Archive for September, 2008

Are US Auto Manufacturers Too Big to Fail?

Posted by Joshy Madathil.

The automotive manufacturers have suffered as soaring energy prices, the collapsing housing market, and the crumbling banking industry have roiled the US economy.

Does it matter if large US automotive firms fail? 

General Motors, Chrysler, and Ford provide over 200,000 well-paying jobs in the US, and many other jobs in factories around the world. [1][2][3] Paying unemployment benefits would represent a significant cost for the US government.  Warranties of purchased vehicles would be worthless, and many dealers would end up with a surplus of vehicles that would be sold for a loss. These companies’ multi-billion dollar pension plans might also require intervention by the Federal Pension Benefit Guaranty Corporation if the automakers filed for Chapter 11 bankruptcy protection. [4]

The auto industry has posted sharp losses and has had several consecutive months of declines in sales.  In August of 2008, Ford’s sales dropped 26.6%, Chrysler’s 36%, and GM’s 20.4%. [5] GM has also forfeited the crown of market share leader, a title it held for an astounding 76 years, to Toyota. [6]  As difficult as it is to keep the US consumer from spending, high fuel costs, the rising threat of unemployment, and a sluggish economy has made it easier for the consumer to cut down to the bare necessities (see related MarketBlog post on Consumer Spending).

Moreover, the recent housing market debacle and meltdown among financial firms has raised consumers’ anxiety levels and made it difficult to justify the need for a new vehicle — especially with thoughts of home foreclosure and/or recession in the back of everyone’s mind.  Couple this with soaring gas prices and there’s a recipe for disaster brewing — American automakers have relied on the sales of high profit trucks and/or SUV’s to drive company earnings. [7]  Slowing sales in this sector were detrimental to Ford and GM and are reflected in their stock prices.  Ford’s stock is trading at a near 20-year low of $4.80, and General Motor’s hit a 53-year low of $9.38 during July of 2008. [8][9] 

Energy and oil prices have also affected the cost of the materials which go into producing vehicles.  In addition, gas prices have increased the overhead of transporting vehicles to dealers, which cuts into the bottom line and reduces overall profitability. [10] Funding the factory upgrades necessary to manufacture fuel efficient vehicles has become a difficult task for the auto industry. Finding this capital at an affordable rate is an issue for an industry in financial turmoil. [11] The credit crunch from the housing and banking crisis has led to widening credit spreads that increase the rates at which Ford and GM can access capital.  This affects Ford and GM more than the average firm because they are perceived as high risk (and rightly so) to investors who, in turn, demand appropriate returns for their investments. [12][13]

Widening Credit Spread

Widening Credit Spread

So how does a seemingly bankrupt corporation find the capital necessary to re-invent themselves?

The automakers have requested $25 billion in low interest loans (4% – 5%) from the government to help in the renovation and upgrade of current facilities. [14] The automotive industry has shown resilience in the past to overcome market downturns, as evidenced by the auto industry in the 1970’s.  In late 1979 Chrysler was in the midst of bankruptcy.  With the help of a federally-backed loan and the leadership of Lee Iacocca, Chrysler paid back the loans ahead of schedule and posted a $500 million profit by 1983. Through a strategy of consolidating suppliers, employee pay cuts, and the leadership of Iacocca during the process — who took a $1 annual salary during the downturn — Chrysler was able to regain its position in the market. [15][16]

There has been much debate over the question of whether a massive federal loan for the auto industry is justified.   If the industry’s downturn is likely to have a significantly negative impact on the US and global economy, then the government can and probably will step in with the requested support.  With the recent government takeover over of Fannie Mae and Freddie Mac, as well as a $700 billion package in the works to help the financial system, the Feds have shown that they will do what is necessary to maintain a stable economy. [17][18]  Without the necessary facility upgrades and strong leadership at the helm, the US auto industry will remain weak and will not see strong profitability until the US economy has stabilized.

The Outlook for Consumer Spending is Weak

Posted by Kristi Larson.


More Americans are struggling to make ends meet these days. The chart below shows that consumer spending has been in a downtrend from 2007-2008. Slow growth in real wages and high levels of indebtedness have raised doubts about the ability of U.S. consumers to keep spending. 


Source: Thomson Financial


Real wages have been growing at historically low rates, particularly over the last decade. Real wages have been impacted by both slower growth in nominal wages and, more recently, accelerating rates of inflation.  The combined effect of these factors has reduced the buying power of workers’ paychecks.  Additionally, the weak job market has led to a decline in average weekly hours worked, putting a further dent into workers’ earnings. [1] The unemployment rate recently spiked to a five-year high of 6.1%.  Not only have employers cut their payrolls for 8 straight months, the unemployment rate for August was 0.3% higher than economists’ forecasts. [2]


Household debt as a percentage of net worth is at 68%, the highest since 2002. [3] A greater portion of the average household debt mix is consumer debt, mainly in the form of credit card debt.  The average American household currently owes around $8,500 in credit card debt.  This is a disturbing 300% increase from 1990.  Moreover, the average interest rate on this debt is approximately 18.9%.  The average American spends $1,200 a year just in interest payments, and a whooping 23% of consumers have reached the maximum limit on their credit cards. This supports the idea that consumers are overextended and unlikely to significantly increase spending in the near term. [4]


Inflation is also eating into consumers’ spending power. The average inflation rate, as determined by the percentage annual change in the Consumer Price Index (below), shows that the rate of inflation is the highest it has been in the last decade.


Source: Thomson Financial


Did the stimulus package have a significant effect on consumer spending? So far there has been mixed reviews regarding the effectiveness of the stimulus package. There was a temporary boost in the second quarter of 2008 in consumer spending, which grew at an annual rate of 1.5%. An estimated $160 billion was injected into the economy, but it was unable jumpstart an economic recovery. [5] Congress is considering a second economic stimulus package in the $50 billon range.  This second package would attempt to stimulate job creation in addition to consumer spending. [6]


Forecasters are predicting consumers will continue to cut consumption, a troublesome prospect for retailers. Early forecasts are predicting a weak holiday shopping season. The National Retail Federation is forecasting the holiday sales season will be around 2.2%, which is significantly below the 10-year average of 4.4% and the lowest since 2002, which saw a sales increase of 1.3%. [7]


The U.S. consumer is heavily in debt, has been overspending his/her budget, and is under considerable financial stress.  There doesn’t appear to be a light at the end of the tunnel in the near future.  Bank of America CEO Kenneth Lewis sums it up best: “American consumers need time to restore some balance to their household finances.” [8]

Some Thoughts on “The Big Socialist Bailout”

Posted by Rob Weigand.

There’s been an enormous divergence of opinion over the way the bailout of the U.S. financial system is being handled (or, more accurately, the way government officials are proposing to handle it). My question is, do any of the critics have a better solution to the problem? Probably not. And I certainly don’t have one, either. One thing we can all agree on is that it is a big, stinking mess of epic proportions.

What the critics don’t seem to realize is that there is a significant chance that the entire global financial system may suffer a liquidity run leading to mass insolvency — something that could trigger a deep recession, maybe even a global depression. Systemic contagion continues to spread at an increasing rate, and rather than run the risk that it will “work itself out” via widespread bankruptcy filings, the powers-that-be opted to cobble together a backstop program. And there’s still no guarantee the government plan will work, despite the almost trillion-dollar commitment.

And yes, this means the U.S. is taking steps towards instituting a European-style socialist solution. It’s probably best to just take a deep breath and let all that go for now. I would argue that one of the main factors that makes the socialist form of the bailout appear so humiliating is the way the ultra-conservatives have spent the last 25 years bashing the European style of capitalism. It’s time to wake up to the truth: The European way of doing things is no better or worse than the American way — it’s just different. U.S. politicians and business leaders should stop preaching to the rest of the world that we have better styles of capitalism and democracy. The collapse of our financial system is a national humiliation, and it would be refreshing to see our business and political leaders begin acting with an appropriate measure of humility over the mess we’ve all made — lenders, borrowers and politicians are all partly to blame. This financial crisis is a by-product of, and harsh commentary on, the American way of life and its focus on profligate consumption.

To make the socialist bailout somewhat easier to swallow, allow me to point out that the U.S. has always practiced subtle forms of socialism. The big bailout is just another (albeit much larger) move in that direction. Public services like K-12 education and police and fire protection are all forms of socialism — our society pools tax dollars and provides everyone with access to the same services regardless of the magnitude of their contribution.

I am also of the opinion that conservatives are trying to focus public attention on the “socialist” smoke screen to take our mind off the role big business has played in creating this crisis. Large financial institutions behaved in a predatory fashion when they loosened lending standards and saddled millions of American households with unsustainable amounts of debt. And, these institutions were aided and abetted by the semi-“socialist” GSAs (Fannie and Freddie), whose existence made possible an explosion of mortgage debt that is now smothering our financial system. Of course, consumers deserve an equal share of the blame — they flagrantly overborrowed and overconsumed. And the failure of regulators to curb excessive leverage in the financial system is another notable cause of the crisis. Everyone shares in the blame.

The U.S. led the world into this mess — we have to accept that, it’s inarguable. We haven’t been practicing a better form of capitalism all these years, just a different form. And the way we practice capitalism will be permanently changed by this bailout. It’s going to be impossible for the ultra-conservatives to claim a rational basis for their Europe-bashing going forward (although they’ll probably continue bashing Europe from an irrational stance). The U.S.’s beloved free-market system has created the biggest financial mess of all time, and the Secretary of the Treasury and Chairman of the Federal Reserve Bank believe we need a socialist mop to clean it up. Let’s get over it and move forward.

For those of you who would like to read some of the more intelligent dissent on the topic — none of which offers an alternative solution to the global systemic contagion that is spreading by the day, I’d like to point out — I offer the following links below.

Naked Capitalism    Bloomberg    Luigi Zingales    Robert Kuttner

The Economics of Alternative Energy

Posted by J.D. Kaad.

The need to implement alternate sources of electricity will continue to increase as the price of fossil fuels continues to rise and the availability these resources decreases.  This article compares the most feasible alternatives that are commonly considered when considering the transition away from carbon-based power. The various costs associated with hydro-electric, geothermal, wind, nuclear, tidal, and solar power are described below. Based on these data we conclude that a heavy reliance on nuclear fission power is likely as the technology necessary to implement other sources continues to develop. [1][2][3][4][5][6][7][8][9]

Hydro-Electric dams offer a reasonable cost in terms of initial startup capital ($1.58 million / Mw) and operating costs (.85 cents / KwH).  These low costs can be attributed to the lack of fuel needed to operate Hydro-Electric plants and the high power output of these plants, which are capable of generating up to 9,800 Megawatts of power. The use of hydro-electric plants can also be controlled and scheduled to meet the power requirements of any grid. The only negative aspect to hydro-electric power is its reliance on rivers and reservoirs, which makes mass implementation difficult. [2][7]

Geothermic sources of electricity are more expensive in terms of initial startup capital ($2.5 million / Mw) when compared to wind, nuclear or hydro-electric, but have lower operating costs ($.01 / KwH) than all other options except for Hydro-Electric. If it was not for two major issues with geothermal energy it would be an ideal option. The first issue is that this method of generating energy is only feasible in locations that have pockets of geothermal heat that can be tapped. Second, geothermal power plants currently do not have enough generating capacity to support the United States’ infrastructure. The average geothermal power plant puts out anywhere from 85-90 Mw, which is miniscule compared with the 976 Mw that an average coal plant produces. [4][10][11]

Wind Turbine generators offer the lowest capital cost per generating capacity ($1.5 million / Mw), equaled only by nuclear power. Wind power’s operating costs ($.015 / KwH) are the third lowest of the options explored in this article. Wind Farms can be used in almost any location as long as the average wind speed is between 10 to 50 mph. Wind farms also offer an efficient use of land; for example, a wind farm that occupies 12,000 acres of land would directly utilize only 6 acres. This allows for electricity to be generated by the turbines and leave the land available for other uses. The only problem with wind power is that wind is unpredictable and cannot be scheduled on a power grid. [3][12]

Nuclear Fission Reactors are currently the most feasible replacement for fossil fuel power plants. Nuclear Power has reasonable initial capital costs ($1.5 million / Mw) because the total generating capacity for these plants is large — over 2,000 Mw. Nuclear power’s operating costs ($.0172 /KwH) have become less expensive due to improvements in fuel production and refining. Waste disposal has also been improved in nuclear plants; the overall cost of disposal accounts for $.001/KwH of its total operating costs. Furthermore, the volume of waste from nuclear plants has significantly decreased with improvements in waste reprocessing. [1][13][14]

Tidal power is not reasonable in terms capital cost ($5.45 Million / Mw) — it is the highest of the options explored. Tidal power’s operational costs ($.03 / KwH) are also less attractive due to the difficulties in transmitting power to nearby power grids. New tidal power generators feature ducted impellers, an improvement that has caused power outputs to triple. These new units are unfortunately controversial due to their environmental impact. The main benefit tidal power has over wind power is that tides are extremely predicable and thereby easy to schedule on a power grid. [5][8][15]

Currently, solar power is the least attractive of alternate power sources. This energy source features the second highest capital costs ($4.16 million / Mw) and the highest operating costs ($.13 / KwH). To make matters even worse, these estimates of solar power’s operating costs include government subsidies ($.23 / KwH without subsidization). Solar is unpredictable, and therefore difficult to schedule on a power grid. Moreover, solar uses land inefficiently — it takes 400 acres of collectors to generate 75 Mw of capacity. [6][9]

In conclusion, to phase out fossil fuels as our primary source of electricity in the most economical fashion we would need to rely heavily upon nuclear power. This power source is the only one that does not have reliability issues or location requirements. Hydro-electric, wind and geothermal energy should also be implemented as circumstances allow. Tidal and solar power’s time has yet to come; they currently fail to beat the cost of coal ($.0221 / KwH), but with technological improvements, the future looks bright for these options. [1]

When Will the U.S. Housing Market Reach Bottom?

Posted by Randy Kidder.

U.S. homeowners, financial institutions and the entire financial and economic system faces a crisis due to the bursting of the U.S. housing bubble. This crisis is rippling through the economy, resulting in business failures and rising unemployment. Treasury Secretary Henry Paulson stated that the housing correction poses the biggest risk now facing our economy [1].   How this is resolved will set the stage for our country’s economic future [2].   

Before August 2007, homeowners were encouraged to take advantage of rapidly-escalating real estate values. Easily-obtained, risky financing enticed many homeowners to extract home equity or take on large mortgages based on low initial payments. Many planned to refinance later or sell to take advantage of increasing home values, never anticipating that the housing bubble might suddenly burst.  Rising real estate values created a false sense of security. Homeowners increased spending driven by a “wealth effect” as described by Robert Shiller, co-developer of the Case-Shiller National Home Price Index [3].  

Contributing to the housing bubble, government policies aggressively lowered the barriers for home ownership. During the 1990s Washington pushed to expand Fannie Mae’s and Freddie Mac’s role in providing loans for low and middle income borrowers. In 2004, the Republican Party platform stated that the down payment is the “most significant barrier to homeownership.” [4] When homeowners have less money at stake and can use relatively lower incomes to buy homes, the chance of foreclosure in times of economic adversity increases. This added an element of unanticipated risk to mortgage loans.     

Financial institutions were in a highly competitive environment, and staying in business often involved providing ever-riskier products. In addition to subprime mortgages, Alt –A mortgages offered interest-only payments, low introductory rates and required little or no proof of income. (Anecdotal evidence describes the so-called Ninja Loan — made to borrowers with No Income and No Job!) Homeowners and the mortgage industry abused Alt-A mortgages, a product originally designed to expand homeownership during a period when interest rates were high. [5]  

Unfortunately, ongoing increases in housing values were unsustainable, and have been followed by a decline in value not seen since the Great Depression.  The housing “debacle,” as described by Federal Reserve Chairman Ben Bernanke in August 2008, is a “financial storm.” This storm is now buffeting the broader economy, muddying the employment picture and creating a vicious cycle that continues to negatively influence economic and financial conditions [6].

Opinion differs on when the housing price market will hit bottom. Compare the comments of Home Depot CEO Frank Blake (“We are getting awfully close to the bottom”) to those of Credit Suisse economists, who predict the bottom is more than a year away [7]. The Case-Shiller National Home price index (and related metrics, e.g., the price to income ratio) imply that house prices still have the potential to fall further before hitting bottom [8]. Uncertainty about when prices will bottom keeps potential buyers on the sidelines, anticipating better prices yet to come. 

Financing is difficult to obtain, keeping would-be buyers from taking advantage of lower housing prices and reducing homeowners’ options [1]. As home loan losses mount, banks are reluctant to lend –they are requiring larger down payments and are increasing borrowing costs [3]. An even larger wave of Alt-A loan defaults may occur soon. Borrowers have few options when payments jump by 50% and they are unable to sell or refinance their way out. [9].  

Foreclosures have increased at the fastest pace in almost three decades during the second quarter of 2008 [1]. A record 9% of mortgage payments were behind or in foreclosure at the end of June [10].   In July, homes sales increased by 3%. Credit Suisse analysts noted that low prices due to foreclosure sales drove the increases [11].   

Housing inventories have jumped significantly. The current supply of houses on the market has increased to 11.2 months. An inventory glut has depressed prices. Builders are struggling to remain in business and jobs losses are growing and spreading to other sectors [2].       

The takeover of Fannie Mae and Freddie Mac is an important step. However, the recovery is still at the mercy of the financial storm [10]. The bailout of the GSAs, undertaken to calm markets, attract investors, and reduce mortgage rates, was necessary [10]. Early indications are that the takeover may have the desired effect. Investors are returning, quickly bidding up the price on mortgage-backed securities, which has effectively lowered rates. Rates fell below 6% for a 30-year fixed-rate mortgage within a day.  Stabilizing the housing market would boost confidence in the entire economy [2]. With the collapse of Lehman Brothers, succumbing to the subprime mortgage crisis it helped create, the outcome remains uncertain [12].

Recovery is dependent on two factors: an upturn in new house construction and firming prices for existing home sales [6].   An upturn in construction would stimulate the job market, and a rebound in home prices would allow existing homeowners the chance to sell. This in turn would help clear “toxic” loans, restore consumer confidence and stimulate spending. But if prices stabilized at today’s values, 10 million owners would owe more than their home’s market value, which would lead to lower confidence and less consumer spending [13].   

Reaching the bottom is crucial.  BusinessWeek recently presented two scenarios to illustrate possible extremes [2].  In the best-case scenario, homebuyers sense a price bottom, spending increases and an improving economy brings investors back to the market. In the worst-case scenario the credit crisis deepens, lenders hobbled with losses are unable to lend, consumers overburdened with debt curtail spending and the record levels of housing inventory perpetuate the cycle of falling housing prices. This leads to higher levels of unemployment as investors move on. Housing plays an important role in our national economy — as Fed Chairman Bernanke said in August, “A stronger economy depends on housing” [6].   

Inflation Will Negatively Impact Growth in the Longer-Term

Posted by Kevin Reinecke.

Large swings in inflation have affected the United States economy throughout its history.  The boom of the “Roaring Twenties” through the banking crisis of the 1980s reflect some of the most volatile periods of inflation America has experienced.  A tighter grasp on the U.S. Monetary system and restored confidence in the banking industry stabilized inflation between 0% and 5% over the last 25 years.


That period of stable prices may be at an end.  As inflationary pressures begin to mount due to several economic factors, including the devaluation of the U.S. dollar, increased oil prices and changes in Chinese labor laws, there seems to be only one ordinary solution: Raise rates to derail a significant wage-price spiral similar to the 1970s. One problem: these are not ordinary times.  In fact, while some economists argue in favor of battling inflation, other economists articulate the need to increase aggregate demand while holding the unemployment rate down.  Within this framework, only one path may be chosen. The question remains: which path? (Read more at RGE Monitor.)

The low interest rate regime of the 21st century has fueled persistently rising prices worldwide.  Inflation in China was 8.7% in May-08 and 27% in Vietnam in June-08.  The U.S. has posted an inflationary rate near 4% over the last 2 years.  With low interest rates and small increases in wages, this rate of inflation has led to both real interest rates and increases in personal income running at negative rates in the U.S.  The globalization of the U.S. economy makes inflation in developing countries a more significant force here at home.  While some economists argue that inflation is not a problem until costs AND wages rise, most workers would argue that accepting inflation is a better alternative than costs rising with no increase in wages.  In the 1970s, rates had to be increased into the 20% range before the rate of inflation moderated.  Reaching double digits in interest rates may not be necessary, but JP Morgan Chase & Co. calculated the real interest rate across emerging countries near 2.3%, compared to 3.7% a year earlier.  European Central Bank President Jean-Claude Trichet believes there is risk of inflation “exploding” if central banks are not quick to act.  As a result, the ECB recently raised its benchmark lending rate to 4.25%.  While rates continue to be low across the world, David Hensley, Director of Global Economic Coordination for JP Morgan, explains that the Fed is hundreds of basis points away from implementing a restrictive policy on inflation. [1]

The following graph illustrates the relationship between the Consumer Price Index and Retail Sales during the 1970s. 


The graph provides insight into inflation’s negative effect on retail sales and the economy. The strong correlation suggests that as inflation continues to grow, consumers feel the brunt of inflation.  Although companies must contend with the rising cost of doing business, including transportation, raw materials and the devaluation of the U.S. dollar, the result of weakening purchasing power falls most directly on U.S. consumers.   In fact, rising inflation may lead to increasing revenues for many businesses.  For example, many companies are experiencing price increases, but are maintaining consistent gross margin rates.  For sales and profits to decline, companies would have to see reduced traffic and transactions by nearly the same amount as the price increases passed on to consumers.  Examples of this include Colgate-Palmolive and British Petroleum (BP).  Colgate-Palmolive announced that it is experiencing soaring costs for energy and raw materials.  As a result the company increased prices by an average of 4.5%.  In addition to the price increases, Colgate-Palmolive reported that the weakening dollar accounted for 7% of the 19% quarterly jump in profit.  [2]

Similarly, BP recorded profits that were $400 million higher than normal for an operating quarter.  Officials note that despite high prices, “companies found it easier than anticipated to pass high prices on to motorists.”  [3]

How great a risk is long-term inflation? Some members of the Fed are currently downplaying the risks.  In fact, a Financial Times report suggests that inflation is expected to continue through 2008 before leveling or falling in 2009.  As economists continue to search for a balance between inflation, unemployment and sluggish economic growth, the Fed has decided that its next move in rates will be up.  Although this is expected to have an adverse effect on the housing market, a tighter monetary policy should impact the U.S. economy favorably in the long term.  Fed Chairman Ben Bernanke recently re-affirmed that the Fed is “committed to achieving medium-term price stability.”  This balancing act is necessary to try to limit inflation without sending the U.S. economy even deeper into financial trouble.  [4] 

Announcements of future intentions to increase rates may be more symbolic than real, but managing inflation continues to be at the forefront of central bankers’ minds.  U.S. central bankers are continuing to search for a balance between inflation and other economic risks.  The Financial Times explains that such a rate increase leaves the Fed “divided.”  As much as it’s ever been, The Fed is torn between battling inflation via rate increases or keeping rates low to perk up aggregate demand and minimize unemployment.  [5]   

The U.S has reached a pivotal point in the inflation-vs.-growth decision-making process.  Americans are struggling, inflation is a real concern and consumer confidence is low.  The Fed is under pressure to deliver extraordinary results during these unusual times.

Understanding the Downward Spiral of the Credit Crisis

Posted by Carolyn VanderStaay.

The Credit Crisis starts its Second Year. A Washington Post article dated August 22, 2008 titled “Bad Begets Worse” describes a “giant negative feedback loop” in the financial market that may cause the global economic engine to seize up [1]. Declining housing prices send a signal to potential buyers to wait for the market to bottom out. While they wait for the market to bottom, there are more foreclosures and additional losses to financial institutions, who then become less and less able to make credit available, commercial or otherwise, and the cycle reinforces itself all over again with each leg of the downward spiral.

Former Chairman of the Federal Reserve Alan Greenspan wrote in The Wall Street Journal in December 2007 that that the “current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated and home price deflation comes to an end” [2].

We need the housing market to bottom out first so that we can break the negative feedback loop and get back to business. According to economists at Credit Suisse, extensive analysis of several home-price indices and metrics reveals that we will not see equilibrium in housing prices for 12-18 months, or late in 2009 as shown in the graph below.  This is the point at which they think the “median existing-home price to median family income” ratio, a key metric from the National Association of Realtors, will reach the narrow range it had before the housing bubble began [3].


How is it going to end?  Lessons From the Asian Crisis 1997-1998. Greenspan also said that the current crisis is “identical” to the ones that occurred in 1987 and 1998 [4], so let us look at the Asian Credit Crisis of 1998 to see if we can predict how the rest of the current crisis will play out. There are many ways that the two crises are similar.  Banks and borrowers were over-leveraged, assets were over-valued (real estate), and when prices stopped going up and started to fall, declining collateral for loans and large losses caused widespread bank failures [5].

Norman Villamin, Head of Investment Research and Strategy for Citi Private Bank in Asia-Pacific, reminds us that how the crisis is going to end is more important than when.   According to Villamin, “the keys to the end of the Asian crisis centered on three areas: recapitalization of the banking system, de-leveraging of borrower balance sheets, and recovery in a demand source” [5].

Go ahead and place a check mark by step one with the US Treasury takeover of Fannie Mae and Freddie Mac on September 6, 2008 [6]. In addition, recent economic news in the U.S. points to exports being the sole economic element driving growth in GDP at this time [7].  It may not be enough to drive us through a credit crisis, but seeing U.S. exports rise is something of a surprise to everyone.  

As for de-leveraging of borrower balance sheets, Gary Wolfer, who is chief economist at Univest Wealth Management & Trust, says he “doesn’t think things are going to go back to normal” because the U.S. economy is shifting from a reliance on debt and consumer spending to an emphasis on saving and exports [8]. According to Wolfer, this will be a long and painful process for the US.

On September 15, the failure of Lehman Brothers and the dire liquidity crisis faced by insurance giant AIG triggered a 4.5% decline in US stocks — the worst trading day since September 11, 2001. Economist Nouriel Roubini, who has been right on the mark about the credit crisis for over 2 years now, predicts that Morgan Stanley and Goldman Sachs are next, and that the business model of the independent broker-dealer that borrows short-term overnight and employs enormous amounts of leverage is permanently over: Roubini’s comments have sparked vigorous debate in Wall Street circles about the viability of the independent broker-dealer model, just as the Federal Government approached Goldman and JP Morgan and asked them to provide a $75 billion line of credit to AIG. If all that seems confusing and contradictory to you, then you’re paying attention . . . 

Thinking Long Term About the Equity Premium

Posted by Rob Weigand.

One of my favorite blogs, Abnormal Returns, recently linked to a post at the blog Zero Beta regarding the Equity Premium “Puzzle.” I’ve published a few papers on this topic recently (Journal of Portfolio Management, Journal of Investing and Journal of Financial Planning — forthcoming in October), so the literature remains fresh in my mind. Here’s the perspective I’ve cultivated after reading over 100 papers on the Equity Premium:

The only way to properly conceptualize risk premia is from a very long term perspective (as in Siegel’s Stocks for the Long Run). US equity markets have set the long term real return on equities at just under 7%. But egg-headed professors look back on the data — with the benefit of perfect hindsight — and say 7% was too large, AS IF EVERYONE KNEW STOCKS WOULD EARN 7% REAL RETURNS. Duh! The equity premium has been that large because people were extremely unsure how compelling global events would play out — at the time those events were occurring.

Try to appreciate the incredible uncertainty associated with two World Wars, the Great Depression and the Cold War. All of these events eventually worked out for the best — and thank goodness for that — but investors didn’t KNOW they would when those events were playing out. Moreover, the US economy was closer in time to regularly-recurring bank panics than we are today (I would assert that we currently suffer from a false sense of security that regulation and Fed monetary policy is better than it used to be).

As if in response to all this contrived thinking about the equity premium being too large historically, the equity premium is smaller today — any way you measure it. Yet, as we’ve seen with the subprime banking crisis, the world is just as uncertain as it used to be. Russia and the Middle East have most of the oil — and we’re no closer to independence from foreign oil than we were under Jimmy Carter. The Chinese have a work ethic that would make the average American faint — just THINKING about it. And we have witnessed a pronounced decline in the value of the US dollar in recent years (the recent rally notwithstanding). Residential real estate is in a protracted bear market and the credit creation system is gummed up beyond all recognition (GUBAR). We’re as up against it as we’ve ever been. And we may very well prevail, just as we always have — but we don’t know that with the type of perfect certainty that warrants real expected returns on stocks of 3-5% (or lower).

When you look at the P/E ratios (use 10-year smoothed earnings as suggested by Graham & Dodd, Shiller and others) and dividend yields on the major indexes, however, these metrics don’t reflect the expected returns necessary to fully compensate for the real risks going forward — at least as those risks appear to a rational person TODAY. (That’s why the super-rich are hoarding cash and cash equivalents and, as the Forbes crowd always loves to do, hoarding gold.)

One of the major factors holding up equity values in the current bear market (and keeping relative valuation high compared to this point in bear markets historically) are all the “jocks” that have migrated into professional money management. You know who they are — they’re lined up a mile deep to get their 5 minutes on CNBC and say things like “Stocks have always paid off and I’m really bullish on America,” or “Stocks look really cheap to me right now,” etc. Of course, they never back up their forecasts with any metrics — they just spout pro-market “feelings.”

Now, all this doesn’t mean that equity values can’t rise from current levels as soon as the news turns more positive than negative, but if they do, we’ll just be perpetuating the rolling global asset bubble that’s been hanging over markets since the latter 1990s (read Jeremy Grantham’s Barron’s interview on the global bubble and credit crisis from February, or his more recent post on the global competence meltdown). Therefore, after reading 100+ papers and publishing 3 myself, my perspective is that markets have set the LONG TERM equity premium just right historically, and this premium remains too low today when considered alongside the financial, economic and political risks that prevail in the current environment.

You can email Rob Weigand at or find him on the web at Rob Weigand’s Home Page.

Peak Oil Theory and the Energy Crisis: Not Just for SUVs Anymore

Posted by Jessica Collins.

Consumers grumble about rising gas prices.  The price of goods – inputs, outputs, intermediates – escalates; businesses struggle.  As the price of oil steadily climbs to an all-time high and U.S. currency, markets, and overall economy are left to suffer in its wake.  You think it’s bad now? The situation may be getting worse.   

In addition to being the backbone of the global economy, oil is a non-renewable commodity whose demand curve has increased steadily over the past two decades. 

Lead by population supergiants China and India, the world has embarked on an unmatched boom in global industrialization (read: oil consumption) that has forced the price of oil up 56 percent to-date in 2008 and over 365 percent over the last decade. [1] 



In addition, analysts estimate combined global demand will exceed 120 million barrels per day (bpd) in 2030, an astonishing 41 percent increase from current production levels. [2] 

The problem?  The world may not have enough oil to go around.  Will we completely run out of oil?  Not likely.  Many have dismissed the idea that the global community could ever completely deplete the world’s oil supply.  However, it’s not extracting that last drop of oil that will send the world into its biggest energy crisis in history.  Not even close.  The true turning point occurs when the gap between the demand for oil and its accessible supply becomes so great that the resulting price brings the world economy to a grinding halt.  Unlike previous energy shocks of past decades, this unprecedented energy crisis is based on accelerating global demand, rather than sudden, short-term interruptions of supply.  The result?  “A long period of significant hardship worldwide.” [3].

Don’t think it could happen?  Assuming a daily consumption of 21 million barrels per day, at $135 per barrel, the U.S. alone spends approximately 15 percent of its $6.8 trillion net income on oil.  Increase the price to $200 per barrel and the percentage of take-home income spent on oil increases to 22 percent.  “In other words, the U.S. [could be] broke long before oil prices hit $200 per barrel, and the rest of the world is sure to follow.” [4]

This is not just a problem for our children’s children.  Several key figures in the oil and gas industry, including the CEO of France’s Total Petroleum and the CEO of Royal Dutch Shell, have recently expressed concern about the situation. [5],[6].  Even ExxonMobil, which continues to post strong financial performance, recently reported a 6 percent decline in production and have readjusted long-term reserve projections. [7]        

Think this is only a problem for SUV owners and Big Oil executives?  Think again.  Every aspect of modern life depends on oil.  Never mind that virtually every type of good is brought to market using oil-based transportation – food, water, modern medicine, and all technological devices rely on oil and oil byproducts.  As explained by commentator Robert Wise:   

Nearly all the work done in the world economy, all the manufacturing, construction, and transportation, is done with energy derived from fuel. … And, the lion’s share of that fuel comes from oil and natural gas, the primary sources of the world’s wealth. [8]

While higher oil prices will stimulate the development of additional oilfields, the remaining oil is difficult to produce, expensive to extract and refine, and is owned by a small majority of the world that seems to hate everyone else – or, at least, the U.S.  Moreover, while new production may slow the decline in production, it cannot completely prevent it. 

What about ‘alternative energy’?  Some alternatives, like natural gas, have showed promise, but it too is a limited-supply fossil fuel. [9]  Further, all of the current ‘viable’ sources of alternative energy (e.g., wind, solar, biofuels, biomass, hydrogen, and even nuclear) are extracted, collected, generated, or otherwise based, in whole or in part, on oil and oil-based fuels. [10] In addition, not one alternative energy technology is currently suitable for wide-spread commercial implementation.  Even if the technologies themselves were ready to be implemented, the necessary infrastructures are primitive, if present.  Implementing alternative energy sources is, at best, daunting:  it requires massive short- and intermediate-term investment and represents a massive drain on the dwindling pool of global capital.

The global shift to alternative energy sources is inevitable.  The challenge, then, is to execute the transition seamlessly and efficiently by appropriately allocating capital to winning sustainable alternative technologies thereby permitting the global economy to maintain reasonable growth levels.  On the other hand, inefficient execution of this crucial transition will almost certainly result in a severe depletion of global capital, leaving little or no financial resources for investment in other areas of the world economy.