Reflections on the Sub-Prime Fallout and Bernanke

Symptoms of the Sub-Prime fallout, sign of deflation

Derivatives and structured products have exploded
The downside of spreading risk
It's hard to understand the risks involved,
Derivatives are like power tools
There is lots of ignorance and fear
People are confused about the complexity of debt
C.D.O.-squared. C.D.O.-cubed.
$2 trillion in global C.D.O.’s
Dangerous amounts of leverage
Confidence crisis

It also looks like the bond insurers, Ambac and MBIA are in real trouble. Between them they insure about 14.5 billion dollar in bonds. About 2% is at risk. The other "investments" I was talking about was stated as"enhanced cash funds known as "cash plus", strategic cash", "enhanced income", "ultra-short bond funds", and money market substitutes"" What are these? Seems to be different from CDOs and CLOs. This is what has people worried about the money market fund expose to the sub prime.

To me, Bernanke is between and rock and a hard place. Productivity gains has significantly slowed down coupled with a tight labor market that will severe shortages by 2010 or so. Raw material continue to go up. Where I work, our suppliers have risen prices on the average of about 10% the last two years. Part of this comes from aluminium metal prices pushing up aluminium unit prices. Most ceramics and refractories are aluminia based products. Also P&G announced lower earning going forward due to rm prices going up 6 to 7% and an inability to pass all of it on to consumers. This is about twice what they originally forecasted. Allied, where I work, has been giving quarterly price increases to our customers as well, about 3% at a time.

So really what can Bernanke do? Inflation is occurring and will continue coupled with the tight labor. Any tightening of money will likely cause a recession. A recession may even occur if the Fed does drop the rates. The housing market slump has put a serious hurting on many manufacturing companies as well as retail. Another bit of information. Vessel rates of product coming over from China has about doubled and this is coupled with barge fleet prices about doubling as well. A large percentage of barges were sunk and lost with Katrina and they still have not recovered. So cost of bringing in goods from China has increased over the past couple of years. Also China around beginning of August placed a 8% export tax on goods, including refractories, to keep the goods inside of China for consumption and to cool off their economy. This has lead to many Taiwanese iron/steel foundries to move to Vietnam. Vietnam is quickly becoming a haven for cheap labor and manufacturing. It seems like the one thing that will help us stay out of a recession,besides what the Fed does, is the weak dollar. If the dollar starts to strengthen, then I think we are in big trouble.



A Deflationary Spiral

It is beginning to dawn upon people how a deflationary spiral works. It all starts with the need and request to satisfy creditors, debtors will sell all they can, even their best assets, to raise cash. That’s one reason why gold and silver are not going up. When the sub-prime mortgage market crashed, guess what: other bonds, including supposedly safe municipal and corporate bonds, also fell. Most commentators believe that forced liquidation is the only reason that perfectly good investments fell in price. As one report dated August 24 said, “There’s really no credit-related reason behind the decline.”

But there is potential possibility that a large portion of currently outstanding corporate and municipal debt will become worthless. Every trend has to begin somewhere, and its ultimate outcomes are never evident at the start of a move. By the end of the price decline in these bonds, when a bit of glue on the back of them will aid their use as wallpaper, observers will finally postulate why the bear market started in the first place. Even if most of the recent price declines are due to forced sales, those sales in turn are decreasing the total value of investments, which in turn will curtail individuals’ and companies’ economic activity, which will lead to an economic contraction, which will stress the issuers of such bonds to the point that they will be unable to make interest payments or return principal. In other words, whether investors understand it now or not, the forced sale of bonds is itself enough reason to sell them also on the basis of default risk.

Every step of the way seems to have an immediate causal precursor, but like credit inflation, credit deflation is in fact an intricate, interwoven process, whose initial impetus is a change in social mood from optimism toward pessimism. If you are still on the fence about this idea, ask yourself: What changed in the so-called “fundamentals” between June and August? The answer is: absolutely nothing. Interest rates did not budge; there were no indications of recession; there were no changes in bank lending policies; there were no chilling government edicts. The only thing that changed was people’s minds. One day sub-prime mortgages were a fine investment, and the next day they were toxic waste....

The following is some comments and concerns:
By Vadim Pokhlebkin

Probably the biggest reason why people in the United States live as well as they do is credit. Without credit cards, easy bank loans and convenient repayment plans few people could afford a car, a house, college education, and some couldn't even afford a pair of pants. Easy access to credit makes Americans seem rich in the eyes of the world, while in reality almost everyone is in debt up to their eyeballs.

The flip side of America's credit-based prosperity is that people who shouldn't be borrowing are able to do so. A certain percentage of borrowers will always default on their loans; for banks it's one of the costs of doing business. But loose lending standards of the past few years pushed the number of unqualified borrowers to an all-time high, and you know what happened next: say hello to the ongoing U.S. subprime mortgage crisis.

The only other Western country that comes close to the U.S. in terms of its widespread use of consumer credit is Great Britain. Lately, the British have grown so "extremely comfortable" with credit cards that in 2003 the number of cards in circulation surpassed the number of U.K. citizens (BBC). Just like Americans, Britons widely use mortgages to purchase homes, and they are also fond of borrowing against their homes' value to spend the money elsewhere.

British are also filing more personal bankruptcies than ever before, dragging down bank profits. So naturally, when the U.S. subprime crisis hit in July, the question that became very relevant for Great Britain was, "Can it happen here, too?"
No, say some analysts, because "the UK property market is not like the U.S. market: there has been no boom in building." Others – for example, the International Monetary Fund and ABN AMRO – say that on the contrary, the UK "is even more vulnerable to a property market slowdown that the U.S." (InvestmentAndBusinessNews.co.uk)

The debate continues, and only time will tell who's right. But Elliott wave analysis may offer you more clarity right now. Back in 2002, here at Elliott Wave International we published a study plotting real estate prices in the U.S. against those of U.S. stocks, as represented by the DJIA. The chart revealed a fascinating relationship: Historically, the U.S. real estate market has always lagged the stock market.

If you think about it, this makes sense. Prices of both stocks and homes fluctuate in response to shifts in mass psychology of stock and real estate investors. Real estate lags because homes are less liquid than stocks, but they both follow the collective mindset.

One thing is for sure: When stocks head higher or lower, eventually so do home prices. For that reason, instead of worrying about interest rates, British analysts and homeowners would be well served to keep an eye on the FTSE-100, the country's main stock index.