Economy Watch:  When I made my list of 10 Potential Surprises on December 24, I didn’t expect one to come true so fast.  Potential Surprise #5 has come to pass.  The Fed Funds rate is now at 3%, with the potential to go a bit further to the down side.  Another of my surprises is looking promising – #10, that John McCain would be the Republican nominee.

Another now looks like it will certainly not come true, #9, that John Edwards would be the Democratic nominee.  As I said in my December 5th essay, Assessing the Presidential Race, I thought John Edwards was the best general election candidate.  I probably overestimated how good Mike Huckabee would have been, but I stand by my analysis that John McCain is a better general election candidate than Hillary Clinton.  I acknowledge that the tide is swelling Democratic big-time this year.  For that reason, I don’t guarantee that McCain would beat Clinton, but I do think he’s the best shot the Republicans have this year.

I stand by, with trepidation, my prediction that the economy will avoid recession this year.

Economy Watch: BusinessWeek (go to chart 4, but the whole slide show is interesting) has a cool chart graphically depicting the "Great Moderation" in GDP growth over the past 20 years.  Maybe the Fed knows what they’re doing after all…

Economy watch:  I like to invest by focusing on the big things and getting on the right side of the big trend.  There is alot of day-to-day noise that can distract me, and I try my best to tune it out.  This decade there have been four big things to get right, and if you got them right, you have invested well.  The four are: (i) the reversion of the dollar to its long term trend from its 2001 high; (ii) continued globalization; (iii) the rise of digital consumer technology; and (iv) the blow off top in the global real estate boom.

Today I will focus on the creation and bursting of the real estate bubble.  First a chronology:

1. In 2001, the US experienced a recession during a period of extreme dollar strength and following the bursting of the telecom bubble, a credit crunch on businesses.
2. The combination of a strong dollar and credit crunch created the threat of deflation, which the Greenspan Fed responded to by lowering the Fed Funds rate to 1%.
3. Even when the credit cycle turned up, Greenspan kept rates at 1% for an extended period of time, resulting in an incredibly steep yield curve.
4. A steep yield curve encourages high leverage.
5. In the meantime, the dollar was starting to fall.  East Asian central banks propped up the dollar by recycling dollars used to buy their exports into US treasury and agency securities.
6. With this inbound liquidity flowing and interest rates low, the credit boom was primed.
7. The demand for credit investments encouraged the creation of asset-backed CDOs to satisfy investor demand.
8. Low interest rates, easy money, positive demographics and a long running trend of positive residential real estate returns, encouraged a speculative frenzy in real estate.
9. Armed with sophisticated math models using normal distributions for default rates, CDO sponsors convince the rating agencies to assign higher-than-deserved ratings for various tranches of the securities.
10. Investors, relying on rating agencies because the complexity of the products was too opaque, were attracted to the securities for their relatively high yields (also due to lack of liquidity).
11. Mortgage originators, incentivized to originate mortgages and sell them off, did what they were incentivized to do, albeit sometimes by cutting corners.
12. In the meantime, the Fed is raising rates in predictable 1/4% increments.  The predicibility at first encourages speculation.  But since the credit boom and resulting inflation raged on, Bernanke kept raising rates to 5.5%.
13. The housing bubble popped as high interest rates and high house prices reduced affordability.  Subprime borrowers began defaulting on their loans (that often had no equity down), house prices began to fall, credit hedge funds began running into trouble and the whole process started to go into reverse.

Everyone in the chain of events is to blame.  But I assign different levels of blame.

Whom I blame the most (because they created the incentives for the bubble):

• Alan Greenspan (for not raising rates faster and sooner)
• The Peoples Bank of China (for building currency reserves to  promote their own exports)
• The rating agencies (for not realizing that defaults are correlated and that the model should have fatter tails)
• Anyone who committed fraud

Whom I blame less (because they were reacting to conditions):

• Borrowers (hey, they give me cheap money with no equity down, I’ll take it)
• Mortgage Originators (hey, you pay me to sell you mortgages, no matter what the quality and with no documentation, fine, I can sell those all day long)
• Wall Street (hey, we’re just doing what we always do)
• Bond Investors (hey, the rating agencies said this was AAA)
• Ben Bernanke (hey, there was an inflationary bubble going on, how can I not raise rates)

The housing crash still has a ways to go.  Demographics are now working against the market, and while house prices fall, its impossible to know what all the CDO securities are worth.  Of course its a vicous cycle, because as the financial institutions take write-offs to CDOs their equity bases shrink and general credit is restricted, which makes the economy worse and housing prices fall more, which in turn cuases more write-offs to CDOs.  Such a scenario is called DEFLATION.  Right back at ya, Greenspan.

Economy Watch:  The economy of China is careening toward disaster and they have no one but themselves to blame.  The mercantilist Chinese policy of building dollar reserves is fuelling not only a preposterous speculative bubble within China, but also in the commodity markets worldwide, and formely in the US housing market (abetted by Wall Street who were able to multiply the incoming reserves via structured financial products and high leverage).  Notice I blame not the pegged exchange rate, but the act of reserve building.  Anyway, now they are imposing price controls to freeze the rising price of oil THAT THEY ARE CAUSING with their expansionist monetary practices. 

The longer the charade goes on, the harder China’s markets and economy are going to fall.  I don’t know when the end comes, but it will come.