The Economy and Financial Markets Down

March 19, 2001

"Government statistics continue to tell us that price inflation is not a problem, and when an inflation statistic comes out it does not like, it drops out food and energy and claims the number is totally benign. Ask any housewife, and they will tell you that the cost of living is going up steadily and much more rapidly than the government will admit. We in the Congress should be prepared for lower revenues in the future since the revenues received in the last couple of years were artificially created by a stock market that had skyrocketed due to the credit expansion by the Federal Reserve. These capital gains tax revenues will soon disappear. The savings rates of the American people are now negative. Without savings, true capital investment cannot be maintained. Creation of credit out of thin air by the Fed was the original problem, so it surely can't be the solution." - Congressman Ron Paul, Congressional Record (11/30/2000)

"After 30 years of watching the economy and investments, I think a president's share of influence on them is not more than 5%. I'd say Congress is 15%; the Federal Reserve 40%; and foreign events 40%." - Richard Maybury, Early Warning Report (January 2001)

"It is becoming increasingly obvious that most Wall Street strategists and economists lack even the most rudimentary turning point forecasting ability and understanding of business cycle dynamics." - Michael Belkin, Strategic Investment (12/2000)

THE ECONOMY AND FINANCIAL MARKETS DOWN

Slowly but surely, the bear market and the economic recession are building momentum. President Bush, Dick Cheney, and Bush's economic guru Larry Lindsey have all acknowledged that the economy is headed for recession. Morgan Stanley Dean Witter's chief economist said on 1/4/01 that the U.S. economy will slip into recession in the first half of this year.

Alan Greenspan began to warn of an economic slowdown in early December. There are growing indicators that we could be descending into the biggest recession since the 1930s. The speed at which we sink into recession is likely to surprise almost everyone. On December 21, the Associated Press reported that the economic slowdown did, in fact, start in July, when "economic performance experienced a striking slowdown from the prior quarter."

Corporate earnings continue to decline; the jobless rate continues to increase despite Clinton's totally fabricated stats to the contrary; the energy crisis (both domestic and global) continues to grow; strains are appearing in the highly leveraged U.S. banking system; corporate bankruptcies continue to increase - along with huge Fed engineered bailouts of the companies deemed "too big to fail"; auto and retail sales are declining sharply; and the U.S. savings rate is the lowest in history (i.e., it is "negative").

Cracks are beginning to show up in the gargantuan, record level American debt bubble (consumer and corporate) and in the $104 trillion derivatives pyramid; the bear market in U.S. stocks continues to deepen in spite of the recent Fed interest rate cuts; the U.S. trade deficit (for one year) is headed for $500 billion; the U.S. dollar has entered a steep bear market decline; and economies all over the world (including Asia and Europe) are beginning to sink into recession.

Amazingly, however, the vast majority of economists remain bullish on the economy. In a Bloomberg survey of 26 economists on December 30, not one of them called for economic contraction in 2001. Of 54 professional economists surveyed by the Wall Street Journal, just one (Gary Shilling of Shilling and Co.) is calling for economic decline in 2001.

No matter how close we get to an actual recession, economists refuse to predict one - just as economists were taken by almost total surprise in 1929 by the crash and depression which followed. It should be remembered that back in 1991, most economists did not acknowledge the existence of a recession until after it was over. Now they are saying that the next recession is over before it has really even gotten started. Securities analysts, mutual fund and money managers are just as bad. Perhaps it is because they are paid to be bullish - to keep the pubic in the markets at all times.

Meanwhile, the Fed is lowering interest rates and expanding the money supply "like there was no tomorrow" in an attempt to slow the decline in the U.S. financial markets and turn the economic tide back to the upside. Since Alan Greenspan became chairman of the Fed (August 1987) he has expanded the U.S. money supply by $3.25 trillion - more in 13 years than in the previous 74 years combined. The highly revered and very powerful Greenspan has only one arrow in his quiver (or bag of tricks) - massive monetary expansion.

Can he bail out the U.S. financial markets where over $4 trillion in assets have evaporated in the past year; the $104 trillion global derivatives bubble; the entire US and world economies; and the global banking system? Apparently he believes he can. If he tries he could destroy the U.S. dollar; trigger super (or even hyper) inflation; and help set the stage for the world's largest ever inflationary depression.

Alan Greenspan (who panicked when he saw the faltering stock market and systemic weakness in the last days of 2000 and early days of 2001, cutting interest rates 50 basis points before the next Fed board meeting) has created the world's largest ever financial bubble over the past eight years (it would seem, at least in part, to help Bill Clinton). If he now tries to perpetuate the bubble (as he seems likely to do) with a massive new flood of liquidity, he could overnight give us a rerun of Weimar Germany in 1923 - only in America.

A. A BRIEF REVIEW OF THE ECONOMIC FUNDAMENTALS

1. CORPORATE BANKRUPTCIES ARE RISING SHARPLY - Trans World Airlines is going out of business, with TWA selling off most of its assets (including its airliners) to American Airlines at the fire sale price of $500 million. Xerox is presently denying rumors that it faces bankruptcy, but the former high flyer has $23.8 billion in debt, only $2.5 billion in fixed assets to secure that debt, and not enough income to meet its interest expense.

In December, ICG Communications filed for bankruptcy leaving $2.2 billion of defaulted debt in its wake. As recently as April 2000, ICG's shares were trading at $39, with a market capitalization of $2.04 billion. Those shares are now worthless. GST Telecommunications (with $1.2 billion in debt) went bankrupt last May, the shares went to zero, and bondholders only got 50 cents on the dollar back.

At this writing the two largest electric utilities in California (Southern Cal Edison and Pacific Gas and Electric) are technically bankrupt and will have to be bailed out to survive. Rumors have surfaced regarding major problems at Bank of America due to huge S.C.E. and PG&E loan exposure.

In 2000, 210 Internet companies went under. Safe Money Report (12/2000) currently counts 168 publicly traded companies hovering near bankruptcy - all with more debt than assets (i.e., $143.2 billion in assets versus $159.2 billion in debts). Safe Money cites another 668 public companies that are hemorrhaging with red ink and may not make it through 2001. [ED. NOTE: That's over 850 publicly traded companies which could be pushed into bankruptcy this year.]

Some of America's largest and oldest companies are in serious financial trouble (i.e., Del Monte Foods, Coca Cola Bottling, Trump Hotels and Casino Resort, Ford Motor, Daimler-Chrysler, JC Penny, Campbell Soup, etc. Daimler-Chrysler finished 2000 with no cash. Kirk Kerkorian is suing Daimler for misrepresentation over the takeover. It is now believed that Daimler grabbed Chrysler for the cash.

Old retailing standby Montgomery Ward has announced it is going out of business. The 128-year old retailer is closing 252 stores in 32 states and terminating 37,315 employees nationally. At Time Warner, for every dollar of shareholder equity, the company owes $2.70 to creditors. GE (which is primarily a financial company today) has $7.20 in debt for every dollar of shareholder equity.

Campbell Soup has $5.1 billion in debt versus only $137 million in shareholder equity - an incredible debt to equity ratio of 37 to 1. As the recession unfolds, bankruptcies will not just be in dot coms - they will include as victims some of America's largest and oldest retailers, telecoms, bio techs, semi conductor, and computer manufacturers.

SMR, a financial research firm, says personal bankruptcies will rise 20% in 2001. On 1/17, Bill King wrote that SSB analyst Ruchi Madden says bad bank loans now total $51 billion, of which $33 billion may default this year.

2. EMPLOYMENT IS DECLINING - Manufacturers cut 62,000 jobs in December on top of 15,000 in November. The December employment report showed average weekly hours worked fell to 34.1 - the lowest level since April 1991 in a recession. That means that companies are reducing the hours people are working rather than laying them off at this point. Challenger Gray says layoffs (133,713) rose 200% in December. As corporate earnings continue to decline and business failures multiply, job layoffs will accelerate.

3. CORPORATE SALES AND EARNINGS ARE DECLINING - Midsize car sales fell 13% in November, while total auto sales fell 7.9% in December. Unsold inventories in early 2001 are huge. Semi conductor sales fell 15% in the 4th quarter of 2000 and chip equipment sales are projected to drop 6% in '01. Corporate earnings dropped 22.6% overall in 2000, while business tax refunds for last year are down 32.8%. Retail sales in December were sluggish (despite Christmas) due to worries about a slowing economy. Film sales by Eastman Kodak (domestically and globally) are down sharply.

4. CONSUMER CONFIDENCE HAS BEGUN TO DECLINE - On 1/10/01, an Associated Press poll indicated that anxiety is on the rise among Americans about the state of the nation's economy. Consumer confidence dropped 14 points in the last quarter of 2000. An ABC-Washington Post poll released 1/16 indicated 55% of Americans think the country is headed into recession. And a Bloomberg poll released 1/16 shows consumer confidence is continuing to decline in January. The collapse in stocks (i.e., $4 trillion in NASDAQ losses alone) is dampening consumer confidence and spending. [ED. NOTE: The latter makes up two-thirds of U.S. GDP.] The "wealth effect" is quickly evaporating.

5. THE U.S. BUDGET WILL MOVE BACK QUICKLY TO A DEFICIT - The surplus was always a sham. The government borrowed hundreds of billions from Social Security and other government pension funds in recent years, giving worthless paper IOUs in exchange, and then used the funds to understate the deficit. But now corporate and personal incomes are dropping sharply (partly in response to the demise of the stock market) so the government tax take is going to shrink sharply.

On 1/2/01, the U.S. Treasury Statement showed Tax and Loan accounts down 36.7% in 2000; corporate income down 22.6%; individual tax refunds down 18.2%; and business tax refunds down 32.8%. This is also happening to states across the country who had gotten used to the large "bubble" induced tax takes.

6. THE TELECOM BUBBLE HAS BURST - Providers of telecom services have borrowed more than $32.2 billion over the past three years. Last year GST Telecommunications and ICG Communications with $1.2 and $2.8 billion in debt went bankrupt.

Teligent bonds trade at 16 cents, Viatel 32 cents and RCN 50 cents and they collectively have $5.3 billion in long-term debt outstanding. Shares of competitive local-exchange companies are off 38.5%. Infrastructure stocks have fallen 86.7%. Lucent has provisioned $501 million for customer bad debt.

The collapse of $300 or $200 or $100 billion in debt could collapse the economy and we are close to that becoming a possibility. Capital raised in the public stock and bond markets for telecoms went from $2.3 billion in 1990 to $69.2 billion in 2000 and bank loans went from $10.3 billion in 1990 to $88.2 billion in 2000. Total investment in 2000 was $157.4 billion or up 10 times in 10 years.

This bubble is bigger than the real estate bubble of the 1980s and represents one-third of real U.S. economic growth between 1995 and 1999. Telecom problems will take 10 years to work off, and will negatively impact real estate and indeed the entire economy.

7. THE REAL ESTATE BUBBLE MAY BE ABOUT TO BURST - Today there is massive overbuilding in real estate across the country, with a glut in major cities. Vacancy rates are climbing rapidly. Commercial real estate space rentals are plunging even as massive new commercial development is under construction. This is the way it started in 1989.

Real estate prices began to top out in New England 15 months ago. In California, housing costs are still going up. The LA Times reports that the percentage of people who can afford a median priced home is falling to 23% in San Diego County and only 10% in San Francisco. As the recession spreads, values will begin to come down across the country - even with 7% (or less) mortgage rates. Even though commercial prices have fallen further to date than residential, the latter will ultimately fall further in the recession due to the much greater leverage. Twenty-eight percent of residential loans are 125% of value, or nothing down, or $5,000 down. Making it even more dangerous is that Fannie Mae and Freddie Mac own 70% of these loans, which are basically backed by derivatives.

Real estate prices on the east and west coasts have reached absurd levels. In New York City, the old St. Moritz Hotel on Central Park South has been refurbished, with giant apartments (5-10,000 square feet) selling for $17 million up to $39.5 million for the largest. East side brownstone homes are going for up to $20 million (up from $500,000 25 years ago). On Wilshire Boulevard in Los Angeles, luxury condominiums are leasing for $10,000 to $30,000 per month.

[ED. NOTE: Americans have short memories. It has not been so many years since residential real estate plunged 50% in Los Angeles and 85% in Houston, or since empty "see through skyscrapers" dotted the skyline of major cities across America. It will happen again!]

8. THE INVERTED YIELD CURVE - An inverted yield curve happens when long-term interest rates, which should be higher than short maturity interest rates, become reversed and the long-term rates fall below the short-term rates. (A yield curve is a graph which compares interest rates on debt instruments of varying maturity dates - short to long.)

Today the yield curve is the most inverted (or distorted) it has been in 20 years. It has become one of the most accurate recession forecasting tools which economists can use to predict a recession. The yield curve went partially inverted in July 2000 and fully inverted in October. A recession historically begins 10 to 15 months after the yield curve inverts. Therefore, recession should hit in the summer of 2001 if not sooner, and as discussed above, the signs of recession are already emerging.

B. CRACKS IN THE MASSIVE DEBT PYRAMID

Debt is the Achilles heel of the U.S. economy. It has been accumulated over the past six years by U.S. businesses and individuals at the fastest rate and in the largest quantities in U.S. or world history. From the end of 1994 to the middle of 2000, U.S. corporate and consumer indebtedness was up $4.75 trillion; financial sector debt grew by $4.15 trillion. So, total private sector debt in the U.S. grew by $8.9 trillion from 1994 to 2000.

Outstanding consumer credit is at an all-time high of $1.5 trillion. Mortgage debt is $4.8 trillion and Americans on average owe $31,200 each. Last November, Americans spent $56.2 billion more than they earned. Personal savings are minus 2% versus, plus 2% in 1999. (see chart)

Since 1995, the total credit supply has grown $9.3 trillion (54%) to $26.5 trillion. Since late 1998, the overall credit supply is up by $5.3 trillion (25%). And the Fed that created this huge debt bubble has let the broad money supply grow by $2.6 trillion (60%) since 1995, and by $1.5 trillion (27%) since late 1998.

1. PERSONAL DEBT EXPLODING - Personal credit card debt is now in the range of half a trillion dollars in the U.S.. But the banks have been issuing new lines of credit card credit on a massive scale. It was $1.5 trillion as recently as March 1996. In January 1999, it was $2.4 trillion. Today, it is $2.9 trillion. Banks are aggressively seeking "new debtors," despite the fact that only 18% of the available credit has been used.

Alan Greenspan and the Fed have created the huge stock market/financial system bubble (the biggest in history) that now threatens to come crashing down in the greatest crash and depression since 1929-33. And Greenspan believes that the only way to extend the life of the bubble (or at least try) is to create trillions more in credit - to flood the U.S. (and world) with massive dollar based liquidity. But if Greenspan does, he risks the collapse of the dollar; hyperinflating the currency; and precipitating an inflationary depression of Biblical proportions.

In September 1998, when Long Term Capital Management went down, jeopardizing 13 large New York banks and brokerage houses and trillions of dollars in derivatives, the Fed pumped several hundred billion in liquidity into the system in a matter of a few days to avert a financial collapse. Today, the financial system is far more vulnerable to a series of financial accidents, which could happen so quickly and proliferate in a chain reaction so rapidly, that their ability to engineer a bailout with hundreds of billions of dollars in new liquidity could be overwhelmed.

2. CREDIT IS EXPLODING - As Doug Noland of the Prudent Bear Fund wrote on 12/18/2000:"Putting it all together, a 1998-style collapse in financial system liquidity should be considered a real possibility. The problem we have in trying to analyze the situation is that the fundamental backdrop for the U.S. financial system and economy is profoundly weaker than it was just two years ago.

"Undeniably, the domestic credit situation is much more problematic than in 1998. A press release from Moody's in December was certainly disconcerting: 'Moody's estimates that between 385 and 450 companies out of the over 9,000 the index tracks will default in the next 12 months, more than triple the 114 that have defaulted since December 1999. Moody's points to greater leverage, often brought about by debt-funded merger and acquisition activity, higher costs for credit, energy, and labor as well as litigation-driven event risk as the reasons for this high level of default risk.

"Moody's forecasting model for the trailing 12-month default rate has been pointing to higher expected default rates for issuers of rated speculative-grade corporate bonds. Moody's is forecasting that 9.1% of those issuers will default on speculative-grade rated bonds over the 12-month period ending November 2001. Already, the record for November shows that defaults are increasing in North America, with 19 issuers defaulting on roughly $9.5 billion of debt. This is markedly up from October's figures of eight issuers defaulting on $2.2 billion of debt.

"And while the credit situation is deteriorating rapidly, what bothers us the most is that the U.S. financial system has been in an unrelenting and most extreme (unsound) expansion since those dark days of crisis in the fall of 1998. For one, broad money supply, at almost $7 trillion, has surged $1.3 trillion, or 23%, since June 30, 1998. Total mortgage debt has also increased about $1.3 trillion, or 23%, to $6.8 trillion. Total outstanding corporate bonds increased 23% to $4.9 trillion.

"Total liabilities of the U.S. commercial banks have increased 16% to $6.3 trillion, although (as discussed in great detail previously) the preponderance of credit creation has been outside of traditional banking sector liability expansion.

"Money market fund assets have increased 36% to $1.7 trillion. Total GSE liabilities have expanded recklessly, surging 52% to almost $1.9 trillion. Outstanding asset-backed securities have increased 34% to $1.75 trillion. Finance company liabilities have increased 37% to $1.1 trillion, while total Securities Brokers and Dealers community liabilities have increased $263 billion, or 28%. Mutual fund holdings have increased 54% to $4.8 trillion, since 1998's third quarter.

"And with credit excess fueling historic trade deficits, the accumulation of foreign liabilities has been nothing short of astounding (frightening). At the end of the third quarter, the 'Rest of the World' held $7 trillion of U.S. financial assets, having increased by 35% ($1.8 trillion) in just two years. Foreign holdings of agency securities have surged 70% to more than $500 billion. Holdings of US corporate bonds have jumped 57% to $950 billion, while equities holdings have increased 80% to $1.7 trillion.

"Holdings of 'Miscellaneous' financial assets have risen 45% to $1.7 trillion. Granted, such an explosion of foreign liabilities works like magic (as it did in Mexico, SE Asia, Russia, Argentina, Turkey, etc.) as long as one's currency holds its value. But make no mistake, foreign debt accumulations in the current global environment dominated by leveraging and 'hot money' flows is just piling up the tinder for the inevitable firestorm.

"We just can't help but to think that sparks are now coming from the derivatives marketplace - equity, interest rate, currency and energy. And with the total notional value of the global over-the-counter derivatives market now surpassing $100 trillion (compared to $70 trillion in mid-1998), the system is in truly uncharted waters. It's all about maintaining confidence, an increasingly difficult proposition. We see big trouble brewing, and a major financial accident is only a matter of time."

C. THE TICKING DERIVATIVES TIME BOMB

"Derivatives have been the key to what has been basically unlimited credit availability that has financed the leverage behind the great bull markets, as well as the protracted economic boom. The proliferation of derivatives has created truly frightening risk, not reduced it." - Doug Noland, Prudent Bears Fund (1/8/2001)

The most extreme manifestation of the greed which has helped to create the biggest speculative bubble in history is the $104 trillion derivatives pyramid - erected over the past decade or so by the largest banks, brokerage firms, and hedge funds in America and around the world. The bubble in derivatives is the biggest single threat to the entire global financial system.

Derivatives are highly complex, sophisticated investment vehicles that are derived from more traditional investments - they are side bets on virtually anything such as interest rates, stocks, stock indexes, foreign currencies, energy prices, etc. Or they are the result of investments such as mortgages that have been broken into pieces. These derivative "side bets" (originally conceived of to "hedge" or "insure" against market risk) can carry incredible leverage of 100 to 1 or even 1,000 to 1.

When Long Term Capital Management (a large hedge fund) hit the wall in September 1998, this fund with assets of $4 billion had leveraged securities positions of over $100 billion and exposure in the derivatives markets of over $1 trillion. Thirteen of New York's largest banks and brokerage firms (also huge derivatives players) had overlapping positions in LTCM's derivatives and ultimately had to have a Fed-engineered bailout costing several hundred billion. The whole U.S. financial system almost went in the tank over one defaulting hedge fund which was a large player in the derivatives markets.

When LTCM went under creating chaos throughout world financial markets, U.S. banks were holding $26 trillion in derivatives positions. Today these banks hold $37 trillion in these highly leveraged financial bets. Doug Noland believes that the reason for the Fed's abrupt, precipitous drop in interest rates on January 3 was not just problems in the economy or stock market, but very possibly a major problem or series of problems involving derivatives and the highly leveraged speculating community.

Rumors surfaced in early January and were quickly quashed of serious derivatives problems at Bank of America. Since the LTCM fiasco, there is no public discussion of derivatives problems. All such discussions are held "behind closed doors" between the "big players" and the Fed.

It is important to remember that in recent weeks and months, we have seen extreme price movements in equities, interest rates, currencies and throughout the energy markets. Not all of these fluctuations are readily predictable, hence, with 100 to 1 or 1,000 to 1 leveraged positions, huge losses (in the billions, tens of billions, or more) can eventuate literally overnight or in hours or even minutes. It should be noted that Microsoft lost $350 million in derivatives in the second quarter of 2000 due to extreme market volatility.

As Doug Noland wrote on January 5: "It sounds extreme, but we have always assumed that the massive U.S./global derivatives market would at some point collapse (perhaps Russian style with systemic counterparty defaults). This, in what we view as sound and rational analysis, is based on the fact that there are serious fundamental flaws in the entire process of relying on sophisticated derivative models, especially to the tune of $100 trillion...

"Derivatives have been the key to what has been basically unlimited credit availability that has financed the leverage behind the great bull markets, as well as this protracted economic boom. As we have said before, the proliferation of derivatives has created truly frightening risk, not reduced it. There is no doubt that the California utility fiasco and an historic spike in energy prices (particularly natural gas) has wreaked havoc within the energy derivatives marketplace. To what extend, only time will tell.

"The bottom line remains that derivatives and Wall Street 'structured finance' are deeply imbedded throughout the entire financial system and economy. The unfolding crisis is systemic and the problems structural. Throwing more credit and 'liquidity' at this extraordinary situation is a grave mistake with extreme risk. This is very much a U.S. financial system and economy 'balance sheet problem.' Not only has the financial sector become grossly overleveraged, the quality of financial sector assets is very poor and rapidly deteriorating.

"The accumulation of unprecedented foreign liabilities continues by the day, only increasing dollar vulnerability. The 'off-balance sheet' derivative issue 'overhanging' the U.S. financial sector makes the situation only that much more precarious. The possibility of an inevitable collapse in confidence for the U.S. dollar and financial system can certainly not be ignored at this point."

[ED. NOTE: Noland actually had a much longer, more detailed explanation of the huge derivatives problem. To read the balance of that excellent article, go to www.prudentbear.com. ]

Gold is found in nature in quartz veins