Tuesday

Part 10 - GM and Chrysler plans

The Auto Industry
As nearly everyone expected, GM and Chrysler have increased their requests for government funding.

Also, unsurprisingly, they have reduced their future market size estimates from their earlier optimistic estimates provided in December 2008, only two months ago.

The top chart here is for GM and the bottom one is from Chrysler.

In early November, 2008 I commented; "It is certain that 2009 will be worse than 2008. If 2009 was to average 900,000 vehicles per month, i.e. 60,000 a month higher than October 2008 sales, total sales for 2009 would be 10.8m, a further fall of 20% on 2008 sales and a reduction of 40% in two years."

In December, the auto company estimates were;
North American auto capacity as projected in 2006, compared to sales
Year ----- Capacity ---- Sales ------ Over Capacity -- Proj -- CHR --- GM --- Ford
2006 ----- 18.82m --- 16.55m ----- 2.27m --- 13.7%
2007 ----- 18.95m --- 16.14m ----- 2.81m --- 17.4%
2008 ----- 19.23m --- 13.00m ----- 7.23m --- 47.9%
2009 ----- 18.76m ----- 11.87m ----- 6.16m --- 58.0% ----- 11.1m - 12.0m - 12.5m
2010 ----- 18.70m --- 13.37m ----- 4.20m --- 39.9% ----- 12.1m - 13.7m - 14.5m
2011 ------- n/a ------- 14.57m ------ n/a ------- n/a ----- 13.7m - 14.5m - 15.5m
2012-------- n/a ------- 14.35m ------ n/a ------- n/a ----- 13.7m - 15.0m -- n/a

Now in February, GM has reduced its baseline total market sales for 2009 from 12.0m to 10.5m, very close to the 10.8m figure I used in early November.

Chrysler has reduced its total market sales for 2009 from 11.1m to 10.1m, which now seems more reasonable.

However, although the revised total market sales are now more realistic, they show how much worse the situation is than that previously projected. This chart shows how dramatic is the fall in SAAR (Seasonally Adjusted Annual Rate) of auto sales.

The Chrysler presentation is very glossy and gives the impression that it is a slick sell. I am always suspicious of glossy presentations. I always feel they are concealing problems and trying to paint things as better than they really are.

The GM presentation is more workmanlike, although neither seem to have come up with plans drastic enough for their present situation.

This chart shows total auto and light truck sales from 1964 to 2008. The consumer bubble in recent years is apparent.

Also worth noting are the 1987 and 1988 figures. Many people remember the stockmarket crash of 1987, but it had very little immediate effect on total auto sales. The 9/11 caused no blip at all. That shows how this Great Recession is very different to 1987 and other recent events which might have been expected to affect total sales.

Thus that is not to say the auto companies are completely to blame for the total loss of consumer confidence. I have previously commented on the decline in value of consumer personal assets. The following table from the Chrysler plan shows the recent fall in the Dow and in house values.

This is the reason for the drop off in sales and sales will not recover until consumer confidence returns.

The majority of the population is against the cost of the stimulus package and fears the cost for the future.

Hence, if anything, I think the stimulus package as currently proposed will make consumers even more fearful for the future and they will save even more.

Part 9 below tells how the stimulus money could have been used to restore confidence to the consumer and the taxpayer.

Part 9 - The stimulus should buy equities

Well the stimulus package was signed to day! Also the GM, Ford, and Chrysler "Plans" are due today.

The Stockmarket has shown what it thinks of the package by almost breaking the November 2008 low.

As mentioned before, the major problem is a lack of consumer confidence in America and I do not think the stimulus will work. The Government is trying to stimulate growth by a lolly scramble. Lolly scrambles only stimulate consumption while they are being sucked and then there is nothing left for growth. The only real benefit attaches to the recipients of the 10%, or $80 billion, which will be pocketed by ticket clippers as the money is spent.

The section of the economy on continuing on welfare benefits have been about the only group unaffected by the Great Recession of 2008-2010.

Apart from this group, all other sectors of the US economy have seen their wealth eroded by 25% or more and many have lost their jobs, due to the consequent lack of consumer confidence and demand.

The $US has risen a great deal while consumer confidence has fallen. That shows a strong dollar does not generate consumer confidence.

Interest rates have fallen, but that has not worked to improve confidence either, not house prices.

The Dow has collapsed and reportedly, there is a vast amount of potential investment money waiting on the stockmarket sidelines for the market to turn upwards.

If I were President, I would not reduce taxes. The tax reductions are not enough per person to grow consumer confidence, given the amounts of their individual losses.

The President and Congress will not have the courage to do so, but I believe there is one easy way to restore US consumer confidence.

The most easily seen bell-weather for the US economy for everyone is the Dow Jones Industrial Index. Regardless of one's opinion on capitalism, and rightly or wrongly, every investor and saver is influenced by the Dow and so it affects their confidence and attitude towards the future, or their pessimism about the future.

Thus, I would carefully spend the $800 billion on selected equities via a USA Sovereign Fund. Ten things would happen.

1. All stock prices would rise from the selected extra buying, on the rule that a rising tide raises all boats.

2. It would encourage other investors off the sidelines, who did not want to miss the recovery. This would compound the positive effect on the Dow.

3. The sellers of the stocks bought by the Fund, would need to find other investments for their money and so help prime the economic pump.

4. Consumer confidence would rise as the Dow rose and retirement savings regained in value.

5. Increased consumer confidence would raise house prices and reduce the need for foreclosures.

6. Increased consumer confidence would raise consumer spending and create jobs.

7. The recovery would be much faster than the proposed drip-feed stimulus package.

8. An improved economy would increase the tax take for states and help their funding.

9. The US Government would make huge investment gains on a gradual sale of the investment, in say three to five years time.

10. The investment gains would likely balance the current Federal budget deficit.

This proposed investment action is an expansion of the comments in my Five Point Plan in Part 8, which included a recommendation for a US Sovereign Fund.

Wednesday

Part 8 - Stimulus, autos, and museums

The Stimulus
The proposed package is currently being debated in the Senate. From the list of items in it, I fail to see how it can work. As mentioned in previous posts, the problem is that virtually everyone in the developed world, say one billion people, has lost confidence and/or been directly affected by loss of wealth, and there will be a flow on to less-developed countries.

I heard the other day, a reference to world wide losses of $30 trillion. I take that to mean total falls in equities, home values, commercial property, and other assets. The sum is enormous, but spread over one billion people, it is about $30,000 each, or at 2.5 people per family, it amounts to say $75,000 per household. That seems a reasonable approximation.

The percentage reduction in personal wealth per household is hard to determine, but could well be 20% or 25% for a family, say as an example, from $300,000 to $230,000. That has set those people back five, ten, or more years in their wealth accumulation. A stimulus package averaging less than $1000 per family will not fix that.

The proposed stimulus appears to be focused on a multitude of specific projects, rather than the general population. It is the general population that needs its confidence restored. Little other than time will heal that confidence, it will only happen as people adjust to their lower levels of personal wealth.

The stimulus, does not appear to be part of a long term plan. A longer term plan is needed. In an effort to be proactive, I repeat the Five Point Plan I proposed last November, which I would adopt instead of the proposed stimulus package [together with some updated comments]. It is still valid.

A Five Point Plan
Point 1 The US Government should announce that from January 1, 2010 Fannie and Freddie will no longer provide government backed mortgage finance, with their existing portfolios being run off over time. [Things are now worse, the objective is still valid, but the withdrawal could be progressive over three years from January 1, 2010]

Reason - There is no long term economic reason for government to provide this funding. Under Capitalism the market will find a way to service this market. Traditional banks and other lenders will assess the risks, then increase their home mortgage lending. They will charge sufficient for the risk. Non-recourse loans will tend to disappear. The market will become much more fragmented and less risky.

Point 2 The Government should institute an energy levy of say, $20 per barrel of oil, both locally produced and imported, and an equivalent tax calculation for natural gas. [to make it fiscally neutral this could be combined with point 3]

Reason - To provide funding for energy research and investment, and to encourage the population to use more efficient use of energy, whether for heating, or for more fuel efficient means of transport, cars, planes, buses, trains, or feet. Adding $20 to the current $60 per barrel, this would still be some $65 less than the peak price of $147 reached earlier this year. While that peak is still fresh in consumer's minds now is the ideal time to reinforce it.

Point 3 The Government should institute a 10% sales tax across the board on everything except financial transactions as many countries have with VAT or similar taxes. The VAT should be made overall fiscally neutral, by increasing benefits or lowering taxes for "95%" of the population. [If any overall stimulus is desired, it should be here, via a change from neutral to positive to consumers]

Reason - The tax would help discourage wasteful consumption. Net savers would benefit and lavish spenders would be penalised. Such a tax is much simpler and more equitable if it applies to everything. In addition, much of the underground economy and illegal immigrants would be unable to avoid paying such a tax. Also, foreign tourists who visit the country would start paying a federal tax for the transport and other systems they use. Thus the tax would generate new sources of revenue.

Point 4 The auto industry and any other distressed industries should be encouraged by government to adopt the same strategy as was proposed at one stage for distressed banks i.e. each be divided into good bank/bad bank, or here into good auto company/bad auto company. [no change to the comment]

Reason - Parts of GM, Ford, and Chrysler must be profitable. If so, these would be put into the "good auto" companies and continue to trade. Being profitable, they would attract investors and allow new car buyers to have appropriate new vehicle warranties. The "bad auto" companies would be run as liquidations until their operations were completely closed down. The process has to be seen to be fair to other car manufacturers.

Point 5 - The Government should commence a "United States Sovereign Fund" for investments and to help provide for future welfare requirements for the ageing population. In the meantime, the fund would invest nationally and internationally, on commercial terms, in bonds, equities, and major infrastructure requirements, for example in nuclear power plants. [no change to the comment]

Reason - Welfare costs will need to be met for many people in the future. Funds released from the run down of Fannie and Freddie should be used as part of the fund, as would TARP assets, and other assets such as the AIG stake. It would also manage the energy tax receipts from Point 1.

Auto sales
January auto sales were 657,000, 37% down on January 2008. The graph prepared by Autodata shows the Seasonally Adjusted Annual Rate of sales. It is now down to 9.57 million. For more, see Green Car Congress: US LDV Sales Fall 37.1% in January; January ...

However, as can be seen most of the graph is still prior to September 2008, thus the SAAR rate is likely to continue to fall. There is little news from Detroit, but one cannot help thinking GM, Ford, and Chrysler should have changed their company names to; Titanic 1, Titanic 2, and Titanic 3.

Their customers are disembarking from them in droves, as they can see there is little chance of the companies avoiding the iceberg called 2009.

The best the three companies can hope is get their standby rescue vessels organised and ready for the impact. They are named; Chapter Eleven A, Chapter Eleven B, and Chapter Eleven C.

Museums
Perhaps as a sign of the Recession, even culture is being tossed out.

For example, Brandeis University trustees voted unanimously last week to close the Rose Art Museum on campus and sell all of its contents. Presumably as a result of heavy endowment fund equity losses. There had been no advance discussion with faculty, students, the museum's own board, or its director. The college said it needed money, and the museum's collection, all donated, of 7,180 works of art (many from the 1960s-70s) is said to be worth $350 million.

But why didn't the trustees sell just a few paintings to cover its $10 million shortfall? The American Association of Museums prohibits accredited museums like Rose from de-accessioning any art except to purchase new art. Brandeis avoids the prohibition by closing the museum, but perhaps the university could have worked out an agreement with the association.

This supports the views I expressed a year ago, when I wrote a piece about how museums needed to look to the Internet for visitors to survive and that smaller museums would close unless they looked to the Internet for visitors. The Recession is compounding their problems. My original comments can be seen at View

My belief is that museums which concentrate on 21C displays of what may loosely be called contemporary art with a view to competing with theme park entertainment, are sacrificing their heritage and they risk disappearing down a long Alice in Wonderland corridor ending only in smoke and mirrors.

I mentioned last year there were some signs of museums paying more attention to visitors, see the March 2008 NY Times report Museums Refine the Art of Listening - New York Times which echoes my February point about museums facing competition; "they’re competing for those customers with local shopping malls, movie theaters, even grocery stores."

The NY Times report also makes the following comment; "When the Museum of Modern Art opened its expanded $450 million home on West 53rd Street three years ago, the ticket desk began compiling the ZIP code or country of origin of every visitor, putting the information in a database. And at the Detroit Institute of Arts, officials recently discovered that the average visitor spends only four or five minutes in any gallery, rather than the 20 minutes the officials had expected. Only 7 percent bothered to read the wall plaques."

I would have to say, to record ZIP codes sounds a pretty half-hearted means of gathering useful data, and the 20 minutes sounds like a wild guess of how long a visitor would spend in a gallery.

Also from the same NY Times article; "A year and a half ago, the (MFA Boston) museum hired the marketing firm J.D. Power & Associates to try to understand what visitors want. “We found out that the No. 1 thing that gets people to the museum is our collection.” " The MFA sounded surprised at this conclusion!!

I think the Recession will cause many more small museums to shut their doors.

Thursday

Part 7 - More on Autos, Stimulus, and the TARP

January 15, 2009
Having been distracted by some unrelated research which has been very time consuming, I will now try and catch up with a few comments about the Great Recession of 2008 (and 2009!).

Auto Sales
First, to compare latest auto sales data with some of my earlier thoughts.

Back on November 17, I commented about 2009 auto sales; "If 2009 was to average 900,000 vehicles per month, i.e. 60,000 a month higher than October 2008 sales, total sales for 2009 would be 10.8m, a further fall of 20% on 2008 sales and a reduction of 40% in two years."

I repeated my prediction of 10.8m units for 2009 in December, with my personal pick "that December sales will be no better than November of 747,000. However, the total sales for 2008 may still just scrape over 13.00m".

December sales are now available. To me, they were surprisingly better than November at 895,000 although still down 35% on 2007.

Total 2008 sales were 13.24m, down from 16.15m in 2007, a fall of 18%. However, the fall of 18% does not tell the story, as sales were severely lower in the last quarter. In OND total sales were 2.48m units, an annual rate of 9.92m units, or an average of 827,000 per month over OND.

The market has made up its own mind about the prospects for the survival of Chrysler and is voting with its feet. December sales for Chrysler were down 53% on 2007.

Amongst, the gloomy auto sales, one can note that Rolls-Royce sales in North America, were up 6.9% for December 2008 over 2007, and up 27% for the full 2008 year! However, there is probably a lead time lag here!

In their "bail-out" plans to Congress, the major US manufacturers projected 2009 unit sales as follows;
Chrysler - 11.1m
Ford - 12.5m
GM - 12.0m

GM also said
it would to" seek extra back-up assistance in case adverse conditions continue and sales only reach 10.5m in 2009".

I will stick with my last November projection, for 2009 sales of 900,000 per month, that is 10.8m for the 2009 year.

Thus GM will be back for more money, as will Chrysler. Whether they get any, will be interesting!

I cannot see there still being three manufacturers by December 2009.

House values and the stimulus package
I noted the other day that the average value of a home in the US has fallen to $181,000. That is a fall of around 5% since September 2008.

Given that, as another blow to consumer confidence, the rising unemployment, and continuing share market uncertainty, I cannot see the proposed stimulus package doing any good. Most commentators are expecting it to give the ec0nomy a "shot in the arm", but my understanding is that a bullet "shot in the arm," will leave a big exit wound and a lot of damage!

The name of the game is consumer confidence, and the only real thing that will resolve that is time. Yes, job security is a factor, but if consumers receive any cash or rebate as part of the stimulus, the money will either go to pay their most urgent credit card debt, or be banked.

Bank Lending and the TARP
There is a lot of uninformed comment about banks receiving TARP money and not lending it. I have commented in previous posts about bank leverage, but will try and explain again, using a simple example.

In simple terms, banks typically lend up to ten times the value of their equity, to keep a Reserve Ratio of say 10%. Reserve ratios have to remain above certain prudent limits by law and/or by the terms of borrowing that a bank has entered into itself, when receiving funds.

1.a Thus, and call them millions or billions of dollars as you please, but a bank might then have;

Equity and retained profits invested in the bank - $10,000
Borrowings and customer deposits with the bank - $90,000
All assets (including loans to bank customers) - $100,000
With a Reserve Ratio of 10% ($10,000 equity divided by $100,000 assets)

1.b Then if the bank loses $5,000 on a major loan or investment, the balance sheet changes to;

Equity and retained profits invested in the bank - $5,000
Borrowings and customer deposits with the bank - $90,000
All assets (including loans to bank customers) - $95,000

With a Reserve Ratio of 5.26% ($5000 divided by $95,000)


At this point the bank has breached its Reserve Ratio and has two broad options.

2.a To seek extra capital or TARP money of $5000, to restore Equity and retained profits to $10,000 and Assets to $100,000 and achieve a Reserve Ratio of 10.0%

Equity and retained profits invested in the bank - $10,000
Borrowings and customer deposits with the bank - $90,000
All assets (including loans to bank customers) - $100,000
With a Reserve Ratio of 10% ($10,000 divided by $100,000)


2.b Alternatively, to reduce assets from $95,000 to $50,000 and use the $45,000 of cash to reduce its borrowings to $45,000. Thus;

Equity and retained profits invested in the bank - $5,000
Borrowings and customer deposits with the bank - $45,000
All assets (including loans to bank customers) - $50,000
With a Reserve Ratio of 10% ($5,000 divided by $50,000)


Normally, losses will not be this great in proportion to equity, and any losses will be covered by a mix of new equity and down-sizing.

But 2008 has not been normal! Relating the above to the financial sector during 2008, banks like Lehmans found that their losses were greater than the total of their equity, and no other bank was prepared to buy all their remaining assets. Thus, Lehmans remaining assets were sold piece-meal at distressed prices.

For the surviving major banks, as in the example above, the TARP money has provided part of the replacement equity to restore the Reserve Ratio to 10.0%.

However, the crux of the matter is that by restoring equity to $10,000 above, only allows the bank to retain its total assets at $100,000.

Given the financial squeeze on most borrowers, some of those existing assets will have fallen behind in their repayment schedules. Thus, any TARP cash is most unlikely to add to a bank's net positive net cash. As such there is very little scope for a bank to use TARP money to make new loans or to acquire other banks.

All that has happened, is that the bank's health has been restored, so it can continue to exist and to serve existing customers, without having to undertake a massive downsizing.

Some banks have merged with Federal encouragement and then found purchased assets were worth less than was expected, giving a new round of problems similar to the above, for example, see
Banks Need More TARP Money To Save Them: Analysts

Tuesday

Part 6 - The Auto Industry and the Price of Gold

News! The Great Recession
I think it was George Bernard Shaw who said "If you take all the economists in the world and lay them end to end, they will never reach a conclusion".

However, he has been proved wrong! Only one year after it started, economists have now confirmed that the Great Recession commenced one year ago on December 1, 2007.

The economists now have a new challenge. To determine whether they can pick the end of the Great Recession, before the next Sharemarket Bubble goes bang.

The Auto Industry
December 2, 2008
Today the North America vehicle sales for November have been released. Sales tracker Autodata said that its preliminary total showed industry wide sales at only 746,789 vehicles for November, the first time sales have been below the 750,000 mark since January 1982. YTD sales for 2008 are 12.35m with only December to go.

The Big Three have also returned to Congress this week to sell their "Boy, Have I got a Deal for You!" cost/benefit analysis, which explains what a great investment opportunity there is for the taxpayer, via a government injection of over $25b.

Readers of Part 5, will recollect that total light vehicle sales in October 2008 were 838,000 compared to 1,232,000 in October 2007, with the ten month YTD drop being from 13.58m in 2007 to 11.60m in 2008.

Last month I said; "It seems likely that with the worsening economic situation, and assuming say, 800,000 per month for November and December, total sales for 2008 may be a little over 13 million. That would be a reduction of 20% on 2007."

A week later, I saw that expert opinion for the month of November was predicting 850,000 see Edmunds.com Forecasts November Auto Sales: Gas Prices and Heavy ...

Now a further week has passed and as it happens, although due to the economic implications there is no cause for celebration, my prediction of 800,000 was closer to actual total sales of 747,000.

My personal pick is that December sales will be no better than November. However, the total sales for 2008 may still just scrape over 13.00m.

The important thing to note however, is that sales for October and November 2008 combined were 1.585m vehicles, which is an annual rate of only 9.51m. If an optimistic figure is taken for December 2008 of say, 815,000, it means that sales for the December 2008 quarter would be only 2.4m or 800,000 per month.

Last month I speculated 2009 sales at 900,000 per month, or 10.80m for the 2009 year, but acknowledged this might be too pessimistic. But note that a 2009 total of 10.80m vehicle sales represents a 13.6% improvement over average sales for October and November 2008.

If I raise the average monthly rate for 2009 to 1,000,000 per month, the annual target for 2009 becomes 12.00m, which is 26.2% above average sales for October and November 2008.

At this stage, my feeling is that 2009 average monthly sales will be closer to 900,000 rather than 1m per month, that is 10.8m for 2009.

As part of the Ford Plan accompanying their second visit to Congress, they have predicted US industry sales for 2009 of 12.5m, for 2010 of 14.5m, and for 2011 of 15.5m. The Ford worse case scenario projects US sales for 2009 of 10.5m, 2010 of 11.0m, and 2011 of 12.0m. See Ford submits business plan to Congress: May be profitable by 2011 ...

At the same date, GM has predicted 2009 industry sales of 12.0m, although it also wishes to seek extra back-up assistance in case adverse conditions continue and sales only reach 10.5m in 2009. For 2010 industry baseline sales are projected at 13.5m, 2010 at 14.5m, and 2012 at 15.0m. GM says that after its restructuring, it will be able to operate profitably in a market of 13m to 14m total vehicle sales. See GM asks Congress to kickstart its heart with ambitious plan - Autoblog

Chrysler has projected North America industry sales for 2009 as 11.1m, 2010 as 12.1m, 2011 as 13.7, and 2012 as 13.7m. It also comments; "U.S. sales are down from a 17 million unit selling rate in early 2007, to an estimated 11 million unit selling rate for the fourth quarter of 2008 - a 38 percent decline." See Chrysler submits plan to Congress, asks for $7 billion in 2008

The 2008 Automotive Crash Test Dummies
Both opening and closing auto plants requires long lead times, say a minimum three years to open a new plant, and probably one year to plan and implement a closure. Thus, like the proverbial super-tanker it takes a long time to change course when an iceberg is seen ahead.

As shown below when compared to previous production forecasts for 2008 - 2010, the North American auto industry is in the process of conducting the largest crash test in history and has hit an iceberg at full speed.

The Big Three auto companies know a lot about crash testing, but this time their managements have been flung forward as if they were crash test dummies without seat belts. Apparently being brought to a shocked halt only by the verbal vitriol cast in their direction at their first congressional appearance.

Based upon the published summary plans, GM seems to be the one of the three most ready to grasp the nettle. Probably that is a sign of how desperate their position is.

Predictably all three contain an element of "Motherhood and the Flag" type platitudes one would expect. However, of the three plans, GM is the one that seems the best put together and from that point of view gives me most confidence that they know what they have to do to survive.

To give an an indication of the industry's previously projected super tanker course and thus how hard the 2008 automotive "crash test" impact is, it is worth looking back two years to see what productive capacity was announced as planned for 2007 to 2010.

On November 1, 2006, only 25 months ago, an authoritative report by WardsAuto.com was published which projected auto factory capacity for 2007 and 2008. It can be seen at North American Capacity to Peak in 2008

The chart shows North America factories rated at 18.82 million units for 2006 and also predicted 2007 capacity of 18.95 million vehicles, based upon average annual straight-time capacity levels and assuming normal schedules each year at each plant.

The report predicted capacity in 2008 would rise to 19.23 million in 2008 before shut-downs at Ford and GM took effect, which would "slice" capacity in 2009 to 18.76 million and in 2010 to 18.70.

The capacity figures do include heavy trucks, whereas the sales figures do not, but that is not a major problem as the trend in over capacity is the important factor. Some capacity adjustments have already been made by the Big Three since the date of the 2006 report, but the table below indicates the magnitude of the task collectively facing them.

North American auto capacity as projected in 2006, compared to sales
Year ----- Capacity ------ Sales --------- Over Capacity ---- Proj -- CHRY ---- GM ---- Ford
2006 ----- 18.82m ----- 16.55m ----- 2.27m --- 13.7%
2007 ----- 18.95m ----- 16.14m ----- 2.81m --- 17.4%
2008 ----- 19.23m ----- 13.00m ----- 7.23m --- 47.9%
2009 ----- 18.76m ----- 11.87m ----- 6.16m --- 58.0% --------- 11.1m - 12.0m - 12.5m
2010 ----- 18.70m ----- 13.37m ----- 4.20m --- 39.9% --------- 12.1m - 13.7m - 14.5m
2011 ------- n/a --------- 14.57m ------- n/a -------- n/a ------------ 13.7m - 14.5m - 15.5m
2012-------- n/a --------- 14.35m -------- n/a -------- n/a ----------- 13.7m - 15.0m -- n/a

For the purpose of the table, I have averaged their projections to predict total industry sales for 2009, 2010, and 2011. However, I think that Ford is being overly optimistic. The over capacity is calamitous. For example, my view is that 2009 sales will be closer to 11.0m, than to Ford's 12.5m.

One thing that does not seem to have been observed by many commentators is that Big Three are effectively already trading in bankruptcy, when considered from a marketing and selling point of view.

Think for a moment, if you absolutely had to buy a car in the next month or three, how confident would you be at buying from GM, Ford, or Chrysler? - Or would you play it more safely and buy a different brand?

They are currently facing very great downward sales pressure due to the public's perception of likely bankruptcy in 2008 or 2009. This is making making potential buyers fearful about future servicing and warranty claims.

Some buyers will just be holding off buying until the situation is clearer, but others will be switching to vehicles made by other manufacturers. Chances are many of these "switchers" will be permanently lost to the Big Three, as they will only return to the Big Three if they become dissatisfied with their replacement vehicles.

The severity of the cuts proposed will compound the Great Recession. GM says it would reduce the number of hourly and salaried employees to between 65,000 and 75,000 by 2012, compared with 96,500 now and 167,500 in 2004. GM expects to reduce the number of dealer locations by 1,750 to 4,700 by 2012. It would also reduce the number of U.S. powertrain, stamping, and assembly plants from 47 to about 38 by 2012.

If Ford and Chrysler also cut in a similar proportion, and this is followed through by their suppliers, it seems that the combined Big Tree section of the auto industry is going to contract by about 25% from current staffing levels and dealer levels.

The other manufacturers will also have to reduce capacity if 2009 sales are 12.0m or lower. Compared to the 16m in 2007, that is a 25% reduction. Over the past fortnight proponents of government support have claimed that 2,000,000 jobs are dependent on the auto industry. This figure may be inflated but for the purpose of these comments is assumed to still be in the ball-park.

If so, an industry wide reduction of 25% would imply the loss of a further 500,000 jobs from manufacturing, sales, dealers, and suppliers connected to the auto industry over the next three years. Also consequent reductions in Federal, state, and city tax revenues that will compound the current financial crisis. That is some iceberg!

The adverse risk factors working against a successful outcome for such a monumental task seem to imply that, unless management, government, and the taxpayer are incredibly lucky, it is perhaps already too late for two of the three to survive, even with a government cash injection.


Why Gold Prices have not risen to $2000 an ounce
I commented in Part 1 why gold prices have not risen, but some commentators still express surprise that gold has not reached $2000 per ounce during 2008.

The reason is threefold, firstly because the financial crisis is affecting consumers across the whole world, rather than people connected to a war in a localised region, or a crisis adversely affecting just one geographic financial sector.

Secondly because two-thirds of gold production is used for jewellery, which is a luxury retail product and so now affected by declining demand.

Thirdly, because of the major moves in international currency exchange rates. Relative increases in the price of gold are much more apparent in currencies which have lost significant strength compared to USD.

Economists like to simplify their analyses by using the term "ceteris paribus", which means other things being equal.

Thus, using a ceteris paribus analysis to discuss the crisis, one would expect "fear" investment money to flee to gold and the price of gold to rise. Such an analysis assumes constant gold jewellery sales and stable currency exchange rates.

But in the current financial crisis, the "fear" investment money is flowing into gold, at the same time as retail jewellery sales are falling due to reduced consumer demand and while currencies are gyrating.

As a consequence the price of gold is fluctuating around variations in demand and exchange rate movements, with investment gold rising and jewellery gold demand falling.

Given the nature of the current crisis, it seems likely that "investment gold fear" will abate at a rate not dissimilar to the rate that worldwide consumer confidence recovers.

In that event the price of gold is likely to continue with significant fluctuations, but without really major moves to the upside or to the downside.

Part 5 - The Effect on Households and the Auto Industry

A Personal View of the 2008 Financial Crisis - Part 5
November 17, 2008
Why a $220 Billion Stimulus Package will not work this year.
In past economic crises, particular regions or economic sectors within the United States have been affected, but since the Great Depression a crisis has never affected the whole country at the same time.

This time is different, the 2008 financial crisis is affecting the whole country, excepting only the very poor and some of the very rich. The main effects on individuals during 2008 are in four areas;
- Value of home
- Value of retirement savings
- Job security
- Access to finance and outgoings

The effects on households have primarily been financial, but the flow on effect from the financial effects has been a huge loss of consumer confidence and a resulting withdrawal of consumer spending.

Value of Home
This graph is created from Robert Shiller's data of home prices from the second edition of his book Irrational Exuberance, Princeton University Press, 2005. It shows from base 100 how home prices up to 2005 increased well out of proportion to increases in building costs.

For most home owners, their home is their main saving towards retirement, with an expectation of downsizing to a smaller home at retirement to free up cash.

Thus a significant fall in house prices will have a major impact on the financial outlook and financial actions for most people aged 40 or over.

Such a fall has now happened as national home prices fell dramatically in 2007 according to NAR data, with the national median price falling nearly 6% to $217,000 in March 2007 from the peak of $230,200 in July 2006.

Since 2007 there has been a further dramatic fall in the median as shown in the graph. So that by September 2008, the median price was $192,000, a drop of nearly $40,000.

In Britain there is a similar story, as it has been recently calculated that in Cardiff, the 2008 housing slump has cost the average family GBP30,000, say USD45,000 with the median house price in Cardiff (i.e. only within one city) falling from GBP215,000 to GBP185,000.

A separate graph shows how different the cycle of home value decline is in 2008, when compared to the last major decline in home value, which took place between 1990 and 1997. The comparison is of the percentage change of the Case-Shiller Home Price Index for the housing correction beginning in 2005 (red) and the 1980s–1990s correction (blue), comparing monthly CSI values to the peak value seen just prior to the first declining month all the way through the downturn and the full recovery of home prices.

The average house owning household is assumed to have had a reduction in their nominal wealth associated with the house value decline amounting to around 20%, or close to $45,000. The amount will be higher for families with a second home, perhaps a combined average of around $50,000 per household.

Many younger households will be facing negative or minimal equity in their homes, which will savage their consumer confidence even more.

Value of retirement savings
In the United States in 2001, the total value of pension funds was about $6.7 trillion, out of total OECD pension funds of about $7.5 trillion, i.e. the USA represented about 80% of total OECD pension investments, with about 50% of the total being invested in equities.

It has been hard to find more recent information on total pension investments but an estimate can be made.

In 2001 the Dow Jones Industrial Average was about 11,000. See The 2008 Financial Crisis and the Art Market - part 3 The Dow peak in 2007 was 14165, say 28% higher than in 2001, applied to say a 50% equity portion, plus an allowance for new savings, would imply US pension funds peaking at around $9 trillion in late 2007.

Since then there has been a 40% fall in the Dow. Applied to the say, 50% or $4.5 trillion invested in equities, this is a loss of value approaching $2 trillion. There are 110 million households in the United States, including those without access to pension funds. Adjusting for those without pension entitlements, the average pension fund investment loss per household between October 2007 and October 2008, might be close to $25,000.

To this must be added the decline in the market value of direct equity investments by households, direct commercial property investments, decreased values of small businesses for owners, and even an abnormal fall in the value of personal motor vehicles, due to reduced demand. The amounts can only be guessed, but might increase the average household loss of retirement investment value from the $25,000 pension fund loss to a total investment loss of $30,000 per household.

By a different measure, the value of equities listed in the United States in 1998 was about $13.5 trillion, when the Dow was about 10,000. A different source, Wilshire Associates, calculated the total U.S. market capitalization at approximately $15.35 trillion on May 23, 2007.

The current Wilshire estimate of total US market capitalization can be seen at http://www.wilshire.com/Indexes/Broad/Wilshire5000/Characteristics.html At October 31, 2008 the total market capitalization was $10.5 trillion.

Applying the 2007 Dow peak of 14165 to those figures, implies a total equity value at the peak of around $18 trillion. Thus current value represents a fall of $7.5 trillion or about $70,000 per household.

This would overstate the loss per household because of the need to eliminate corporate cross-holdings and US shares owned by foreign households. It does however suggest that $30,000 is a modest estimate of the investment losses per household.

Naturally, these are losses from a notional Dow peak, rather than a direct loss compared to the purchase price of the investments. Nevertheless, there will be a feeling by households of great loss over the last twelve months from the peak, which will take households some time to adjust to. The rate of adjustment being affected by when/if the Dow recovers over the next year and by how much.

Job Security
Today Citigroup announced 50,000 job reductions. Many other reductions have been announced which are not yet reflected in the statistics.

The unemployment rate in recent years is shown in the table. Currently the rate is 6.5%, but some predictions suggest it may rise to 10 percent.
YearJanFebMarAprMayJunJulAugSepOctNovDecAnnual
19984.64.64.74.34.44.54.54.54.64.54.44.4
19994.34.44.24.34.24.34.34.24.24.14.14.0
20004.04.14.03.84.04.04.04.13.93.93.93.9
20014.24.24.34.44.34.54.64.95.05.35.55.7
20025.75.75.75.95.85.85.85.75.75.75.96.0
20035.85.95.96.06.16.36.26.16.16.05.85.7
20045.75.65.85.65.65.65.55.45.45.55.45.4
20055.25.45.25.15.15.05.04.95.15.05.04.8
20064.74.74.74.74.74.64.74.74.54.44.54.4
20074.64.54.44.54.54.64.74.74.74.84.75.0
20084.94.85.15.05.55.55.76.16.16.5


If unemployment reaches 10%, that means that 90% are still employed, but many more will be fearing they might lose their jobs. Even if unemployment only reaches 8%, for as long as the fear of job losses lasts, even employed workers will tend to be cautious with their consumer spending.

Access to Finance and Outgoings
Most households are in continuing employment with existing commitments to mortgage and car loan repayments. Thus, they have not actively been looking for finance and on a day to day basis their net income has been relatively constant, except for food and gas price increases in the first half of 2008.

Market commentators keep saying that the second half fall in gas prices is giving the consumer more to spend. However, I think this overstates the case. When gas prices were at a peak, and food prices were increasing, much consumer expenditure would have gone onto credit cards or been financed by withdrawals from household savings.

This view is supported by studies of the early 2008 financial stimulus which showed that it had less impact than was expected. A significant portion seems to have been used to repay debt.

The financial crisis has significantly worsened since then so it seems even more likely that households will aim to save any stimulus "windfall" or use it to repay temporary credit card debt from when gas prices were so high.

Household costs will increase in 2009. It has to be remembered that many local authorities are running deficits and will need to increase property and similar taxes. These will be an extra financial impost for consumers in 2009. It is highly likely that insurance rates will increase due to equity losses within insurance company reserves and hurricane losses. Credit card interest rates will be increased to cover losses.

The Auto Industry
Full-year 2007 sales dropped almost 3 percent from 2006, to 16.14 million vehicles (i.e. cars and light trucks combined), the lowest since 1998 and down from 16.55 million a year earlier. Industry-wide sales for December 2007 were off almost 3 percent at 1,390,000 vehicles.

Since then it has got even worse.

Total light vehicle sales in October 2008 were 838,000 compared to 1,232,000 in October 2007, with the ten month YTD drop being from 13.58m in 2007 to 11.60m in 2008. The last time monthly light-vehicle sales were lower was 822,200 in January 1991.

It seems likely that with the worsening economic situation, and assuming say, 800,000 per month for November and December, total sales for 2008 may be a little over 13 million. That would be a reduction of 20% on 2007.

[Since writing the above, I now see a week later on Nov 25, there is an authoritative prediction of 850,000 for November, see Edmunds.com Forecasts November Auto Sales: Gas Prices and Heavy ... to make the Seasonally Adjusted Annual Rate (SAAR) for November expected to be 11.5 million.]

It is certain that 2009 will be worse than 2008. If 2009 was to average 900,000 vehicles per month, i.e. 60,000 a month higher than October 2008 sales, total sales for 2009 would be 10.8m, a further fall of 20% on 2008 sales and a reduction of 40% in two years.

Some portion of the October 2008 drop may be due to difficulties in buyers obtaining credit, but it seems more likely that much of the drop was due to buyers staying at home. There is now a large overhang of new and used vehicles to be sold, effectively at distressed prices.

Trade in values will be much lower, hence reducing available funds for deposits. Thus buyers are likely to prefer replacing with 2008 and earlier models at these lower prices, rather than paying for 2009 production at 2009 prices.

There is now much discussion about whether the big three should be loaned Federal funds, or file for Chapter 11. Their fear of the latter, is that no-one will buy a car from a bankrupt company.

Few commentators have observed that it is already effectively happening in the mind of the public, due to the ongoing media debates about Chapter 11. Who would risk buying a vehicle from the big three during the current debates about Chapter 11?

As an indication of how badly GM has been caught out with it planning, the following quote is dated Jan 3, 2008:
"GM Chief Executive Rick Wagoner said he expected the market in 2008 would be about as tough as the year just ended. "There are some obvious reasons for concern, but on balance I suspect '08 will be similar to '07 in total, although likely weaker in the first half and stronger in the second," Wagoner told reporters in an online chat." Other GM sales executives said the automaker expected that the current first quarter would be the weakest of the year with the U.S. economy managing to avoid recession.

For the industry to survive in its present form, 2009 sales would need to recover to 2007 levels of 16.14 million, or 1,350,000 per month. While the above estimate of 900,000 per month for 2009 may be too pessimistic, 1,350,000 per month is out of the question.

Thus, one way or another, the industry structure will be substantially different twelve months from now.

Conclusion
United States home owning households have seen combined falls of about $80,000 in average house values and pension/investment entitlements, mostly in the last twelve months. Consumer confidence levels are therefore very low.

A stimulus package in late 2008 of say $220 billion, if paid out to households as a grant or tax rebate would amount to about $2000 per household, an amount equivalent to only 2.5% of the $80,000 of house and investment losses per household.

For householders aged 40 or more, $2000 will seem a drop in the bucket compared to their losses and the need to save for their retirement. Realistically, only time will "heal" their spending habits.

Thus, given the adverse economic climate and the present lack of clear leadership, a stimulus package will not provide a significant economic impetus. Most households would instead "save for a rainy day" or repay some debt.

Unfortunately that is why the 2008 crisis needs to be regarded as a fever that has to run its course.

By now, most of the United States population realises that the next year is going to be very tough and are settling down to concentrate on survival for the next year or so. As with personal crises, it is a case of "time heals all wounds". Thus consumer confidence will gradually return in a year or so, once people in general have adjusted to the "new order".

Apart from the poor economic outlook, the equity market is also in disarray due to the constantly changing "bail-out" rules and the lack of visible leadership. The Dow Index is therefore currently unable to act as an optimistic beacon towards a better future.

What is needed most urgently is strong visionary leadership, acknowledging the coming difficulties of 2009, but giving an economic vision for 2010 and beyond, leading to what might loosely be called the "Promised Land".

Perhaps such a vision might include some elements of the Five Point Plan suggested in Part 4. See George Washington and the 2008 Financial Crisis - part 4

The general population will desperately want to believe in such a vision, even if some aspects seem unpalatable, provided they can accept the vision points the way to better times than those which will prevail in 2008/2009.

As there is now a lame duck presidency, such a vision cannot be promulgated until late January 2009, at the earliest.

Time will tell if the baton is taken up by the new president.

Afterthought
(Only for those with a sense of humor)
Although there are various contributing factors, the current financial crisis is essentially the result of poor Government stewardship and so, as with any corporation, the buck stops at the top .

Given the increasing size of the mess, please forgive one for wondering "a little tongue in cheek", whether the United States Constitution provides scope for the current President to be impeached for incompetent financial leadership or, alternatively, for telling "untruths" about the strength of the economy?

President Nixon was to be impeached for lying to Congress, but his "untruths" did not cost the country any money. There were calls for impeachment of the President Clinton for un-Presidential like actions which are not condoned, but his "untruths" did not result in trillions of dollars of losses.

Thus what should be the future test for considering Presidential impeachment? Just a thought!

Part 4 - The Election Result and a Five Point Plan

The 2008 Financial Crisis - part 4
November 7, 2008 - With apologies to staunch Republicans and to Emmerson, the cartoonist for my local paper, here is his cartoon on the morning after the election.

One has to retain a sense of humor, despite these adverse times, and so I was also quietly amused by the following reference in the satirical newspaper "Onion".

"Black Man Given Nation's Worst Job - African-American man Barack Obama, 47, was given the least desirable job in the entire country .... As part of his duties, the black man will have to spend four to eight years cleaning up the messes other people left behind."

The End of the Golden Summer
On a more serious note here are some personal thoughts about the financial crisis, which I believe is not likely to markedly improve in the next 12 months and may get worse before it gets better.

I am a "baby boomer" and feel I must share the overall blame for the financial crisis, along with everyone else in the "baby boomer" generation. As a generation we have been too focussed on consumption and instead should have had a more balanced view, with a greater thought for future pressures.

My parents were born before the Russian Revolution, lived through World War I, the 1920's General Strike in England, the Great Depression, and World War II. My father had to leave school at age 15 and later fought overseas for six years, where he was unable to prevent my mother being bombed in London.

Thus most of their life was spent facing adversity, but they did it cheerfully as they were looking to to make the world a better place for their children. They were unable to even start saving until after World War II, when they were already in their late 30's. As evidence of their attitude, I even remember my mother saying shortly before she died, that she "had always considered herself as part of the lucky generation".

In contrast, until now baby boomers have not had to face adversity as a generation. Rather than "adversity", "consumption" has increasingly been the magic word since 1950.

Most Western democracies have been influenced by United States consumption via TV and films and thus, by following the leader, their economies have also had a consumption bias.

Great technological advances have been made since world War II, but the Western democracies have been a little too biased towards consumption. For short terms that did not matter, but the imbalance has continually grown until consumption is now at an unsustainable level.

Other Western economies, which are all less economically powerful than the United States, have gradually fallen by the wayside. They have been forced to react to domestic pressures from excess consumption in their own economies and take drastic structural actions at varying times, such as introducing VAT taxes.

The United States has avoided restructuring until now, due to its dominant economic power and, more recently, its ability to borrow from overseas to continue to fund its consumption.

Since before 1900 the United States has regarded itself as the bastion of Capitalism. Ironically, I feel it is a feature in the American economy which is closer to Socialism, which has now acted as the straw that broke the camel's back and so has brought the country to its economic knees.

That Socialistic feature being "affordable housing" encouraged with the best of motives, but in the wrong manner. Housing has been financed on loans based on interest rates that were set too low, for too long, by the Federal Reserve Bank. Many loans are non-recourse, and funded by unlimited, Government backed, mortgage finance.

That combination has led to a housing bubble, with an abdication of risk responsibility by home owners, home builders, developers, financiers, and banks.

With the bursting of the bubble, the crisis has struck hard and we are seeing huge job losses, corporate failures, and tremendous sums of cash thrown at many problems. Now there are calls for more cash for the auto industry, for more stimulus packages, but still with little apparent discussion about long term restructuring.

Thus, as a lone voice, here are some personal thoughts on restructuring. In my mind long term restructuring is now more important than the current crisis, which will run its course no matter what action is taken.

Somewhat ironically, the crisis now provides an opportunity when the whole population is listening and waiting for its leadership to speak. It is therefore timely to gain bi-partisan acceptance for some long term restructuring of the United States economy.

A Five Point Plan
Thus, rather than commenting on the short term measures, where most people are looking, here is a five point long term plan that should be incorporated into a stimulus package.

The points are major. They are aimed avoiding a repeat of the current problems and getting a better balance in the United States economy for future generations.

A Five Point Plan
Point 1 The US Government should announce that from January 1, 2010 Fannie and Freddie will no longer provide government backed mortgage finance, with their existing portfolios being run off over time.

Reason - There is no long term economic reason for government to provide this funding. Under Capitalism the market will find a way to service this market. Traditional banks and other lenders will assess the risks, then increase their home mortgage lending. They will charge sufficient for the risk. Non-recourse loans will tend to disappear. The market will become much more fragmented and less risky.

Point 2 The Government should institute an energy levy of say, $20 per barrel of oil, both locally produced and imported, and an equivalent tax calculation for natural gas.

Reason - To provide funding for energy research and investment, and to encourage the population to use more efficient use of energy, whether for heating, or for more fuel efficient means of transport, cars, planes, buses, trains, or feet. Adding $20 to the current $60 per barrel, this would still be some $65 less than the peak price of $147 reached earlier this year. While that peak is still fresh in consumer's minds now is the ideal time to reinforce it.

Point 3 The Government should institute a 10% sales tax across the board on everything except financial transactions as many countries have with VAT or similar taxes. The VAT should be made overall fiscally neutral, by increasing benefits or lowering taxes for "95%" of the population.

Reason - The tax would help discourage wasteful consumption. Net savers would benefit and lavish spenders would be penalised. Such a tax is much simpler and more equitable if it applies to everything. In addition, much of the underground economy and illegal immigrants would be unable to avoid paying such a tax. Also, foreign tourists who visit the country would start paying a federal tax for the transport and other systems they use. Thus the tax would generate new sources of revenue.

Point 4 The auto industry and any other distressed industries should be encouraged by government to adopt the same strategy as was proposed at one stage for distressed banks i.e. each be divided into good bank/bad bank, or here into good auto company/bad auto company.

Reason - Parts of GM, Ford, and Chrysler must be profitable. If so, these would be put into the "good auto" companies and continue to trade. Being profitable, they would attract investors and allow new car buyers to have appropriate new vehicle warranties. The "bad auto" companies would be run as liquidations until their operations were completely closed down. The process has to be seen to be fair to other car manufacturers.

Point 5 - The Government should commence a "United States Sovereign Fund" for investments and to help provide for future welfare requirements for the ageing population. In the meantime, the fund would invest nationally and internationally, on commercial terms, in bonds, equities, and major infrastructure requirements, for example in nuclear power plants.

Reason - Welfare costs will need to be met for many people in the future. Funds released from the run down of Fannie and Freddie should be used as part of the fund, as would TARP assets, and other assets such as the AIG stake. It would also manage the energy tax receipts from Point 1.

Conclusion
I do not envy Barack Obama his task. Today I watched his first press conference since the election result and did feel he handled it well.

Given the various components of the crisis, including; jobs, credit, equities, autos, wars, and the huge budget deficit he has little room to move, and few assets to offer.

As he is a student of history, he may well do to repeat the words of Sir Winston Churchill in Britain's darkest hours of World War II; "All I can offer you is blood, tears, toil, and sweat".

Part 3 - The Outlook for the Dow in 2009

A Personal View, continued
October 16, 2008 As alluded in Part 1, major factor in the fall in the Dow Index has been deleveraging by banks, investment banks, mutual funds, hedge funds, and individuals.

To date in 2008 there have been several well publicised cases of failure or emergency support, involving large banks and investment banks.

However, it seems highly likely there are many lesser players who cannot survive the chaotic daily trading swings and will succumb as forced sellers, perhaps via trading losses, margin calls, and/or excessive redemptions.

Thus it is to be expected that the names of other, smaller failures will emerge over the remainder of this year.

This has all followed the credit/housing/leveraging bubble in the Dow Index from late 2006 to mid 2008, so that the Down Index for that period, from late 2006 to early 2008 needs to be discounted.

In Part 1, I commented on the Dow Jones Industrial Average. These graphs below show the Dow Index and relative share volumes from 1928 through to Oct 16, 2008 in the top graph. Then the most recent five years in the middle graph and just the latest year in the bottom graph.

The graphs better illustrate what I said in Part 1; "Using a 2008 low point of say 8450 and the 2007 peak of 14165, a simple average is about 11300. The 11,300 mark represented the level of the Dow in late 1999 and was touched again in 2000, 2001, and also between 2006 and 2008. The equilibrium level between 1999 and 2008, however looks closer to 10000 and so between 10,000 and 11000 seems a more likely target range over the next year or two.

With 12000 being a more likely maximum recovery by 2010 than the previous peak of 14165.

Thus, as a result of the financial crisis, there may be a small decline in average living standards in America and Europe, perhaps equivalent to the loss of two or three years of growth, say of the years 2006 to 2008. This would be an inconvenience for most people in America and Europe, but not a catastrophe."

There seem to be varying opinions as to when the various economies will recover. My personal view is that it will take longer than many people think. I would be surprised if the Dow reaches 11000 before 2010.

My reasons for saying this are the number of people "burned" at both ends of the market.

At the top end, banks, funds, and wealthy private investors will be very cautious with lending and investing for at least 12 months.

At the bottom end, ordinary people have seen both their house and stock investment values fall. Many have already lost jobs and the number losing jobs is likely to increase.

Thus, nearly everyone will have seen their personal assets fall in value and/or know someone who has lost their job or had their business fail.

Foreclosed, unsold, and partially completed housing will be a constant visual reminder of the crisis for a year or more.

Until confidence is recovered, people will hold onto their old cars for longer and wear their clothes longer. Anecdotally, I have heard of recent increased foot traffic at estate auctions and at stores which recycle clothing.

A personal prediction is that prices for antiques will increase significantly during 2009 and beyond.

This will be because partly as there will tend to be a mood to look backwards with nostalgia and away from the minimalist style, which will likely be seen as associated with the financial excesses of recent years.

But price increases will also occur as antique furniture and other antique decorative items are recognised as appreciating assets, in contrast to minimalist items which probably fall in value by 25% to 50% as soon as they leave a store.

Part 2 - The Dow Tumbles and Ethics

A Personal View, continued
October 15, 2008 It will be interesting to follow prices for miniature portraits and other art, during and after the present financial crisis. As I write this on October 15, the Dow has dived again, nearly reaching the level of October 10 and from the level of the Dow Futures, it looks as if the Dow may reach a new low tomorrow.

(Later note re Oct 16. Yes, it did fall 300 points in early trading, down to 8198, but then ended 400 up from the opening at 8979!)

From the examples shown below, it can be seen there has been some downward pressure on miniature art prices, but I do not expect that to be long term.

Please forgive the following diversion from art, but advanced age does give privileges! Today CNBC had an interesting conversation with Carl Icahn. He made comments I have heard him say before. That the Board and Executive structure of many companies is often a cosy club, with the Board and Executive more interested in golf, private aircraft, functions, and personal rewards, than running a large company in the best interest of the shareholders.

Having worked in a number of large listed corporates, at both CFO and CEO level, and never having been attracted to the baubles Icahn mentioned, I agree with his comments.

I once recollect reading that one should avoid working for a company where any four of the following applied;
1 the Chairman had a knighthood,
2 the Chairman drove a Bentley,
3 he employed his son in the company,
4 the company owned a company yacht,
5 the company owned a company airplane.
6 the Chairman had a number of pet projects

At the time I was CEO of a listed investment company and had to answer "yes" to all six points!

I used to inwardly groan at needing to attend cocktail parties, sports and other functions, and to fly on the company plane. (I managed to avoid the company yacht!) When needing to travel, I quickly tired of eating out and so often had cheese and biscuits in a hotel by myself.

A little later, I resigned after a major argument over the Chairman's then pet project, to buy an airline, as part of a consortium he was trying to put together.

The project evaluation was very detailed, including visits to Boeing and McDonnell Douglas, but I became more and more nervous about the risks during the evaluation.

Therefore I recommended against the project, saying to the Directors; "the risk was too great for the company to pursue"!

Although they were scared of the Chairman, the Board seemed relieved at my recommendation and agreed with me, but the disagreement with the Chairman could not be mended.

(The airline was purchased by the other members of the consortium, but soon failed! However, I never ever received any belated thanks for saving the company from the same fate!)

In my previous analysis of the crisis I mentioned one personal credo "Profits are interesting, but cash is vital".

I had a couple of other personal credos when facing difficult situations, such as the airline project, one was; "The shareholders are paying my salary and hence I want to do what is right for them".

Another was "I have to look at myself in the mirror every morning when I shave, and so want to be able to tell myself I have done the right thing."

Corporate politics can be vicious, with many executives and directors pursuing their private agendas at the expense of the company and its shareholders. Not infrequently, I found myself a lone voice, forced to consider how to react to such private agendas.

On more than one occasion my conscience and personal credos led me to resign, rather than follow the private agendas and rewards sought by others. That was where I felt the direction proposed was incorrect for the shareholders and so could not support it.

However, once the stress of the events leading to my resignation had reduced, I normally slept a lot better! Now, I miss the income, but not the politics!

Part 1 - Introduction and Opening Oveview

Introduction - A Personal View
October 12, 2008. I originally set out below, to try and predict how the present financial crisis might affect the market for miniature portraits, but I am afraid it has turned into rather a long analysis of the crisis!

A Personal Sense of Deja Vu
It is unclear how long it will take to recover from the current financial crisis, but over the last couple of weeks, CNBC has been compelling viewing. With a few exceptions, most commentators have seemed like deer caught in headlights, without any idea of what is coming next.

As the crisis will be looked back on as a once in a lifetime event, I feel it is worth recording some personal thoughts about it.

Initially, my greatest personal sense was one of deja vu, as in late 1989 I was recruited at short notice as Chief Financial Officer for a major regional bank with over $20b of assets which had got into financial difficulties and needed managerial assistance. (Cartoon sourced from www.berryreview.com/.../)

Previous to that, I had managed an investment company which survived the 1987 crash, largely due to my personal credo that; "profits are interesting, but cash is vital". Thus, it could be said I tend to be conservative by nature.

Anyway, a month after joining the bank in 1989 and assimilating the financial situation, I found I needed to meet with the directors and tell them that a cash injection of $600m to $1000m was required to meet the required capital adequacy ratio.

This was because abnormal losses on lending of $60m to $100m were becoming apparent. If the accumulated capital of the bank was reduced by these losses, the bank would then need to either increase capital or reduce its asset base by ten times the amount of the losses to meet its required capital adequacy ratios.

To put it another way, an abnormal and complete loss by a bank of say $10m, on a loan of $10m, will require the bank to reduce its lending to other customers by ten times that, i.e. $100m so as to meet its legally required capital adequacy ratios, or alternatively to seek $10m of new capital to offset the abnormal loss.

The reaction of the directors to the advice of the capital requirement was effectively denial, which caused me a great deal of stress and worry from their inaction and their desire to paper over the problem.

Eventually matters reached the public domain and over the following months, there was a lot of political infighting which gave me an even greater sense of deja vu, as it had parallels with the current US Presidential election and the politicised actions of Congress.

In the end the bank was saved by a large cash injection of public money and the setting up of a "bad bank" to hold the bad assets, much as with the Paulson plan. Subsequently, the bank was acquired by a much larger bank, but the stock holders had been ill served by bank management and lost most of their investment.

Lessons About Bank Failures
In my view the reason for the near failure, was that several years previously the bank had been publicly listed for the first time and to assist with the issue, $100m of new capital had been injected into the bank.

This extra $100m sounded like a sensible idea, but it gave rise to a major problem. Banks usually have capital adequacy ratios of around $10 capital for each $100 of assets. Thus the capital injection of $100m immediately gave the bank extra lending capacity of $1000m.

This was like Aladdin's Cave, or the Genie in the Bottle, for the lending staff who saw it as an opportunity to grow market share at the expense of their competitors. There was a flood of loan applications as the sales force aggressively sold loans.

With a stable economy and the low nominal value of house and car loans, compared to the new lending pool of $1000m, many of the new loans were for property development and in the lending "feeding frenzy" insufficient account was taken of the risks.

The 1987 share market crash revealed the risks and led to a rapid slow down which, paradoxically, the bank might well have absorbed if its capital had not been increased at the time of listing.

However, the high proportion of risky loans made from the capital increase, meant the bank was brought to its knees.

Thus, for me the parallel with 2008, was the much increased lending ability of the major investment banks when they were freed from regulation and able to increase their lending from ten times their asset base to 30 or 40 times their asset base. As with the example bank mentioned above this immediately meant that the banks concerned could increase their lending from $100 per $10 of capital, to $300 per $10 of capital.

Again it must have seemed like Aladdin's Cave or the Genie in the Bottle for the lending staff and in competing for market share, they went for riskier loans and sought new financial products to use up their vastly increased lending ability.

Like auditors, risk management staff and credit committees in a bank are seen as killjoys, who are trying to prevent lending staff from doing deals and making money. If top executives are also trying to increase market share and their bonuses, the credit committees are in a lonely and invidious position. To use another analogy, the credit committees are like a combination of the boy in the story of "The Emperor's New Clothes" and the goddess Cassandra, shown here.

As an executive, I can recollect a number of occasions when I have also felt like Cassandra; "destined to be able to forecast the future, but at the same time cursed that no one will believe the forecasts".

The problem is compounded in 2008, in that many banks are affected by abnormal loan losses. Thus there are many banks competing to reduce their asset bases by ten times their losses to maintain their capital adequacy.

In many past banking crises, there was only one bank affected and hence other banks were available and ready to lend to the good customers of any failing bank.

In2008, many banks have abnormal losses and hence the lack of alternative banks willing to loan money to customers of failing banks, coupled with a combined need for many banks to reduce total banking assets, has led to a major credit squeeze.

The 1873 Example

Peter Kedrosky has observed on his website at paul.kedrosky.com/.../10/03/get_your_bankin.html as below that the 1873 crisis is more similar to the current 2008 crisis, than that of 1929 is to 2008.

"A banking crisis in Europe took hold in 1872 after a mortgage lending boom, one in which house prices climbed endlessly, houses became loan collateral, and all sorts of dubious banking and lending behavior went on, much of it pushed by return-seeking banks. Everything came unglued in late 1873 as the European economy unwound and housing prices began falling, thus causing European banks to fail in a cascade, and interbank lending rates to soar as no bank knew which other bank would fail next. The problems spread to the U.S. in 1873, where debt-needy railroads began failing as European banks withdrew funding, this after a long boom had produced an over-levered mess, and then large numbers of U.S. banks followed afterwards.

The whole thing took around four years to unwind in the U.S., and slightly longer in Europe. Admittedly, there was little done at the federal level to ameliorate things in any meaningful way, and there were widespread labor troubles at the same time, both of which helped cause the economy to stay down for the count, adding to the woes."


The Origin of the 2008 Crisis
A major element was the low interest rates offered from 2001. Although 9/11 was a major shock for America and the effect on families who lost loved ones can not be understated or ignored, the event was not as calamitous for the US economy as might be first thought.

It is not intended to be callous, but from an economic point of view the death toll should be compared to the far higher annual US death toll from violence and motor vehicle accidents.

On 9/11 there were about 2750 deaths, compared to annual US deaths reported to be 42,000 for highway deaths in 2001 and 29,000 deaths in 2000 in incidents involving fire arms. A combined total of 71,000 or about 25 times as many as on 9/11.

After the initial shock, the Federal Funds interest rate was reduced to stimulate the economy, but in my view the rate was reduced to a level lower, and for longer, than was necessary.

This is shown in the accompanying graph of the Federal Funds rate.

I think after a short stimulus, if one was needed at all, rates should have been increased to curb demand.

The Federal Reserve Bank should have realised sooner that the required underlying interest rate needed to be closer to 4% or even 5%, not levels of around 1% to 2%, as it was reduced to in 2002/2003.

If this analysis is correct the person most able to have anticipated and prevented the current crisis, but who did not do so was Alan Greenspan who was Governor of the Federal Reserve Bank from August 11, 1987 to January 31, 2006.

The Psychology of Investing at Low Interest Rates
For a highly leveraged investment, low interest rates are seen to be very attractive and so encourage risk taking.

A borrowing rate of 3% compared to one of 6%, gives a much better cash flow and hence seems to reduce risk.

However, for highly geared investments, the major risk is more often with the overall asset value, not the interest rate.

Thus on an investment leveraged at 25:1, a reduction of the interest charge from 6% to 3%, will on the face of it, greatly improve the investment return.

But if at the same time, the overall asset value falls by as little as 4%, the fall in asset value will wipe out the equity completely.

The Effect of Low Interest Rates
The very low interest rates were coupled with Fannie and Freddie being encouraged by politicians to make loans to enable more people to buy homes, some of whom could not afford their repayments when interest rates increased.

The low interest rates also made it attractive for hedge funds and private equity funds to increase their own gearing to make investments and launch large takeover bids for listed companies.

However, I believe the markets could possibly have managed these elements and they would not have led to the current crisis without the removal of capital adequacy ratios for the major US investment banks.

To utilize their lending capacity they aggressively loaned money and developed new financial products right at a time when interest rates were low.

Traditional banks saw this aggressive drive for market share by the investment banks as leading to a reduction in their own market shares. Thus to protect market share the investment arms of traditional banks developed their own new products.

The drive for new lending and investments acted as an incentive for the major players to sell more and more securitised home mortgage products. Small mortgages were grouped for administrative simplicity and sold as larger packages to major investors.

Hence there was continuing investor appetite, and a selling incentive, for rapidly increasing, and consequently more risky, home lending. Therefore the risk profile of new home owners and their mortgages became worse and worse.

To satisfy their lending procedures and spread their risk, the banks trading and on-selling the securitised home mortgages to investors, mutual funds, hedge funds, and private individuals, took out insurance against with major insurance companies such as AIG against the failure of investment banks who were parties to the products, such as Lehman Bros.

Given the familiarity and mammoth size of the named parties, the risks were assumed to be minimal and hence premiums were also minimal. These insurance products were called Credit Default Swaps (CDS).

The End of the Golden Summer
Inevitably, the increased risk profile of the basic home mortgages, coupled with an increase in interest rates led to rising mortgage defaults and foreclosures.

This situation might possibly have been manageable, if there had been early action to reduce the number of foreclosures.

However, as the number of foreclosures increased in the summer of 2008, investors started to worry about the financial instruments they were holding. The banks started to reassess their risk, with rumour and speculation being exchanged about other financial organisations.

AIG was an early target from its holding and insuring of high values of CDS. It sought and was granted $80b from the US Treasury to remain solvent.

All the five major investment banks were seen to be at risk and were becoming shunned by lenders. Apart from their exposure to CDS, as mainly investment banks, they did not have a large retail deposit base to assist with necessary funding. Now none of the five major investment banks remain trading in their pre September 2008 format.

As mentioned earlier to offset abnormal loan losses, banks need to reduce lending to other customers by ten times as much as the amount of any abnormal losses to maintain their capital adequacy ratio. Thus abnormal losses need immediate attention.

Most bank lending is fixed term lending of various terms, but on the other side of the balance sheet, much borrowing is short term and is from other financial institutions.

The Deepening Crisis
Thus, to guard against a bank breaching its ratios in the event of abnormal losses, it must hoard cash resources by raising capital, deferring new loans, reducing lending limits where possible, ceasing to lend to other banks, and raising cash by selling assets.

We have seen this during in September and October, as interest rates for interbank lending have soared and much interbank lending has dried up. Banks are not willing to make new loans and so the ability to buy and sell commercial property has dried up.

Where this did not happen fast enough the banks affected; such as Bear Stearns, Lehman Bros, Washington Mutual, and Wachovia failed, with portions being acquired by larger and stronger competitors.

Additionally, the reluctance of banks to lend has meant that corporates, mutual funds, and hedge funds have been unable to access funds as readily as in the past. Corporates need funds for normal trading purposes, such as seasonal Christmas inventory.

Hedge and mutual funds need cash for greater planned than redemptions, as has now been happening as their investors get more nervous. The large hedge funds and major share investors now also need extra cash resources to meet any margin calls from lenders.

The effect of the drying up of bank credit has led to there only being two main sources of accessing short term money.

Firstly, by banks, corporates, and hedge funds with any overseas cash or marketable assets, selling them and repatriating their cash assets back to America to operate their core businesses in survival mode. This inwards flight of USD has caused the USD to appreciate rapidly.

Secondly, the only freely operating market mechanism to readily raise cash has been by selling on the share market, both in the United States and overseas.

As the American banks, corporates, many major investors, and hedge funds are all effectively forced sellers, they far outweigh the number of buyers, who themselves are likely to be tight for cash. Hence there are far more sellers than buyers and the share markets round the world have plunged.

Mark-to-Market
Followers of the financial crisis will have seen references to mark-to-market valuations being a problem.

To try and explain this, one should imagine that one owns a small business called Fred's Lights, say selling light fittings. The business has capital of $50,000 and inventory of light fittings which had cost $100,000.

In the same area there is another identical sized competitor, Joe's Lights, also selling identical light fittings, but who goes bankrupt and all his inventory is sold at a liquidation auction. Although it had originally cost $100,000, at auction Joe's inventory only realises $25,000, so there is an actual loss of $75,000.

Under mark-to-market rules assets need to be valued at the lower of cost or current realisable market value.

Using this accounting rule Fred's Lights also has to value its inventory effectively on a forced sale basis, at a notional value of $25,000, i.e. $75,000 below cost. This loss of $75,000 notionally wipes out the capital of $50,000, so the business shows a capital deficiency of $25,000 and appears to be insolvent.

When the rule is applied to banks, it means that its assets need to be valued at the same distressed value for similar assets, as were achieved on liquidation of any forced sale of similar assets by a failed bank.

Following on from previous comments above about abnormal losses and the need to reduce bank total assets by ten times the amount of abnormal losses, the market-to-market rule further forces banks to reduce total assets as fast as possible.

Thus, there is a big debate over what asset values should be adopted by surviving banks in these circumstances. The pros and cons are too complicated for this attempt to explain the present financial crisis.

The Japanese Ripple Effect
The impact of all the falling share markets has caused fear amongst Japanese investors who had invested in high yielding currencies, as Yen interest rates were so low.

Thus, there has now been a rapid rise in Yen and a fall in high yielding currencies such as AUD and NZD.

Other Downward Pressures
The drying up of bank credit for corporates and increasing consumer nervousness, has now led to a dramatic fall in consumer demand. For example, US auto sales in September 2008, were 30% lower than in September 2007.

The flow on effect of this tightening of consumer demand has led to reduced earnings outlooks for corporates in 2009 and so put more downwards pressure on the share market.

At present these fears of reduced corporate activity are leading to a view of sharply reduced world demand for commodities. This itself is causing commodity prices to fall, catching hedge fund with large long commodity positions which they are needing to sell at losses.

Some people have wondered why the price of gold has not increased further.

My view of this apparent paradox in a time of fear, is that it is because there are more hedge fund and mutual fund sellers of gold, than there are private buyers of gold. Also remember that two-thirds of world gold production goes into the jewellery trade.

Hence if demand for gold fashion jewellery falls by 10%, say from 67% to 60% of total gold production, then investment buyers will need to buy 20% more gold (i.e. 33% to 40%) to offset the fall in demand and keep the price constant.

Programmed Share Trading - Down and then Up
Yet another downward pressure in the share market has been programmed trading, where selling and buying parameters are incorporated into a computer program and the program trades without human intervention.

It used to be that most trading was by human traders who would have an emotive feel about prices dropping too quickly, but now some 70% of trades are by computers which are unemotional and just trade according to their programmed parameters.

It seems a fair assumption that the recent abnormal share market volatility and index moves have not been adequately built into the trading programs. Hence some irrational buying and selling decisions are being made by computers, with a preponderance on the selling side.

Sooner or later the market will turn upwards. While there may be a sudden large initial rise , I am more inclined to think that the preponderance of programmed trading, will lead to continuing volatility, with further market recovery being of stepped increases over a longer period of time.

This is because programmed trading will trigger selling into any rally.

In addition, it must be expected that individual share trading programs will be adjusted to take account of recent volatility. Thus it will be hard to predict how the various programs will interact over coming weeks.

There were signs of this on October 10, after the initial fall caused by margin covering, when traders decided it was time to buy, but programmed trading wanted to sell more stock on each intra day rally, than the traders were prepared to buy intra day.

Do you still have a sense of humor?
Those without a sense of humour may prefer to skip this section. On eBay there is currently on offer the following item with an opening bid of $1.00 Bankruptcy Sale: United States of America

It is described as;
"Country for sale: Must sell to pay off debt. Great News for potential buyers... own your own country for pennies on the dollar due to credit crisis, high debts and poor management. Low minimum bid and no reserve. This is a bargain! Motivated sellers. (Sale proceeds to be divided equally among all citizens. Sorry, residents who are not citizens will not participate.) Purchase requirements:

1. Must assume all debt to complete purchase and run country with a balanced budget after purchase.
2. Must initiate a "one-man-one-vote" democracy since "representative democracy" is not working and most citizens feel disenfranchised under the current system.
3. Must guarantee the availability of health insurance without pre-existing condition exclusions and allow citizens to join congressional health insurance and retirement program.
4. Must install term limits on all elected positions so there is no longer such thing as a "career politician." Representatives must be required to return to previous work after completing term of service.
5. Must agree to create law stating that any elected official at any level of government including, local, state or federal, found to have acted in his/her own interest over the citizen's will be deported and permanently barred from entrance to the United States of America.

Shipping not available. Take possession in Washington, D.C. before November elections. Special interests welcome to bid since you already control the country anyway as long as you agree to the above non-negotiable terms."


Where to from here? - Short Term
On a more serious note, on Friday 10 October there were signs on the market that the bottom might be near. One sign was that a major settlement of Lehman CDS was settled without apparent problems. The parties who insured the product are now required to pay the insured parties around 90 cents in the dollar.

The US Treasury now appears to be considering investing in major American banks. The best way for the Treasury to do this is to act as underwriters at each bank for a cash issue of say, five year convertible preferred stock, to existing stockholders.

This would enable existing stockholders to subscribe to avoid being diluted and avoid criticism of the effects of such dilution. Being five years convertible preferred stock would help protect the Treasury investment and the conversion would provide an exit strategy for the Treasury.

Insofar as the various world economies are concerned, for most countries I doubt there will be a large recession. The most likely scenario is really for the average citizen in America or Western Europe to need to imagine that their financial position is likely to revert to what it was several years ago. That is, not as wealthy as the Dow peak in 2007, but about the same as in 2003.

For example, and as a crude measure, on October 10, 2008 the Dow index was 8451 and well below its peak of a year earlier on October 9, 2007, when the Dow Jones Industrial Average closed at the record level of 14165.

But even so, at the October 10, 2008 close of 8451 was equivalent to where the Dow was in 1998 before the drop in interest rates. Thus before any recovery, the Dow October 10 level is similar to 1998 level.

The 14165 peak must include an element of Housing Bubble, so must be discounted as a target in the medium term. It seems therefore be that recovery is likely to settle somewhere between the 1998 index and the 2007 index.

Many investors will measure their investment recovery against progress towards the 14165 peak, but they are likely to have to wait a long time to reach 14165 again.

Using a 2008 low point of say 8450 and the 2007 peak of 14165, a simple average is about 11300.

The 11,300 mark represented the level of the Dow in late 1999 and was touched again in 2000, 2001, and also between 2006 and 2008. The equilibrium level between 1999 and 2008, however looks closer to 10000 and so between 10,000 and 11000 seems a more likely target range over the next year or two.

With 12000 being a more likely maximum recovery by 2010 than the previous peak of 14165.

Thus, as a result of the financial crisis, there may be a small decline in average living standards in America and Europe, perhaps equivalent to the loss of two or three years of growth, say of the years 2006 to 2008.

This would be an inconvenience for most people in America and Europe, but not a catastrophe. It is therefore to be hoped that consumers in Western economies can recover their confidence before any further damage is done to Western economies.

Where to from here? - Longer Term

The two major growing consumer economies at present are China and India. Much of their investment capital comes from within their own countries, plus Japan, Taiwan, Singapore, and the Middle East.

The population of China and India is close to 2.5 billion, with over another 1 billion in Indonesia, Pakistan, Bangladesh, Philippines, Vietnam, Thailand, and smaller developing countries in Asia.

The Asian total population of around 4 billion for developing Asian countries (and excluding Japan and South Korea at 180m) is nearly five times that of America and the European Union combined, which is about 800m.

There continues to be a rapid growth in living standards in China and India, although off a very low base. There is also likely to be continuing consumer growth within Russia, population 140m, even if some of the Russian oligarchs have lost large amounts of money on their equity investments.

Thus a 10% drop in consumer confidence in the USA and Europe, affects 80m people.

But if 10% of people in China and India alone feel more consumer confidence, that affects 250m people even if their average consumption is much lower than in Western economies.

Thus, although Chinese and Indian exports to America and Europe will suffer in the short term, I think the growth of Chinese and Indian internal consumer demand over time, will more than compensate for their lost exports.

Rapid growth will continue in China, India, and some other Asian countries. Thus exporters of commodities to those areas should be able to grow strongly in parallel with the Asian growth.

Part of the reason for the current rapid increase in the value of the USD is due to investment funds flowing into America from investors in Asia and the Middle East to take advantage of the cheaper American equity market.

Overall, I therefore see an increasing change in the balance of the world economy as America and Europe overcome their financial indigestion, while Asian consumers spend more in their own economies.

This will mean faster growth in Asia over the next five years than in Europe or America.