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From the Inside Looking Out
Perspective on the News
Monday, May 16, 2011
Ed DeShields

Your view can be very different depending on where you are seated.  This week I caught a view from the inside as I sat among a small group of executives invited to discuss the economy and our government’s view of our economic future.

I am usually not such the insider as the outsider mind you.  I’m more a member of the rank and file I call the “great unwashed” – those Americans just living their life everyday trying to make some kind of a difference in our community.  But I am an investor and own a credit rating firm as well as an arm-chair economist per se, so I got seat at the table.  I was pretty curious on what the so-called experts on the next pay grade level might say in a more intimate setting without the cameras around.  

The guest list was impressive and over a day and a half the corporate jets shuttled them in and out with precision (nice ride if you can get it; I flew Southwest where my bags were free, but they lost them). 

Among the guests were Paul Krugman, the liberal Nobel laureate whose boss at Princeton was Ben Bernanke now the Chairman of the FED.  Krugman and Bernanke are clones on economic issues.  Meredith Whitney, the Oppenheimer analyst credited with blowing the lid off the housing crisis, and later exposing the coming municipal debt crisis on 60 Minutes (talk about two contrasting visions of the economic world!) was there – and one of the more interesting invitees.   The chairmen of both FreddieMac and FannieMae who purchase or insure about 96% of the all the mortgages in the U.S. were there with their messages of hope.  Oh, the audacity of it.  More on this later.

Not to be out done, the private capital “Wall Street” guys were not to be left out.  Both the Managing Directors of Blackrock (3.4 trillion under management and bigger than most countries) and FBR Capital Markets were there along with a rather long list of ratings agency types who were pretty dreary types with a dreary message.   But, this was a meeting of the investment machine in America and it was a meeting that foretells our future. 

So what did I learn?

Perhaps the largest contrast was that of the monetary policy wonks responsible for the way the government thinks, compared to the private investment managers – the guys with the real capital that’s worth real money.   The former generally have the opinion that while things are difficult now, everything is completely under control evidenced with a large, but incomplete, collection of impressive slides and graphs.  Mr. Krugman reminded us several times that his boss, and the administration, has this all thought out and we’re going to be alright, except for 10 years of slow-to-negative growth similar to Japan.  Don’t worry though.  Our population isn’t as old as the Japanese and the average American family spends their paycheck versus saving it.   It took Mr. Krugman awhile to admit we have a debt problem but if we got this worked out we’d be fine. 

Additionally, the dollar doesn’t seem to matter from the perspective of being the world’s reserve currency.   We’re aren’t going back to the gold standard and the dollar has no equal – but if it did so what?  The world’s a pretty integrated place now.  After all it’s Europe that has the problem and with regards to Russia; they’re still a wanna-be. 

China is a mystery because according to policy wonks, their data can’t be deciphered.  Everyone was pretty sure China could experience their own housing bust – but they weren’t sure yet.  Never the less, it is the emerging market countries and their associated currencies that are red hot with inflation trying to keep up with our buying needs here in the U.S. 

Meredith Whitney, a petite but firey blond, pointed out the contrarian view.  Not only is the federal government insolvent, but so are the states.  In the last ten years, states have spent two-and-a-half times tax revenues, looted and under funded their pension plans for state workers and run their deficits to unprecedented levels of debt from which there is no easy solution.   Ms. Whitney brought it home as she explained, “the politicians are not going to pay their investors instead of paying their policemen, firemen and school teachers.  The cities will default; hundreds of them.  And the looting will begin next month as the federal government’s state funding runs dry”.  

If you live in the coastal states you’re going to be faced with much higher taxes and must lower services.  Whitney says, “you moved to New Jersey, or California or where ever because it had nice schools, parks and libraries.  Then you awake to the realization that all those things are going away”.   

The states with the least debt issues represent a geographical triangle starting in Wisconsin, stretching southward and to the west and east – therefore covering “the red states” of the central U.S.  These are the states that will survive the crisis with reasonably manageable social and financial outcomes.  The other states will lose their populations, and their societies, to this new centrally-shifted social-economic zone.   Whitney blew it way with facts and indisputable documentation. 

Half the country, on each coast, will better resemble Detroit, while the central U.S. will experience great growth from foreign and state immigrant populations over the next twenty years. 

The capitalists, viewed the government as being in the way and until the coast was clear they weren’t about to risk their money while the U.S. government was running the financial system. 

Consequently, our government with its new regulations and reform initiatives will keep the markets in turmoil for several years.  For example, the Dodd Frank reform stipulates 350 new regulatory initiatives, which haven’t yet been written!  

Driving the bus, economically speaking, is the housing market.  The two largest players, FannieMae and FreddieMac are both in conservatorship.  Conservatorship is not receivership where assets would be liquidated, but is a form of workout where these two behemoth loan guarantors exist courtesy of the U.S. taxpayer.  Ninety-six percent of all mortgage loans made in the U.S. are purchased or guaranteed by them.  Or, did I say us?

What was astounding was that they’ve made great progress in lending only to those who have near perfect credit – those above 760.   The affect of this underwriting has reduced the available mortgage funding to $1 trillion from $2 trillion annually and crashed the housing industry.   Consequently we know have a three year supply of houses to be sold and another five million pending foreclosures headed into the market clearing process.   This continues to push housing lower where we’re losing about 3 to 4 percent per quarter.  

In summary, there are great headwinds ahead.   There is a unquestionable gap between those responsible for solving the problem and those with the will to actually face it.    And this gap couldn’t have been more evident among the insiders looking out.

About Ed DeShields

Last article: End of the Road for the Ship of Fools (Part 2)

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