Energy Infrastructure: In The Aftermath (II)

The Daily Reckoning PRESENTS: In the final installment of this two-part essay, Justice Litle explains what effect this year’s volatile hurricane season will have on consumer and government spending. Read on...

IN THE AFTERMATH, PART II

by Justice Litle

"Everybody came in here with every car they had and took everything we had in the ground."

- Kip Neuhart, Chevron station manager, Marietta, Ga.

As the linchpin of the global economy, much depends on the American consumer. With consumer spending representing more than two-thirds of U.S. economic activity, and consumer import consumption the engine that keeps Asia humming, money to spend and willingness to spend it are critical for turning the fiscal merry-go-round. In this regard, Katrina has had a sharp financial and psychological impact.

Consider the shift in perception of gasoline prices. An editorial cartoon from a few months back does a good job of illustrating the difference between then and now. A carefree motorist fills up his SUV at the gas pump, whistling aimlessly, with electrodes attached to the back of his head. Two scientists observe from behind a one-way mirror. One is manipulating a large dial - the price of oil listed in $10 per barrel increments - as the other takes notes. The first scientist has a look of surprise and concern as he tentatively turns the dial toward $60. The second scientist frantically observes, “It’s not having any effect!”

Fast forward to the present: That carefree, “what-me-worry” mood is long gone. It has been replaced with anger, anxiety and fear as prices break the $3 per gallon mark nationwide, with outliers as high as $6 reported at gas stations in the Southeast. There is real pain at the pump. The governor of Georgia has publicly denounced gas gouging, President Bush has asked drivers not to horde gas and fears of shortage become self-fulfilling prophecy as anxious drivers blitz their local filling stations and run them dry. The long lines of the ’70s have returned, and a few illiterate politicians from Hawaii and Florida have even called for the reinstatement of price controls. (Hopefully, they will be muzzled or ignored.)

Things were already looking precarious before Katrina, with the consumer savings rate in negative territory, discretionary income dwindling and energy prices high enough to cause fresh concern. The disruption of Gulf Coast production did not create a new problem. It merely kicked an existing one into overdrive.

While gasoline prices will ease a bit as initial panic dies down and excess driving is curtailed, there is another psychological bogeyman waiting in the closet: natural gas.

Natural gas futures were already challenging all-time highs before the disaster struck. They have since gone into orbit on concerns that commercial storage inventories may not be enough for a cold winter ahead.

From a psychological perspective, the unknown often generates more anxiety than the known. Consumers are already dealing with shock and awe as they fill up their gas tanks. Now they have to endure a more frightening question: How high will the heating bills be this winter? It’s impossible to know, and there are many months to dwell on the question...before we find out just how cold the coming winter will be.

As consumers adjust to these new realities, the instinct to cut back may finally kick in. We are likely to see the savings rate tick up over the next few months, as anxious consumers brace themselves for a further body blow this winter. This shift in sentiment could put further pressure on the retail sector as discretionary income erodes, and a slowdown in import consumption may put economic pressure on Asia, as well. Of course, if China starts to feel the pain due to consumer slowdown, the complimentary Treasury purchases that have kept interest rates low and home values high may grind to a halt.

“At some point, the sense of confidence in capital markets that today so benignly supports the flow of funds to the United States and the growing world economy could fade. Then some event, or combination of events, could come along to disturb the markets, with damaging volatility in both exchange markets and interest rates.”

- Paul Volcker, “An Economy on Thin Ice”

“What we are looking at... is one of the biggest U.S. public finance projects of all time.”

- Joe Mysak, Bloomberg columnist

As a result of Katrina, the pace of government spending will increase rapidly. At the same time, the Federal Reserve is facing increased political pressure to pause in its campaign of interest rate hikes. This combination is likely to weigh heavily on an already weakening dollar, as foreign creditors look on with growing concern. (All this with a vulnerable Asia in the background, no longer so anxious to provide vendor financing.)

This is not a criticism of the coming rebuilding efforts, or a denial of the need for federal assistance in time of disaster. It is simply an observation that the bill is coming due at a time when U.S. finances are decidedly shaky. Government officials have promised whatever it takes in terms of federal funds, and estimates have consistently estimated, with some suggesting Katrina could ultimately cost more than the wars in Iraq and Afghanistan combined. This comes on top of more than $100 billion in estimated economic damage, with long run energy costs still unclear. Not to mention federal assistance for a million displaced individuals. Meanwhile, fiscal conservatives are disgusted with the lack of political will to cut back pork in other areas as we are hit with these massive expenditures.

It is hard to play the role of fiscal hawk in the face of human suffering. The natural moral instinct is to give with compassion and expect the government to spare no expense in restoring order. The problem is not the financial realities of disaster relief, but rather the fiscal excesses that came beforehand, putting the country in such an untenable financial position in the first place. Nothing has been put aside for a rainy day. The credit card of last resort is already loaded with charges. Nature’s misfortune has compounded the ill winds of poor financial planning.

At the end of the day, America has essentially borrowed $2 trillion from the rest of the world and spent it in mostly nonproductive ways. The Fed fueled this binge and facilitated a gold rush in paper assets (what else do you call $400,000 condos that don’t yet exist?). To the degree that real estate appreciation is fueled by borrowed dollars, the appreciation is not real wealth, but rather a temporary loan from overseas creditors. Consumers are not using these generous loans to start productive businesses with an aim for future return on investment. They have been swapping houses, monetizing their mortgages and living it up on the proceeds. When that money has to be paid back, America will have little to show for it. The only way out will then be to manage the dollar downward, which in turn triggers a deliberate erosion of purchasing power for all those holding dollars and dollar-linked assets. The consequences of fiscal profligacy may be long delayed, but ultimately cannot be denied.

The inevitability of a managed dollar descent is not in question. In fact, it is a key piece of the “optimistic” scenario for a soft landing. America has all but admitted that its fiscal rehabilitation plan hinges on inflating its way out of trouble, a “burn the bag holder” scenario. Only an issuer of the world’s reserve currency could get away with such a brazen plan - and probably not more than once.

Reserve currency or not, no credit line reaches to the sky.

It is a foregone conclusion that America’s net borrowings from foreigners will eventually cease, and then head into reverse as fiscal imbalances sort themselves out. When this happens, the dollar will begin its slide in earnest, and moneymen the world over will pray that the descent is an orderly one.

No central bank stands to gain from a free-fall scenario in which the world reserve currency plummets. But if things start getting precarious, it could easily become every financier for himself. As Jesse Livermore dryly noted, in times of crisis, the bankers do not stand around saying, “After you, my dear Alphonse.”

Hopefully, the destabilizing event that former-Fed Chairman Volcker hypothesized was not a natural disaster. Hopefully, we are not already making our way down the slippery slope.

Justice Litle

P.S. Still, if the final-straw event (or combination of events) has not yet arrived, the hour is surely coming, and Katrina may have hastened it.

But you can protect yourself - and even profit - from this scenario. Find out how here:

Energy = Wealth

Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall).

Energy Infrastructure: In The Aftermath (I)

The Daily Reckoning PRESENTS: In part one of this two-part essay, Justice Litle looks at an existing problem - energy infrastructure - made worse by Hurricanes Katrina and Rita.

IN THE AFTERMATH, PART I

by Justice Litle

There is a common saying among strategic planners: “Hope for the best, prepare for the worst.” In Katrina, we have seen the worst, or close to it - and not just in terms of physical destruction.

The stories range from heart-rending to gruesome. The level of human suffering was staggering, with thousands of Americans subjected to conditions resembling a third-world combat zone. And the idea of a great city washed away is almost too big, too alien, to fathom.

In the deluge of news and commentary following Katrina’s wake, Bloomberg columnist Joe Mysak offers particular insight:

“This is a story being told on the ground right now, in hundreds of stories detailing human misery, particularly of the poor. But you know what? All those little stories don't give you the big picture any more than the obsessive, agonizing stories of individual casualties in Iraq tell you about what's really going on over there. Individual human tragedies offer insights into the human condition, not into what's going to happen next.”

This is not meant to trivialize the scope or seriousness of suffering, but to put it in context. The bigger picture cannot be distilled into sound bites, and will take time to reveal itself. As long-term investors - not to mention participants in the global economy - we have a vested interest in trying to make sense of what the aftermath will bring.

There is open debate as to the long-term effects Katrina will have. The most optimistic argue with a straight face that natural disasters have a “net positive effect” on corporate profits. This may be true in certain past cases, but not when an energy crisis is embedded in the mix.

The real viewpoint distinctions were made before the storm took shape. Observers and commentators can be placed in two groups: those who believed we were already in a dangerous place pre-Katrina and those who thought things were fine before the hurricane struck. For those in the concerned camp, the greatest natural disaster in American history has sped things along, moving the world closer to an inevitable endgame that was already on its way.

There are three areas in which Katrina has created urgency by magnifying an existing issue: energy infrastructure, consumer spending and building inflationary pressures. Today, we will look at energy infrastructure, and at the other two issues in the second part of this essay, to come next week.

“Americans have taken cheap energy for granted for years...Now it’s coming home to roost.”

- Robin West, PFC Energy Chairman

When it comes to rebuilding and upgrading the nation’s energy infrastructure, America has been hitting the snooze button for too long. The devastation in the Gulf Coast is a painful wake-up call. Prices have eased somewhat with the release of emergency reserves from the IEA and SPR, but the long-term horizon is still unclear. For quite a while, we have had the luxury of postponing action; now we are forced to take emergency measures in the face of a catastrophe.

America’s energy infrastructure is cracked and strained, patched together with duct tape, outdated in some areas and pushed to the breaking point in others. Power grids are in dire need of upgrade and replacement; fuel distribution networks are inadequate and subject to disruption; desperately needed refineries and liquid natural gas terminals have fallen victim to excessive environmental regulation, stifling government procedure and, worst of all, a nearly impenetrable wall of NIMBY/ BANANA style politics (Not In My Back Yard; Build Absolutely Nothing Anywhere Near Anybody).

The problem can be described on one level as “out of sight, out of mind.” Basic necessities are often taken for granted. In normal times, none of us thinks too much about the electricity that runs our homes, the water that pours from our faucets or the gasoline that fuels our cars. When the flow is disrupted, however, we notice very quickly.

The same benign neglect applies to the hidden web of energy infrastructure that makes modern life possible. As long as things are working, we don’t pay much attention. If the system is being put under increasing strain, we don’t notice - until something goes wrong. But the old cliché, “If it ain’t broke, don’t fix it” is very bad advice in this area. The farther infrastructure lags behind growth, the more disruptive it is when the creaking framework breaks down. The fewer fail-safes in place, the greater the likelihood of a small disruption causing big problems. And that is where we are now: Stomach-lurching volatility in fuel prices is the result of small demand shifts at the margin, thanks to a ”lack of slack” in the system.

The climate for capacity increase and capital investment has been stymied by one of the biggest flaws in the political process: an overwhelming bias toward short-term time horizons. There is little political incentive to address long-term problems hidden from the public eye. On the other hand, there is usually strong incentive to seize on the popular “quick fix” whose long-run effects are hidden or postponed. Furthermore, those who benefit from sound policies are typically the unorganized silent majority, whereas anti-energy special interests (think NIMBY) are organized and vocal. Last but not least, the pool of political dollars is always finite - so issues without immediate political resonance are ignored. The system works against common sense. Promises are made without analysis, favors are doled out without foresight and the eventual mess is left to be cleaned up on someone else’s watch.

This logjam of neglect and aggressive special interests requires a jarring shock to be broken through. That shock is now upon us. Daniel Yergin of Cambridge Energy Research Associates makes an argument for why Katrina’s aftermath has created an “integrated energy disaster”:

“What makes it an integrated crisis is that the entire energy supply system in the region has been disabled, and that the parts all depend upon each other for recovery. If the next weeks reveal that the losses are as large as some fear, this would constitute one of the biggest energy shocks since the 1970s, perhaps even the biggest. Unlike the crises of the ’70s or the Persian Gulf crisis of 1990-91, this does not involve just crude oil: It includes natural gas, refineries and electricity.”

Fortunately, as of this writing, the assessment of the situation is a little less pessimistic (though there are still plenty of unknowns). It looks like damaged ports and refineries may be brought back on line faster than feared, and worst-case scenarios may yet be avoided. The most intractable problem may be rebuilding communities to which the tens of thousands of displaced oil workers can return. Wage costs will no doubt have to rise sharply in efforts to convince them back. Regardless of details, we have learned a powerful lesson here; wake-up calls don’t come much stronger. Hopefully, the point has been driven home strongly enough to dislodge the special interest groups who fail to see the gravity of the situation. Yergin expands on what needs to be done:

“This more expansive concept of energy security requires broader coordination between government and the private sector; more emphasis on redundancy, alternatives, distributed energy and backup systems; planning and prepositioning of vital supplies (“strategic transformer reserves” for electric substations); and methods that can quickly be applied to promote swift market adjustment. As with the August 2003 blackout, this crisis underlines the need for modernization and new investment in the energy infrastructure that supports our $12.4 trillion economy.”

All these elements were critical pre-Katrina, and circumstances would have demanded implementation sooner or later. But now that public awareness is high - and the dangers of complacency are thrown into stark relief - the timetable will be accelerated. There is a lot of work to do, and no avoiding it. In the event of a recession, energy prices may fall as global demand slows. But even then, energy security would be critical as ever, as businesses and consumers would show more sensitivity to price shocks in the midst of a downturn.

A wave of rebuilding is coming, and it will encompass more than what was destroyed. There will be expansions, upgrades, new technology and new safeguards put in place. The Gulf of Mexico will be rebuilt to Category 5 standards. Legislation pressing for new refineries and new LNG terminals will finally gain the upper hand. New avenues will be explored. Uncle Sam will be whipping out the checkbook, big time. The situation demands it.

Justice Litle

Part II

P.S. In the second part of this essay, I’ll look at the effect that this hurricane season has had on consumer spending and increased inflationary pressures. In the meantime, check out my latest report - you could find out how to actually profit from this global energy crunch. See here: The Story of Energy

Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall).

The Booming 51st State

The Daily Reckoning PRESENTS: Puerto Rico is experiencing its own property boom...and as it is on the mainland, this boom is fueled mainly by cheap credit. Chris Mayer watches from the sidelines in Toa Alta, Puerto Rico...

by Chris Mayer

“I used to drive out on the island...you could see the ocean and the beautiful views...and you could stop off one of the little restaurants along the way...enjoy a cold beer, a nice steak. Now, you see nothing but housing developments and the traffic is horrible.”

My grandfather was telling me about the changes in Puerto Rico over the last several years.

Puerto Rico is a Commonwealth - existing in the gray area of non-statehood, a sort of vassal in America’s empire, a prize in a long-forgotten war with Spain.

Puerto Ricans have voted many times before on the issue of statehood. The voting has been very close. So far, the status quo has won out. But the last election fiasco was eerily similar to the U.S. presidential election in 2000, with the Supreme Court of Puerto Rico casting the deciding votes, along party lines, that sent their man into office. Statehood lost its closest contest yet.

I’m confident that at some point in the not-too-distant future, Puerto Rico will join the Union as the 51st state.

Until then, it will continue to mirror the United States in other ways. Puerto Ricans seem to love SUVs and fancy cars as much as continental Americans. Consumerism is also in vogue, with retail chains such as Walgreen’s, JC Penney and Macy’s enjoying success here. Plus, nearly 70% of the island’s workers are employed in service industries.

And Puerto Ricans, too, have their own housing boom.

The economy of Puerto Rico is likely the region’s most dynamic economy. Nearly every major U.S. and European pharmaceutical company has significant operations on the island. Other companies and industries also find the island attractive for a host of reasons: the population is largely bilingual and educated; there are tax incentives to move operations to Puerto Rico; nearly 5 million tourists come here every year and spend more than $3 billion; and it is a bridge to the rest of Latin America.

In order to capitalize more on the island’s appeal, the government has spent more than $13 billion in the last 10 years improving the infrastructure. There is, for example, a new deep-water port, urban train, and coliseum; along with more common amenities like better signage and expressways.

My grandfather notes the passing of sugarcane fields and farming from the landscape. Instead, shopping malls, hotels, condominiums and auto malls are popping up all over the island. And new housing developments, too - sturdy cement houses painted in the pastel colors favored in the tropics, like cotton candy pink, lime green, sunflower yellow and sky blue.

Housing is in short supply and prices are rising. For years, Puerto Rico’s housing market reliably appreciated 5-10% per year. This year, the market is getting hotter. In 2005, the average sales price is about $311,000 - up nearly 16% from 2004.

The demand for residential loans is higher here than in the United States, after adjusting for population differences. Nearly 75% of Puerto Ricans own their own home.

It’s no wonder prices are rising. Population density is among the highest in the world, with nearly four million people living on an island of about 3,500 square miles. By some estimates there is a housing shortage, with 100,000 more units needed.

Still, as in the mainland United States, the housing bubble is also being fueled by cheap credit. Curiously, while late payments occur four times more often than on the mainland, Puerto Ricans are less likely to wind up in foreclosure.

As in the mainland, there is also cause for worry.

Doral Financial is the dominant mortgage company on the island, with 40 branches and $11 billion in assets.

This, from Doral Financial’s annual report:

“Borrowers use equity build-up as a means to consolidate high-cost consumer debt of credit cards [sic], auto loans and other types of credit.”

Basically, the islanders have succumbed to the temptation of using their home as an ATM machine - just like Americans.

Doral, by the way, enjoyed a stellar run over the last 10 years - riding the crest of Puerto Rican prosperity. Its stock price rose more than 8,000% from 1995 to its 2005 peak. That's an annualized return of about 56%.

In March of this year, the whole enterprise seemed to come apart at the seams. The stock was ripped in half, on news that the company was being overly aggressive with its derivative portfolio and would write off hundreds of millions of dollars.

But the beating was just getting started. Downgrades from various analysts continued to push the stock lower. Then the credit agencies got in on the act, with Fitch downgrading the company as well. Eventually, the stock hit bottom under $10 per share, but has since rallied.

Today, however, I’m inclined to stay on the sidelines with housing - if not actively bet against it. My readers closed out a 53% gain in Countrywide last week, prospering from the mortgage giant’s deflating stock price.

When the housing bubble finally finds its pin, it will be like an ATM machine that no longer dispenses cash. That won’t be good for banks, homebuilders, credit card companies and a slew of other businesses that have, to date, prospered in the credit-induced revelry of the housing boom.

Freeman Tilden, in his book A World in Debt (published in 1935, but still a terrific read), described fortune as a “willful jade” that set about victimizing human beings, “especially debtors.”

Credit cycles turn, dear reader, and this one will turn also - both in the mainland United States and in the future 51st - and anywhere else easy money has left her unmistakable footprints.

Chris Mayer

P.S. Wouldn't it be nice to have at least one investment in your portfolio that just grows and grows over time? Well, I’ve found one company that’s poised to become the next Berkshire Hathaway that’s hell-bent on one thing only - building real, tangible wealth. Check out my new special report that details this company - and five more - that you hold onto forever... The Next Berkshire

Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer's essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is the editor of CrisisPoint Trader and Capital and Crisis - formerly the Fleet Street Letter.

The Iraq War

The Daily Reckoning PRESENTS: There is much controversy surrounding the war in Iraq...but most who speak out against it, miss the true geopolitical importance of the war. Bill Bonner explains...

THE IRAQ WAR - PART I

by Bill Bonner

"We have brought torture, cluster bombs, depleted uranium, innumerable acts of random murder, misery and degradation to the Iraqi people and call it 'bringing freedom and democracy to the Middle East,'" said yesterday's winner of the Nobel Prize for literature.

"But as we all know, we have not been welcomed with the predicted flowers. What we have unleashed is a ferocious and unremitting resistance, mayhem and chaos."

Invading Iraq was a "bandit act, an act of blatant state terrorism, demonstrating absolute contempt for the concept for International Law. An arbitrary military action inspired by a series of lies upon lies and gross manipulation of the media and therefore of the public. And act intended to consolidate American military and economic control of the Middle East masquerading - as a last resort (all other justifications having failed to justify themselves) - as liberation."

Harold Pinter is a playwright. That he should fail to see the geopolitical importance of the war is hardly surprising.

But Zbigniew Brzezinski, a former U.S. national security advisor, ought not to miss it. Quoting Arnold Toynbee, he accuses the Bush administration of "suicidal statecraft...the ultimate cause of imperial collapse."

What neither man seems to realize is that 'suicidal statecraft' is just what the situation calls for.

The great Anglo-Saxon empire has reached its 'sell by' date. Its imperial advantage - its lead in the Industrial Revolution - has disappeared. It now counts on the savings of foreigners to keep going. But while its homeland bound citizens groan under the burden of debt, its military and political leaders still talk tough. 'You got terrorists with a grudge against the United States?' asked the Commander-in-Chief. Well "bring 'em on." He might as well have put a gun to his head. Now, with the curiosity of a reporter watching a hanging, we wait to see if he pulls the trigger.

Iraq is full of potential terrorists with grudges. Had the Anglo-Americans bothered to look before they leaped they would have seen a country that is a mix of tribes, clans, families, and religious groups - all of whom loathe each other and all of whom take it as an inherited obligation to avenge any wrong done to any of their own group by any member of any other group back to five generations.

But there is one thing these people despise more than each other - a foreign invader.

Patrick Cockburn, writing in the Independent, reminds us of the insights of a British civil servant, Arnold Wilson. Mr. Wilson wrote this in 1919, two years after the British took Baghdad from the Turks:

"Wilson...warned that the creation of a new state out of Iraq was a recipe for disaster. He said it was impossible to weld together Shia, Sunni and Kurd, three groups of people who detested each other. Wilson told the British government that the new state could only be 'the antithesis of democratic government.' This was because the Shia majority rejected domination by the Sunni minority, but n 'no form of government has yet been envisaged which does not involve Sunni domination.'. The Kurds in the north, whom it was intended to include in Iraq, 'will never accept Arab rule.'"

All of this was correct. But what they would accept even less was rule by the British. The whole country soon rose up against British forces; there were more than more than 10,000 dead before it was over.

This was the world into which the Bush administration bumbled. Every great empire - from the Assyrians to the Mongols to the British had taken Baghdad. America had to do it too.

"Nobody likes armed missionaries," said Robespierre when the French tried to export their democracy, at the point of a gun, throughout Europe. That too was an insight missed by the Bush team, but that is why the Bush bunch are so perfectly suited to the present circumstance. They seem to have no knowledge or apparent interest in history; they get to relive every bit of it as if for the very first time.

There is hardly an error chronicled in any history of imperial wars that American forces have not committed. They went into Iraq on bad information. Where were the WMD? Where were the rose petals upon which they expected to tread? Where were the happy new democrats, ready to shop at Wal-Mart for backyard barbecues and granite countertops?

Then, of course, they went in preaching democracy and freedom - about which the Iraqis were as indifferent as Americans themselves. What Iraqis really wanted at first was just a chance to steal something; later they would welcome a chance to kill someone. The desert tribes are looters. They climb gleefully through the ruins of a tank or a hotel, looking for something that might be useful.

But their new rulers are little better. Soldiers have a license to kill. A video aired on American TV showed a U.S. soldier gunning down a helpless prisoner. "This one is still alive." Sounds of gunfire. "Now he's dead." A poll taken days later signaled just how far the public had gone in its descent into imperial madness - most people said they thought the killing was justified.

This attitude goes down badly in a place with 100,000 Iraqi casualties...and where revenge is such a serious matter. Pretty soon, talk of 'insurgents' and 'foreign fighters' was beside the point. The average Iraqi now jumped for joy when an American soldier went down...and rushed to give the man a kick before his compatriots came to his rescue.

More to come...

Bill Bonner
The Daily Reckoning

Editor's Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).

He and Addison have paired up again in what will surely be their newest bestseller, Empire of Debt. It just went to print this week, but you can preorder your copy by going to the Daily Reckoning's bookstore. See here:

Empire of Debt: The Rise of an Epic Financial Crisis

Focus on Autos

by Mike "Mish" Shedlock

MarketWatch is reporting "Ford's SUV Sales Halved in September":

"Ford Motor Co. reported Monday that sales of its traditional SUVs plunged 51% in September, as consumers continued their mass exodus from the thirstiest vehicles on the road amid record gasoline prices.

"Overall, Ford turned in a 19% decline in U.S. sales last month, to 228,157 cars and trucks. Crossover and passenger car sales actually improved, but not nearly enough to make up for the steep decline of its bulkier SUVs.

"Sales of the Ford Explorer and Expedition were both off about 60% from a year ago while the much smaller Escape, which is available with a hybrid engine, shed only 4%.

"And the trend doesn't appear to be going away anytime soon, according to Steve Lyons, head of Ford North America sales.

"'Traditional SUVs will continue to face headwinds in the coming months,' he said, adding that customers did most of their buying in the summer months when employee discounting sparked an industry-wide sales boom.

"Sales of the top-selling F-Series truck fell 30%, to 69,643."

Ford was not alone with SUV woes. General Motors SUV and pickup truck sales were down by one-third. Now that sounds pretty bad to me. I would assume it would sound pretty bad to everyone, but that is not the case. GM sales analyst Paul Ballew described sales as "pretty comforting":

"'I would describe final industry results as actually pretty comforting,' said GM sales analyst Paul Ballew. 'We're still waiting for a portion of the industry to report, but from the estimates we have, as well as what's been released to date, the industry right now is at or above our expectations heading into the month.'

"General Motors posted a 24% decline, to 349,202 vehicles. Car sales fell 14.5% while truck sales plunged 29.5%.

"Some of the biggest decliners included the Cadillac Escalade ESV, down 39.5% and the Chevy Suburban, off 56.6%.

"The world's top automaker blamed a tough comparison to last year when it was promoting zero-percent financing. The diminishing effect of its employee pricing plan was also a factor, GM said.

"GM is looking for its new GMT900 lineup, due out next year, to boost sales in the sluggish SUV segment."

It does not take much to get these guys excited, does it? Since when is a 33% decline in sales anything to take comfort in? While GM is ramping up production of SUVs, Toyota and others are ramping up production of hybrids like the Prius.

"Toyota Q1 Profits Jump 28.8%."

This is what Toyota is doing: "Starting in the April-October 2005 period, Toyota plans to increase its production capacity of its popular hybrid Prius vehicles by 50% to 15,000 units a month from the current 10,000."

Yes those are Q1 profits, but I am looking for forward strategy and leadership. Toyota seems to have it. GM and Ford do not. This is just a hunch, but with soaring gasoline prices I bet those hybrids do very well.

Mish, is that the extent of GM's problems? Hardly. Let's summarize all of the problems I can think of off the top of my head:

1. Falling sales
2. Enormous debt
3. Union strife
4. Delphi and supplier problems
5. Cost disadvantages versus Toyota to the tune of several thousand dollars per car
6. Piss-poor management
7. Poor quality versus foreign competition
8. Lack of industry vision
9. Medical benefit problems
10. Pension woes

Those were the problems that came to mind in about 15 seconds flat. There are probably more.

Mish, didn't GM say its pension funding problems were solved and it is fully funded? Yes it did.

Unfortunately, "GM and a U.S. Agency See Pensions in Different Lights":

"The federal government contends that General Motors' pension fund is $31 billion short of what it owes its work force, according to closely held government data, a figure in stark contrast to GM's assurances that its pension plans are 'fully funded.'

"The government's finding of a huge imbalance suggests that the pension fund may have much larger claims on the company than GM's financial filings have indicated. It was calculated by the Pension Benefit Guaranty Corporation, the federal agency whose job it is to insure employee pensions if a company fails to meet its obligations.

"Both the government agency's and GM's methods of tracking pensions are legally acceptable, and their ability to produce such widely varying results shows the difficulty that employees or shareholders have in trying to ascertain the true condition of a corporate pension fund. But the disparity in such estimates has grown increasingly important as some large companies like United Airlines have gone bankrupt, leaving the agency, which took over United's pension plan, with far greater unfunded obligations than previously thought.

"The discrepancy between the government's and the company's figures is the result of different assumptions made about how long GM would keep operating the pension fund. The federal guarantor made its estimate on what is called a termination basis -- it measured the amount that GM would owe its workers if it were to terminate its pension plans immediately. GM's calculation that its pension plan is fully funded assumes that the fund will keep going, rather than being ended.

"Since 1994, companies with weak pension funds have been required by law to calculate the value of their pension funds on a termination basis and to send the information to the pension guaranty agency. But Congress also enacted a measure keeping the information secret, in response to the stated concerns of companies, who argued that the information could be misconstrued if shared with the public.

"The pension agency did not release GM's own estimate of its pensions on a termination basis, which continues to be secret. GM said it sent its most recent calculation to the agency about a year ago. The agency made its own calculation at the end of June and released the figure in response to a request under the Freedom of Information Act.

"In response to questions about the federal agency's calculation, GM released a statement saying it considered it 'unrealistic and not indicative of GM's ability to provide future retirement benefits.'

"'GM takes its pension obligations very seriously,' the statement continued. 'The corporation has contributed more than $56 billion over the last 12 years to fund our pension plans and meet our obligations to our current and future retirees.'"

Now I don't know about you, but I have a problem taking seriously a company that is comforted when sales decline a mere 33% while banking on selling more SUVs with soaring gas prices. The article continues in explaining the discrepancy. Let's tune back in:

"GM's pension fund is actually made up of two big plans, one for salaried employees and one for hourly workers. At the end of 2004, GM reported that the two plans had total assets of $91 billion, and total benefits owed of $89 billion, for a surplus of $2 billion.

"The government's calculation involves a variety of different assumptions about the future value of benefits the company owes. Terminating the fund means workers would no longer build up any new benefits, and GM would no longer provide cash from its continuing operations. But someone -- either the government or an insurance company -- would still have the obligation to pay all retirees the benefits they had earned, on schedule, in the future.

"(Companies with plenty of money can also terminate their pension plans by paying an insurance company to take over the obligations. In GM's case, the government estimated that an insurer would charge $31 billion in addition to the money in the fund.)

"The government says its figure gives the more truthful picture of the plan's condition. The current pension accounting standard specifically cites the Pension Benefit Guaranty Corporation's method as 'appropriate.'

"But most companies have resisted using the termination method, both because it can make their pension plans look very weak, and because they say they do not intend to end their plans. Business groups say that reporting pension values on a termination basis would needlessly alarm and confuse employees.

"But as big corporate bankruptcies and pension plan failures accelerated in the last few years, weakening the entire pension system, a small but growing number of economists, accountants, and government officials began to take the position that companies with low credit ratings -- like GM -- should be required to disclose the termination values of their pension plans.

"Labor Secretary Elaine L. Chao called for such disclosure in a speech in January. Access to the termination data, now secret, would 'empower workers, investors, regulators, and the public,' Ms. Chao said.

"'The goal is to ensure that the assumptions that go into measuring a plan's liability better reflect whether or not it will be terminated.'

"United Airlines, for example, kept reporting its pension values on the usual, continuing basis, even in its third year of bankruptcy, when it was no longer making the minimum contributions required by law and it was clear that termination was inevitable. On this basis, United, a unit of the UAL Corporation, reported a $6 billion shortfall as of the end of 2004.

"But when the government agency finally took over the plans this year, it recalculated them on a termination basis and found a total shortage of $10.2 billion. United's work force and the Pension Benefit Guaranty Corporation will bear that shortage."

The article said that the PBGC will bear any shortages. That, unfortunately, is not entirely accurate. The PBGC is just an arm of the Federal Government. Pension shortages when a company goes under will be covered in one of two ways:

1. Reduced benefits
2. Taxpayer bailouts

When it comes to GM, I expect both to happen. An existing law due to expire in December let companies get away with murder on their pension assumptions. Presumably, it was enacted to help companies tide themselves over while the "recovery" was gaining traction. Well, here we are with a recovery that seems all but dead just as we are about to head into the recession of 2006. By postponing the problem, all we did was make things worse. I guess we will now see if Congress has the guts to mandate full funding of pension plans on a conservative basis, as well as change the rules for pension accounting as applied to corporate quarterly earnings statements, or if it will kowtow once again to industry lobbyists.

In the meantime, anyone working for GM that has a chance at an early retirement and a lump sum pension payout might wish to talk to a financial advisor about taking it. I remain convinced that GM is headed towards bankruptcy unless and until it confronts that mammoth list of problems head-on. I see no reason to believe it can or it will.

Mish

c/o Whiskey & Gunpowder

Personal Bankruptcies Soar

by Mike "Mish" Shedlock

PERSONAL BANKRUPTCIES HAVE skyrocketed lately. Is anyone surprised? The primary reason is not Katrina or Rita as some might think, although I am sure hurricane floodwaters pushed quite a few over the edge. The real culprit is the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.

Following are some of the highlights of the bill:

1) Before anyone can file bankruptcy under the Bankruptcy Reform Act, he or she must receive a certificate from an approved nonprofit credit counseling agency that states that he or she has received a briefing on opportunities for available credit counseling and has been assisted in performing an individual budget analysis. The legislation mandates that the agencies offering the counseling be nonprofit in nature, such as the Consumer Credit Counseling Service of America (CCCS). But according to Jeffrey Morris, resident scholar at the American Bankruptcy Institute, the amount of time necessary to complete the counseling may take debtors away from work, which would put the struggling debtor even further behind.

2) A small but vitally important part of the 500-page bill is the six-page section dealing with a "means test." The "means test" is the system by which the IRS determines who can legitimately file for bankruptcy and who cannot. The test is a rigorous process involving examination of the debtor's income and expenses, calculations as to whether or not their expenses meet the standards of their area, and judgments relating to whether or not they genuinely qualify for a Chapter 7 filing. If the combined gross income of your family is greater than the median family income in your state, you may be required to file a Chapter 13 repayment plan where you repay a percentage of your debts over a 36-60 month period, and you are not allowed to file a traditional Chapter 7 bankruptcy where your debts are eliminated. The "means test" is an inflexible standard designed to leave no leeway for debtors to abuse the system, but in the process it is bound to penalize a great many people who have fallen into bad circumstances through no fault of their own.

3) If required to file a Chapter 13 under the means test, your monthly expenses will be compared with the IRS National and Local Standard Expense guidelines. The Bankruptcy Reform Act strictly limits the amounts you can claim as expenses.

4) Another provision of the bill places the burden of proof for bankruptcy on the debtor's lawyer, requiring the attorney's signature on the petition and verification that they have investigated the claim sufficiently and found it to be solid. Many lawyers will demand their fees up front, or they will decide the case isn't worth their time.

Back in April I chimed, "Anyone currently on the edge will be best advised to file for bankruptcy BEFORE this bill takes effect in October. There is an incentive now, if at all in doubt, to file now and get it over with. I expect a dramatic increase in bankruptcies before this bill kicks in."

Well Surprise, Surprise, Surprise. Here we are with bankruptcy filings soaring as the Oct. 17 deadline looms. The following chart says it all:

Thanks to The Washington Post for that chart. Let's tune in to what the article is saying:

"Two weeks before a new, more restrictive national bankruptcy law goes into effect, financially strapped Americans are rushing to file for protection from their creditors, with filings climbing to an unprecedented average of 13,000 a day last week.

"Week after week records are toppled. Last week's 68,287 filings surpassed the record set the week before by 24%, and this week's total is likely to be higher, according to data released yesterday by Lundquist Consulting Inc., a financial research firm. Daily filings averaged 10,367 in September, compared with an average of 6,079 in September 2004.

"The surge is in anticipation of the new bankruptcy law, long sought by the financial industry, which takes effect Oct. 17. The law will make it harder and more expensive for people to completely wipe out their debts under Chapter 7 bankruptcy.

"'We are seeing a rush, mainly from people we saw a year ago,' Northern Virginia bankruptcy lawyer Robert Weed said. A year ago his clients thought they would be able to work their way out of debt without filing for bankruptcy, he said, 'but now they're in a panic to get in before the law is changed.'"

The Charlotte Business Journal is singing verse two of the same song. Let's take a look:

"It's boom time for bankruptcy in the Charlotte region. But it's hard to find a personal bankruptcy lawyer who's happy about it.

"'We're scraping by with as little sleep as possible,' says Susan Robicsek, a solo practitioner who does bankruptcy work for individuals. 'The number of calls is staggering.'

"'We are seeing some people who say, "I have heard it will be hard for me later, so I will go ahead and file now,"' Robicsek says.

"The increase in filings began in the spring, when Congress approved the provisions and President Bush signed them into law.

"Cases filed in the three divisions of the U.S. Bankruptcy Court covering the 12-county Charlotte region are up 25% from a year ago. As of Tuesday, 4,110 Chapter 7 filings have been made in the region this year, up from 3,127 by that point in 2004.

"'I'm getting very close to booked up -- and very tired,' says Dave Badger, dean of bankruptcy lawyers in the region.

"The new bankruptcy rules were more than a decade in the making. Pushed largely by the credit card and banking industries, it seeks to curtail the use of personal bankruptcy to wipe out debt.

"The law imposes a means test to determine who can file for Chapter 7. And it authorizes judges to penalize individuals and their attorneys if they file but don't qualify.

"Other requirements include a six-month counseling period before filing.

"The means test attempts to determine how much of a person's income goes to essential living expenses. If an individual has enough left after those expenses to pay 25% of unsecured debt, and the person makes more than the state's median income, the individual cannot file for Chapter 7.

"Experts predict the rush in filings will end abruptly after Oct. 17. But the filings will rebound, Robicsek predicts. The economy, she notes, has been difficult for many working people. Gas prices are high. Layoffs have been frequent. Many have been forced to take lower-paying jobs than they had in the past.

"'You can change the law, but the problems underlying a decision to file bankruptcy don't change,' she says."

Indeed. That last sentence says it all. It's also why I have a hard time feeling sorry for credit card companies -- with interest rates of 30% and fees for damn near everything -- weeping about not collecting every last penny from people they have no business lending to in the first place. Profits are at record levels but greed has been insatiable. Yes, some people have taken advantage of the system, but the bulk of filers have been those hit with huge medical bills, the loss of a job, or nasty divorce proceedings. Bush's "ownership society" striving to make second-class citizens out of renters has not helped, nor have teaser rates on loans. With the economy slowing there will be another rush of filings next year in the aftermath of Katrina and Rita and the bursting of the housing bubble.

The idea behind the law is simple: to make debt slaves out of people forever. With that in mind, I have been thinking about ways the "means test" could backfire. Without knowing the legal specifics, it seems one way to pass the test is to make sure you have no job and no income when you file. I believe it's easy enough to get fired if you need to. Cap off the loss of a job with a six-month mandatory counseling period during which lots of expenses are racked up, and write-offs just might increase, not decrease as a result of the bill. I also think the law will backfire in another way. Anyone going through this process will think twice about unnecessary expenses and credit card purchases for a long, long time. That is a good thing, except of course for the greedy credit card companies thriving on usury and absurdly high fees.

Bottom line: I think the credit industry slit its own throat with this bill, in more ways than one.

Except for the additional suffering incurred by someone trapped with huge sudden medical expenses, that is just fine by me.

Mish Shedlock


c/o Whiskey & Gunpowder

Will the Housing Bubble Fizzle or Pop?

by Mike "Mish" Shedlock

Standard & Poor's reports "Regional Housing Bubbles Vulnerable," and then asks a follow-up question: Will they fizzle or pop? Let's have a look.

"With housing prices continuing to outpace both income and inflation from coast -to coast, it is hard not to see a housing bubble, according to a comprehensive report published today in Standard & Poor's CreditWeek. The report looks at the implications of the bubble for builders, bankers, and owners in the United States and abroad, as well as in the structured finance and REITs markets, from both the credit and equity perspectives.

"'If the past is a guide,' says S&P Chief Economist David Wyss, 'home prices in the United .States are less likely to crash nationwide than to stop accelerating and then stabilize until incomes catch up with unsustainably high mortgage debt. This happened after home price spikes in the late 1970s, and again in the late 1980s. The coming rebalancing period could last half a decade, because it will take a 20% correction nationally to restore the normal ratio of home prices to income.'

"Echoing a similar theme abroad, Standard & Poor's senior economist in Europe, Jean-Michel Six, forecasts an orderly slowdown in house price inflation in Europe, owing to a combination of demographic, financial, and structural factors, with a soft landing likely in the United Kingdom and near-term overheating in Spain.

"'While the overall outlook may be reasonably benign,' Mr. Wyss continued, 'there's a regional danger: the possibility of deeper, more disruptive corrections in the most overvalued markets. In urban areas on both coasts, for instance, housing costs have risen 30% or more above the normal home-price-to-income ratio -- all the more alarming considering that in these regions this ratio was about twice the U.S. average before prices soared. This could make such places particularly vulnerable to economic shocks or rising interest rates.'"

The economists at S&P seem to be parroting the consensus view:

1) The overall outlook is benign

2) There is no national housing bubble

3) There are indeed regional housing bubbles

4) There will be a housing soft landing in both the United Kingdom and the United States

5) The only real problem is in the most bubbly areas on the coasts.

Wyss did attempt to give himself an out by mentioning a "possibility of deeper, more disruptive corrections in the most overvalued markets," but his overall "benign" view seems to me to be the equivalent of the "permanently high plateau" theory. It is based on his interpretation of "prior history," but more importantly on a belief in rising incomes: "If the past is a guide, home prices in the United States are less likely to crash nationwide than to stop accelerating and then stabilize until incomes catch up with unsustainably high mortgage debt."

Well, judging from the experience in Japan, if past history is any guide, U.S. home prices will sink for the next 18 years. Since there are differences between Japan and the United States, let's instead focus on the income side of the statement.

Are incomes likely to catch up to "unsustainably high mortgage debt"? I think not.

** We are losing manufacturing jobs

** We are outsourcing technical jobs

** We are gaining service jobs at Wal-Mart, Pizza Hut, and retail outlets

** Pension plans are going under (United Air and Northwest Airlines, to name two), and auto pension plans at Ford and GM are under attack

** 50% of the jobs gained in this recovery were related to housing expansion. What happens to those incomes if housing so much as slows?

** Will pay raises at Wal-Mart catch up with mortgage debt? When?

** What about rising energy costs and peak oil? When will wages catch up to those costs?

** What about those on ARMs, whose mortgage costs will start rising dramatically in 2006 and 2007 from low teaser rates?

** What about rising property taxes and increased medical expenses, or does S&P suggest that such items are not a concern?

Mish wonders what the economists at S&P are smoking when they think that rising wages will catch up to the absurd home prices in the bubble areas in any sort of likely "soft landing." We are three years into a recovery, and real wages in general are still declining. Demand for housing, as suggested by rising inventories, is now slackening at the same time. Demand for gasoline even seems to be declining recently. What about real estate sales commissions if home sales even modestly decline? What about other sales commissions if retail spending slackens? Is Wyss aware that there is an 18-to-1 or 20-to-1 wage differential with China that is putting pressure on jobs, wages, and benefits? Under what logical scenario will overall wages finally start rising now, this far into a recovery? The only way I can see wages rising is if the bubble keeps inflating. All that would do is postpone the problem and make it bigger in the long run.

Note too, that S&P also seems to be discounting the effects of Katrina, as well as any upcoming recession. Perhaps the economists at S&P think that the spend-and-spend policies of this Congress and this administration have forever eliminated the business cycle as well. Who knows? Whatever they are smoking sure is powerful stuff.

I do not buy this "permanently high plateau" nonsense or any talk of a miracle "soft landing," either. Nor do I accept that the business cycle has been defeated and there will be no more recessions. The next consumer-led recession is going to be a doozy, and along with it will come a severe strain on home prices. The upcoming correction is likely to be dramatic in terms of price action or length of time or both. It may come about as a very long, painful slow leak (the Japan scenario) or some sort of faster price crash. I think the latter is the most likely scenario, perhaps in a sloping stair-step fashion. The least likely ending is the widely held fairy tale belief that wages keep rising, jobs will be plentiful, the business cycle is defeated, and "everyone lives happily ever after."

Mike Shedlock / Mish

http://globaleconomicanalysis.blogspot.com/

Courtesy Whiskey & Gunpowder