Issue 71- May 24, 2011


The Question is…How many Years?

Consider the task now facing the Federal Reserve. Having successfully fought off the liquidity crisis of 2008, the Central Bank has subsequently flooded the system with excess liquidity through not one, but two rounds of Quantitative Easing. Two billion dollars had traditionally been considered normal excess reserves. That number now stands at $1.4 Trillion. Traditional market mechanisms for fine tuning the target Federal Funds rate are simply swamped by the level of liquidity which stands at 700 times what was customary. The water is so deep effectively that even the new methodology of paying interest on reserves would be relatively impotent unless of course the central bankers were prepared to radically raise rates which given the fragility of the recovery they are not. Therefore, the path forward is going to be a slow, deliberate, methodical unwinding of mortgage and Treasury holdings. The term now being tossed about is “exit” and this should not be construed with the raising of short term rates. They are likely to be “exiting” for at least a couple of years and this supposes that the recovery remains more or less intact. This recognition and acceptance by the market of this path forward has meaningful implications for the shape of the yield curve.

Now we know that everyone tells us that rates have no where to go but up, and that Bill Gross has sold all his US Treasuries and then some, but we would like to consider another possibility. In this case, the fragile recovery and the unwinding of the Federal Reserve’s balance sheet promote investor’s appetite for longer duration income producing assets if it is no longer assumed that rates will rise rapidly. The unusual steepness of the yield curve; some 265 basis points; could well provide ample compensation to those who see the road ahead as long and protracted. A flattening of the yield curve led by longer term rates rallying would be a most welcome development to the Federal Reserve and to the moribund housing market as well.

“Unexpected” Housing Weakness

C’mon people. Pundits who are still surprised by the continued weakness in housing should find new work. With more than 1/3 of all homeowners underwater on their primary residences, no one should be expecting an imminent rebound. Builders have slowed their production to a trickle and that is good news. We already have on hand more than 2 years of housing inventory and that was a run rate that presumed a functioning mortgage market which we currently do not have. The simple math for those who continue to pay their monthly payments on their underwater homes bought in 2006 would require another 5 to 7 years in order to pay down sufficient debt and therefore rebuild sufficient equity to be flat with today’s prices. This is clearly a case of years of work ahead of us.

In addition to rebuilding the equity in current homes, the mortgage market itself looks like it will also need to be retooled – no small feat. There are those who want all mortgage lending to come from the private sector and they point to Canada as proof positive that this can be done. We have no argument that Canada has done an excellent job for their 34 million people, and are also quite confident that we too could do an excellent job if we simply wanted to create a market for 10% of the US population. The US Agencies tasked with promoting home ownership provided two singular advantages. First, they created a uniform underwriting process and conduit system whereby private capital, outside of the banking system, could comfortably invest in home loans. Secondly, the agencies had the ability to borrow longer than a traditional bank, say 30 years versus 10 years, thereby providing the platform for the 30 year amortizing mortgage. A new system that intends to simplistically rely on banks or the promises of the discredited investment banks will be a rump of its former self.

This is not to say that the government needs to stand behind every loan made, but there needs to be an understanding by those in positions of authority that an ill conceived transitioning to a private market with shorter term loans will dramatically and absolutely erode housing prices further.

P.I.G.S. Can’t Fly…

It has been just over a year since the conflagration led by Greece came to the fore of European financial issues. Since that time, governments have been fired, austerity measures have been implemented, and billions of Euros have been lent in an effort to avoid a default in any of the impaired sovereign debts. Historically, if a nation found itself in such dire straits, the currency would be devalued and a restructuring would ensue. As recently as the late 1980s, Mexico found itself in similar conditions. Working through a committee of banks and the US Government, concessions were achieved and new debts collateralized by US Treasuries were issued. In time, 17 different countries took advantage of this avenue to restructure.

The conundrum this time is made up of two parts. Each of the would be supplicants is a current member of the ECB which means they have no unique currency in which to operate. In addition, much of their debt is held as tier one capital in many of the largest banks in Germany, France, Spain, and the UK. Since the Euro cannot be devalued sufficiently to permit any meaningful restructuring of the P.I.G.S debts, the weight of any deal would fall upon the banks to absorb what could effectively be de-stabilizing losses and one can certainly understand the resistance to relive a “Lehman” size liquidity crisis on their side of the Atlantic. This leaves very little room under the current architecture of the Euro and the ECB. That said, it may be time to pull out Occam’s razor: "The simplest explanation for some phenomenon is more likely to be accurate than more complicated explanations." If there is no room to devalue, and the banks can not be expected to fall upon the default sword, then we should expect the system to give in some other area. A restructuring of the Euro Zone into those solvent and those insolvent members might ultimately be the most palatable path forward for all. Talk about years!


For these past three years markets and participants have been faced with the relentless aftermath of the bursting of a global financial bubble. There have been in most cases no good solutions and we are currently living with many unwelcome and unintended consequences of actions that were taken in the heat of the moment. But necessity is the mother of invention and we have seen a dramatic improvement in the efficiencies and productivity of businesses large and small. Many companies now represent far improved business propositions than they did at similar valuations three years ago. Recently we have seen states and local municipalities begin to address the pressing conditions of their finances; an admittedly unflattering process but necessary nonetheless. We have seen dramatic increases in commodity prices but these have been matched by similar declines in housing and labor costs offering a very unsatisfactory benign algebra to those most impacted by the corrosive costs of day to day necessities.

As investors, we have moved along the continuum of denial then anger followed by bargaining and now it seems depression. Our problems which took decades to present themselves will in fact not be resolved by a painless “V” shaped recovery. The acceptance of the current state of our finances will lead to solutions. This is precisely what we have seen in the business sector. We continue to see good values in those companies with high quality balance sheets and in those essential service bonds with dedicated revenue sources. For those willing to suspend the notion of instant gratification, investing in quality should afford long term success.

Best Wishes –

Jen & Patsy


In this Edition

  • The Question is... How Many Years?
  • "Unexpected" Housing Weakness
  • P.I.G.S. Can't Fly
  • Stages

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

70 - 04.11.11
Inflation for thee, but not for me/ On the Other Hand .

69 - 04.05.11
Implications - A Bevy & A Wedge/ Implications - Quantitative Easing 2.0/ Implications - Rules Rules Rules/ Catching Up with the Can.

68 - 03.03.11
What Ever Happened to Housing?/ Where Do Loans Come From?/
Where Do Loans Go?/ The Last Straw/ The Path Forward/ Equity/ Clearing Mechanism/ Restart Your Securitization Engines.

67 - 01.10.11
Curiosity of the Federal Reserve/ Complacency & Fragility

66 - 11.12.10
Phew/ Taxes and Employment/ Quantitative Easing Returns/ Incentives & Unintended Consequences/ Dear Mr. President

65 - 09.28.10
Progress in the Absence of Milestones/ Changing Nature/ Correlations & Valuations/ Synthetic Securities

64 - 08.18.10
A Tricky Diagnosis/ Traditional Treatment/ Bad Medicine/ New Age Medicine/ Homeowners/ The Banks/ Pension Plans/ Bull Flattening

63 - 06.17.10
Hip & Groovy/ The Trouble with Zombies

62 - 05.24.10
Next Sequel/ 2012

61 - 05.04.10
Intensity/ Principles versus Rules

60 - 04.01.10
Grand Isle to Lincoln
/ Mile Post 312/ Mile Post 353/ Mile Post 399/ P.I.G.S. are a Problem

59 - 02.17.10
Surprise, Surprise, Surprise/ P.I.G.S. Matter/ Leverage vs. Debt/ Going Forward

58 - 12.29.09
2009-The Year in Review/ 2010 - The Year of "The Exit"/ Deflation or Inflation?/ 4 Cylinder Economy/ Rates and Returns

57 - 11.04.09
Banks-Back to the Future/ Navigating the Tsunami/ TARP 3.0/ Implications

56 - 09.15.09
Are We There Yet?/ The Beginning? The Present/ The Journey is the Destination

55 - 08.04.09
A Transformation is not a Recovery/Not All Economic Data is Created Equal/
Smallest, Lowest, "Shortest"

54 - 06.24.09
Aftershocks/ Fragility/
Inflation and the Fed

53 - 05.29.09
A Brave New Road to Recovery/ Vehicle Choice/ Speed Limits

52 - 04.07.09
The Things We Know/The Things We Don't Know/Savings and Sensibility

51 - 03.25.09
The Correct Problem/ The Need for Speed/ No Good Deed Goes Unpunished

50 - 03.05.09
Rebuilding Credit/ Under Repair/Problems Persist/Big Chore

49 - 01.12.09
The Year in Review/ The Path Forward/ 2009


More Past Issues
can be found in our

Newsletter Archive


Market Highlights



12/31/10 12/31/09 12/31/08 12/31/07 12/29/06 12/30/05 12/31/04
DJIA US 12,381
11,578 10,428
S&P 500 US 1,317


1,258 1,115


Nasdaq US 2,759
2,653 2,269
EAFE Int'l Equity 1,661
1,658 1,581


5 Yr Treasury 1.83 2.30 2.02 2.71
5 Yr AAA Muni 1.32 1.77 1.75


10 Yr Treasury 3.23
3.38 3.92
10 Yr AAA Muni 2.83
3.44 3.26
30 Yr Treasury 4.30 4.50 4.325
30 Yr AAA Muni 4.40 4.82 4.9
EUR Currency 1.40 1.41 1.34
JPY Currency 81.83 82.87 81.32


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