Fear and Greed Newsletter

Christopher Wood's Fear and Greed newsletter for March 2008 is a worthwhile read, and was brought to my attention by a reader a few days ago. A great compliment to Basic Points for the Macroeconomic viewpoint.

J

Fannie Mae in Trouble

Todays IHT published a revealing story about mortgage giant Fannie Mae. Their deceitful and worrisome accounting practices are sadly a microcosm of the troubles facing the financial sector.

J

Worries grow over big backers of U.S. mortgages

By Charles Duhigg
Tuesday, May 6, 2008

As home prices continue their free fall and banks shy away from lending, Washington officials have increasingly relied on two giant mortgage companies Fannie Mae and Freddie Mac to keep the housing market afloat.

But with mortgage defaults and foreclosures rising, Bush administration officials, regulators and lawmakers are nervously asking whether these two companies, would-be saviors of the housing market, will soon need saving themselves. The companies, which say fears that they might falter are baseless, have recently received broad new powers and billions of dollars of investing authority from the U.S. government.

As Wall Street all but abandons the mortgage business, Fannie Mae and Freddie Mac now overwhelmingly dominate it, handling more than 80 percent of all mortgages bought by investors in the first quarter of this year. That is more than double their market share in 2006.

But some financial experts worry that the companies are dangerously close to the edge, especially if home prices go through another steep decline. Their combined cushion of $83 billion the capital that their regulator requires them to hold underpins a colossal $5 trillion in debt and other financial commitments.

The companies, which were created by Congress but are owned by investors, suffered more than $9 billion in mortgage-related losses last year, and analysts expect those losses to grow this year. Fannie Mae is to release its latest financial results on Tuesday and Freddie Mac is to report earnings next week.

Concerns over the companies' finances have prompted a fierce behind-the-scenes battle between nervous government officials and the two companies. Bush administration officials, the Federal Reserve and lawmakers all believe that the companies' financial safety cushion is far too thin and have pleaded with them to raise more capital from investors.

Freddie and Fannie, which are enjoying new growth and profits, have largely resisted those pleas, people briefed on the talks say, because selling new shares could dilute the holdings of existing shareholders and drive down their stock prices. Though executives have promised to raise money this year, they refuse to specify how much and when.
Moreover, the companies are using their new found clout to push Congress and their regulator to roll back the limits that were imposed after recent scandals over accounting and executive pay, according to participants in those conversations.

As a result, high-ranking government officials are now quietly threatening to publicly criticize the two companies if they do not soon raise large amounts of capital, people with firsthand knowledge of those threats say. William Poole, a president of a Federal Reserve bank who has since retired, has warned that companies like Fannie Mae and Freddie Mac are "at the top of my list of sources of potentially serious trouble."

A report released last month by the agency overseeing the companies warned that they pose "significant supervisory concerns" and that Freddie Mac suffers "internal control weaknesses." Lawmakers are pushing to rein in the companies with new legislation. Senator Christopher Dodd, the Connecticut Democrat who leads the Banking Committee, will soon take up legislation giving the government broad authority over the companies. Lawmakers say it is likely a bill will pass this year.

"They are on real thin ice financially," said Senator Richard Shelby of Alabama, the senior Republican on the Banking Committee. "And the way the law is written right now, there is very little we can do to correct that." The companies say such criticisms are without merit. Their latest regulatory filings, they note, show a combined financial safety net that exceeds required minimums by $7 billion. The companies raised $13 billion from investors last year and say any future losses will be offset by new revenue and by money they have already set aside.

"The irony is that right now I'm seeing the best opportunities since I've been in this business," said Daniel Mudd, chief executive of Fannie Mae, in an interview conducted last month. The companies also say that they have not demanded anything. Rather, they say, the limitations have been dropped because of the companies' commitment to financial transparency and aiding the housing recovery.

(J's comment: I have a feeling we will be quoting these soon to be ironic and telling statement in a few quarters when Fannie Mae is struggling just like we did for a certain Bear Stern's CEO on the eve of his company's destruction.)

But others remain concerned. Though the companies' main regulator, James Lockhart III, director of the Office of Federal Housing Enterprise Oversight, has voiced strong confidence in the companies, a high-ranking member of his staff said some officials had begun considering the worst. "It's not irrational to be thinking about a bailout," said that person, who requested anonymity, fearing dismissal.

Fannie and Freddie do not lend directly to home buyers. Rather, they buy mortgages from banks and other lenders, and thereby provide fresh capital for home loans. The companies keep some of the mortgages they buy, hoping to profit from them, and sell the rest to investors with a guarantee to pay off the loan if the borrower defaults.

Because of the widespread perception that the government would intervene if either company failed, they can borrow money at lower interest rates than their competitors. As a result, they have earned enormous profits that have enriched shareholders and managers alike: from 1990 to 2000, each company's stock grew more than 500 percent and top executives were paid tens of millions of dollars.
Those profits were threatened earlier this decade, however, when new competitors emerged and after audits revealed that both companies had manipulated their earnings. The companies were forced to replace top executives, pay hundreds of millions in penalties and consent to strict growth limits.

To keep profits aloft and meet affordable-housing goals set by Congress, the companies began buying huge numbers of subprime and Alt-A mortgages, the highly profitable loans often taken out by low-income and riskier borrowers. By the end of last year, the companies had guaranteed or invested in $717 billion of subprime and Alt-A loans, up from almost none in 2000.

Then the housing bubble burst. In February, the companies revealed a $6 billion combined loss in the fourth quarter of 2007, and both companies' stock prices fell more than 25 percent in two weeks. Despite those troubles, however, lawmakers had few alternatives to asking Fannie and Freddie to buy more and riskier mortgages. "I want these companies to help with affordable housing, to help low-income families get loans and to help clean up this subprime mess," said Representative Barney Frank, a Massachusetts Democrat and the chairman of the House Financial Services Committee. "Otherwise, why should they exist?"

But now that the government depends on Fannie and Freddie to keep markets humming, the companies are making demands of their own namely, repealing some of the limits created after the scandals and even some established by law. Last year, in return for buying billions of dollars of subprime mortgages to help stabilize the market, executives won the right to expand their investment portfolios. In March, the companies agreed to raise more capital within the year. In exchange, they received an additional $200 billion in purchasing power.

Last month, the companies promised to pump money into pricier reaches of the housing market. In return, Congress temporarily raised the cap on the size of the mortgages they can buy to almost $730,000 from $417,000. "We have to bow and scrape and haggle each time we need help," said a senior Republican Senate assistant who spoke only on the condition of anonymity.

Each time Congress or regulators have given the companies new room for growth, their stock prices have risen. But so far the companies have balked at raising more capital. That hesitation has lawmakers concerned that when the companies raise money this year, it will not be enough.

In a March meeting, Freddie Mac's chairman, Richard F. Syron, bolstered those fears by saying the company would put shareholders' interests first. Michael Cosgrove, a spokesman for Freddie Mac, said Syron is committed to both satisfying the company's public mission and creating shareholder value. Fannie Mae, which is in a regulatory-imposed quiet period because it will soon release financial information, declined to comment on capital-raising issues.

(J's comment: Mr. Syron will be "putting the interests of his shareholders first", before his government-backed entity created to help make homes affordable for Americans does anything else. The only thing more troubling than Mr. Syron's comments is the statement made by his "spokesperson" Micheal Cosgrove regarding commitment to their public mission and creating shareholder value. That sounds alot like a financial win-win. The telltale signs of trouble: platitudes by spokesmen. How anyone finds these statements assuring is beyond me and Fannie Mae's inflated share price.)

As worrisome as the need for new capital, some analysts say, are the companies' books. A report released earlier this month by Lockhart, the regulator, noted that although Freddie and Fannie had a combined $19.9 billion of "unrealized losses" on mortgage-related investments, neither company had reduced its earnings to reflect those declines. That is because they judged the losses to be temporary in essence wagering that the mortgage market would recover before those assets were sold. Such a wager is permitted by the rules but difficult for outsiders to analyze.

(J's comment: who decides said losses shouldn't count against the books, and who's crystal ball is being used to surmise that the mortgage crisis will be long gone before they decide to sell any troubled assets?)

Fannie Mae declined to discuss unrealized losses. Cosgrove said Freddie Mac's accounting choices had been the best way to reflect financial realities.

(J's comment: There go the spokespeople: ignoring losses reflect a reality to which only the Fannie Mae brass and their PR folks live in)

Both companies have also recently changed their policies on delinquent loans, which they previously recorded as impaired when borrowers were 120 days late. Now, some overdue loans can go two years before the companies record a loss. Fannie Mae declined to discuss the accounting of impaired loans. A representative of Freddie Mac said marking loans as permanently impaired at 120 days does not reflect that many of them avoid foreclosure.

(J's comment: 120 days... 4 months late on mortgage payments and Freddie Mac declined to comment on how this is not considered impaired? Change accounting rules to benefit your company and send in a representative to decline comment other than to suggest 4 month arrears on a mortgage payment doesn't reflect the reality that most don't foreclose. While we're at it lets consider that most people who have heart attacks don't die right away, why bother sending them to the top of triage at emergency rooms!)

But the biggest risk, analysts say, is that both companies are betting that the housing market will rebound by 2010. If the housing malaise lasts longer, unexpected losses could overwhelm their reserves, starting a chain of events that could result in a federal bailout.

A version of those events began in November, when Freddie Mac's capital fell below Congressionally mandated levels. The company stemmed the decline by selling $6 billion in preferred stock. But it might not manage that again if there is another unexpected loss, analysts say.

"The last two years have shown the real need for a stronger regulator," Lockhart said. If his agency did not curb the companies' growth earlier this decade, he added, "they would be part of the problem right now instead of part of the solution."

State tax revenue drops first time since 2002

Money News is reporting the first drop in sales tax revenue in 6 years. With American states running budgetary shortfalls, looking to cut back spending and reduce entitlement programs while their federal counterparts continue to accelerate budgetary deficits, who or what will continue to prop up the US consumer-led economy?

J

U.S. Sees First Sales Tax Revenue Drop in 6 Yrs.

MoneyNews
Friday, May 2, 2008

WASHINGTON -- U.S. consumers are cutting back on spending, driving the first nation-wide decline in sales tax revenues in six years, according to a report released Thursday. From January to March, sales tax revenue fell in 21 states from the same quarter last year, according to the Nelson A. Rockefeller Institute of Government.

Forty-five states rely on sales taxes as a major revenue source and by Thursday, 36 had reported on collections for the past quarter. "The sales tax declines suggest that consumption, retail sales and the income needed to support spending are slowing considerably," the report said. The institute researches state and local governments for the State University of New York.

Sales tax revenue dropped 0.1 percent for the nation as a whole, according to the report, the first decline since the first quarter of 2002. The government Wednesday said that consumer spending grew last quarter at the weakest rate since 2001.

Sales tax collections dropped the most in the Southeast, falling 3.8 percent. The Rocky Mountain region, which includes states such as Colorado and Idaho, had an average decline of 1.8 percent. Collections rose the most in the Mid-Atlantic region, up 2.4 percent. The institute said Maryland registered the largest gain, up 8.9 percent. The state had boosted its tax rate to 6 percent from 5 percent.

After Maryland, Texas had the biggest rise, at 6.7 percent. The largest revenue drop was in South Carolina, but it was due to a new law eliminating sales taxes on unprepared food. The second largest decline was 7.0 percent in Virginia, followed closely by Florida.

Most states have laws requiring them to balance their budgets this year, and drops in major revenue sources could force them to cut programs and other spending. According to the National Conference of State Legislatures, sales taxes provided a third of state tax collections in 2004, with individual income taxes making up nearly another third.

Since the housing market bubble burst and the credit crisis gripped the country, many states have cut spending. For fiscal year 2009, 23 states and Puerto Rico are projecting budget shortfalls, according to the conference.

Nouriel Roubini on CNBC

This interview by Nouriel Roubini on CNBC Europe discusses the implications and his outlook for further cuts by the Federal Reserve. I follow Dr. Boubini's viewpoints closely on his blog archive at the RGE Monitor site.

Nouriel has long been bearish on the US economy, His August 23rd, 2006 article:

The Biggest Slump in US Housing in the Last 40 Years"…or 53 Years?

His core thesis was summarized in 3 points:

I have also argued before that the effects of housing on US economic growth and the role of housing in tipping the US economy into a recession in early 2007 are more significant than the role that the tech sector bust in 2000 played in tipping the economy into a recession in 2001. There are three reasons:

1. The direct effect of the fall in residential investment in aggregate demand will be as high as the effects of the fall in real investment in the 2000-2001episode. Then, real investment fell by about 2% of GDP. This time around the fall in residential investment alone – let alone the role other components of real investment, such as software and equipment, that are already falling in Q2 – will be as large as residential investment could fall from the peak of about 6.2% of GDP (the highest level since the 1950s) to as low as 4% of GDP at the bottom in 2007.
2. The wealth effect of the tech bust was limited to the elite of folks who had stocks in the NASDAQ. The wealth effect of now falling housing prices – yes median prices are starting to fall at the national level - affects every home-owning household: the value of residential real estate has also increased to 48.5% of household wealth in 2006 from from 38.7% in 1996. Also, the link between housing wealth rising, increased home equity withdrawal (HEW) and consumption of durable and non durables is very significant (see RGE’s Christian Menegatti brief on this), much more than the effect of the tech bubbles of the 1990s. Last year, out of the $800 billion of HEW at least $150 or possibly $200 billion was spent on consumption and another good $100 billion plus went into residential investment (i.e. house capital improvements/expansions). It is enough for house price to flatten – as they already did recently – let alone start falling - as they are doing now since they are beginning to fall in major markets – for the wealth effect to disappear, the HEW dribble to low levels and for consumption to sharply fall. Note that this year there will be large increases in the borrowing costs for $1 trillion of ARM’s while this figure for 2007 will be $1.8 trillion. Thus, debt servicing costs for millions of homeowners will sharply increase this year and next.
   
3. The employment effects of housing are serious; up to 30% of the employment growth in the last three years was due directly and indirectly to housing. The direct effects are job lost in construction, building materials, real estate brokers and sales agents, and employees of the mortgage finance industry. The indirect effects imply that the role of housing is even larger than 30%. The housing boom led to a boom in consumer durables spending on home appliances and furniture. Indeed, in Q2 real consumption of such goods was already negative: as you have less new home built and purchased and less old homes refurbished and expanded, you get less purchases of home appliances and furniture. There are also other indirect effects of the housing bust on employment, even on the purchases of motor vehicles. Indeed, the current auto sector slump is not unrelated to the housing slump. As the Financial Times put recently, the sharp fall in the sales of Ford's pick-up trucks is related to the housing slump as such truck are widely purchased by real estate contractors. And indeed in Q2 real consumer durables (that include both cars, home appliances and furniture all related to housing) already fell, consistent with the view that we have now have a glut in the stock of consumer durables (durables consumption has a investment-like nature to it as such goods last for a long time). Thus, as housing sector slumps, the job and income and wage losses in housing will percolate throughout the economy.

Today's job numbers are being given a positive spin by the buy-side media pundits becuase the numbers werent as bad as expected. When job losses fuel a market rally because the economy, while bad, isnt as bad as a mythic group of economists fortold, I worry. Mish's blog outlines why the jobs report and the current rally in equities is no more than an April fools joke a month late.


J

Outsourcing Debt Collection

Todays IHT is reporting on the proliferation of debt-collection outsourcing to India. Not the type of activity one would associate with outsourcing, but the irony of India's economy growing on the backs of American addiction to debt is just too much to pass up.

J


India's kinder, gentler debt collectors remind Americans to pay their bills

By Heather Timmons
Thursday, April 24, 2008


GURGAON, India: In a glass tower on the outskirts of New Delhi, dozens of young Indians are on the telephone, calling out-of-work, forgetful and debt-stricken Americans to ask for cash. "Are you sure that's all you can afford?" one operator in a row of cubicles inquires politely. "Well, how do you take care of your everyday expenses?" presses another.

Americans are used to receiving calls from India for insurance claims and credit card sales. But debt collection represents a growing business for outsourcing companies, especially as the U.S. economy slows and its consumers struggle to pay for their purchases. Debt collectors in India often cost about one-quarter the price of their American counterparts, and are often better at the job, debt collection company executives say.

"India will be the only place we grow this year," said J. Brandon Black, the chief executive of Encore Capital Group, a debt collection company based in San Diego. India is Encore's largest operating area, with about half the company's collection force of more than 300.

Companies like Encore buy bad loans from banks and credit card issuers for pennies on the dollar and pocket the cash they collect. The delinquent borrowers often owe at least a thousand dollars. So far just a tiny fraction, maybe 5 percent, of U.S. debt collection is done outside the country, industry executives estimate. But new business is in the pipeline. Financial services clients are saying, "We want you to collect my debt, to analyze it and change the way that we sell" the loans, said Tiger Tyagarajan, executive vice president at GenPact, the business processing company spun off from General Electric that has roots in India.

Telephone debt collection represents new, more aggressive territory for India. "This is really a sales job," Hughes said. "It is commission-intensive, and you're paid on your ability to collect." Like many sales teams, Encore's collectors in India gather for a daily pep talk before their shift. In one recent session, they were schooled on the intricacies of American tax policy.

Once the calls start flowing, the Encore office at Gurgaon resembles nothing less than the headquarters for an enthusiastic fund-raising telethon. Just minutes after collectors have put on their headsets, a supervisor yells out "Rajesh, for $35 a month for three months." All employees enthusiastically respond by clapping three times, and the name Rajesh is the first on the day's sales board.
Companies like Encore often schedule dozens of payments and make dozens of calls before a loan is paid off.

Mortgage loans, which involve complex state and national laws, are nearly always handled by collectors in the United States. But credit card, auto and other debt are prime candidates for collection overseas. Just over 4.5 percent of all bank credit card accounts were delinquent in the fourth quarter of 2007, according to the U.S. central bank, the Federal Reserve, up from 3.5 percent two years before. Businesses in the United States put $141 billion in delinquent consumer debt up for collection in 2005, according to a PricewaterhouseCoopers survey commissioned by an industry group, and debt collection agencies collected $51 billion that year. They kept nearly a quarter of that in profit.

Encore hires people with call center experience in India, and then trains them in unexpected skills like sympathy. Clients "get very abusive, very emotional, very sad," said Manu Rikhye, vice president at the Encore unit in Gurgaon. The collector's job is to "try to empathize with the consumer," he said, and try to figure out, if they are angry, why. "Maybe it's us, maybe it's someone else," he said. "You have to hear what they have to say."

Encore pays its collectors in India an average base salary of 17,000 rupees, or $425, a month, and they earn bonuses - sometimes more than $1,000 a month - for getting customers to pay. In contrast, collectors in the United States, make about $6,500 a month. Thanks to the income, a windfall in India, where the average monthly wage is $63, collectors are buying some of the status symbols that probably got their clients into trouble in the first place - new scooters, iPods, Swatch watches and exotic vacations.

Captain Credit-Crunch

Look up in the sky
It’s a CDO!!
It’s an SIV!!
No It’s a bear market.


After sitting down to a nice hefty bowl of Captain Credit-Crunch cereal I thought Id take the time to discuss something other than the complexities of this bear market in the making. Just like a good Captain I have come to realize it was the tactical plans laid by those in command which sowed the seeds of the current crisis.

The tactics employed by various financial institutions are at best voodoo accounting practices; dropping doll-like charts and graphs before the audience, poking them with needles in hopes of eliciting a positive reaction from the market.

More subversive has been the shuffling of assets into "tiers" with varying explanations of what said tiers actually represent, while delaying at all costs reporting of asset rotation through various levels of accounting hari-kari.

Last March Alan Schwartz, Bear Sterns CEO uttered these now famous lines on CNBC “Bear Stearns' balance sheet, liquidity, and capital remain strong... Our liquidity position has not changed at all, our balance sheet has not changed at all” Bear Sterns would effectively declare bankruptcy by the end of that week. Such carefully crafted statements about an institution’s “strong” or "solid" balance sheet and healthy "capitalization" are dubious at best.


Ive looked these terms up in the dictionary and have no idea what constitutes a "solid" balance sheet. In high school my friends used to talk about the girls who were a “solid” 8 out of 10, good house parties were "solid" jams, and my favorite record had 15 tracks on it but 10 of them were "solid" tunes.20 years later, 20 pounds heavier and many hairs lighter, in the most sickening of rerun’s we are told by men in fine woolen suits that their bank’s balance sheets are "solid"?
I don’t know whether to buy more shares or chest-thump them over a cigarette along the butt-wall after gym class?

Granted I did look up "well capitalized" in the dictionary and it made perfect sense from a fiscal point of view. Certainly I never referred to girls or my mother's cooking as "well capitalized". Yet within this sound definition, I wondered why banks kept uttering this phrase. Why was being well capitalized so fantastic? Who needs sound capitalization if all is well? And why have banks grown gun-shy about lending to other “well capitalized” institutions with “sound” balance sheets?

Its sheer madness that black swan events are even being discussed, if one just happened 6 months ago, what are the odds of another so in 2008 right? Sorry was my mic on?

I would gladly surrender the prospect of double digit returns YOY just to hear a CEO of a major financial institution give this speech after the credit crisis:

"We believed a new paradigm of wealth was being created in which we earned double digit returns on triple A rated bond-like creatures that only MIT trained mathematicians understood.For years we enjoyed the upside but seemingly none of the risk, as blue-chip financial institutions, the vanguard of wealth creation in America, our stock was rising in double digits annually while still holding "conservative blue-chip" status. It was the very definition of a financial WIN-WIN.

Surprisingly our clients enjoyed the returns and blindly trusted us to keep risk parameters in check. In a sense we began drinking our own Kool-Aid when we spoke of safe returns, of "risk-adjusted" parameters, and sound money management.When the risk hit the fan we fired our "risk" analysts because they failed to do their job. In their place we hired the finest PR and consultants (our client’s money could buy) who could begin the delicate process of applying lipstick to the pig we placed on the market's stage.

For some time they made the pig dance, stocks resumed their upward rise, and our PR people averted a disaster, convincing the masses the worst was over. We lost upwards of %30-50 of our share price but the financial media still said our company was a buy. I mean, you can’t buy that kind of support, bless their hearts.

The lower prices went the more ways people came up with ways to keep the pig dancing, our stock became "cheap", a bargain. It was as if the credit-crisis was this external event that was hurt our share price, yet we maintained our stance of mere victims in this crisis that spread like cancer across the financial landscape. It was going on out there but in here we were fine, just fine, and we would weather the storm because of all these words that drummed up images of fortress like risk-aversion.

It was 2nd most popular definition of a financial WIN-WIN.We rehired our old risk-analysts to find out the odds of 2 WIN-WIN's happening to big banks in the same 12 month time-frame. they said the odds were so improbable, their mathematical models required 4 dimensional fractal combinatorics to express the exponential.

We slid down in our high-backed leather chairs sipping the most delicate of ancient single-malts, the saltiest of caviar's while cloaking our thievery in the softest of silken suits

The fiscal ship may have been sinking but the passengers were certainly not rushing for the life rafts. If anything the people were content with the first-mate's explanation that the ship was on a "well-charted" path.

I guess its true what they say about us….Captains of Industry."

Paul Volcker blasts Fed's printing press ramp-up.

Thanks to www.beearly.com for this article from the Globe and Mail. Former Fed Chairman Paul Volker has strong words for the current Fed regime.

J



THE BUY SIDE: POLITICS

AVNER MANDELMAN
APRIL 12, 2008


A few days ago an unusual event took place: Paul Volcker, the mythical U.S. Federal Reserve Board chairman from the Reagan years, criticized the policy of the current Fed chairman, Ben Bernanke, in a speech to the Economic Club of New York. Just so you grasp how extraordinary this was, you should first understand that normally a past Fed chairman scrupulously avoids saying anything at all about current Fed policy - for the simple reason that the current Fed chairman's words are one of his most important tools: They can sway markets.

This ability does not fade entirely when a Fed chairman leaves. So when a past Fed chairman speaks, his words can clash with those of the present one and make that one's job difficult. Out of professional courtesy, past Fed chairmen therefore keep quiet; Mr. Volcker especially - the man who hiked interest rates to 20 per cent to kill inflation, at the cost of a deep recession. But last week Mr. Volcker spoke his mind bluntly. He said, in effect, that the current Fed is not doing its job.

This would have been unusual enough. But Mr. Volcker went further. Not only is the Fed not doing its job, he said, but it is doing the wrong job: It is defending the economy and the market, instead of defending the dollar. And just to stick the knife in, Mr. Volcker added that this bad job now will make the real job - defending the greenback - much harder later. It'll cause even greater economic suffering.

In plain words, Mr. Volcker implied that the current Fed is not only incompetent, but that its actions are dangerous. There is no record of Mr. Bernanke's reaction, nor that of anyone else inside the Fed. But there was plenty of buzz in the market because what Mr. Volcker said amounted to a rousing call to raise interest rates. Yes, raise rates, and do it now.

Can you imagine what this would do to the market? I sure can, which brings me to the gap between physical economic reality as we witness it every day in our physical investigations, and the surreal market chatter we see and hear on TV. This gap has never been wider - but it will inevitably close as markets catch up to reality - as just forecast by former president Ronald Reagan's Fed chairman.

Let me cite three items, then go back to Mr. Volcker. First, commercial real estate. You surely have read about the residential real estate problems - subprime loans syndicated and resold, causing the implosion of several U.S. financial institutions. The writeoffs and damage here total close to a trillion dollars, said the IMF recently. That's about one-seventh of the U.S. gross domestic product, or more than three years of growth. But what of commercial real estate? I heard recently from some savvy private real estate investors that although commercial real estate fell by 20%, it should fall by a further 20 to 30 per cent before it provides a reasonable rate of return. So whatever economic damage was done to the economy by residential real estate speculation may eventually be equalled by commercial real estate. Say another 10th or seventh of GDP erased, or another two-three years of growth gone.

Second, there's also the war in Iraq. Some U.S. economists recently estimated it has cost about two trillion dollars to date - another two-sevenths of U.S. GDP. That's five more years of GDP growth gone.

And third, we haven't even begun to tally the private equity blowups that are surely coming. Taken all together, the economic damage spells a very bad and long recession. How to fix it? No problem, say the actions of Mr. Bernanke's Fed. Let's print the missing money - and it doesn't matter if it causes inflation and tanks the dollar. Because that's not our job.

Up to now Mr. Volcker kept quiet, but no more. In his speech he just said, in effect, that the recession is not the Fed's problem. It's the government's. The Fed's job is to defend the currency and fight inflation - exactly the opposite of what this Fed is doing. The solution? Raise interest rates, Mr. Volcker practically said, no matter the consequences now, because if you don't, you'll have to raise them even more later, with even more awful consequences.

Will rates indeed rise? I have no doubt they must. Not now, perhaps, but at the end of this year or the beginning of 2009, with a new president in the White House. The stock market, which usually looks six to nine months ahead, already understands this and may soon react. In fact, when Mr. Volcker's words sink in, the markets are likely to sink as this bear market rally ends. For surely you understand we are still in a bear market - and only in the beginning of it? Yes, we are experiencing a rally, and like most bear rallies, it is sharp and spiky. But when bear rallies end, they leave a lot of spiked bulls behind - and this rally should be no different. When it is over -in the next few weeks, methinks - the waterfall could continue, as the market begins to digest the inevitability of higher inflation and higher interest rates ahead.

Against all protocol, Mr. Volcker just went out on a limb and warned you of this. I urge you to heed his words.

food riots breaking out across the globe

The Toronto Star is reporting on food riots breaking out across the globe. I recently posted a story regarding wheat export suspensions in Kazakhstan here. In what could become the front-page story for many months to come, food riots are an extremely power destabilizing force in already unstable central Asian and African states. Haiti has considerble problems and staggering poverty, but if people cannot afford to eat, no measure of law can prevent an outright war over basic resources.

UN: Food riots 'warning sign'

REUTERS/ EDUARDO MUNOZ

Demonstrators form a barricade in the town of Les Cayes, Haiti April 7, 2008 during demonstrations over rising food prices. High food prices could bring unrest and instability around the world, official says.

DUBAI, United Arab Emirates –

The recent outbreak of food riots is a warning sign that rising food prices could cause unrest and instability across the world, the UN's top humanitarian official said Tuesday. Combined with the negative impact of climate change and soaring fuel prices, a "perfect storm" is brewing for much of the world's population, said John Holmes, undersecretary general for humanitarian affairs and emergency relief co-ordinator.

"The security implications (of the food crisis) should also not be underestimated as food riots are already being reported across the globe," Holmes told a conference in Dubai, addressing challenges facing humanitarian work. His comments came after two days of rioting in Egypt, where the prices for many staples has doubled in the past year. And violent food protests were continuing for a second day in the capital of Haiti.

"Current food price trends are likely to increase sharply both the incidence and depth of food insecurity," Holmes said, noting a 40-per-cent average rise in prices worldwide since the middle of last year. Holmes said that the biggest challenge to humanitarian work is the effects of climate change and the resulting "extreme weather" that has doubled the number of recorded disasters – from an average of 200 a year to 400 per year in the past two decades.

Adding food scarcity and expensive fuel to the mix have made for a very volatile situation, he said. "Compounding the challenges of climate change in what some have labelled the perfect storm are the recent dramatic trends in soaring food and fuel prices," he said. One of the factors pushing food prices higher and sparking protests all over the world is more expensive diesel fuel, which is used to transport most of the world's food.

Along with the riots over food scarcity in Haiti and clashes with police over high prices in northern Egypt, UN employees in Jordan staged a day-long strike for pay raises due to a 50-per-cent rise in prices there. A teenager injured in the clashes in the northern Egyptian city of Mahalla al-Kobra has died from his wounds.

In Port-au-Prince, the Haitian capital, UN peacekeepers fired rubber bullets and tear gas into a crowd outside the presidential palace Tuesday on the second day of protests over soaring food prices. Some protesters were trying to break down the palace gates before the UN troops established a security perimeter around the building. ``We are trying to deal with the situation," said Fritz Longchamp, chief of staff to President Rene Preval who was at work inside the palace. The food unrest began last week when Haitians burned cars and attacked a UN police base in the southern city of Les Cayes. At least five people were killed there. The demonstrations reached the capital Monday as thousands marched past the National Palace, some of them crying out: "We're hungry!"

John Powell, the deputy executive director of The United Nation's World Food Program, emphasized the need for developed countries to help governments in the developing world. Developing countries experiencing unrest over high food prices need help in developing "social safety net programs," he said. "Riots today mean you need a solution tomorrow," Powell said. Governments with no "policy space" and under pressure from organized discontent in urban centres "is not likely to be the best decision" in trying to solve the problem, he said.

Powell said the planet is getting hungrier with four million people added to the list of those in most dire need for food to survive. The rise of fuel and food prices is unlikely to stop soon and it affects everyone, Powell said. In the past, natural disasters, wars and ethnic conflict made the rural areas most vulnerable to poverty and hunger. Now, the most vulnerable live in the cities, Powell said.

"They see food on the shelves but they cannot afford to buy it," said Powell. He called urban poverty the "new face of hunger."