of This Start?

I answered that last week. I said that for the most part this started with a relaxation of lending standards and that was created by greed and stupidity. But greed and stupidity are forces which are always present.

The question I will address is "Why did this happen now?"

This happened because we have been living in an "Age of Abundance" and too much money has been available to lend and lending standards in the mortgage industry and elsewhere were lowered. Strangely, we try to disguise this. Our notion of poverty is strange if many people below the poverty line own a car and a cell phone. But I am not trying to comment on society except to say that this abundance of wealth engendered bad lending. The wealth is not merely here in the US. There has been a massive decrease in worldwide poverty recently and there are massive wealthholders all over the world. Most of these wealthholders had a piece of the MBS market.

An end to bad lending may be a temporary inconvenience to most mortgage folks and a downright disaster to the folks who capitalized on bad lending but, going forward, it will be entirely good and hopefully the economy will be a little smarter.

For me the truly interesting thing is the functioning of this free market. It is not about the Fed or the mortgage business per se this is an absolutely perfect example of the free market working to correct a very serious problem. The invisible hand of the free market is rewriting morgage guidelines right now.

---

Dick Lepre

Offshoring

Bush has by both by default as well as due to his conservative values had to take the position that offshoring is good and will lead to long-term benefit. Interestingly he had backers like Alan Greenspan.

Populist politicians such as John Edwards and populist, brain-dead commentator Lou Dobbs have railed against offshoring for its simplistic notion, "You need me looking out for you 'cause companies don't care about you they care only about the bottom line."

Edwards as well as any other politician wanting to score some points is no fool. Concerns about trade and offshoring are (according to CNN & NYT exit polls of last November) issues more important than Iraq. At present with the economy doing very well there is little political traction to be gained by doing an "it's the economy stupid" thing but the offshoring thing is simplistic. You and always scare a certain number of people into believing that their jobs will be offshored by contending that you cane prevent it.

But offshoring has been a longstanding issue and what do the effects of this look like at present?

With unemployment low, GDP growing (albeit at at too slow pace), it is difficult for me to see that offshoring has caused any sort of economic catastrophe. Of course it has hurt some folks but that is something that happened in any changing economic paradigm. Blacksmiths lost jobs with the invention and popularity of the car.

My point merely is that the harm done to date by offshoring has not been on any dramatic scale.

The following is something I wrote a couple of years ago about offshoring.

1) offshoring is going to happen, so learn to deal with it. If you think that your job may get offshored don't wait and be a person who goes to the doctor and finds that he has 3 months to live. Instead, get started by getting training for another job. Maybe, people in India will start doing mortgages and my job will be offshored. I will find something else to do. I got started as a loan officer in 1992 because I found that the set of computer skills that I had was nearly obsolete. I chose to do what I now do because I had, from doing computer software for an S&L, learned about the mortgage business.

2) suggesting that the government pay companies to keep jobs here is absurd. Why should tax dollars support someone's price inefficiency? In all likelihood the money would be ripped off by people who have skills at scamming the government. The U.S. government cannot do things like this correctly.

Recognizing that some people are going to be jobless for an extended period as a result of this shift, perhaps the federal government needs to help them by extending unemployment benefits.

3) businesses that, for whatever reason, decide not to offshore when their competitors do offshore may lose 100% of their jobs by going out of business.

A broader view might be this: if offshoring is a bad idea because of inefficiency or some such thing then the marketplace will determine the fate of those who offshore. If it is a good thing, those who offshore will be more successful (greater profits or market share).

4) the number of jobs being offshored is not so great when taken as a percentage of the labor force. This would be a problem if offshoring went on forever but it will not.

5) complaining that somehow foreigners are "unfair" and taking advantage of our open market and we should somehow lead a jihad to keep these jobs here misses the fact that there are a lot of domestic US workers who work for foreign-owned companies. This is a 2-way street. If you want to lead a jihad against offshoring, be willing to tell Sony and the Japanese car manufacturers to take their jobs back first.

6) there is an almost sinister irony of unintended consequences at work here. A few years ago we were talking about "the new economy" wrought by the Internet. What resulted was the laying of a large amount of fiber-optic cable so that the same infrastructure that you use to check out Paris Hilton's adventures on the little screen enables some person in India to access the database that the title companies to create preliminary title reports.

As an aside here there are three areas in which offshoring has touched the mortgage business - and I am only talking about what I know firsthand:
1) the preparation of preliminary title reports which, at least here in California, are now done almost totally in India
2) appraisal reviews and
3) software.

7) There is a strange "second order" effect at work here, at least in regard to programming jobs going to India. About seven years ago, when I was president of Homeownmers.com, I needed programmers. I went to a large employment agency. I interviewed about 6 people. They were all from India. The fact was that the US did not produce a large enough supply of skilled programmers to fill the demand. We reached out. Folks with the training came here and, in a sense, took the jobs back home with them.

8) I am conscious of the fact that real people who are my neighbors are losing their jobs. This is sad, but this is also inevitable. I would rather encourage them and help them to find new training, new careers and new jobs then commiserate about the forces that took these jobs away.

9) Offshoring produces advantages:
a) less expensive goods and services
b) political-economic stability that comes from working together. I don't intend this to
be glib, but maybe if we could get North Korea to take some of these jobs then we won't have to worry about them nuking us.
c) it brings the nations of the world together in a way that has meaning. It is literally "working together." More sociopolitical advantage will come from offshoring than from the United Nations.

10) if you don't believe me, here is what Greenspan once said: "As history clearly shows, our economy is best served by full and vigorous engagement in the global economy,"... "new protectionist measures" were being proposed, without specifying what he was referring to, and said they could be self-defeating.

"These alleged cures could make matters worse rather than better," he said. "They would do little to create jobs and if foreigners were to retaliate, we would surely lose jobs."

In 1900 America was on the verge of an Industrial Revolution. An equal amount of dissatisfaction about the loss of jobs by farmers and blacksmiths likely existed. Somehow, we got over it.

---

Dick Lepre

Apres Moi le Deluge Numero Deux?

Nicolas Sarkozy was elected President of France this past week. On the surface Sarkozy is a conservative openly attacking liberal values. Conservative columnists have pointed to this and the German move to the right as strengthening those nation's ties with the U.S. This is, to me, but another example of American's myopia about things foreign. The implications of this elections are vast but have as much to do with Franco-American relations as they do with Franco-American canned spaghetti.

If one reads, for example, the French daily LeMonde one can see the extent to which French folks with political savvy see Sarkozy's election in relationship to the conservatism of Reagan and Thatcher and what they view as Bush II's neoconservativism.

I think that the issue that Sarkozy is going to concentrate on is the relationship of French labor unions with the rest of French society. France has issues that are similar to economic issues in the U.S. and the key to success is finding the correct balance between the power had by business, labor and the government. The issue is not merely economic health but rather the well-being that should flow from economic health. Until now, France has taken a different track that the U.S. In is in this limited sense, I believe, that Sarkozy wants France to be more like the U.S.

Relative to the U.S., French labor unions wield a tremendous amount of power. The first time I was in France in 1981 I was driving a rented car and managed to become accosted by something called Cidunati (see: http://cidunati.online.fr/ Note: that page is in French) which is a French labor union. My car wound up slightly redesigned and I would up so curious as to why the police allowed this to happened that I spent an hour talking to someone who was (and this was a while ago so I forget the actual title) the equivalent of the Captain of a city police station.

In France labor unions have a de facto power to wield control over government policy by general strikes. A general strike is designed to bring virtually the entire economy to a halt. These strikes are generally aimed at any attempt to change the work week or social benefits provided to workers. France has an economy which is substantially more socialist that that of the U.S. I, personally, see that as something of interest. If the French can figure out in an economically stable manner how to get as much of the good life out of a 35 hour week as Americans can out of a 40 hour week then we have something to learn from them. I am not being cynical or comic here, I literally mean this.

When Sarkozy expresses that France should adopt some of the views of the U.S. He is not talking about U.S. cultural views or Iraq he is talking about socio-economics and the relationships among business, labor and the government.

For France the question may be something like this: can France compete in the world economy with the likes of the U.S. much less China with its present quasi-socialist system? It is an unpleasant proposition. Sarkozy, I presume, wants to modify the balance of power in a manner so as the make France more competitive on the world market. The resistance will be enormous. Folks simply are disinclined to give up that which they construe as something they are entitled to.

Presumably Sarkozy wants the French government to take away some of the power that unions have. In essence he may want a French Taft-Hartley Act. For you youngsters (hey, I was 3 years old at the time) the Taft-Hartley Act was passed by Congress in 1947 over the veto of Harry Truman who described it as a "slave labor bill." (There is a great web page at: http://www.holtlaborlibrary.org/tafthartley.html showing some of the language as well as those fantastic posters which were so popular in the 1940's.) Willian F. Buckley's current article in the online National Review is about this exact subject.

Taft-Hartley limits certain union actions but tries to serve the public interest by requiring unions and employers to give 60 days notice before undertaking strikes. It interdicts the Federal government into the process. In 2002 Bush II invoked Taft-Hartley to stop a lockout by the Pacific Maritime Association which was in retaliation for an alleged slowdown as an alternative to a strike.

For France & Monsieur Sarkozy some contentious times are ahead. Changing the relationship between labor, business and the government in France would appear to me to be nearly impossible. General strikes in France tend not merely to be what we here in the U.S. would see as demonstrations or riots but have the ability to topple the government. See for example the May '68 Wikipedia article.

The bigger picture is that of the annoyances caused by the global economy. Competition from China and India has changed the way business is done in the U.S. and we are still struggling with those changes. It seems to me that the fact is that we do have a world economy fueled by inexpensive telecommunication, computerization, travel and shipping. It is better dealt with than avoided. One almost bizarre example of the world economy is in today's Los Angeles Times. The website Pasadena Now has hired two reporters to watch the broadcasts of the Pasadena City Council and report the contents on the web site. The reporters are both in India. This redefines the expression "local coverage."

France also faces problems with dealing with Muslim immigrants. This is, frankly, a complex topic and not one I will go any further with here. My point is that the effect on the French economy in this regard bears similarity to Mexican (and other Latin American) immigration into the U.S.

If you have something to add to this discussion please post a comment on the blog.

---

Dick Lepre

The Good Old Boy-sans Come to Daytona

On February 18 there will be a major fluctuation in the force. On of the bastions of American culture - NASCAR - is about to be invaded by Toyota. While NASCAR was until recently a Southern sport with mainly regional interest it has grown gigantically in the past few years. It is now a monster money printing machine. Here in the San Francisco Bay Area the NASCAR race is in Sonoma County which culturally is about as far away as you can get from the South.

Toyota will be racing the Camry at Daytona. Calling this a Camry is like calling the other cars Chevys and Fords. NASCAR employs a body design that has the rough shape of the car named and an engine manufactured by said company but the rest of the car is anything but stock. The engines specifications try to stay true to stock engines demanding such things as carburation and steel blocks. But I digress.

Most of the Camry's sold in the US are made in Kentucky. Toyota has become an American car - sort of.

In addition to the coming of Toyota the 2007 NASCAR season will also feature Colombian driver Juan Pablo Montoya. In short it looks as if NASCAR is planning on taking over the planet.

There are two things happening here: 1) NASCAR is broadening its appeal probably in an attempt to inculcate international interest and 2) it is recognizing that Toyota makes cars in the U.S. and should be part of the sport. It also sends a signal to the Big Three auto manufacturers that they'd better keep playing in the NASCAR game.

This is the reaction of Jack Roush, one of the heavyweight team owners, "Americans shouldn't buy Japanese cars," Roush said. "When we're faced with the prospect of having somebody come into our world and strip our economy of its essence, and go convey that for interests that are abroad, then we're not doing the right things for our country. If we're forced, based on the fact that we can't be competitive or that their consumers won't buy as many things from our manufacturers and our workers as we buy from theirs, well, then there's a train wreck coming."

Really Roush may be concerned about the increased cost of remaining competitive when another player particularly one with deep-pockets shows up.

In 2007 Toyota will for the first time probably surpass GM in world auto sales. The American automobile industry is no longer the dominant force which it once was. The reasons are myriad. Some of it is economic: American car manufactures are locked into pension agreement which add significantly to the cost of production and Japanese manufacturers has simply passed them both in design and in manufacturing technology and in attention to quality.

The key to success at Toyota is the Toyota Production System created by Sakichi Toyoda based in part on the work of W. Edwards Deming. (Links are http://en.wikipedia.org/wiki/Toyota_Production_System
and http://en.wikipedia.org/wiki/W._Edwards_Deming.)

The United States is not totally behind is advanced production techniques. The best known may be Six Sigma a series of practices developed by Motorola. (See: http://en.wikipedia.org/wiki/Six_Sigma)

NASCAR is all about money. Toyota has a lot of money to spend and this is going to create angst not just for the American auto manufacturers but more so for the big teams which need to spend a ton of money (Hendrick, Rouch, Gibbs).

The success of NASCAR has been largely a secret in the mainstream media. 17 of the top 20 sporting events by attendance last year were NASCAR races. The two brothers who own NASCAR are each worth (according to Forbes magazine) more than $1.2 billion.

In a sense the coming to NASCAR of Toyota and the success that is likely to have is another step on the road to globalization. The folks in North Carolina are going to have to learn to deal with it.

One of the most interesting aspects about NASCAR is their ability to change rules and specifications as often as necessary to maintain competition. While "parity" may have made the NFL boring the ability to have a 500 mile race decided by tens of feet is what makes NASCAR compelling. Once the season starts if one body design or engine spec has a clear advantage it is nerfed to make it less dominant.

The relevant issues here are the economic power of NASCAR, the blurring of the line between US and foreign cars and the importance of not just technology but of sophisticated manufacturing methodologies. Some of this is about auto safety. These are cars which can have accidents at speeds of 160 mph and have the driver walk away.

---

Dick Lepre

Universal Medical Coverage

Unless I am losing some of my memory (a distinct possibility) we are seeing a relatively large amount of attention devoted to the 2008 Presidential election at a very early time. As someone who tends to, at best, be distrustful of politicians I find this distressing. I suppose that the unusual circumstance of having neither a sitting President or Vice-president in the mix makes the discussion a bit more valid.

This past week I saw one candidate, Obama, who clearly has a strong appeal to the young folks make a pitch for universal health care. CNN reported: "The time has come for universal health care in America," Obama said at a conference of Families USA, a health care advocacy group. Obama was calling for coverage for all Americans by 2013.

While Obama may be somewhat of a media phenomenon the discussion about universal medical care is not about to go away. Senator Clinton framed such a plan during her husband's first term.

Two Really Big Problems

The notions that the government should be able to provide some sort of medical coverage for everyone is something that I personally find acceptable- in principle. It's (for me) a sort of "why not?" proposition. As always the devil is in the details and the details here are significant.

There are two enormous obstacles. The first is that in my opinion the Federal government is an incompetent bureaucratic entity. To reduce it to simple terms it cannot operate with anything approaching the efficiency of an HMO such as Kaiser Permanente. It is my predisposition to believe that expecting the Federal government to be able to do this is akin to believing in Santa Claus.

But that, frankly, is a minor point. Any discussion about universal medical coverage absolutely, positively must be deferred until a modus of solving two other things is up and running. Those things are Social Security and Medicare/Medicade.

Spending for Social Security, Medicare & Medicade amounted to 40% of total Federal expenses in 2006. The problem is not so much that as the present/future demographic of the American population. Baby boomers are nearing retirement. The birth rate has lowered.

At present 12% of the population is over 65. There are 5 people between 20 & 64 for each person 65 or older. According to the Trustees of Social Security in 2030 folks over 65 will make up 19% of the population and the ratio of those 20-64 to those 65 and over will fall to 3:1.

Superimposed on this is the rising cost of medical care. There is no reason to believe that the cost of medical care will stop increasing at a rate well in excess of core-CPI.

This problem is vastly complex and of monumental importance but I am sure of one thing. Until such time as Congress can frame and enact legislation to address the existing fiscal problems with Social Security and Medicare/Medicade suggesting that the scope of the problem be multiplied before a solution to the present situation is found is totally inane.

There is no "mojo" working here. You simply need to match the intake (taxes) with the spending. The real art is doing this without hurting the economy. The present system of doing this on credit is a further inanity.

Any system based on passing some massively dysfunction plan for the sake of obtaining votes should be punishable with the death penalty. I shall drop any discussion about solutions here and pick that up in a future newsletter.

There is a speech by Bernanke from just last week which details much of this at

http://www.usatoday.com/money/economy/fed/2007-01-18-bernanke-text_x.htm

---

Dick Lepre

Equities

In October 2000 I wrote a newsletter called "The End of the Bull Market for Equities." Equities seem only now to be recovering from an extended vacation.

The economy did quite well in the 1990's. Buyers of equities anticipated that those profit gains would continue. The P/E for the S&P 500 was in the low 20's in the early 1990's. It increased to a record 39 in January of 2000. In general, the bull market that we have been in has been justified by the continued healthy performance of the economy. The built-in presumption was that the performance would continue.

"New" Economy

In 2000 it seemed at if the attention of all of Wall Street was devoted to Yahoo's earnings report. While Yahoo! was indeed be a bellwether of the Internet business I was genuinely concerned that something is amiss if this company's earnings report were guiding the markets.

The phrase "new economy" is something that I find interesting. I am not exactly sure what it means. Sometimes it is used to describe the fact that the economy in the 1990's was booming with very low unemployment and little inflation. This used not to happen. It was accepted, for decades, that low unemployment caused inflation. If the "old" rules do not work then this must be a "new economy". The phrase "new economy" is more often used to describe tech stocks. In this sense, the "new economy" is the Internet, the PC business in general and all tech stocks.

Somewhere along the line, someone got everyone to believe that these stocks needed a new method of establishing valuation. As it turned out this was almost entirely Wall Street hogwash. Hype cause folks to buy but it could not sustain the dot-com thing. In essence the "new economy" was a Wall Street scam.

Why are stocks worth what they are worth? Stocks are sold in an open market. Stock prices rise because there are more buyers than sellers. Stock prices fall because there are more sellers than buyers.

In the "old" economy stock prices reacted to news that was perceived to affect earnings. For some strange reason, I think that stocks in the "new economy" have been governed by what I will politely describe as "the bigger jerk" theory. It made sense to buy Red Hat at $100 is some "bigger jerk" is willing to pay $150 next week.

Let' take a step back. What is the purpose of the stock market? To my simple mind it has only two purposes. 1) When a company wants to make a public offering (either an IPO or a secondary offering) the stock market is where this happens. The companies get the capital. People buy shares of stock and own a part of the company and are thus entitled to a share of the future profits. 2) The market provides an instant way for shareholders to sell their stock. This makes stock extremely liquid and increases the value of the shares somewhat.

The aftermarket for stock shares is not the heart of capitalism. Raising capital is. The constant reporting of the fluctuating prices of equities increases their perception as speculations and diminishes their perception as investments. An aftermarket for shares helps but 3.3 billion shares traded on the NYSE and NASDAQ today. The extent to which trading represents speculation rather
that investment translates into volatility and risk.

Cash Infusion

Whatever the numbers may say, to a certain extent, stock prices rose in the 1990's because more and more money was poured into the markets. In fact, the rationalization behind "new economy" stocks may have been based on the mere fact that there was a market and the product did not exist. Product (IPO's of tech companies) was rushed to market, rationalization (don't worry that these companies don't make money) was offered and the Red Hat Linux's of the world soared to multi-billion dollar market caps.

Funds managers and investors were faced with a strange situation vis-à-vis the "new economy" stocks. Funds managers were reticent to not climb aboard the tech rocket. The fact is: these stocks were soaring. The fact that the flight was unjustified made no difference. A fund manager who did not play would wind up looking like a yutz.

The IPO Market

The healthy runup in equities had an effect on the way that businesses were built. To a greater extent than ever, corporations strategize IPO's in order to grow. In the past, businesses went to banks for loans. Banks have become more risk-adverse and IPO money easier. Business people turned to VC's for capital. IPO's offered obscene rewards for executives who could pull them off. But VC's depend on IPO's as an exit strategy. They do not want to get their capital tied up in companies. They want to recycle it. There existed a complex relationship between the VC side of business and going public with hype.

On-line Trading

I am speculating here and open to comments but in 1998 I started on-line trading. I am by no means a sophisticated investor.
People in the office that I worked in saw what I was doing and though that it was cool. Online trading. That is cool. I watched what some of them were doing. It seemed that no one knew the difference between a market order and an order a specific price. They did not even know that a difference existed. I started to think about this. If there are buy orders for a few hundred thousand shares "at market" made overnight what is going to happen the next morning. The point here is that the lack of sophistication of these investors increased the volatility of the market.

What is the Effect of "Day Trading"?

Day trading is the purest form of speculation. If you buy a stock in the morning with no intention of owning it at day's end I dare say that that qualifies as speculation. Speculation is the purchasing of something today just because you think the price of it will be higher tomorrow (or this afternoon). It pays no heed to the inherent value of the asset. This happens in real estate markets and fine arts markets. The Hunts did it in the silver market around 1980. Day trading, increased margin debt, Internet stocks and Index funds have all added to speculative investing. Index funds make for a "bandwagon" approach to investing. As the value of the encompassed stocks increases the index rises. That attracts more money and that money is used to runup the value of the stocks and another cycle starts. The increase in speculative investing during this boom has driven market beyond where it would have otherwise have gone. More volatility.

What Caused the Bull Market?

The decade long bull market of the 1990's was not based entirely on hype. It was based on a combination of things - the main one being higher corporate profits. If one does a regression analysis of the S&P 500 and examines what causes equities to move the fact is that there are three things. The first is corporate earnings as measured by the Bureau of Economic Analysis. The second is the yield on the 10-year Treasury. The third, strangely enough, is demographic. It is the percentage of the population in their 40's and 50's. These folks are in their prime time with regards to earnings and have lower risk aversion.

If one runs the model the conclusion is that 80% of the gain in the S&P 500 was explained by these three factors. The other 20% may be hype or speculation and may well represent the extent of the market overvaluation.

The Other Type of Bull Market

In the past several years we have seen numerous examples of improper accounting designed to inflate stock prices. Enron might be the most obvious case. The present issue with option backdating is interesting because it may not be illegal but it hardly represents a situation where the company is looking out for the best interests of the stockholders.

I find the present situation at Apple to be interesting because Apple has long been a company that depends on perception to justify the prices of its products.

Culture

It is really hard to get any work done much less have time to write a newsletter when there are so darn many Christmas parties to attend but...

As the year comes toward its end there are things which continue to mystify me. I think that first and foremost is why anyone cares about Paris Hilton or Britney Spears. I know that Paris Hilton had a TV program and seems to be able to get in the news weekly but the simple fact is that the is merely a famous nobody. I know that Britney Spears is a singer but, alas, I don't even know if I have ever heard anything that she has done. There is something to this entire issue of celebrities that I just don't get. I care nothing about what Tom Cruise, Brad Pitt or Angelina Jolie are doing. That is not true of Pamela Anderson.

I suppose that there is a symbiotic relationship between movie stars and the media just as there is between sports and the media. Sports and celebs sell papers. My insightful analysis of Treasuries is not of interest to the general public and, besides, you folks get it for free. But people are, you know, like interested, like, you know in what Paris Hilton, like, has to you know say. Maybe we need to blame Bush for this spate of bad grammar. While folks may discuss his politics to no end there is no question that he is the most inarticulate President I have ever, you know, like listed to.

As long as we are talking about culture I must reveal that I have a large folder with stuff I have written in the past intending it for these newsletters and am never really sure if some of this actually made it into a past newsletter.

Wait. First I am going to repeat last weeks "blurb" about refinancing in 2007.

I want to address here one set of folks. This includes everyone with a 5/1 or 7/1 ARM and especially those who have good rates (say something near 5%) and a couple of years left.

Assuming that you plan on keeping this property for more than a year after the rate adjusts you must not be lulled into thinking that you can forego this refinancing opportunity and get the same deal two years from now.

There should be two things that you are looking to do in 2007.

1) get a fixed rate loan that will last you a lifetime or

2) replace your current ARM with one at the same or lower rate and move the date on which the rate will adjust out another 5 o7 7 years.

You must not fret over the fact that if you go for the 30 year fixed rate option you may be paying more for a year or two. The difference will be marginal but the entire point is letting the lender/investor take the rate risk for the next 30 years. The economic value of that cannot be know at the time. This is about risk avoidance.

2007 will be a year to ditch your ARM for a fixed rate or, at bare minimum, push out the rate adjustment date.

The French

I have been to France twice. Paris is an incredibly beautiful city. The first time that I went to Paris was in 1981. Near the end of my stay there I had a remarkably odd experience. I had a rental car and was driving back from the Louvre to the Bristol Hotel when I came upon a group of a dozen people blocking the intersection with their cars. They were shouting. I realized that while I speak a certain measure of French all bets are off when it comes to understanding what a group of people are screaming. I really had no idea what was happening.

The people in the cars around me seemed calm. I was not sure what this meant. I mean, that's the same thing they did
when the Germans invaded. I had no idea what was happening, what the demonstrators were saying and what their intentions
were. After about five minutes I decided that I was going to get out of there. Mine was the first car stopped so I decided to go very slowly and make a 90 degree right turn and drive in a direction perpendicular to the scene. I was not driving toward the demonstrators but away from them at a pace of, perhaps, 3 mph, I mean, 4 kph. All hell broke loose. Two or three of the demonstrators jumped on the hood of my Fiat Ritmo and dented the crap out of it. In hindsight, I had broken protocol. The thing to do (I later found out) was to just wait until they were done demonstrating and drive on.

The group demonstrating was called "CIDUNATI" which is an acronym for some French expression. I think that at that time this was a labor union for professional and technical workers.

I think that part of understanding the French is recognizing that they have a different viewpoint about the relationship of capital
and labor than Americans do.

I think that the French subscribe to classic Marxist theory.

They believe in the notion that the proletarians (folks who sold their labor for cash) would be taken advantage of by the bourgeoisie (the bosses or company owners). Marx was rooted is the concept of classes which have largely vanished in modern America where the vast majority of us are middle class homeowners. These notions are more accepted in a country
such as France which has an advanced capitalistic economic system which is imbued with socialist notions about labor and
entitlement. Americans are more pragmatic. We believe that everyone is better off with a house and two cars. The notion of
"bourgeoisie" does not exist to any significant extent in America.

The contributions of the French to contemporary philosophy are rooted in the secular notions of moral relativism (existentialism) and the extended inanities of the recently deceased Derrida and deconstruction. Whereas existentialism and moral relativism are
philosophical ideas meriting discussion, deconstruction is drivel.

The French see themselves as sophisticated compared to Americans. By their standards they are totally correct. But no one
who does not have too much time on their hands can take deconstruction seriously. In the United States its proponents are
college students who are attracted to it because it is intellectually stimulating even though it is drivel.

For me the difference between the French and Americans can be most easily seen in food. Classic French cooking is an
art based of starting with mediocre ingredients. The solution is to cook the heck out of food and put spectacular sauces on it. Contemporary American haute cuisine starts with the proposition that we have great, fresh meats and vegetables and raise them to new standards by dazzling feats of daring with colors and ingredients. The only rule is that there are no rules. American cuisine is like American movies or theater - the emphasis is on entertainment, not art.

America thrives by having little value for what went before. The only contemporary politician who has a strong sense of the importance is history is Newt Gingrich. Whether it is food, technology or pop culture we are "out there." The French have a deservedly proud tradition of veneration of their culture.

I think that the French also have a different perspective about work. The French are not workaholics as are Japanese, Germans or Americans. The are trying to shape an economic system with a minimal work week. Indeed they may discover a better relationship between work and the rest of life than Americans do and that is relevant to my piece last year about how technology will diminish the necessity of a long work week. In short, the French may be onto something.

It is impossible to separate the roots of existentialism from French experience in the two World Wars. World War I created
it and World War II sold it. Existentialism emphasizes moral relativism. There is no higher authority. Life is what we make it. The notions of esistentialism and moral relativism did not occur in vacuum. They were the consequence of educated people philosophizing about the meaning of life after some grim events. In a very real sense this can be compared to contemporary rap and African-American city culture. Like it or not, rap seeks to explain life amid the chaos of drive-by shootings, crack and a confused notion about women.

Credit Cards

A long time ago - when I was graduating from college, even before I actually started my first job - I was sent applications for credit cards.  They were very easy to get.  They still are. Young folks getting their first jobs are introduced to the world of credit cards.  Credit cards are a modern necessity but for some they become a serious problem .  Credit card debt can destroy young people's lives.

This section is for people getting started in the credit world.

If you want to become a homeowner you need to have credit cards work for you.  It is OK to get credit cards.  It is OK to use them. The purpose in using them should be to establish a credit history. What is not OK is carrying any sizable credit card debt.

Let's say that you want to buy a new TV for $700. Do not do it unless you have the $700 set aside for the purchase.  If you are not the best in the self-control department, perform this drill: 
buy the TV on your credit card only when you have the money in your checking account.  When you leave the store (OK you can take the TV home first but you can't plug it in yet) write a check to the credit card company for the amount that was billed. 

Go home, take the TV out of the box, plug it in and Scotch tape the envelope with the check to the top of the TV. Mail it (the check not the TV) to them when you receive the credit card statement. You will have accomplished two things: 
1) established credit usage and
2) not run up any debt.

Obey the following rules when using credit cards:
- use them infrequently
- do not buy anything that you do not have the money in hand to pay for
- pay off all of your credit card debt when you receive the statements.

At present, I use credit cards only when
1) shopping online
2) buying "big ticket" stuff because BofA gives me 1% back and I pay the bill immediately
3) in an emergency.

It is only in the last few years that I have broken down and used them to pay for gasoline.  It is a lot easier to stick the card in the pump than to deal with the attendants at gas stations. It is a strange comment on American culture that in the '60's the people at gas stations charge thirty something cents a gallon, gave you Blue Chip trading stamps, checked your oil and washed your windshield. Now they sit behind bulletproof windows, charge you $2.50-$3.00 a gallon and act like you are nuts when you ask where the freaking squeegee is.

If you want a DVD and do not have the cash then you cannot afford it.  Wait until you have the cash and pay cash for it. 

If you feel that you need to get away for the weekend and do not have the money - stay home and watch TV.  Watch cartoons on Saturday and football on Sunday. 

Don't go to restaurants and put it on your credit card - pay cash. If you don't have that kind of cash - eat at McDonalds. If you cannot afford that then you really are in trouble.

Have some understanding with your spouse about that what will be spent for birthdays and the anniversary will be limited to cash-on-hand. Mutually agree that you love each other but that your love would be enhanced if you could buy your own house some day.  If you are not married then be grateful that you do not have this problem.

Avoid getting a lot of credit cards.  When the kindly woman at the cash register at Macy's asks you if you want to apply for a credit card and tells you that you will get 5% off whatever you buy that day - resist.  She is working for Satan. She represents the forces of evil even though she looks innocent. She is out to destroy your credit.  She probably owns apartment buildings and wants to make sure that you become a permanent renter.

Do not succumb to the concept that we live in a "credit card economy" and that using credit cards helps the economy.  I suppose that in the 1970's people bought cocaine and cocaine dealers made money and that gave the economy a boost.  In the long run neither drugs nor credit card debt really helps the economy.  Those who are ruined by them become economically marginalized. 

There is a point to make here which is important. If you suddenly see your need to maintain credit cards balances when you formerly did not and this is not the result of an emergency the underlying problem is probably that your income went down or expenses went up and you had no savings to make up the shortfall. In a real sense the problem with credit cards is that the are often used by folks with no savings. In general, we would all do well to save more. (For the shopping crazed "save" here means "put money in a savings account" not "buy while stuff is on sale.")

The Credit Industry

If you look on-line you will see that there are thousands of listings for credit cards, debt consolidation, credit repair, debt counseling and bankruptcy.  The credit card industry has spawned other new industries.

What Should You Put on Your Credit Cards?

On-line shopping, emergencies: tow trucks, bail.  Use them also as a "deposit" when traveling.  You need them to make hotel reservations and to rent a car.

The Plastic House

In the past few years we have seen a mutant form of the plastic monster.  It is the 125% LTV mortgage.  The  proposition is simple enough - pay off all of your credit cards by getting a second mortgage on your home.  The interest is probably less that you are now paying and it may be tax deductible.

These are ill-advised.  The wrong people get them. People who have problems meeting their credit card debt now tie this debt to their home and can charge more stuff. 

Let me draw an analogy.  Around the year 1900 the German pharmaceutical firm Bayer (the aspirin people) marketed a cure for morphine addiction. This wonderful product was sold under the trademark"heroin". The 125% LTV loan may likely do to your finances what heroin does for your body.  Seems like a good idea at the time - feels good at first but it's nasty and hard to get rid of.  It is no more a cure for credit card debt than heroin was for morphine addiction.

If you are in this credit card abyss you need to work very hard to get out of it.  You need to stop charging and seriously do all that you can to maximize your income. You need to pay off the credit cards with the highest rates first.  If you work overtime or get a second job do not reward yourself for it. You have already spent the money that you are working so hard for.  If your debts are so large that you cannot possible pay them off with a 3-year austerity program you need to consider a bankruptcy. This will have a negative effect on you creditworthiness for years to come but you may be able to regain control of your life and do away with the hideous effects of being a captive of the P-Monster.

If you decide to get a "cash out" refinancing or a second mortgage to pay off existing credit card debt you must do yourself the favor of seriously reducing the balances.  Do not close the accounts.  That can have an adverse effect on your credit score.

Living With Plastic

Credit cards are a necessity.  Get them.  Use them wisely.  Make them work for you by enhancing your credit history.  Don't charge anything that you do not have the cash to pay for.  Pay all credit card debt off immediately unless there is an emergency.

Not Just Plastic - Other Credit

I have seen many young people who could not qualify for a home loan because they had two car loans. If you cannot afford to pay cash for a car, keep the payment low.  As a rough guide, if more that 15% of your gross income is spoken for by debt you may not qualify for a home loan.

There is "smart" debt.  If you take out student loans and get through medical school that is smart debt. If you buy a car which you need to get to work or use for work that is smart debt.

For the More Sophisticated

Please understand that most (maybe all) of the advice above is for beginners.  Folks who have well-established credit may seen the picture differently.  They may "put everything" on credit cards for the purpose of accounting or to get some subsidiary benefit such as airline miles or cash. If your approach to credit is that sophisticated, feel free to pass this along to people who need it.

---

Dick Lepre