I. SL                                              COVER

   A.Thank you for inviting me to speak

        1. while I miss...
B. I Want to Start Today With a Quick Story -- Sum Up My View of the World

      1. there used to be a car company called...
2. the next GM is the United States

      a. we have too much debt
            (i) we've promised to pay for retirement a...
C. Before I get started: My Key Themes for Today:

      1. the short term pain is subsiding
             a. the rate of d...
II. The Long Term -- Unsustainable Debt Level

   A. The Great Myth -- How We Speak About Debt

          1. we say debt i...
B. The Long Term Consequences

      1. over the next 25 years, the amount that the gov't lends to itself will decrease

 ...
D. I Hope I'm Wrong

      1. but this shapes my view of the world

      2. I don't think anything is imminent by any mea...
III. The Bottoming Process

  A. GDP

        1. the rate of decline in GDP is decreasing
               a. of course, the...
B. Manufacturing is Turning Up -- and this is a leading indicator
                                                      IS...
D. Improvement in Steel Industry -- another good leading indicator

      1. industry wide capacity utilization improving
...
F. Financial Markets Have Turned Up

      1. S&P 500                            S&P

      2. IPO market is showing some ...
5. credit spreads are shrinking

      a. average junk-rated bond is no longer distressed
            (i) distressed is 10...
8. slight signs of "animal spirits"

      a. falling dollar shows risk tolerance   EXCHANGE RATES

      b. huge demand f...
G. Housing

     1. sales of new homes rose for three consecutive months
           a. increased 11% last month
          ...
H. Labor Markets                               WEEKLY INSURANCE

      1. monthly average of weekly initial unemployment i...
I. Other

      1. Leading Economic Indicators has turned up
            a. interest rate spread               LEI
       ...
4. microchip manufacturers say they've bottomed

        5. dry shipping rates

              a. Baltic Dry Index
        ...
A. Consumer spending (70% of GDP) is unlikely to have a rapid recovery.

      1. consumer confidence is weak

           ...
4. individuals feel the need to save   SAVING

      a. we've wanted people to save for a long time
            (i) but th...
B. Business spending will be slow to recover.

      1. capital expenditures are declining            Cap Ex
            a...
C. The housing marke is far from healthy.

      1. approximately 21.9% of homeowners are under water

             a. 17....
3. June's 11% surge in new home sales was misleading
                                           New Home Sales
      a. sa...
D. Commercial Real Estate

      1. commercial property prices are down 35% since October 2007

      2. estimates are for...
E. We're seeing signs of weakness in the Treasury market.

      1. issuing huge amounts of debt

             a. last wee...
5. Treasury debt had poor demand last week

      a. sold record $39 billion in five year notes on Wednesday
            (...
F. We face great uncertainty with inflation / deflation.

       1. Tremendous increase in the monetary base              ...
4. a few thoughts on inflation

      a. when labor markets recover, higher level employees will do everything
           ...
G. The Fed is losing its independence and this creates great risk for monetary policy

      1. Bernanke spends half of hi...
H. Markets seem to be euphoric right now…how long can it last?

      1. stock market is up 40% from its bottom

         ...
4. distrust of markets

      a. algorithmic trading and flash trading
            (i) Sen. Schumer told SEC to stop this
...
I. The employment situation is horrible and it's worsening!

       1. the unemployment rate has increased to 9.5%        ...
4. we could have a jobless recovery

      a. Bernanke says 1% growth expected in 2H of 2009
            (i) said that wou...
J. Banks are not helping the recovery.

      Background
        banks are incredibly procyclical
              overextend...
2. Industrialized nations have provided less than half the support…

      a. that they pledged to prop up fin'l sector (p...
4. bank earnings are being subsidized right now

      a. saving $24 billion in borrowing costs (on $238 billion of debt)
...
7. Leveraged loan index is slightly higher than right before Lehman collapsed

      a. but huge disparity
             (i...
8. long term disparity in wealth and income has led to anger towards banks

      a. Senate panel has subpoenad fin'l inst...
9. Fannie and Freddie are unlikely to be able to repay gov't in full

          a. gov't agreed to pump $200 billion into ...
K. There is growing frustration with government plans.

      1. regulation is becoming excessive

             a. pay cza...
3. Cash for Clunkers is a temporary effect
                                        referring to buying Amer cars

      a....
4. more spending in future -- healthcare

      a. proposals:

             (i) tax most expensive policies worth more tha...
5. BUT DON'T WORRY…

  cabinet found $102MM of savings
        .006% of deficit
        double sided photocopying
        ...
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Sandy Leeds on the U.S. Economy, Speaking Notes 8 09

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Speaking notes from Professor Sandy Leeds' speech on the U.S. economy, given August 7, 2009 in Quebec.

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Sandy Leeds on the U.S. Economy, Speaking Notes 8 09

  1. 1. I. SL COVER A.Thank you for inviting me to speak 1. while I miss the 102 degree Austin heat… 2. and while this hotel isn't the La Quinta that I'm accustomed to… a. it's really nice to be here 3. I felt bad telling my wife that I'd be in the Motel 6 in Des Moines a. but honey, they don't have phones, there… (i) so I'll call you 1
  2. 2. B. I Want to Start Today With a Quick Story -- Sum Up My View of the World 1. there used to be a car company called GM a. maybe some of you have heard about it b. I've spoken about it for 10 years: (i) had too much debt (A) promised to pay retirement / healthcare (ii) employees were overpaid / protected by partisan union (iii) yr after yr, spent more than took in (iv) management refused to address problems (v) others produced better products that were cheaper c. it was easy to see that it was not sustainable (i) I would argue that everyone knew it d. the question was "when would it happen" (i) my answer was that I have no idea (A) but it was unavoidable e. a better answer would have been "I see an economic crisis starting in 2007, resulting from credit bubble and a housing bubble" (i) of course, I didn't know when, but you knew it would happen f. there were times that you could successfully trade GM's stock (i) but the buy and hold investor got killed 2
  3. 3. 2. the next GM is the United States a. we have too much debt (i) we've promised to pay for retirement and healthcare for everyone b. we are separated by partisan political parties c. we continually run deficits d. we refuse to address the problems e. others are producing what we used to produce (i) and they're doing it cheaper 3. the question is when will something happen a. again, the answer is that I don't know, but it will happen 4. this shapes all of my views and I'm going to speak about this today 5. the order of my presentation will be: a. I'll start with my long term view b. then, I'll discuss our current state of affairs c. finally, I'll end with what I'm worried about -- why I'm pessimistic 6. the reality is that none of us know what's going to happen next a. my role is to present ideas to you 3
  4. 4. C. Before I get started: My Key Themes for Today: 1. the short term pain is subsiding a. the rate of decline is slowing 2. the intermediate term is not promising a. it will take a long time before the economy operates at full capacity again (i) this recession is very different than past ones we've lived through b. we can't recover without the financial sector (i) this recovery will be slow 3. the long term will be ugly a. John Maynard Keynes said that in the long term, we're all dead b. I'd add that when we see our long term, we're going to be happy we're dead (i) people will look back to the good old days of 2007 - 2009 4
  5. 5. II. The Long Term -- Unsustainable Debt Level A. The Great Myth -- How We Speak About Debt 1. we say debt is approximately 40% of GDP a. supposedly risk that it could increase to 80% 2. the truth about this 40% a. this is "publicly held" debt b. ignores government held debt DEBT 1 3. in reality, we have $11 trillion of debt DEBT 2 a. our GDP is $14.15 trillion (i) so we're already at 79% b. $7 trillion is held by the public (i) investors like you and me… (A) really you and you (1) don't group me in there (ii) institutional investors (A) mutual funds, pension funds, etc. (iii) foreign government b. $4 trillion is held by our government (i) this is the point of confusion (ii) people say, "if gov't borrows $4 trillion from itself, it's not really debt" (iii) for simplicity, lets imagine that the $4 trillion is being loaned by: (A) Social Security (iv) so Social Security has $4 trillion today, but they have a $20 trillion liability (in PV terms) (v) when we talk about our debt, we're ignoring that unfunded liability (vi) if you combine Social Security, Medicare, Medicaid, Veterans Affairs… (A) how much would it take to fund our liability today? (1) according to the Treasury Dep't… -- $45 trillion -- others think more (B) but that puts our debt at 400% of GDP currently 5
  6. 6. B. The Long Term Consequences 1. over the next 25 years, the amount that the gov't lends to itself will decrease a. that will have to be picked up by private investors (i) this will require higher interest rates 2. over the longer term, the Chinas of the world will lose confidence in us a. our dollar will decrease in value (i) this will continue a long term trend b. we will not be able to finance our debt c. we will have an economic catastrophe (i) we will have an event like the third world countries C. Who Will be the Winners in this Event 1. first, I don't know 2. everyone asks about gold… a. maybe… (i) it's priced in dollars (A) so it will take more dollars to buy an ounce of gold (ii) but I'm not sure that gold has intrinsic value (A) when you're hungry or want interest bearing assets b. other commodities are probably more compelling (i) food and energy 3. big winner: anyone who has fixed rate debt outstanding a. if I buy a $500K house with a $400K mortgage (i) devalued dollar…my house will be worth $2MM (A) I only owe $400K 6
  7. 7. D. I Hope I'm Wrong 1. but this shapes my view of the world 2. I don't think anything is imminent by any means a. we had several times when GM's bad news came to the forefront (i) eventually we had the perfect storm b. I think that the same thing will be true with us 3. I think this is very difficult to fix… a. cut social security or medicare and consumer spending will be hit increase taxes (i) politicians will find a way to spend the money (ii) hurt business in other ways b. in sum, we're in a brutal position 4. lets move back to the happier current times 7
  8. 8. III. The Bottoming Process A. GDP 1. the rate of decline in GDP is decreasing a. of course, the rate of my hair loss is declining… (i) doesn't mean I'll have a full head of hair anytime soon 2. first time in 60+ years of record keeping… GDP 1 a. that we've had 4 consecutive qtrs of shrinkage 3. a few things to notice in the GDP report GDP 2 a. sales have stopped dropping (i) great news b. business spending has dropped precipitously c. gov't spending is starting to show the stimulus (i) problem: states spending less d. interestingly, our trade situation is improving (i) part of that is oil dropping (ii) interesting since trade partners weak TRADE PARTNERS e. the inventory adjustment has been intense INVENTORIES (i) but, inventory to sales is still high (A) we'll see this later 4. in sum: we're bottoming…but we've had significant loss in production a. we're bottoming off a low base 8
  9. 9. B. Manufacturing is Turning Up -- and this is a leading indicator ISM 1. ISM (formerly Purchasing Managers' Index) a. weighted average of diffusion indexes for: (i) new orders (ii) production (iii) supplier deliveries (iv) inventories (v) employment b. with a diffusion index… (i) ask a person if conditions better, worse or same (A) better counts as 1 (B) same counts as .5 (C) worse counts for 0 (ii) reading above 50 shows things getting better c. came close to hitting 50 this month (i) widely followed and important C. Beige Book 1. said slowing pace of decline is marked improvement 2. see signs of improvement in: a. manufacturing b. housing 9
  10. 10. D. Improvement in Steel Industry -- another good leading indicator 1. industry wide capacity utilization improving a. increased from 45% to 52% 2. US Steel -- somewhat upbeat news a. recalled 800 workers b. restarting an idled Minnesota plant c. said prices are firming in US and Europe (i) expects shipments and rates to increase in Q3 d. strength coming from autos and appliances (i) building / construction still weak 3. other steel producers reporting uptick a. uptick in construction of roads and buildings (i) India, Russia and Eastern Europe b. no uptick if steel production is for construction E. Auto Industry is Picking Up -- Cash for Clunkers Car Sales 1. 15 - 33% of volume is coming from this program a. car dealers had highest weekly sales in two years 2. used the $1 billion in one week a. getting approval for $2 billion more b. of course, Germany (1/3 of our size) used $7 billion 3. GM and GMAC are also starting to provide leases again (Aug. 1) a. 20% of new car sales b. resale values are firming up -- crucial for residual values 10
  11. 11. F. Financial Markets Have Turned Up 1. S&P 500 S&P 2. IPO market is showing some signs of life a. KKR is underwriting Dollar General (i) growing from 8,362 to 8,900 stores (A) not sure what that says… b. four other IPOs coming soon (i) Avago Technologies -- $540MM (ii) Emdeon -- $333MM (iii) Cumberland Pharmaceuticals -- $105MM (iv) CDC Software -- $62MM c. in July, only one IPO 3. yield on long term treasuries LT TREASURIES a. UST yield = real rate + expected inflation (i) shows expected growth in GDP and inflation b. might also show reduced risk premium (i) investors sold bonds and bought stocks (A) selling pushes up yields 4. the yield curve is becoming more normal YIELD CURVE a. single best predictor of economy (i) shows growth and inflation expectations (ii) banks borrow s/t and loan l/t 5. credit spreads are shrinking 11
  12. 12. 5. credit spreads are shrinking a. average junk-rated bond is no longer distressed (i) distressed is 10 points above UST (ii) yields have dropped from 21.8% in December (A) 12.3% in July (1) average 10.7% b. spread between investment grade and UST cut in half (i) from 6% to 3% SPREADS c. comments by Moody's Chairman and CEO (i) Q2 results "reflect some improvement in credit market activity" (A) of course, same guys who gave AAA ratings for CDOs 6. LIBOR has dropped LIBOR a. shows banks are willing to lend to other banks (i) part is nothing bad has happened (ii) belief gov't won't let anything happen… (A) after Lehman b. LIBOR vs Fed Funds rate Ted Spread (i) spread approaching .25% (ii) Greenspan said this would evidence end of trouble 7. leveraged loan market has improvedLeveraged Loan Slide 8. slight signs of "animal spirits" 12
  13. 13. 8. slight signs of "animal spirits" a. falling dollar shows risk tolerance EXCHANGE RATES b. huge demand for leveraged ETFs (i) we never learn! c. demand for gold is lessening (i) recently had friend tell me that some of his friends were burying gold (A) asked if I was doing that (B) told him no (1) I spend time trying to figure out where your friends buried gold IF YOU THINK OF THESE AS SIGNS OF FIN'L STRESS, THEY SEEM TO BE GONE DON'T FORGET: WE HAD ALL THE INGREDIENTS OF A FIN'L STORM 1. large shifts in asset prices a. measure stock and bond returns 2. an abrupt increase in risk / uncertainty a. stock and currency volatility 3. abrupt shifts in liquidity a. TED spreads 4. health of banking system a. beta of banking sector b. yield curve 13
  14. 14. G. Housing 1. sales of new homes rose for three consecutive months a. increased 11% last month b. but…sales are ~50% below 2006 2. sales of existing homes rose for three consecutive months a. but…annual pace is 30% lower than 2006 b. talk about other problems later 3. median prices up 10% from low 4. housing starts were up in June a. builder sentiment increased in June (i) although still at record lows 5. Case-Shiller index rose .5% for the three month period ending May a. first increase after 34 months CS 1 AND 2 b. home prices remained down 17% YOY c. strongest gains were in Cleveland (4.1%) (i) the problem is that while prices went up… (A) you still live in Cleveland 6. conditions are right for home sales to improve a. low mortgage rates b. $8,000 federal income tax credit for first time buyers c. FHA financing with 3.5% down 14
  15. 15. H. Labor Markets WEEKLY INSURANCE 1. monthly average of weekly initial unemployment insurance claims a. seen as best single indicator b. number of US workers filing new claims rose last week, but well below peak (i) rose by 25,000 to 584,000 (ii) four week average is 559,000 (A) lowest level since January 24 (iii) continuing claims fell by 54K to 6.197MM (A) lowest since April 11 c. again, we've bottomed… (i) but the labor market is sick right now 15
  16. 16. I. Other 1. Leading Economic Indicators has turned up a. interest rate spread LEI b. building permits c. stock prices d. weekly initial claims (inverted) e. average weekly manufacturing hours f. index of supplier deliveres g. manufacturers new orders for consumer goods h. real money supply i. manufactueres new orders for nondefense capital goods j. index of consumer expectations 2. 3 month moving average of ADS Business Conditions Index ADS a. weekly initial jobless claims b. monthly payroll employment c. industrial production d. personal income e. manufacturing and trade sales f. qtrly real GDP avg weight is zero in last two recessions, never dropped below -2 3. 3 month moving average of Chicago Fed's National Activity index CHICAGO a. weighted average of 85 monthly indicators (i) national economic activity b. average value of zero (i) standard deviation of one 16
  17. 17. 4. microchip manufacturers say they've bottomed 5. dry shipping rates a. Baltic Dry Index (i) dropped 94% from peak to 22 year low in December (ii) up five fold since then (A) much of this is China and iron ore 6. copper has turned up -- 17% increase in last three weeks of July a. demand from China b. still no demand from US housing market Final Thoughts on "Bottom" or Trough a. doesn't mean we're out of recession (i) means things have stopped getting worse (A) rate of change has slowed b. realize that going from losing 700K jobs to 500K is improvement (i) but we're not growing c. because we're in such a deep recession… (i) the time gap to actual growth will be longer than normal 17
  18. 18. A. Consumer spending (70% of GDP) is unlikely to have a rapid recovery. 1. consumer confidence is weak a. Conference Board consumer confidence (i) fell from 49.3 in June to 46.6 in July (ii) 60% expect high unemployment to persist b. University of Michigan survey also turned down Sentiment 2. consumers continue to "trade down" a. Grocery stores that have not lowered prices are getting killed (i) Supervalue earnings dropped 30% (A) customers won't buy undiscounted foods (ii) Stop&Shop and Giant-Landover have seen increase in sales (A) aggressively reduced prices (iii) now, 1 in 3 shoppers only buys items that are on sale (A) it was 1 in 6 eighteen months ago b. Luxury retailer Coach is buying lower cost handbags (i) CEO Lew Frankfort believes that consumer spending won't return to pre-recession levels 3. securitization has dropped precipitously 18
  19. 19. 4. individuals feel the need to save SAVING a. we've wanted people to save for a long time (i) but this has been our growth engine (ii) is this a long term change? 5. individuals are borrowing less CONSUMER CREDIT a. hard to know if this is: (i) consumer decision (ii) bank choice b. maybe shows that they are just relying on credit less deleveraging 19
  20. 20. B. Business spending will be slow to recover. 1. capital expenditures are declining Cap Ex a. earnings are down b. sales are dropping c. businesses are pessimistic about future 2. real interest rates are high Real Rates 3. we've seen inventory drawdown… Inventory to Sales a. but it might take a long time before b. there is need to build up again 4. if consumer is weak and businesses are weak, how strong will the recovery be? 20
  21. 21. C. The housing marke is far from healthy. 1. approximately 21.9% of homeowners are under water a. 17.6% under water at end of Q4 b. a significant percentage of these will default c. this will push prices down further d. people forget the importance of housing… (i) largest investment for most people (ii) when you have 20% equity and prices drop 20% (A) you've lost everything e. mortgage rates could be headed up (if believe thesis) Mortg rate (i) fewer buyers will qualify (ii) more expensive to refinance 2. home foreclosure prevention program isn't working a. hope to help 3 - 4 million (i) 200,000 have rec'd trial modification b. must have liquid reserves of less than 3 months of mortgage pmts (i) and a few hundred dollars or les at end of month c. multiple problems (i) some people are being told they must fall behind first (ii) others are having to wait too long (iii) home equity loans often owned by different party than mortgage (iv) no help for option-ARMs (v) huge incentives for mortgage servicers 21
  22. 22. 3. June's 11% surge in new home sales was misleading New Home Sales a. sales often have big jumps in June b. better comparison: down 21% from last June c. the 36,000 units sold in June is the lowest June total since 1982 d. high sales resulted from discounting (i) 12% lower than last year (ii) lowest June price since 2003 4. existing home sales were also misleading a. fewer home sales in March through May were distressed (i) 33% of May sales (ii) 31% of June sales (iii) down from 50% earlier this year (A) banks' moratorium on foreclosures ended in March b. distressed = foreclosure or short sale 5. there is a huge inventory overhang Home Inventory a. many homeowners want to sell… (i) but have not put house on market (ii) more homes are being rented Rent b. tremendous increase in vacant homes for sale Vacant 22
  23. 23. D. Commercial Real Estate 1. commercial property prices are down 35% since October 2007 2. estimates are for defaults and late payments on CMBS to reach 7% this year a. occupancies are dropping b. rents are falling c. there is no ability to refinance 3. defaults and delinquencies were 2.99% in Q2 a. increase from 1.8% in Q1 b. .66% one year ago 4. CMBS market is $700 billion a. 22% of nation's $3.4 trillion of commercial real estate debt 5. loans made in 2005 and 2006 have the highest amount of problems a. loans were made at peak 6. $1.3 trillion of properties bought or refinanced 2004 or later are worth less than loan 7. market is pretty much locked right now… a. buyers want fully occupied properties b. sellers only want to sell distressed properties 23
  24. 24. E. We're seeing signs of weakness in the Treasury market. 1. issuing huge amounts of debt a. last week, we issued $200 billion of debt (i) through July, issued $1.15 trillion (A) $434 billion (2008) (B) $350 billion (2007) 2. need foreign governments to support auctions a. can only sell short term debt b. we've seen large indirect bids in a few auctions (7 yr last week) (i) strikes me as a coordinated effort (A) to eliminate fear 3. China continues to jawbone about the deficit and the value of the dollar a. 2/3 of their $2 trillion of reserves are in dollar denominated assets (i) including more than $800 billion in Treasuries b. China (and others) may stop buying our debt 4. hard to find buyers when there is stock market rally a. easier to sell Treasuries when people are risk averse 24
  25. 25. 5. Treasury debt had poor demand last week a. sold record $39 billion in five year notes on Wednesday (i) on heels of $42 billion of two year notes on Tuesday (A) both had less demand than normal (ii) five year yields increased from 2.63 to 2.70 b. foreign gov'ts are passing on long term debt (i) this tells you something (ii) indirect bids were 36.7% of five year note (A) near typical average of last year (B) but far below 62.8% of last five year note (C ) five year auction was horrible (iii) China seems to not be participating in auctions (iv) coverage (A) 2.75 for two year (B) 1.92 for five year (v) strong interest in $28 billion of 7 yr notes (Thursday) (A) indirect bids came in strong…interesting 6. our borrowing costs are going to increase a. will increase our deficit more… 25
  26. 26. F. We face great uncertainty with inflation / deflation. 1. Tremendous increase in the monetary base Monetary Base a. since Aug. 2008, monetary base has more than doubled (i) to $1.7 trillion b. could expand more as Fed buys UST and MBS (i) trying to stop expansion of money supply… (A) by paying interest on reserves (B) may let Fed issue debt a. Our ability to control inflation is untested. (i) we are in unchartered territory 2. can you imagine the pressure Bernanke will face when he tries to raise rates 3. the factors that drove dis-inflation are disappearing a. inflation expectations have increased and could jump (i) there is a plausible story that could catch a lot of press b. deregulation is going away c. good monetary policy and confidence in this policy 26
  27. 27. 4. a few thoughts on inflation a. when labor markets recover, higher level employees will do everything (i) higher level employees will do everything they can… (A) to recover lost wealth b. a shock to the value of the dollar (i) could increase importance of exchange rates… (A) as iport prices rise c. inflation expectations could quickly changeExpec 1 and 2 (i) we could see a quick change in the pace of price increases d. protectionism could diminish our ability to import from low-cost countries e. fiscal policy has lost all restraint Fiscal Policy f. we thought that we understood the economy better than we actually did 5. bottom line: a. we've seen what happens with deflation…see the housing market a. the housing market b. if we have inflation a. Fed will need to slow economy c. because of combination of factors: a. deep recession b. huge increase in monetary base …we have much more variability in process that means we have more risk 27.1
  28. 28. G. The Fed is losing its independence and this creates great risk for monetary policy 1. Bernanke spends half of his days testifying 2. Congress suggesting GAO audit of monetary policy 3. uncertainty over whether Bernanke will be reappointed a. can we stand more uncertainty b. does this mean we have no choice 4. Fed's enhanced regulatory responsibilities… may take away from monetary policy per Philadelphia Fed President Charles Plosser 5. tremendous political pressure when Fed tries to raise rates 28
  29. 29. H. Markets seem to be euphoric right now…how long can it last? 1. stock market is up 40% from its bottom a. we're not going to get another 40% b. Companies are beating expectations simply by cutting costs (i) 82% have beaten estimates (ii) only 50% have beaten sales targets (A) need sales to increase to grow again 2. we're seeing rampant speculation a. Leveraged ETFs account for roughly 5% of US equity volume 3. emerging markets may be re-bubbling a. investors put $35.5 billion in emerging mkt stock funds in 1H b. investors withdrew $61 billion from developed markets in 1H c. MSCI Barra Emerging Markets index +45% in first 7 months (i) Shanghai Composite Index is up 85% 29
  30. 30. 4. distrust of markets a. algorithmic trading and flash trading (i) Sen. Schumer told SEC to stop this b. CFTC issued a report saying speculators played big role in oil price swings (i) oil indexes have $300 billion in July 2008 (A) 4X what they had in 2006 (ii) CFTC Chairman says we need to seriously consider strict limits on energy traders c. SEC is going to start protecting against short sales by posting data from prior month! 5. muni market is in for more pain a. Ambac's bond insurance unit was dropped from BBB to CC (i) significant deterioration in the company's insured portfolio of RMBS b. states are having budget problems (i) at least 10 states are projecting budget gaps of more than $3 billion (A) on top of $139.2 billion in shortfalls from before July 1 (B) California has $24 billion shortfall (ii) other examples (A) Pennsylvania going without paycheck (B) Georgia mowing less (C ) Arizona is selling House and Senate buildings (1) at least now it's in the open… (iii) going to see some large tax increases 30
  31. 31. I. The employment situation is horrible and it's worsening! 1. the unemployment rate has increased to 9.5% Unemployment Rate a. jobless rates in 372 metropolitan areas rose from a year ago b. 18 had rates of at least 15% employers have been cutting 500K jobs per month this year Change in Nonfarm Payrolls 2. we are headed well over 10% Unemp and Job Openings a. we're losing 400K jobs per month b. need 100K - 200K jobs per month c. average weekly job hours is at all-time low Avg Weekly Job Hours 3. the more inclusive unemployment rate is close to 17% a. include people who have accepted p/t work b. include people who are too discouraged to look Discouraged Workers 31
  32. 32. 4. we could have a jobless recovery a. Bernanke says 1% growth expected in 2H of 2009 (i) said that wouldn't bring down unemployment b. it's going to take a lot to get people back to work (i) job losses have been much steeper than prior recessions (ii) paychecks more important when consumers won't take on more debt (iii) as the workforce grows 1% per year and productivity grows 2%... we need 3% to maintain employment c. tremendous number of people in total pain Duration 5. With unemployment increasing 5%, how could the economy not slow 6. there is a possibility of a nasty feedback loop… a. further sales drops… (i) could lead to more job cuts… (A) could lead to more losses on consumer debt… 32
  33. 33. J. Banks are not helping the recovery. Background banks are incredibly procyclical overextend balance sheets based on higher asset values reducing perceived risk fostering more lending then deleveraging starts banks reduce lending as bank capital falls prompts slowdown 1. Recessions are more severe when preceded by financial distress a. economic output loss tends to be 2x - 3x greater b. recovery takes 2x - 4x as long Other factors make the risk greater 1. how much home prices appreciated prior to crisis a. individuals more exposed to decrease in asset price b. lack of credit results in home prices dropping 2. aggregate credit rise prior to crisis a. greater reliance on external financing creates risk b. firms and individuals more dependent on external financing (i) see large change in spending 33
  34. 34. 2. Industrialized nations have provided less than half the support… a. that they pledged to prop up fin'l sector (per IMF) (i) injected $425 billion (A) 42.3% of promise (ii) spent $333 billion to purchase assets (A) 18.4% of announced amount 3. banks are not lending C&I Loans a. total loans held by 15 largest banks shrank 2.8% in Q2 (i) hold 47% of federally insured deposits (ii) received $182.5 billion in TARP money (iii) had $4.2 trillion of loans (A) down from $4.3 trillion b. more than half loan volume in April and May was: (i) refinancing mortgages (ii) refinancing businesses (iii) not new loans c. banks are preserving capital for losses d. loan demand is also falling (i) companies eliminating expansion plans (ii) consumers trim spending e. Beige book indicated banks are continuing to tighten lending standards Fed Loan Survey 34
  35. 35. 4. bank earnings are being subsidized right now a. saving $24 billion in borrowing costs (on $238 billion of debt) (i) FDIC's Term Liquidity Guarantee Program b. eight largest saved $2.2 billion in Q2 (i) C saved $600MM (A) on $44.6 B in debt (B) 14% of Q2 profits (ii) GS saved $205.5MM (A) why are we subsidizing company that is able to (B) pay $11B of bonus in 1H (C ) in total will save $754MM (iii) JPM $3.1 billion ($246MM / qtr) (iv) FDIC has collected $6.9 billion in fees 5. Too big to fail has led to even bigger banks (and more risk) a. BAC b. WFC 6,668 branches after taking over Wachovia c. JPM has 5,100 branches after taking over WM 6. US credit card bad debt is rising faster than unemployment CC Delinquencies a. annualized write-offs of securitized credit card debt hit record 10.8% in June (i) Moody's expects it to hit 12% - 13% in mid-2010 b. chart includes, AMEX, BAC, C, Capital One, Chase and Discover (i) increased savings, less spending probably explains downturn 35
  36. 36. 7. Leveraged loan index is slightly higher than right before Lehman collapsed a. but huge disparity (i) BB- or higher has risen 2% during this period (ii) CCC loans are off 22% b. B and CCC loans have had best return this year -- up 65% 36
  37. 37. 8. long term disparity in wealth and income has led to anger towards banks a. Senate panel has subpoenad fin'l institutions (i) looking for fraud in mortgage meltdown (ii) did they express private doubts b. House voted to allow regulators… (i) to bar banks from offering executive compensation… (A) that encourages too much risk c. Cuomo -- huge bonuses to TARP recipients (i) many paid out more than their profits for year (ii) GS earned $2.3 billion and paid out $4.8 billion (A) $10 billion in TARP (B) 212 people got more than $3 million (iii) JPM had 1,626 people get $1MM (iv) Nine banks that received gov't aid paid out $33 billion in bonuses. (A) more than 5,000 people received $1MM (B) $33 billion is 1/3 larger than California's budget deficit (C ) six of the nine banks paid out more in bonues than they earned in profit (D) one in every 270 employees received $1MM (1)what risk are they taking? (E) compensation and benefits at the bank fell 11% (F) the nine firms lost $100 billion (G) gov't injected $175 billion into these banks (v) bonus furor continues (A) GS has set aside $11 billion and MS $6 billion (B) MS lost money for the 3rd straight quarter (C ) C has Andrew Hall -- $100MM 37
  38. 38. 9. Fannie and Freddie are unlikely to be able to repay gov't in full a. gov't agreed to pump $200 billion into each b. used these entities to institute programs c. Fannie and Freddie guarantee $5.4 trillion of mortgages Remember: tight credit markets cut both ways for factors: they can't get funding businesses need factors 38
  39. 39. K. There is growing frustration with government plans. 1. regulation is becoming excessive a. pay czar is perfect example (i) seven banks and industrial companies must… (A) submit proposals for compensation packages (B) C, BAC, AIG, GM, Chrysler, Chrysler Fin'l, GMAC (ii) Kenneth Feinberg oversees comp of top 100 employees (iii) will it be hard to lure talent (A) can't limit comp at some companies and not others (iv) if someone has a contract that overpays them this year… (A) it will be subtracted next year (1) we'll see massive outflow (v) bonuses can be no more than 1/3 of total compensation (A) and payable only in preferred stock (1) per TARP 2. public is questioning the stimulus plan (and the government) a. GDP numbers are crucial b. it takes longer than a few weeks to put together an $800 billion plan (i) the Administration says spending is by definition stimulative (ii) so is flying over the country and randomly dropping $800 billion 39
  40. 40. 3. Cash for Clunkers is a temporary effect referring to buying Amer cars a. we allocated $1 billion and it was gone in a week (i) on the average car, we're saying 20% off b. may simply be speeding up purchases (i) program ends November 1 c. typical government program (i) 136 page instruction manual d. good example of unintended consequences (i) junkyards not prepared for all of these cars 40
  41. 41. 4. more spending in future -- healthcare a. proposals: (i) tax most expensive policies worth more than $25K (A) is demand inelastic (B) will this not be passed on (C ) idea is to save $180 billion (ii) surtax on wealthiest (A) House -- tax anyone making more than $350K (B) Obama -- $1MM b. there's no question we have a problem: (i) 71% of Americans employed by private industry had access to employer sponsored health benefits (ii) just 25% of the people in the lowest 10% of wages have insurance c. 42% think Obama's health care plan is a bad idea (i) 36% think it's a good idea (ii) numbers were even -- one month ago (iii) people with private insurance really dislike the idea d. healthcare will cost $1 trillion over next 10 years but we can't afford what we've already promised e. some of my favorite things about the healthcare debate: (i) one proposal says can't charge older people more (A) should life insurance cost the same (ii) while insurers would get many new customers, they don't want public competition scares the hell out of me when you're afraid to compete with the gov't f. companies will have to put 8% of payroll towards health insurance (i) I'd rather hire a star than two people (ii) 46 million people are uninsured g. GS execs have $40K health plans -- taxing high priced health insurance is known as the GS tax 41
  42. 42. 5. BUT DON'T WORRY… cabinet found $102MM of savings .006% of deficit double sided photocopying not repainting vehicles delete unused email accounts 42

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