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Consumers, Credit and Complications


Economy worsening still.


The evidence continues to mount that the US is in a recession. In this week's column, we will look at the blind spot in the unemployment statistics, the continuing meltdown in the credit markets, and the simply awful service sector implosion in the ISM data, and then add a few thoughts on the housing market. There is a lot of data to cover, so this week's letter should be particularly interesting.

But first, we are finalizing the speakers for my annual Strategic Investment Conference (co-hosted with my partners Altegris Investments) in La Jolla, April 10-12. I am extremely happy that Minyanville Professor Greg Weldon has been able to clear his schedule to attend. Greg is one of my favorite analysts, with his uncanny ability to tease the most important facts out of the fog of data we are deluged with each week. He has been on top of the whole credit crisis for as long as anyone, and his thoughts on what is coming next will be valuable. Greg joins Paul McCulley of Pimco, Don Coxe of BMO (two of my favorite economists anywhere, and simply brilliant speakers), Rob Arnott, George Friedman of Stratfor, as well as your humble analyst and a dozen hedge fund managers who will show you how they navigate in these troubled waters. By the way, George's new book should be at the conference ahead of the bookstores. He will be writing on how the geopolitical world will change over the coming century. I have read a rough copy, and it is fascinating.

The conference is limited to those with a net worth of over $2,000,000, due to regulatory requirements. I simply hate to put limits like that, but rules are rules. You must register here and subscribe, someone from Altegris Investments will call you (again, a regulatory requirement), and send you the detailed invitation about the 2008 conference, including a link to past and current conference speakers and details.

Unemployment is Understated

For the first time since August of 2003 we had a drop in the employment number. Employment fell 17,000 in January. The BLS also released its benchmark revision with the January report. The year ended with 376,000 fewer jobs than were reported a month ago, and 1.14 million net jobs were created December to December. Downward revisions were spread throughout the year. This translates into 95,000 new jobs per month, down from 175,000 in 2006. Remember, it takes 150,000 jobs per month (or so) simply to maintain the employment rate, due to growth in the population. The January loss is likely to be revised down over the next year. The median duration of unemployment also rose from 8.4 months to 8.8 months. The trend is most definitely not your friend.

Chart from

Two weeks ago jobless claims rose almost 20%, to 378,000. Last week they came in at 356,000. These last two weeks represent a marked increase in initial unemployment claims but, as many bulls point out, that number is nowhere near the levels that would indicate a recession.

As I have explained in numerous letters, the jobs report put out by the Bureau of Labor Statistics can be misleading both when the economy is coming out of a recession and when it is going into one. It tends to underestimate the number of jobs as the economy is recovering and overestimate the number when the economy is slowing down. That's because the data is basically trend-following. A year later, better data comes in and the numbers are revised, as they were this month. But those revisions are basically stuck on page 16 in fine print in the Wall Street Journal. Who cares about year-old data, except economists?

The problem is, if we're in recession we should be seeing a higher initial unemployment claims number. The "we are not in a recession camp" is absolutely correct about that. And yes, we've seen a marked rise in continuing claims the last two weeks, but not as high as one would think to be the case if we were in a recession. Yet continuing claims are up by 10%, which based on the past would suggest we are in a recession. So why the seeming disconnect?

An answer comes from David Rosenberg, the North American economist for Merrill Lynch, who points out that jobless claims number may be suspect. Let's look at what he says in his recent analysis:

"First, the jobless claims are being distorted right now because the seasonal factors are looking for retail sector layoffs in January but these layoffs are not happening because there was no hiring in November and December. So the seasonal factors are depressing the claims data to the downside right now - look for them to hook up in coming weeks. But anyone putting their faith in claims in January given all the early-year distortions ... good luck. No mention made, by the way, that the backlog of continuing claims has spiked up 10% over the past year and the last time that happened, well, was in late December 2000 - the recession began the very next quarter.

Second, the focus on payrolls at this stage of the cycle is fraught with risk. In 90% of the business cycle, the payroll survey is the one to focus on, given its lack of volatility and huge sample size. But the 10% of the time when the payroll survey does not work well is at turning points in the business cycle. Why? Because being a poll of companies, what the payroll number misses are the self-employed and there are more than 10 million of them.

Click to enlarge

So the bottom line is that what the payroll data have missed is the fact that over the past six months, 520,000 self-employed individuals have fallen by the wayside (more than were lost in the entire 2001 recession). This may also be why it is that claims are suppressed - having never paid into the unemployment insurance program, these people are not necessarily entitled to any benefits. The population- and payroll-concept adjusted data show that employment fell 400,000 in November-December combined (because Thanksgiving landed so late in 2007, both months have to be looked at together, whether it be for jobs or retail sales). So we think the view that job growth is hanging in is, just in plain simple language, wrong."

Look for unemployment to rise to 6% (or more) in the coming quarters. This will of course put a damper on consumer spending.

The Credit Crisis is Simply Getting Worse

Goldman Sachs CFO David Viniar warned yesterday that some key mortgage bond insurers could collapse. Viniar, speaking at a CSFB conference, said credit markets are trading as if we are in a "worst recession"; and there is a "total disconnect between the equities market and the credit market." (The Bill King Report)

There was a convention this week in Las Vegas of the American Securitization Forum. I talked to good friend Michael Lewitt who attended the conference, and he said the mood was simply dismal. The credit markets have gone from bad to worse. There's almost no trading being done in the $2 trillion Collateralized Debt Obligation (CDO) markets. Perfectly good bank loans are trading at discounts of between 10-20% to par, in addition to much higher and wider spreads. There are a lot of opportunities for intrepid investors who can distinguish solid value, as funds, banks, and pensions are having to unload loans without regard to value. It is a buyer's market. Let's take a look at a few graphs from

This first one is an index of asset-backed paper, mostly mortgage-backed. This is the BBB-rated paper issued last year. It is trading at an 86% discount. This pays a coupon of 3.89%, so it is yielding almost 30% if you are looking for yield. (For the four people who might be tempted to do that let me point out that was a joke.)

Click to enlarge

I should also point out that this index is composed of bonds and trusts put together by some of the biggest names in the investment banking world less than one year ago. One year ago these banks sold these bonds as investments worth 100 cents on the dollar. Cue lawyers. I was recently sent a link to a conference that will be held in New York next month. It is basically for people who are interested in litigation over the subprime and credit mess.

Look at some of the topics:

"Look inside the mortgage industry, its underwriting, risk analysis procedures and loan approval technology...Get up-to-date on who is suing whom and the status of the recent wave of securities complaints ... Learn the key elements necessary for proving or disproving fraud and negligent misrepresentation ... Find out what to look for when it comes to disclosures, disclaimers and limitations on standing ... Learn the role played by rating agencies, insurers and the feds ... Acquire the skills necessary to successfully prosecute or defend mortgage-backed securities suits."

This is going to take years to sort through.

I wrote in late 2006 that the housing and subprime crisis was going to result in massive litigation. The lawyers will be looking at every deep pocket to see what they can get for their clients who lost money. I can guarantee you the rating agencies are in the crosshairs of hordes of attorneys from around the world. (If you are interested in the conference you can go here.)

The Falling Knife of Credit Spreads

Let's talk about credit spreads for a moment. The "spread" is the difference you pay, typically over LIBOR (or the London InterBank Offered Rate). LIBOR is the most important interest rate in the world, as massive amounts of debt are set according to it. Let's say you are an AAA-rated borrower. Last summer you might have been paying as little as 3.84 basis points over LIBOR. If LIBOR was at 5%, you would be paying 5.0384%. There was very little premium for what was considered risk-free money.

Today you are paying as much as 1.89% more. Granted, 3-month LIBOR is now at 3.10, down 2.16% over the last six months, due to aggressive Fed, Bank of England, and ECB (European Central Bank) action. Thus your net cost of funding is the same, but only if you are AAA. There are actually very few AAA borrowers in the world. Let's look at how your costs may have risen if you are still barely investment-grade at BBB.

Now you have a problem. Your costs may have risen from a mere 1.45% over LIBOR to as much as 13%! The spread on some junk bonds is running as much as 18%! (All this data can be had at This is a credit market that is in serious trouble. No one wants to lend unless they can be sure of getting repaid, so the price of risk is rising rapidly.

Interestingly, there are many who actually benefit. For example, I am involved with some hedge funds in Europe that use modest leverage. We borrow at a fixed rate over LIBOR. Our spread has actually done down, as well as actual LIBOR going down. So we are well ahead of where we were last summer in terms of borrowing costs. It is an ill wind that blows no good to at least someone. Those borrowers with solid balance sheets find their costs going down.

Continued on Page 2

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