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Is America On The Road To Financial Ruin?

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
June 23, 2009

IN THIS ISSUE:

1.  Obama’s Government Takeover Continues

2.  Editorial: “Too Big to Fail, Or Succeed”

3.  Americans More Concerned About Deficits

4.  Economy May Have Seen the Worst of It

5.  Conclusions

Introduction

The more I think about it, I believe that last week’s E-Letter which revealed President Obama’s plans to double the national debt over the next decade was one of the most important e-letters/newsletters I have ever written.  If by chance you did not read last week’s E-Letter, you need to click on the link above and do so now, since Obama’s planned explosion in US debt will be a continuing theme in these weekly E-Letters for some time to come.

I sincerely believe that if our current $11.4 trillion national debt doubles over the next 10 years (and possibly even sooner), it will bankrupt America and send us into an even worse financial and economic crisis.  President Obama’s plans to run trillion dollar annual budget deficits for at least the next few years are almost certain to wreck the US dollar, which in turn will be very bad news for the stock and bond markets, not to mention the long-term inflation implications.

I have warned for over 25 years that politics are intimately intertwined with the course of the economy, the markets and thus our investments.  This argument has never been clearer than today, and more and more Americans are coming to realize this.  A Wall Street Journal/NBC News poll late last week found that 58% of respondents now believe that Obama’s trillion dollar deficits are a greater concern than the recession in the economy.  Maybe I’m making some progress!

President Obama has made public statements in recent weeks that he would prefer a smaller government had he not “inherited” this recession and financial crisis from George W. Bush.  He has also said that he does not want to run (own) companies like AIG, GM and Chrysler.  Yet his administration continues to promulgate new regulations that will make it even more likely that the government will eventually own much larger stakes in the private sector.

Obviously, Obama’s plan to have the government take over national health care is a prime example of his intentions to greatly expand an already bloated, inefficient government and run unprecedented trillion dollar budget deficits.  I have not chosen to weigh-in on the healthcare debate so far, partly because polls show that a majority of Americans want major healthcare reforms.  All I will say at this point is, be careful what you wish for.

Last week President Obama announced sweeping regulatory changes that will dramatically affect the financial and investment markets for years to come.  These so-called “reforms” could result in the government and/or the Fed owning some of our big banks and financial institutions that are deemed to be “too-big-to-fail.”  While the recent financial crisis suggests that some reforms are needed, having the government own or control many of our largest financial institutions is not the answer.

I will discuss these sweeping new financial regulations as we go along.  I will also discuss the latest economic indicators which remain mixed, along with my thoughts on the investment markets.  It’s a lot to cover, so let’s get started.

Obama’s Government Takeover Continues

Last Wednesday, President Obama announced the most sweeping financial industry reforms since the Securities and Exchange Commission was created in 1934.  Obama unveiled new proposals that would refashion the federal rules governing almost every corner of finance, and will push the government and the Federal Reserve much more deeply into banks and the private markets.  The administration’s 85-page “white paper” on financial reform sounded the opening salvo in a likely overreaching regulatory process that could expand for several years.

Most importantly, government supervision of all financial firms that are deemed to be big enough to threaten overall economic stability (“systemic risk”) will be consolidated under, and be regulated by, the Federal Reserve.  We’re not just talking about banks here – the new regulations will allow the Fed to oversee any private or public companies that are deemed to pose systemic risks (ie- “too-big-to-fail”).

These entities will be required to hold more capital and liquidity than other firms, and will face other regulatory requirements as deemed appropriate by the Fed and/or the Treasury Department.  Firms that cannot meet the Fed’s requirements can be taken over, partly or wholly, by the government – as was the case with insurance giant AIG, or simply shut down – as was the case with Lehman Brothers.  This is scary!

Obama’s regulatory net is also being cast over the credit markets whose growth contributed to the financial crisis.  Those who package loans together for sale in securitizations (including mortgages) will have to disclose more and will be required to keep 5% of any deal to encourage sounder underwriting.  Likewise, the new plan calls for payment of their fees to be spread over time and reduced if the loans go bad.  Frankly, these specific regulations may actually make sense, while others are simply unnecessary government intrusions in the private sector.

The president’s new reforms also include the creation of a Consumer Financial Protection Agency (CFPA).  In theory, this new government agency will safeguard against mortgage, credit card and other abuses that may have contributed to the current crisis.  In reality, this new agency may ultimately be the arbiter of who can – and cannot – get a home mortgage, what interest rates lenders and credit card companies can charge, etc., etc.  Concern is already mounting that the new agency will take an overly restrictive view of permissible financial products, limiting access to credit and curbing good as well as bad innovation.

What follows are excerpts from an Investors Business Daily editorial published last Friday that fairly, I think, points out the assessment of those who will oppose Obama’s sweeping regulatory reforms:

“Many on Wall Street have been stunned by a plan that subjects America’s free-market capitalism to the controlling whims of bureaucrats, newly appointed czars and congressional committees headed by anti-business liberals such as Rep. Barney Frank.

‘We intend to take our case to Congress to explain why we believe adding new layers to a broken regulatory system is not the answer,’ David Hirschmann, who heads the U.S. Chamber of Commerce's Center for Capital Markets, told the Los Angeles Times. Indeed, there are lots of objectionable things in the plan.

…We hope Wall Street — banks, investment houses, hedge funds, private investors — continues to speak up. The Democrats’ plan slips the government’s fingers around the economy’s neck, choking off the risk-taking that is the very essence of America's capitalist success. Bold risk-takers will be replaced with risk-averse bureaucrats, and the dynamic growth engine that feeds our ever-expanding standard of living will be shut down.

This in turn will create a permanent bailout culture — one that will deem certain companies ‘too big to fail’ and subsidize their failure with taxpayer money, while burdening small, entrepreneurial companies with unnecessary and costly regulatory oversight.”

The IBD editors hit on only a few of the potential problems with President Obama’s sweeping new regulatory reforms included in his 85-page report released last week.  Analysts are still sorting out the details and considering the long-term implications.  Certainly, some of the reforms will be welcomed by many Americans, especially those who believe that the government should control the private markets.  But with any such government intervention, freedoms are sacrificed and free markets are restricted.  A June 18 Wall Street Journal editorial makes the best argument I have seen regarding Obama’s sweeping regulatory reform proposals. 

QUOTE: TOO BIG TO FAIL, OR SUCCEED
Everyone will want to become big enough to enjoy 'systemic risk' protection.
by Peter Wallison (senior fellow at the American Enterprise Institute)

In a speech at the White House yesterday, President Barack Obama outlined what he envisions for future regulation of the financial system. He called his plan "a new foundation for sustained economic growth . . . a transformation on a scale not seen since the reforms that followed the Great Depression." Indeed it is.

His plan, if adopted, will fundamentally change the nature of our financial system and economy. The underlying concerns and assumptions are clear, and they are made clearer by considering other ways that his administration has dealt with the consequences of competition -- particularly the faux bankruptcies of General Motors and Chrysler and the impending change in antitrust policy. Although the president said in his speech that he supports free markets, these initiatives confirm that the administration fears the "creative destruction" that free markets produce, preferring stability over innovation, competition and change.

According to the administration white paper circulated prior to the president's speech, the Federal Reserve would be authorized to create a special regulatory regime -- including requirements for capital, leverage and liquidity -- for any firm "whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed." In addition, if a large financial firm is failing, the Treasury is to be given the power -- in lieu of bankruptcy -- to appoint a conservator or receiver to "stabilize" it.

Designating particular financial firms for this kind of special regulatory treatment clearly signals to the markets that these institutions are too big to fail. It will reduce the perceived risk of lending to them, enabling them to raise funds at lower cost than their smaller competitors.

In other words, the administration's plan would create what are essentially government-sponsored enterprises like Fannie Mae and Freddie Mac in every sector of the financial economy -- insurers, securities firms, finance companies, bank holding companies, and hedge funds -- where these specially regulated firms are to be designated. The result will be devastating for competition. Larger firms will squeeze out smaller ones and aggressive small companies will have less opportunity to overcome the government-backed winners.

Moreover, the administration's proposal to provide a special bailout mechanism for large firms confirms the likelihood that these firms will never be closed down or liquidated. Citing the market turmoil that followed Lehman's collapse, the administration will argue that failures like this are "disorderly." But failure comes from risk-taking -- the very source of our economy's strength -- and it is ultimately risk-taking and its consequences that the administration's plan is intended to prevent.

The turmoil following Lehman’s failure occurred because market participants expected, after the rescue of Bear Stearns, that any larger firm would also be rescued. When Lehman wasn't, all market participants were required to recalibrate the risks of dealing with all others, causing a freeze-up in lending and hoarding of cash. Lehman’s failure itself did not cause any substantial losses, and within two weeks of its bankruptcy filing, Lehman’s trustee sold its brokerage, investment banking, and investment management businesses to four different buyers.

Contrast this with AIG, the administration's paradigm, which was saved by the government because it was allegedly too big to fail. That firm is gradually wasting away under government control, with the taxpayers footing the bill.

The administration's fear of competitive outcomes is not reflected solely in financial-sector policies. Consider General Motors and Chrysler. They were defeated in the marketplace. Simply put, they failed to build automobiles [that] enough Americans wanted to buy.

Their disappearance would not have threatened the stability of the financial system, although it would undoubtedly have been disruptive for suppliers, dealers and employees. Yet the administration wouldn't allow them to fail, either. Despite all the talk about credit priorities, the fundamental point is that the administration used taxpayer money to overturn the market's verdict. If we want a preview of what the administration will do with the resolution authority it wants for large financial companies, we need look no further.

The same pattern with regard to competitive markets can be seen in the Justice Department's new antitrust policy. Christine Varney, the new assistant attorney general in charge of antitrust policy, has said that U.S. policy should be more like Europe's. Until now, U.S. antitrust policy has tried to protect competition. Europe attempts to protect competitors. Protecting competitors means blunting the skills of superior players, allowing inferior managers and business models to remain in business and thus preventing better managements and business models from emerging. Again, stability wins out over change and progress.

The president has said on several occasions, including in yesterday's speech, that "I've always been a strong believer in the power of the free market." But his administration's prescriptions tell a different story. In AIG, GM, Chrysler, Fannie Mae and Freddie Mac we can see the future that the administration envisions for our economy -- a sclerotic and unchanging structure of big companies working with, protected by, and relying on big government.
END QUOTE

I could not agree more with Mr. Wallison’s analysis above.  Yet most Americans have no idea what President Obama’s sweeping regulatory changes really mean, much less how they may negatively affect competition and the free markets.  Most Americans only hear the media sound-bites which leave the impression that the Obama administration reforms will “fix” the financial markets once and for all.

Were some changes in regulation of the financial markets in order?  Certainly.  Subprime loans, “no-doc” loans and “liar” loans allowed millions of Americans to purchase homes they could never afford.  Likewise, credit rating agencies allowed investment bankers to create AAA-rated bonds secured by these questionable mortgages, which greatly broadened the impact of the subprime debacle. 

These and other abuses ultimately led to the housing crisis, the credit crisis and the most severe recession since the Depression.  So, changes to the financial regulatory system were needed.

As I noted above, some of Obama’s new regulations on mortgage lenders make a lot of sense and will help to curb abuses.  But many others are nothing less than purposeful government intrusion in the private markets in ways that will stifle competition.  In many ways, these new rules look more like nationalization than regulation.

Americans More Concerned About Deficits  

While President Obama continues to enjoy high (but falling) approval ratings overall, the public is growing much more concerned about Obama’s record-large budget deficits and government intrusion in our lives, as noted in this week’s SPECIAL ARTICLES below.  In particular, a new Wall Street Journal/NBC News poll published last Thursday had some surprising findings. 

For example, a solid majority – 58% – were more concerned about the budget deficit than they are about the economy.  Specifically, they said that the president and Congress “should focus on keeping the budget down, even if it takes longer for the economy to recover.”

When asked about the expanding role of government (e.g. ownership stake in GM, executive compensation, health care, etc.) a whopping 69% said they were very concerned (49% answered “a great deal” and 20% answered “quite a bit”).

On the issue of Obama’s health care plans, the WSJ poll results suggest that the president still has a lot of convincing to do.  33% think it’s a good idea, 32% think it’s a bad idea, and 35% have no opinion.  Put differently, 67% either think government run health care is a bad idea, or they’re not sure.

The New York Times also released its latest poll last Thursday.  It also revealed that the public is growing more wary of the expanding role of government.  When asked if the government is doing too much or too little, the result was: 56% too much versus 34% too little.

These surprising poll results suggest that more and more Americans are realizing just how dangerous it will be for America to double the national debt in a decade or less, as I discussed in detail last week.

Economy May Have Seen the Worst of It

Barring a major negative surprise, I think we have likely seen the worst of this recession.  The Commerce Department will release its final estimate of 1Q GDP on Thursday, and most forecasters expect it to be in the -5.5% to -5.7% range (annual rate), which is at least mildly less negative than the -6.3% plunge in the 4Q of last year.  Together, these two quarters should prove to be the worst of the most severe US recession since the Great Depression.

There is a broad consensus that the US economy has continued to contract during the 2Q, with most suggesting a decline of 2-3% in GDP over the last three months.  From there, though, forecasts vary widely as to what will happen in the economy during the second half of the year.  While I continue to believe that GDP will remain in negative territory all year, a growing number of analysts believe that GDP could actually go positive in the 4Q.

We have had more good economic news in the last couple of weeks.  Most importantly, the Index of Leading Economic Indicators (LEI) rose a better than expected 1.2% in May, following a 1.1% gain in April.  These were the first back-to-back monthly increases in almost three years.

The Commerce Department reported on June 11 that retail sales rose 0.5% in May, the first increase in three months.  However, the report indicated that much of the rise in sales was due to the significant increase in gasoline prices.

On the manufacturing front, the latest reports were mixed.  The ISM Index rose modestly to 42.8 in May versus 42.3 in April.  Remember that any reading in the ISM below 50 indicates an economy that is still contracting.  Industrial production fell another 1.1% in May, while the factory operating rate slipped to 68.3% in May, down from 69% in April.

On the housing front, there was a bit of encouraging news.  Housing starts rose sharply in May, thanks in large part to the federal home tax credit that expires in November.  Building permits were also up modestly in May.  However, the inventory of unsold homes remains at a record level with over 11 months’ supply on the market.  Home prices nationally plunged 19.1% in the 1Q and are down 32% from the peak in 2006.  So the housing slump is far from over.

The US unemployment rate continues to spike higher, rising to 9.4% in May, up from 8.9% in April.  A recent Wall Street Journal survey of economists found a consensus opinion that the unemployment rate will hit at least 9.9% by the end of this year.  The continued rise in the unemployment rate is almost certain to keep consumers on the defensive.

While we are seeing signs that the worst of this recession is behind us, that does not mean the economy will move into positive territory by the end of this year.  Consumer spending is still lagging and is likely to stay below trend for some time to come.  The personal savings rate jumped to 5.7% in April (latest data available), the highest level in more than 14 years, and this trend is likely to continue.

The combination of declining housing and stock-market values with the heavy debt loads Americans took on during the housing boom has inflicted significant damage on household finances.  The Federal Reserve’s latest “flow of funds report” earlier this month showed that household net worth fell $1.1 trillion in the 1Q from the 4Q of last year to $50.4 trillion, putting it $13.9 trillion below its 2007 peak. Collectively, homeowners held 41.4% of the equity in their homes, the lowest level since records have been kept and down from 53.9% two years earlier.

Conclusions

As noted above, we have seen some encouraging signs in the economy.  If you watch any of the financial channels, you will find that there is a great deal of optimism that the recession will be over before the end of this year.  Sorry, but I just don’t buy it.  I continue to believe that the economy will still be in negative territory at the end of the year, as measured by GDP.  I hope I am wrong.

As for President Obama’s sweeping financial regulatory reforms he announced last week, we would hope to be implementing new regulations that should prevent anything similar to the sub-prime meltdown and the credit crisis from ever happening again.  However, I believe that most of Obama’s proposed regulatory changes are over-reaching and onerous.  But Congress is likely to pass most or all of them, despite the long-term market implications.

On a positive note, I am very encouraged that more Americans are becoming increasingly concerned about the mammoth level of spending and deficits planned by the Obama administration over the next decade.  Doubling the national debt in the next decade (or less) will have extremely negative consequences for the economy and stocks and bonds. 

I feel that more of the public is coming to realize just how much exploding federal deficits will affect the future of their children and grandchildren.  Perhaps we have come to realize just how large a sum one trillion dollars is, how long it could take to pay it back and who will be required to make those payments.  More people want the government to do what every family must do - make tough decisions on which expenditures are most important and which can be deferred. 

Finally, I believe that the public is picking up on the fact that capitalism’s very structure is changing.  Specifically, the government has switched from a role of economic supporter and regulator to owner and controller.  This is a fundamental shift in the very nature of capitalism and could have ramifications far into the future.  To me, this is the most disturbing of all of the recent events that have come to pass.

Let’s hope that our representatives in Washington get the message that the recent polls are sending – that Obama’s incredible spending and bigger government plans will wreck our economy over time.  If not, it could be a very bleak future that we leave to our heirs.  Sorry to end on a negative note, but it is what it is.

 Wishing you a great summer,

Gary D. Halbert

SPECIAL ARTICLES

Independent voters worried about Obama’s spending
http://online.wsj.com/article/SB124570175501838333.html

More polls show growing concern over Obama’s deficits
http://www.nydailynews.com/opinions/columnists/goodwin/index.html

Public confidence in Obama stimulus plan is falling
http://www.washingtonpost.com/wp-dyn/content/article/2009/06/22/AR2009062202000.html?hpid=moreheadlines


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