Issue 66- October 29, 2010



The past week concluded an unusual period of major political, economic, and monetary policy announcements. Trying to make sense of all that just transpired will take some time. Practically speaking however, none of these singular events fundamentally changes the underlying trends of sub par economic growth and a continuing credit contraction. If anything, last week’s events were simply a reflection of this reality.

Taxes and Employment

The debate on tax policy now moves front and center. It seems clear that market participants are anticipating some form of a compromise on at least a modest extension of the status quo. But at the risk of stating the obvious, congressional compromises have been hard to come by recently. The absence of a deal in the coming lame duck session would certainly be a short term disappointment. The absence of a deal in the early New Year would translate into something much more damaging, with potential reductions to GDP estimated to be in the 1%-2% range. This looks ominous for an economy growing at about 2% with every known form of stimulus currently providing support. State and local municipalities are also going to be asked to do much more for themselves going forward. The new political reality will not provide much in the way of additional support beyond that which has been promised. At best, cuts on this level will account for additional, albeit hopefully smaller, economic headwinds.

The news on employment was, on the surface, a bit better than had been expected which is certainly a welcome development. However, like many of these reports, the devil is in the details. The U6 report which measures total unemployment and underemployment remains at 17%, and the measure of the share of the population that is working fell to a 10 month low. If we were to put ourselves back into Ben Bernanke’s shoes this past August armed with much of this outlook, it is no wonder that the Federal Reserve felt compelled to once again step into the spotlight.

Quantitative Easing Returns

The Federal Reserve at its November 3rd meeting released the following comments:

Information received since the Federal Open Market Committee met in September confirms that the pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

That the Federal Reserve is concerned about the sub par nature of the recovery makes perfect sense. However, that they would announce the purchase of $600 billion of securities that are largely trading at yields of 1.75% and below requires a bit of explanation and faith.

Simply put – traditional transfer mechanisms of stimulating the economy through lower interest rates are not working well enough. That is largely because banks are the traditional pipelines and the banking system continues to struggle with real estate write downs and restructurings. Since 2008, financial institutions, broadly speaking, have become hyper cautious in regards to most traditional forms of lending. They have also availed themselves of cheap deposits and a steep yield curve to buy short term US Treasuries thereby earning themselves a reliable, low cost, low risk return. The challenge therefore for the Federal Reserve has evolved: what additional or alternative means can be employed to stimulate the economy outside of the banking system?

The purchase of intermediate and longer term US Treasuries is designed to help bring interest rates down along the full spectrum of the yield curve in what is known as a curve flattening trend. This could promote a number of desirable outcomes. Lower longer term rates should promote additional economic activity as it has historically. In addition, QE2, as it is known, will deny the banks the ability to earn passive investment returns and force them back into actively soliciting loans. Both of these results should be modestly helpful but the real motivation as laid out by Ben Bernanke in an Op-Ed in the Washington Post is to drive investors towards more risk based assets. (

Incentives & Unintended Consequences

Individuals and institutions make active asset allocation decisions every day. The need for income and capital preservation is weighed against the requirement for growth. If income opportunities are deemed to be too unattractive, then marginal dollars should flow towards more growth oriented assets. However, the level of rates is not the only input into the equation. Growth assets also have to have a reasonable basis for investment. Buying one thing simply because it does not look as unattractive as another is a sure fire recipe for problems down the road.

Proponents of Quantitative Easing cite the stock market’s effect on the overall economy and so called animal spirits. A strong market buoys consumer confidence and thereby supports consumer demand. Call it a “Field of Dreams” approach to stimulus – “if you build it they will come”. Leaving aside for the moment the question of whether or not this is a reasonable proposition, it most certainly relies on a whole host of assumptions and leaves us with a number of potentially ugly consequences.

In the short run – QE weakens the dollar thereby fueling speculation in commodity markets. This has very real and unpleasant consequences. It does a weak economy very little good to trade a slow growth trajectory for rising gas and grocery prices. Recall how damaging $4 gas prices were in the summer of 2008 before we had the failure of Lehman Brothers and the ensuing liquidity crisis. Longer term, a weaker dollar is helpful to US exporters but this does not come without cost either. The US enjoys many benefits as the global reserve currency owing to some two thirds of all world wide deposits. In addition, roughly 42% of all transactions are Dollar based. However, a country which is deemed to be careless or uses it status in a bullying fashion will ultimately pay the price by losing that privileged position. In terms of effectiveness, it is fair to question whether a program designed to increase spending and economic activity essentially out of “animal spirits” will be any match against continued high unemployment and housing market weakness. David Rosenberg notes in his November 9, 2010 newsletter that housing prices are at least three times more important to consumer spending than any wealth effect generated by equities. Why doesn’t the Federal Reserve just come in and buy $600 billion worth of foreclosures if they really want to inflate an asset class and thereby stimulate the economy? While that may sound silly on its face, it is certainly no more outrageous than admitting to inflating asset prices outside of their economic value in the hopes that the tail will ultimately wag the dog.

Dear Mr. President -

There are two fundamental roadblocks to a robust US economic recovery and they go together hand in glove: banking and housing weakness. We can’t cure housing without healthy banks and we can’t cure the banks without an improvement in housing. Time may prove to be the ultimate restorative but we would like to respectfully put forward a plan that encourages and rewards prudent, individual economic behavior and sets housing on a path to a healthy and solid recovery.

As you know some 40% of US mortgage holders are currently unable to avail themselves of attractive current mortgage rates. While a certain percentage of these home owners have impaired credit scores, the majority are simply underwater on their homes. Consider the plight of a family who in 2005 purchased a home for $400,000 with a $50,000 down payment and who took out a 6% 30 year mortgage. The current assessed value of that home is now $300,000. This family has no current opportunity to take advantage of today’s low interest rates. Interest rates that should be helping to stimulate the broad economy. Despite having never missed a payment and owning an above average credit score, lenders simply dismiss any refinancing applications as non starters due the value of the collateral. Meanwhile, everywhere these upstanding homeowners look, they see all manner of moral hazards being rewarded. Banks that had no earthly idea of their total leverage were bailed out using these very interest rates that they are told are unavailable to them. Individuals who took on unreasonable amounts of leverage and have been unable to maintain their debt service are offered program after program in efforts to support them. But for the responsible homeowner – they are told to get stuffed and keep on paying. There is another possibility that has been floated and we would like to add our voices to the conversation.

Consider the terms of the aforementioned mortgage holder. A loan of $350,000 taken out 5 years ago at 6% has a monthly payment of $2098 and has a balance now due of $325,000. If a 4% mortgage were to be offered, our responsible homeowner could either lower the monthly payment or more importantly, could keep the same payment and shorten the term of the remaining loan from 25 years to 18.5 years. Armed with a new, shorter term loan and a payment that they have demonstrated they can reliable make, our responsible homeowner will begin to build home equity at a much faster clip. In just two years they will have the balance down to $300,000. In 4 years, the balance will be down to $275,000. In this way, responsible homeowners can see a path forward. We will be rewarding the exact (good) behavior our society has historically encouraged and we will begin to repair the equity underpinnings of the residential real estate market and banking system in a manageable time frame.

The rub of course is the current value of the collateral. None of the current home loan programs have any provision for refinancing a home that is underwater. But consider that the current holder of the loan is implicitly willing to hold the current 6% loan with insufficient collateral, the fact that they don’t have the ability to call an underwater loan notwithstanding. We have seen in the commercial market that borrowers who may violate their equity provisions do not see their loans called so long as they remain current. Look no further than the 11 properties owned by the Goldman Sachs’ affiliate Whitehall:


What is needed is a program for responsible homeowners to refinance their current balances into shorter term loans at say, 4% where they maintain their current payment stream. Let’s call $600 billion a start.

Respectfully yours,

Patsy and Jen


In this Edition

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

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

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

48 - 12.15.08
An Old Fashioned Swindle/ Who,What, Why, & How/ The Lure/ Getting Back to Fundamentals

47 - 12.05.08
Unwinding/ The Past/ The Present/ The Future.

46 - 10.07.08
History/ Changing Hands/ Dominos/ The Road Block.

45 - 07.02.08
Black Gold/ The Federal Reserve, The Banks, & The Earnings/ Moving Forward/ The Recovery

44 - 06.03.08
Shallow Waters/ Odds and Evens/ Changing Times

43 - 04.09.08
Q1 2008/ The Call/ The Response/
Investing Opportunities

42 - 02.27.08
Credit Hangover/ Busy Banks and Brokers/ Insurance Cleanup
Risk vs Reward

41 - 01.02.08
2007-Year in Review
2008 - Outlook



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Market Highlights

  11/11/10 09/30/10 06/30/10


12/31/09 12/31/08 12/31/07 12/29/06 12/30/05 12/31/04
DJIA US 11,283 10,788 9,774
S&P 500 US 1,214 1,141 1,031




Nasdaq US 2,556 2,367 2,109
EAFE Int'l Equity 1,640 1,561 1,348


5 Yr Treasury 1.22 1.26 1.80 2.55 2.71
5 Yr AAA Muni 1.26 1.21 1.7 1.80


10 Yr Treasury 2.67 2.55 2.96
10 Yr AAA Muni 2.71 2.51 3.09
30 Yr Treasury 4.35 3.70 3.9 4.71
30 Yr AAA Muni 4.25 4.11 4.43 4.46
EUR Currency 1.38 1.37 1.23 1.35
JPY Currency 82.24 83.32 88.77 93.42


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