• Gold crashes through the $1,050 per ounce mark…and keeps going,
• V-shaped delusions and sluggish to non-existent re-hiring,
• Plus, day and night…love and loss…paper and metals and plenty more…

Eric Fry, with a few words about life, love and the value of adversity…

“Love is blind,” the poets observe…But no need for dismay; loss of love usually restores complete vision.

Furthermore, lovers never complain about their blindness…at least not until they are squaring off in divorce court. At that point, the now-former lovers possess such acute vision that they can pinpoint flaws the Hubble telescope could not detect.

Blind love is not such a bad thing, however. In fact, it is usually much more fun than 20/20 solitude. But these two extremes go hand-in-hand…or arm-in-arm…or whatever. Without heartbreak; true love holds no value. Until one has suffered the agony of lost love, he or she (but usually, she) cannot fully appreciate the value of rediscovered love. In fact, he or she (but usually, she) might not even recognize true love when it finally arrives.

On the other hand, without having known the euphoria of romance; who would fear its counterpart, lost love? That fear sometimes keeps petty grievances in check…and mutes the inclination to gripe about an open toilet seat.

This interaction between love and loss typifies the bipolar forces that define and influence most of the human experience…including that part of the human experience that unfolds in the financial markets. (Your editor will complete this transition from love to finance momentarily. But patience please; the digression continues…)

A rapturous romance is exhilarating, it’s true; and a ruptured romance is depressing…but oh so illuminating…

“If we lived in a world without tears,” the blues singer, Lucinda Williams, mournfully muses, “how would misery know which back door to walk through? How would trouble know which mind to live inside of? How would sorrow find a home?”

Of course, tears are not merely meant to provide “lodging” for sorrow and misery. They are also meant to evacuate pain and clear the way for new joys or unexpected delights. In other words, some knowledge of failure is essential for creating a love that can flourish. Don’t take your editor’s word for it; just try conducting a long-term relationship with someone who has never been rejected by anyone; try building a loving relationship with someone who has never “loved and lost” – someone whose past is littered with romances that THEY, alone, ended. This individual’s love and devotion will be slightly more reliable than a cat’s…maybe.

But that’s okay. The loss of love produces personal growth, emotional development…and alcohol abuse.  Two of these three results are constructive. The individual who eschews substance-abuse to face the pain of romantic bereavement head-on gains the opportunity to evolve emotionally and to learn important lessons for the next time…like which secrets to reveal or conceal; or which personality quirks in your lover are mere idiosyncrasies and which are psychological disorders.

And once you begin to understand what’s healthy and what’s merely entertaining (for a while), you are on your way to something better…at least in theory. Most of us simply repeat the same mistakes over and over. (Perhaps the native languages differ; but the neuroses remain eerily similar).

Nevertheless, as we hurtle through our existence – buffeted by the extremes of love and rejection – we gain at least the chance to enjoy something better, richer, healthier. That’s what life’s adversity furnishes…the opportunity for something better.

In fact, almost every facet of life unfolds between extremes – between deluge and drought; between war and peace; between wealth and poverty; between no and yes; between No! No! and Yes! Yes!; between prosperity and recession; between darkness and light; between sunshine and rain; between male and female; between sobriety and intoxication; between vigilance and slumber; between toil and rest.

Bipolarity is simply the way of the world.  It’s the way the world works and behaves.  And in many ways it’s the way the world MUST work.  Without both sunshine and rain, crops do not grow.

Economies are no different. They require the pain of recession if they are ever to enjoy the fruits of robust growth.  Without recessions, economies cannot achieve their full potential. They cannot unburden themselves of inefficient industries or sub-optimal regulatory structures, etc. Without recessions, economies cannot clear the way for better, healthier industries.  They cannot kick out the old, lame enterprises, for example, or enable the “younger, hotter” enterprises… so to speak.

The US economy, thanks to the dubious policies of the Federal Reserve and US Treasury, has been clinging to the old, lame companies and industries… instead of pushing them out the door to make way for healthier ones.

“The biggest problem going forward is the U.S.,” billionaire investor, George Soros, recently remarked, “as that’s where consumers are over-indebted and the banking system is basically bankrupt. The U.S. will be very slow in recovery and can’t really get going. The United States has a long way to go.”

You see, dear investor, that’s what happens when you don’t allow bad businesses to fail; they just keep hanging around making your life miserable. They keep blocking the path to newer and better things.

Dan Amoss, editor of the Strategic Short Alert, provides a bit more detail in the column below…

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The Joys of Recession
By Dan Amoss

The big questions of the moment: What kind of economic environment do we face? And more important, what’s already priced into the stock market? Here’s my view on these themes: The real job creators in the U.S. economy, small businesses, will not expand hiring as expected. There are many reasons for subdued hiring plans; an emerging reason to avoid expansion and hiring will be heightened expectations that tax rates will soar in the future to pay for out-of-control government spending.

So I expect over the next several months, mainstream pundits and forecasters will start worrying about tepid hiring, even as the pace of job losses slows. As we “lap” the 2009 corporate cost cutting by early 2010, and top lines fail to rebound, earnings estimates will have to come back down. I’m amazed at how many sell-side analysts are modeling V-shaped recoveries in 2010 earnings. Most stock prices are disconnected from reality.

Another big question is how will policymakers respond to a sluggish-to-nonexistent rebound in hiring? The economically illiterate, and those with preconceived “big government” agendas, will use any crisis as an excuse to expand government. You’ll be ahead of the game if you realize — as many in the media and academia clearly do not — that the government has no resources. It’ll take money out of one of your pockets, skim some off for its cronies, and expect you to be grateful when they put some of it — debased by the Fed’s inflation, of course — back into your other pocket.

The labor market is dealing with a structural imbalance fueled by government-sponsored housing and credit bubbles. Many will call for the government to “solve” this labor market problem, which will cause a new type of market dislocation. By early 2010, some will push for the federal government to start hiring the chronically unemployed in “New Deal” type of programs.

Where you stand on this question will determine your expectations for the future performance of most stocks. I certainly don’t enjoy having such a bearish outlook on the economy, but it’s the conclusion I reach after weighing all the evidence about the real economy; the credit markets; and policymakers’ damaging, distorting influence.

For example, corporate CFOs and Treasurers are happy about the recent bull market in risk. They know much more about their prospects than outside investors, so their balance sheet management is revealing. In a word, the approach toward capital structure is “defensive.” Heavily indebted companies are flooding the market with follow-on stock offerings to pay down debts. They’re also taking advantage of the Pollyannaish mood of the corporate bond market to issue risky bonds at attractive rates, as default risk seems to be a distant memory of bond buyers. Many corporate bond investors have taken the Fed’s bait to reach for yield, regardless of credit risk.

Amazingly, credit risk is a quaint, distant memory for most, when it should be the first consideration for shareholders — especially shareholders of highly leveraged companies like banks and REITs. In leveraged companies, shareholders’ claims can evaporate very quickly when asset values deflate and cash flow dries up.

For banks in particular, credit risk often accelerates out of nowhere. Remember how many big-time investors bought stocks like the failed Washington Mutual because it appeared to be “well capitalized”?

It’s shocking how many banks the FDIC still deems to be “well capitalized,” despite the fact that foreclosure activity is accelerating.

Foreclosure activity is crucial to the outlook for bank earnings. Mortgage losses will become a big problem for bank stocks in 2010. Mark Hanson of Mark Hanson Advisors does great work on the details behind the headline foreclosure and housing price statistics — the kind of granular, non-ivory-tower research that’s missing in Wall Street and Washington, D.C. In an update a few weeks ago, Hanson wrote:

The chart below shows the national monthly notice-of-trustee sales (late stage) versus foreclosures (last stage) counts from March through August. In that short six-month period, there have been 390,000 NTSs that have not resulted in a foreclosure (circled in red). Many are on trial [modifications].

If we assume that 250,000 of the 390,000 are presently on a trial and 40% fail, then beginning shortly 100,000 new foreclosures will spit out over a short period of time that will be added to the foreclosures that will occur naturally for reasons mentioned previously. If 60% fail, then the number goes to 150,000. With foreclosures only averaging 73,000 over the past six months, this new stream of foreclosures is significant — it has the potential to double foreclosures over a single month.

The banking system has slowed down the necessary process of “working out” unmanageable debts. Deliberately delaying loan foreclosures and write-offs — whether through government edict or smoothing out loss recognition over time — has the effect of backing up the plumbing in the system of credit intermediation. It’s the post-1990 Japan scenario of sweeping bad loans under a rug because “we can just hold on until asset values come back.”

I’ve written repeatedly about the accounting for — and resolution of — toxic assets throughout the banking system, because I see it as crucial to the outlook for both the U.S. economy and corporate earnings. The longer this is delayed, the more likely the U.S. economy suffers a fate even worse than post-bubble Japan. We have a scenario of defensive, undercapitalized banks, combined with a huge population of effectively bankrupt U.S. consumers. This is a problem that requires comprehensive debt restructuring and resolution before we can have a sustainable economic recovery.

Net-net, the outlook for economic recovery is questionable, at best…which means that the outlook for rising share prices is even more questionable.

— From the Desk of Dan Amoss: Strategic Short Report —

Hidden Government “100-F Documents” That Let You Predict Which Stocks Will Go up or Down

Discover how one small group of Americans uses government-mandated “100-F Documents” to easily predict gains or losses for any household-name stock in America…

On at least 58 different dates, each year…

And how you can now use these same “secret” documents to post returns as high as 400 – 600% over the weeks ahead. Learn How Here.

—————————————–

[Rude Endnote: Another record high for our favorite precious metal overnight. Gold punched through whatever “resistance” the $1,050 mark could muster…then added another $8 an ounce by the time we checked it this morning. So, what’s driving the metal? Fear of inflation? Fear of hyper-inflation? Overflows of speculative cash from institutional funds regaining their appetite for risk? All of the above? A and C? Other?

Who can say, really. The specter of runaway inflation has been lurking for some time now, despite assurances from the Feds that they have an adequate plan to mop up all the excess liquidity they created to deal with the credit crisis. Could it be that investors have finally lost faith in the greenback, the world’s reserve currency? What started as a rumor earlier this week about a few oil-producing nations (among others) ditching the dollar has now spiraled into all out war against Bernanke’s bills.

Indeed, a large part of gold’s rise is due to the poor performance of the battered greenback. The dollar index made fresh two-week lows overnight as recovery hopes drove investors into the arms of higher yielding assets, including foreign currencies. The Aussie dollar, for example, is galloping toward parity with the U.S. dollar once again after a not-that-surprising interest rate hike from the RBA earlier in the week. Compared to the Aussie dollar’s gains, gold’s 18.1% for the year looks somewhat tempered. The Aussie is up about 24% against the greenback from Jan. 1.

The question now, of course, is what happens to these “riskier” assets – gold, emerging market indexes and foreign currencies – if “the recovery” dies on its derrière? Do investors still trust the greenback as the ultimate save haven? Will they scamper back to ol’ Uncle Sam’s unloving arms? Or will movie gangsters of the future produce suitcases full of reals, Aussies, or renmimbi to buy the world’s onscreen supply of drugs and firearms?

Stay tuned.

Until tomorrow…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

• Stocks trading at 19 times FALLING earnings…whaa?
• Remembering Rude…with one of the calls of the meltdown,
• What to make of all this effervescent trading action and more…

Eric Fry, reporting from Laguna Beach, California…

To judge from the stock market’s effervescent trading action, all is right with the world. But to judge from the “Business Section” stories of almost any newspaper, there’s almost nothing that isn’t wrong with the world.

Unemployment is rising; activity at factories is falling; and consumers aren’t doing much of anything. All of this adds up to a sluggish economy…much more sluggish than the bulls on Wall Street expect.

If the bullish investors on Wall Street are too optimistic, it would not be the first time. Investors are prone to excess, both on the upside and on the downside. We cannot say that today’s upside is excessive, only that it is without any fundamental underpinnings. Stocks are trading at 19 times FALLING earnings, and there’s very little indication that earnings will improve – much less, accelerate – any time soon.

To the contrary, Dan Amoss, the insightful mind behind the Strategic Short Report, believes the U.S. economy remains very sickly, mostly because the banking sector remains infected with toxic assets.

“The backlog of [mortgage] foreclosures is building like water behind a dam,” Dan observes in a recent missive to his subscribers. “Once the dam gives way, the market may be shocked at how quickly the headline foreclosure numbers accelerate. Are the quant funds currently bidding up the price of financial stocks incorporating this foreclosure backlog into their models? I doubt it.

”The Sept. 23 issue of Amherst Mortgage Insight is the best attempt I’ve read to quantify the ‘shadow inventory’ of houses,” Dan continues. “It leads with a sober estimate of the residential housing supply situation:

The single largest impediment to a recovery in the housing market is the large number of loans that are either in delinquent status or in foreclosure that are destined to liquidate. This creates a huge shadow inventory. We estimate this housing overhang at 7 million units, 135% of a full year of existing home sales.

“Amherst Securities has been ahead of the curve,” says Dan, “in warning about the deterioration in mortgage securities and this market’s impact on the health of the banking system.”

Truth be told, Dan has also been ahead of the curve. In the May 21, 2008 edition of the Rude Awakening, Dan observed, “”Billions of dollars of future write-downs and losses are still buried inside Wall Street’s balance sheets. Lehman Brothers (LEH) appears to be among the most vulnerable of all the investment banks.”

Just a few months later, Lehman was a zero and Dan’s subscribers were walking away with gains of 400%, or more, on the Lehman put options he had recommended.

In celebration of Dan’s analytical mastery, today’s edition of the Rude Awakening will present his dead-on analysis of Lehman Bros. from May 21, 2008 – just four months before Lehman’s collapse. The title of that day’s issue was, “What If the Worst is Not Over?”

Good call, Dan!

— From the Desk of Dan Amoss: Strategic Short Report —

Hidden Government “100-F Documents” That Let You Predict Which Stocks Will Go up or Down

Discover how one small group of Americans uses government-mandated “100-F Documents” to easily predict gains or losses for any household-name stock in America…

On at least 58 different dates, each year…

And how you can now use these same “secret” documents to post returns as high as 400 – 600% over the weeks ahead. Learn How Here.

——————————————

What if the Worst is Not Over?
By Dan Amoss

Since the rescue of Bear Stearns on March 17, the Amex Securities Broker/Dealer Index has rallied 20%. The shares of Lehman Brothers have rocketed more than 30%. These dramatic rallies support the popular thesis that “the worst is over” for the financial sector.

But these dramatic rallies also provide attractive short-selling opportunities for every investor who believes that the “worst is yet to come.”

Most of Wall Street’s money-making machines have shut down. Mortgage-securitization activity has gone kaput, while IPO and M&A activities are sputtering. Even worse, Billions of dollars of future write-downs and losses are still buried inside Wall Street’s balance sheets.

Lehman Brothers (LEH) appears to be among the most vulnerable of all the investment banks. The stock has rallied hard since the Bear Stearns rescue. Because its business model closely resembles that of Bear Stearns, Wall Street thought Lehman was next. And it might have been, if not for the Fed.

The Fed instituted a lending facility allowing the investment banks to temporarily swap the ugliest “alphabet soup” assets for Treasuries. These alphabet soup assets – mortgage-backed securities (MBS), asset-backed securities (ABS), collateralized loan obligations (CLO), and others – had been smothering the brokers to the point that Bear Stearns was hours from declaring bankruptcy.

In the hopeful words of Lehman Brothers CEO, Dick Fuld, the Federal Reserve’s lending facility “takes the liquidity issue for the entire industry off the table.” Sure, the Fed’s actions may have forestalled a modern-day “bank run” on Wall Street. But the Fed has not solved the bigger, longer-term crisis.

The Fed’s new facility allows Lehman to temporarily swap its garbage assets for Treasuries. What it doesn’t do is protect Lehman shareholders from losses on these securities. Lehman shareholders will be the first to absorb these losses. Shareholders are in the most junior position in every company’s capital structure. So the more leverage – or debt – a company employs, the quicker shareholders get wiped out when assets sour.

As the chart below shows, Lehman’s equity (in red) supports just a tiny sliver of Lehman’s towering liabilities. Lehman’s gross leverage ratio amounts to about 32 times equity. This means Lehman’s assets can fall only about 3% in value before equity is wiped out.

Lehman is scrambling to reduce leverage and raise capital by selling illiquid assets into a weak secondary market. Unfortunately, illiquid mortgage-backed securities aren’t a particularly hot item these days. There are few buyers for such assets – even at steep discounts.

According to Bernstein Research, Lehman’s “troubled” residential and commercial mortgage assets amount to nearly three times its tangible equity. That’s danger level for Lehman shareholders. And the danger is growing…

Last year, the investment banks, including Lehman, adopted a new Financial Accounting Standards Board rule called “FAS 157.” This new accounting rule segregates balance sheet assets according to their liquidity and marketability. “Level I Assets” have readily available market prices. “Level II Assets” can be valued by comparing them to prices of similar assets. But “Level III Assets” lack any observable market price or price inputs. They are “marked to model” – not “marked to market.”

So how many Lehman assets are Level II and III? According to its latest 10-Q, Lehman categorized $60.5 billion and $23.8 billion of its mortgage securities as Level II and III assets, respectively. This adds up to $84.3 billion – or more than four times tangible equity per share! Therefore, if just 12% of Lehman’s $153 per share in Level II and III mortgage assets were written off – a reasonable assumption – such losses would eat through half of Lehman’s tangible equity.

The odd thing about Level III assets, also know as “mark-to-model” assets, is that the owner of them gets to decide how much they’re worth. I’m not kidding. Lehman management determines for itself the value of the Level III it owns. Therefore, no one can really know what the true value might be. There’s no way to know, for example, what models management uses to value its Level III assets. Hopefully, they are not using the same badly flawed models that predicted smooth sailing for subprime mortgage-backed securities.

This lack of pricing transparency (or pricing reality) can be management’s strongest ally…for a while. But eventually, the truth will out. Eventually, the Level III assets will make their way from the dark recesses of Lehman’s balance sheet into the unforgiving light of real-world pricing. Eventually, living and breathing buyers will determine the value of these assets, not some mainframe computer in the Lehman back office. And as these real-world transactions occur, Lehman might face billions of dollars of additional write-downs and losses.

Lehman management has not been terribly forthcoming about reporting quarterly losses and write-downs. Brad Hintz from Bernstein Research hinted that fuzzy math produced Lehman’s “strong” March earnings report: “We believe the quality of these earnings was weak, as the firm benefited from a lower tax rate and enjoyed a $600 million mark-to-market gain on its liabilities.” That’s a polite understatement.

Believe it or not, accounting rules allow investment banks to book a profit when the value of the bonds they have issued FALL. Follow along with this crazy logic if you can: Because the holders of Lehman’s bonds became fearful that Lehman would declare bankruptcy, the bondholders dumped the bonds at very low prices. Therefore, because Lehman’s bond prices tumbled, Lehman could, theoretically, buy back the bonds at prices much lower than the stated value of those bonds on Lehman’s balance sheet. As a result, this bizarre accounting rule concludes, Lehman can book a “profit” on the difference between the issue price of its bonds and the depressed market prices. Taken to an extreme, Lehman could probably post one if its most profitable quarters ever, just by declaring bankruptcy!

Obviously, falling bond prices indicate financial stress, and certainly do not produce sustainable, high-quality earnings. Such “earnings” do not generate cash or create any value of shareholders whatsoever.

Net-net, Lehman is still facing the likelihood of losing tens of billions of dollars over the course of the next few years. As losses pile up, Lehman will have to raise capital. That means flooding the market with LEH shares. Lehman may have to issue hundreds of millions of new shares at a discount to rebuild its capital shortfall, severely diluting the existing shareholders.

David Einhorn, an accomplished hedge fund manager, recently explained why he’s still selling short Lehman shares. In a speech at the April 8 Grant’s conference, he said that Lehman may have to boost its capital by as much as $30 to $70 billion. If Einhorn’s guesstimate is anywhere close to the mark, Lehman’s shareholders are in for a very rough ride.

The worst might be over for the financial sector, just like so many investors seem to believe. But a lot of bad stuff is still rolling our way. For the rest of 2008, therefore, investors might want to take their cue from Credit Suisse CEO Brady Dougan when he said, “The number of times people have seen the light at the end of the tunnel, it turned out to be a train coming down the tracks.”

Joel’s Note: Dan’s Strategic Short Report offers one of the best bear market strategies we know of. Simply put, his track record speaks for itself. If you are interested in learning more about his Ultimate Bear Market Strategy Report, please read on Right Here.

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Elite alliance of experts warn: don’t hold your breath waiting for a recovery this year or even in 2010. The three toxic timebombs they name below make a quick rebound next to impossible.

Yet, they also name seven “Super Shields” you can use to safeguard against further losses… plus at least five surprising “long” plays you can still use — even now — to get very rich. Read On Here.

—————————————–

[Rude Endnote: No doubt you’ve heard by now that The Rude Awakening is closing its doors. (Notice that nifty banner add up top of your mailing…?) So, we thought it might be nice to intersperse a few “remembering Rude” columns in with your regular insights over the coming weeks. Today was the first in that series. We hope you enjoyed it.

Be sure to catch your editors at their new home, from Monday October 19, over at The Daily Reckoning. In fact, you can sign up for free right here, if you like, just to ensure you don’t miss a single issue.

We’ll be back with more this time tomorrow.

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

• REITs to retreat and more banks to bust as the “next wave” begins,
• Hope vs. Hype on the economic “recovery,”
• Plus, Main Street reality vs. Wall Street fantasy and plenty more…

Joel Bowman, reporting from Taipei, Taiwan…

Since those murky depths back in March, stock markets around the world have mounted a rally of truly Homeric proportions. The Dow Jones Industrial Average is up almost 50%. The broader S&P 500 is higher still, up 56% to yesterday’s close. Around the world, too, indexes have clawed back tremendous losses.

By anyone’s account, it has been a remarkable six months. It is worth remembering, however, that “remarkable” is not a synonym for “reliable”…or “sustainable”…or “irreversible”…or a dozen or so other adjectives the conservative investor might like to see thrown in the mix. (To be sure, “irreversible” will never be in the mix.)

But even if the rally did continue, let’s even say, “indefinitely,” what does it really mean anyway? “If this is a recovery,” any one of the 7 million Americans who have lost their jobs since the crisis began might vent, “then I’d hate to see what a recession looks like…much less a DEpression!”

Indeed, the gaping chasm between the fantasy on Wall Street and the reality on Main Street has grown too offensively large to ignore.

People want to know, if the recovery is the real deal, and not the raw deal, why are millions of Americans still losing their jobs, homes, cars and loans? And how can, by the president’s own admission, the employment situation be expected to worsen as the economy simultaneously improves?

Put simply, if “the economy” is supposed to be an average measure of the welfare of the citizens within it, how can “the economy” recover so assuredly while we citizens, the component parts of it, suffer so badly?

And therein lies the conundrum. “The economy” is not an average measure of a nation’s welfare. In fact, “the economy” – as defined by the current measurements of it – doesn’t really exist beyond its literal sense. It is an academic invention, in other words…textbook parlance…a malleable, nebulous, esoteric phrase to be twisted and tortured as one public servant or another so chooses. More importantly, “the economy,” as it is currently measured, has almost nothing to do with the reality the individuals “within” it experience from day to day.

To take just one example of this divergence between the individual and “the economy” he is said to be part of, let us consider consumption.

Even the idiot reader (none of whom will receive this email) understands that he cannot spend his way to riches. He knows full well that a penny spent is not a penny saved. So, like any good individual during a time of crisis, the American consumer is saving his money right now and paying down his debts. That means the consumer is not consuming, or at least not as much.

But such prudence, conventional measurements tell us, is bad for “the economy.”

And yet, during the boom years preceding the crash of 2008, measures such as retail sales, consumer confidence indexes and GDP figures were lauded as testaments to growth. We remember asking ourselves at the time, “Who is buying all the lampshades and throw pillows around here? Everyone is broke!”

As it turns out, those consumption indicators were only indicative of the speed at which America was ruining herself. An entire nation drove their collectively financed SUV off a ramp made of debt and plunged into the sea. And, all the while, the popular economic metrics were telling them to keep their feet on the gas.

We’re going to revisit this “man and state” theme in the next couple of days but, for now, let’s get into your regular column. In today’s Rude, our resident short seller, Dan Amoss, explains the important difference between hype and hope and arrives at a grim diagnoses for both the banking and commercial real estate sectors. Details below…

— Urgent: From The Desk of Addison Wiggin —

Major News Outlet Calls This the “Next Crisis”…

THE GREAT AMERICAN”RECOVERY RIP-OFF!”

America on the mend? HORSE HOCKEY!

Here’s what’s real: Brace yourself for what’s about to go down as the BIGGEST FINANCIAL SWINDLE in world history, engineered by none other than Wall Street and Washington, D.C.

How does their scam work? It’s a crafty “triple-swindle” just clever enough that most Americans won’t even see it happen… until it’s too late!

The short of it is, every three days, these flim-flam artists use this strategy to secretly suck wealth out of your savings account. Don’t Be Fooled. Read On Here.

——————————————

Hope Doesn’t Pay the Bills
By Dan Amoss

Hope doesn’t rhyme with hype…but it should. Because the hope-driven rally that’s unfolding on Wall Street relies on little more than hype. Stock market bulls continue to buy stocks on the basis that improving confidence — not an improving labor market — is all we need to have a roaring economic recovery.

Hmmm…I’m not so sure about that.

The bulls expect that confidence, government spending, and inventory restocking will lead to a recovery in employment, which will lead to an improvement in credit quality throughout the banking system. They have yet to think through why the economy would even need an inventory rebuilding cycle if incomes and private sector credit are both still contracting.

One would hope that inventories aren’t being rebuilt in response to “faux demand” from federal stimulus spending, because those inventories would have to be liquidated in the future, once manufacturers realize that it was simply a “head fake” in demand.

We can’t accurately label what’s happening now a “jobless recovery,” because the labor market has yet to even stabilize — let alone recover. Hiring intentions remain near an all-time low, and there’s little reason for hiring activity to pick up on a sustainable basis. The National Federation of Independent Business Index that measures job openings fell to a 27-year low in August.

In my view, stocks have rallied far beyond any link to underlying value or probable earnings prospects. Instead, stocks continue to rally on the basis of Ponzi psychology. This rally, led by “junk stocks,” seems to be reaching some kind of crescendo, as weaker and weaker hands become the marginal buyers. This is how markets usually top — when the marginal buying pressure dissipates, and stronger, more patient buyers wait until prices go much lower before investing.

The stocks of Fannie Mae, Freddie Mac, AIG, and Citigroup have led the charge, despite all being zombies propped up by gigantic government guarantees of their towering liabilities.

It’s interesting that the media and analyst coverage of bank earnings reports have focused on “provision expenses” – i.e. the money that banks set aside to cover future loan losses. Provision expenses, overall have been dropping, thereby leading the bulls to assume that the worst of the housing/credit crisis is over. But the reality is that banks should be INCREASING their provision expenses, not reducing them…at least if they wish to be honest about the growing losses still lurking on their balance sheets.

For example, as I pointed out to the subscribers of my trading service, Strategic Short Report, investors need to focus on the balance sheet, not the income statement. Washington Federal (WFSL) is a classic example. The bank’s steady net interest income seems to be all that investors are focusing on right now, while ignoring the massive imbedded credit losses from bad loans that are still sitting on the bank’s balance sheet.

WFSL is following the “hope and pretend” playbook, because it’s not building up its allowance for loan losses as quickly as its non-performing loans (NPLs) are mounting.  For instance, management is slow in accounting for its 43% in non-performing land development loans in its income statement. Management hopes that recoveries will be high if they can hold onto those loans for a few years. Wishful thinking is not prudent banking.

Washington Federal’s fiscal year ends on Sept. 30, it will report earnings in mid-October, and it will file its 10-K by the end of November. Odds are good that management — along with its auditors — uses this reporting period to air its dirty laundry. Analysts would lower their earnings estimates in response.

Washington Federal is just ONE of the many banks in the country that still face serious – and perhaps fatal – balance sheet stresses. Commercial real estate loan losses will create the next major balance sheet trauma for most banks.

Commercial real estate loan losses are still in the “first inning,” which will be a problem for almost every bank in the country…but good for the ProShares UltraShort Real Estate ETF (SRS) – a stock that goes up in value when REIT stocks go down in value. This stock has been revisiting its lows lately, as REITs have been rallying. But this is no reason to panic. The fundamental outlook for REITs (which SRS sells short) remains bleak, and the market will soon wake up to this fact.

The core of the bear case for REITs rests on falling comparative property values, falling rents, falling occupancy rates, and tight to non-existent refinancing conditions. Refinancing conditions are important because if lending remains tight, this will push up the amount of property foreclosures and liquidations. And conditions will remain tight because the regional and community banks that typically lend against commercial real estate collateral are not answering phone calls from desperate borrowers. They’re nursing hangovers from their existing commercial real estate loans, and have regulators watching their every move.

Richard Parkus, head of mortgage backed security research at Deutsche Bank, published an interesting piece on the horrid performance of commercial real estate and commercial construction loans. Parkus estimates that net charge-offs on commercial construction loans could be in the range of 25%, since cumulative default rate could be in the 50% range, with 50% loss severity. Multiply the default rate by severity to get a 25% charge-off rate on the roughly $530 billion in construction and land development loans within the U.S. banking system. This equals about $132 billion, which is an awfully big hole to fill, considering the tiny size of the capital cushions at most of the smaller banks with exposure to these loans. The hole is so large at hundreds of tiny community banks that they will be taken over by the FDIC.

Most of these construction loans were underwritten with “interest reserves,” which is money set aside to cover the loan’s payments during the construction phase of the project. Delinquency rates are already high, but usually soar when the borrower eventually burns through its interest reserve.

This is an area that the banking bulls are missing: default trends tend to be non-linear, especially in an economy as weak as this one, and especially in mortgages in which so many borrowers have massive negative equity — and therefore have little incentive to keep paying. By non-linear, I mean that default rates can appear to be under control for a while, then shoot up in the shape of a “hockey stick” if you’re looking at a graph.

Parkus estimates that cumulative commercial real estate charge-offs will be in the range of 10% of the banking system’s $1 trillion in core commercial real estate loans. That’s a $100 billion hole in the banking system’s capital that many banks will not be able to “earn their way out of.” I think 10% cumulative charge-offs could be conservative. Thus far, according to SNL Financial data, commercial banks have charged off just 1-2%. So in baseball parlance, “we’re only in the first inning” of the process of recognizing and writing off whole commercial real estate loans sitting on bank balance sheets.

As this occurs, this will lead to a flood of foreclosures and liquidations, which will push down market prices for commercial properties — the same types of properties owned by REITs. Look out below.

Joel’s Note: Dan has a couple of financial institutions in his Strategic Short report portfolio right now, both with some “dirty laundry” to be aired in the coming months. As with his Lehman Bros. call last year, we suspect Dan’s suspicions are very well placed. Check them out here.

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[Rude Endnote: European and Asian markets joined in the selling overnight after Wall Street’s main indexes finished the day down yesterday. The Dow had slipped a not-insignificant 0.8% by yesterday’s close. The S&P 500 ended lower by 1%.

Markets in Europe responded by inching slightly lower. The losses were very modest, however, with London’s FTSE, France’s CAC and Germany’s DAX all edging just 0.1% lower, as if squinting into a bright light.

Asia measures provided a bit more excitement. Japan’s Nikkei 225 rallied 1.65%..Hong Kong’s Hang Seng slid 2.5%. China’s CSI 300 rose 0.7%…but the Aussie All Ordinaries slipped just as much. All in all, a pretty mixed bag over here today leading into the G20 meeting…

Over in the crude pits, oil is off the boil, trading down on a surprising inventory build in the U.S. A barrel of the black goo goes for $68.35 this morning. And gold…well, we mistakenly wrote that gold hovered “around $916 per ounce” in this space yesterday (obviously $100 shy of what it actually was, $1,016 per ounce). And boy, didn’t you let us know about it!

Well, we can safely say that gold is trading at EXACTLY $1,016.60 an ounce as we write this morning. (Seriously, sorry about that. We frightened ourselves as much as we did you, let us assure you!)

And with that, we’ll sign off for the day. We’ve got a conference call with our colleagues in Baltimore later this evening (your editor is 12 hours ahead here in Taiwan) and, apparently, there’s some juicy news concerning all Rude Awakening and Daily Reckoning readers. Hmmm…we’ll let you know as info comes to hand.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

• Make like the Chinese…employ a crude dollar hedge,
• Protecting against the invisible creep of inflation,
• Plus, continental drift, prehistoric golf clubs and more…

Eric Fry, wondering about continental drift from Laguna Beach, California…

Every night, your California editor and his teddy bear sleep on the extreme western edge of the North American tectonic plate. From the deck of your editor’s house, he could throw a rock and hit the extreme eastern edge of the Pacific tectonic plate.

In theory, these two powerful geologic formations – suddenly and without warning – could simply swallow up your editor (and his teddy bear) and save the world from suffering through any future editions of the Rude Awakening. And yet, your editor never loses a wink of sleep worrying about this possibility.

Instead, he muses about the way that small incremental changes over time can produce surprisingly dramatic results. Small changes over time can convert a trickle of water into a Grand Canyon; or a bucket of grapes into a rich Bordeaux; or a simple friendship into precious romance. In other words, small changes can sometimes produce minor miracles.

Thanks to small changes over time, for example, nothing on the globe is where is used to be. The tectonic plates, as if inspired by a kind of geologic wanderlust, are constantly moving from wherever they were to wherever they will be.

A few billion years ago, the aboriginal inhabitants of Scotland could have teed up a prehistoric golf ball almost anywhere at the seaside locale that has become the St. Andrews Golf Links, taken a good swing with a prehistoric golf club and landed their drive in Norway. That same tee shot today would land your Titleist in the North Sea.

How different the world might have been if those tectonic plates had simply remained where they were! How different…and how boring. If the tectonic plates had never separated, the planet might have never achieved its arresting diversity of flora, fauna and philosophies.

But the plates did separate…and as they drifted apart across the earth’s mantle, they developed their own distinct identities. The Antarctic Plate formed ice caps and glaciers, while the South American Plate sprouted rainforests. And the Arabian Plate, probably the most cunning plate of all, just piled up sand, year after year – never letting on that, below the surface of those sands, it was also busy converting Cryptosauruses into crude oil.

Yes, dear investor, small changes that occur over time can produce surprisingly dramatic results – either for better or worse.

Once upon a time, back when the inhabitants of the North American Plate and the Eurasian Plate routinely broke bread together (or twigs or weeds or bark or whatever they actually broke), they probably added similar seasonings and side-dishes (think: fried Pterodactyl). But after a few billion years – and a few thousand miles of Continental Drift – the inhabitants of these two plates now indulge in very different culinary practices.

Over on the Eurasia Plate, meals sometimes feature foie gras, duck a l’orange and champagne. But here on the North American Plate, meals are more likely to feature French fries, Big Macs and Coca-cola.

Who could have ever imagined that the slow, invisible drift of continents would produce such divergent results?

Today, in the financial markets, the ground beneath our feet seems a little less stable than normal. We can’t really feel the ground shaking or moving beneath us, of course. But even so, we’ve got the uneasy feeling that we are moving SOMEWHERE…and maybe not in the right direction. We can see that stock market is moving; that’s obvious. But inflation is also moving, even though we can really see or feel it.

Over time, however, the invisible creep of inflation has the power to crush the very visible returns that the stock market seems to be delivering. Counteracting the forces of inflation is no easy task. But Dan Amoss, the mind behind the Strategic Short Report, offers one possible tactic in the column below…

— Strategic Short Report Research Paper —

Hidden Government “100-F Documents” That Let You Predict Which Stocks Will Go up or Down

Discover how one small group of Americans uses government-mandated “100-F Documents” to easily predict gains or losses for any household-name stock in America…

On at least 58 different dates, each year…

And how you can now use these same “secret” documents to post returns as high as 400 – 600% over the weeks ahead. Continued Here…

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The Perils of Inflation
By Dan Amoss

If I had to guess, I think oil prices will have a sharp correction this fall as Chinese stockpiling slows down and as oil and refined product inventories remain more than adequate to meet sluggish U.S. demand. But this correction will offer trading and investing opportunities on the long side. Oil is a “Buy” for at least two reasons:

1)            Rising Inflation

2)            Falling Supplies

“Oil is the most likely commodity to lead an inflationary trend,” asserts Andy Xie, the insightful former strategist at Morgan Stanley. “Its price has doubled from a March low, despite declining demand. The driving force behind higher oil prices is liquidity. Financial markets are so developed now that retail investors can respond to inflation fears by buying exchange-traded funds individually or in baskets of commodities.

“Oil is uniquely suited as an inflation-hedging device. Its supply response is very low. More than 80% of global oil reserves are held by sovereign governments that don’t respond to rising prices by producing more. Indeed, once their budgetary needs are met, high prices may decrease their desire to increase production. Neither does demand fall quickly against rising prices. Oil is essential for routine economic activities, and its reduced consumption has a large multiplier effect. As its price sensitivities are low on demand and supply sides, it is uniquely suited to absorb excess liquidity and reflect inflation expectations ahead of other commodities.”

To Andy Xie’s important point about oil as an inflation hedge, I’d add that OPEC planners understand that they are trading a nonrenewable, depleting asset for paper money. They also are beginning to grasp that indebted oil importers plan to ease their debt burdens by employing the heavy guns in the inflation arsenal: “quantitative easing.” So the producers’ portfolio preferences will shift away from government paper and toward retaining scarce oil in the ground for future revenues. In other words, “Why should we trade oil for dollars now if we receive higher prices five years down the road?”

But the growing threat of inflation is not the only reason the price of oil has doubled from its lows. Oil prices are up because the marginal cost of new supply — including from Canadian tar sands and from under thousands of feet below the ocean surface — is so high.

Sure, oil prices could correct sharply this fall as traders panic about a temporary glut in aboveground supply at storage terminals. But to use manufacturing terms, it’s the “raw material” and “work in process” inventory that really matters. That type of inventory, sitting higher up in the supply chain, is much tighter than the “finished goods” inventory sitting in storage terminals like Cushing, Okla. I expect we’ll see this tightness reflected in prices by 2010, even if demand remains stagnant.

Production capacity in oil and gas looks plentiful right now, but capacity naturally falls every year, and requires hundreds of billions in global capital expenditures just to keep supply steady. According to an exhaustive analysis published by Neil McMahon of Bernstein Research on Aug. 10, non-OPEC oil supply will keep declining in the coming years, despite healthy levels of investment. Outside of OPEC (where information regarding capacity and investment plans is murky at best) explorers are targeting smaller formations, as production from giant, decades-old fields declines. McMahon writes:

In the long term, we believe that oil prices will increase in line with the marginal cost of supply, which continues to rise as the complexity of new wells increases and production rates from established fields decline. Basically, not enough significant discoveries have been made in non-OPEC countries in recent years to help the supply situation before 2015. Additionally, flow rates from the few discoveries that have been made do not give rise to much optimism and, as in the past, the drop in absolute oil demand will be offset by rapidly declining mature field production with the recent fall in industry spending. So the continued decline in non-OPEC supply will provide an additional support for prices, as it feeds through to OPEC spare capacity. We believe that 2010 will see the next inflexion point in prices, as OPEC spare capacity begins to decline and demand shows positive growth for the first time in a number of years and we expect to see oil average $80 in 2010, $103 in 2011, $111 in 2012, and increasing to $140 in 2015.

You can imagine what this type of price trajectory will do to U.S. businesses that rely on cheap fuel, and have no ability to push through price increases. Considering how many more trillions of U.S. dollars will be floating around the global economy in 2015, and savers’ willingness hoard them declines, $140 per barrel might be conservative.

Global oil production capacity, rather than demand, will eventually drive prices. Bernstein projects 2020 oil production capacity will be about the same as it is now: 85 million barrels per day. We must consider net exports too; the global trade flows of this oil will certainly change. Over time, more tanker shipments will be diverted away from the U.S. and Europe and head to Asia. Also, in recent years, OPEC countries have been consuming more of their own product at home. Plus, the Chinese government has shown that it will beat any and all comers in the competition to secure supply under long-term contracts.

Always follow the oil market closely, because it will impact the fundamentals of many businesses — including those you might be interested in selling short.

Joel’s Note: One year ago Lehman Bros. bit the dust…and Dan’s Strategic Short Report readers cashed out of their put option positions for a 462% gain. Incidentally, Dan has another couple of shaky banks in his portfolio right now. If you’re interested in taking a peek, you can sign-up for a 90-day, risk free trial today. Here’s a link. [WARNING: Recovery flag wavers need not apply.]

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[Rude Endnote: Markets in Europe and Asia kind of bobbed around overnight, seemingly unsure of what to make of Wall Street’s mild gain yesterday.

Japan’s Nikkei 225 inched 0.15% higher while China’s CSI 300 index and the Aussie All Ordinaries moved slightly higher, up 0.3% and 0.2% respectively. Hong Kong’s Hang Seng slipped 0.3% also.

Last we checked, the action in Europe was equally underwhelming. London’s FTSE had moved 0.4% higher, France’s CAC was up 0.3% and, over in Germany, the DAX barely managed a 0.01% move. “Zzzz…”

Crude oil gained back a little mojo last night, creeping back towards that $70 mark. It was about 50 cents shy a few moments ago. And gold dipped below the $1,000…but just by a tad.

Oh yeah…and it was 90F and humid in Taipei…again.

See you here again tomorrow.

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

Ouzilly, France

• Banking next big casualty and an offer you can’t refuse,
• When debt reaches 370% of GDP…and other precarious situations,
• A man in Sydney calls his mate near the North Pole and plenty more…

Joel Bowman, with a quick heads-up before today’s issue…

In five hours, Dan Amoss is going to release the name of what he believes will be the next casualty in the banking sector. For one dollar, you can be on that mailing list.

Now, if you are already on Dan’s list, or you’re simply not interested, please skip to our usual Monday column, below.

If you are curious about how you can grab a trial subscription to Dan’s service [including the name of the bank he’ll release later today], take the three minutes you usually spend reading your editor’s intro and have a gander at this: Strategic Short Report $1 Order Form.

And now, back to your usual Rude program…

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No Recovery, Not Now…Not Ever
By Bill Bonner

That we live in an age of miracles has become common knowledge. A man may sit on a beach near Sydney, with nothing but the bucket bottom of the universe over his head, and still carry on a casual conversation with an Eskimo near the North Pole. Using an Internet-based phone service, he may do so at negligible cost. If this were not miracle enough, he may now grow himself a new nose, if he needs one, on his own arm.

In this age of miracles, people seem ready to believe that anything is possible. Recklessly crossing the street at the end of the Late Bubble Epoque, the world economy got hit by a cross-town bus. Now, the feds propose to reverse and run over the poor fellow again. It will be as if they had reversed the film; the economy will be as good as new, they say.

But we are suspicious. And we begin today’s rumination by examining the bus driver’s motives.

In its naked form, government is not evil; it is merely a self- interested parasite, like a bank lobbyist. Its main value comes from its ability to elbow out other parasites. Of course, the typical citizen is no saint either. Instead, he is merely a parasite in the larval stage. If he is lucky enough or cunning enough, he could grow into a parasite himself. The citizen, generally, doesn’t mind being lied to and robbed – just so long it is by someone he elected. Or at least by someone whom tradition or local connivance put in place. He does not usually resent his homegrown government, even though it routinely costs him a substantial part of his output. On the contrary, he grows so fond of it he even dons his helmet from time to time to protect it. Naturally, the feds return the favor.

The basic business model of government is to keep order, protect campaign contributors and lure supporters with the promise of other peoples’ money. The game plan of the typical citizen is even simpler: to be on the receiving end, not the paying end. Over time, more and more of them get into position. And the whole society becomes more costly, and more corrupt.

In the United States, entire industries now operate as wards of the state. They may have too little capital. Or, their operations may be too costly. Or, their products may be simply out-of-date and unattractive. Still, government keeps them going – even at the cost of at the expense of competitors. And the money doesn’t only go to business. Cities stay solvent only by the grace of federal government grants. Whole sections of the population depend on government – including 34 million who draw their rations directly from the federal food stamp program. The spectacle is breathtaking and alarming at the same time – like a Pakistani bus on a mountain road, freighted with passengers clinging to the roof. The old rust bucket could tip over at any time, but what politician would tell a voter to get off?

That preface on the state out of the way, we turn to the state of the economy. The key to understanding the great credit bubble of 1945-2007 is to capture the codependent relationship between China and the United States of America. It seemed to serve both parties well. Each enabled each other’s excess. China added mightily to the world’s supply – far more than was actually needed. America, meanwhile, did heroic work on the demand side. While the growth in the United States was led by consumer spending, the growth in China was led by capital investment; factories expanded, towns were built, and output was revved up. But there was a flaw. Americans ran out of money. After the ’70s, they could only increase their buying by going into debt. This they did with insouciance bordering on insanity. Total debt rose to 370% of GDP and then blew up in 2007, with major lenders forced into bankruptcy and mergers, while GDP sank at its fastest pace since the end of WWII.

Now, the old formula no longer works – neither for Americans nor for the Chinese. Despite the urging of their government, Americans cannot be expected to take on more debt in order to consume more stuff from China. As savings rates grow toward 10%, demand from the United States will collapse by an estimated $1 trillion per year. With the China trade now accounting for 83% of America’s non-oil trade deficit, you’d think the Chinese would panic. They already have as much as two times the output capacity needed to meet real demand. They should trim their manufacturing sector, not expand it.

We draw out that relationship only to show how hopeless it would be to draw it out further. Borrowing to consume is merely tricking stuff from the future to enjoy in the present. By 2007, some $30 trillion worth of spending that would have occurred ‘in the future’ had already occurred in the past. Factories that would have produced consumer items for 2009 discovered that they had already produced more than enough of them in 2005 and 2006.

It would be better to invite the future in…let her collect her debts…and then get on with things. Yet government officials on both sides of the Pacific continue their numbskull efforts to revive the bubble economy. On the US side, the feds are trying to stimulate demand for more stuff. On the far side, Chinese stimulation is going into producing more stuff. As if the world didn’t have too much stuff already.

But the role of government is neither prosperity nor plausibility…but protection of the pests and parasites. They will keep paying them off and carrying them along…until the bus runs off the road.

Joel’s Note: Books forecasting the future only make it to a second edition if what they said in the first edition came to fruition. Fans of Bill Bonner and Addison Wiggin’s bestselling books, Financial Reckoning Day and Empire of Debt, will therefore be pleased to see them updated for the second print.

Whether you are a long time “sufferer,” or a first time fan, be sure to check out Bill and Addison’s monumental works right here, complete with additional chapters and updated charts to reflect the predicted collapse and where to go from here.

Financial Reckoning Day Fallout and The New Empire of Debt

— Gold Rallies Again: Full Report Below —

From Hulbert’s No 1-Ranked Advisory Letter Over 5 Years, Our Most Shocking Forecast Yet…

GOLD $2,000

“I’m so sure gold will soar higher I’ll even make you a guarantee… plus, I’ll give you five entirely new ways to play the trend…”

“Including one hidden way to snap up gold… for less than one penny per ounce…”

How can that be possible?

Give me the next four minutes and I’ll show you how…

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[Rude Endnote: Finally today, much was said by the Rude readership in response to an essay we ran last week, also by Bill and Addison, pertaining to the unfunded liability crisis in the United States. [If you missed the original column, you can check it out here: Social Security? Not Exactly.] Plenty more emails came through over the weekend, including this thoughtful musing from reader Tex Norton:

“If you consider how health care professionals are currently paid, you’ll quickly realize that the sicker you become, the more they make. Doesn’t sound like a win-win to me. How about you? Wouldn’t we all be better-off if the medicos were paid more on the basis of keeping us healthy rather than keeping us sick? I for one would gladly pay more to remain healthy than to be treated for sickness…

“One way to accomplish this turn-around would be for every individual to take control of his/her medical costs and treatments. Instead of an HMO deciding what costs they will pay, you would decide directly. This system already exists in the form of Medical Savings Plans, MSPs. You get immediate treatment and the doctor gets immediate payment. No forms to send to the HMO or Medicare nor a wait for months to then get reimbursed. Cash and carry works.

“But wait, you say. ‘I don’t know enough about medicine to be able to make my own decisions.’ Then I suggest you learn. And the very, very sad fact is that very few in the medical profession “know” either, but that’s a topic for another article. Suffice it to say that when the customer demands competence, the medicos that survive the scrutiny will become the best choices for medical services. No one is instant-smart and there will be a learning curve, but the effort will be well worth time allocated.”

Thanks to everyone who wrote in with their take on the impending, and growing, disaster. We’ll keep you posted as this discussion heats up over the coming months. But for now, we’re done.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

Taipei, Taiwan

• The canary in the financial coal mine,
• Banks burn their furniture to stay warm,
• Modern Economic Blunders 101 and plenty more…

Joel Bowman, reporting from Taipei, Taiwan…

Lesson 1: 2 + 2 = 5. Got it? Notice that only the economists nod their heads.

The numbers have stunk for a long time, Rude reader. But now they emit stench enough to make an abattoir blush.

Since last Friday, the Dow Jones Industrial Average has ADDED about one point for every thousand American jobs LOST over the previous month. The rally comes on the back of some typically bogus numbers.

The non-economist reader might wonder, for example, how the unemployment rate could slip from 9.5% to 9.4% as 247,000 workers were given their marching orders. (Readers may choose to refer to lesson 1, above, at this juncture.) How can this be? How can a quarter of a million people join the unemployment line while, simultaneously, the percentage of the workforce without employment falls?

The answer is simple: The size of the workforce itself declined…by a not-insignificant 422,000. Almost half a million Americans fell off the “unemployed” list and into the “discouraged worker” category; no longer looking for work, but functionally unemployed nonetheless. In fact, the number of “long-term” unemployed – those who have been on the dole for 6 months or longer – jumped by 584,000 in July to 5 million.

In other words, we saw more people falling OFF the unemployed list (simply because they stopped looking for jobs) than people who fell ON the list. Hence the downtick in the unemployment rate. Sneaky, huh?

So, why all the cheering? Good question. Again, it really only makes sense once you’ve grasped the core idea of Econ. 101, Lesson 1, above.

The trouble with economics is that the “smart” guys got hold of it. Their first mistake was to label their craft a science. From there, it was a quick step from moral philosopher to numerology monger. Then, they committed the worst crime of all: they began to believe their own impossible math and skewed excel sheets. One needn’t look far to find examples of their reckless theories playing out in society.

Who else but a delusional, bean-counting jackass with an abacus could possibly conceive of something so offensively idiotic as the cash-for-clunkers program, for instance? The scheme, if you haven’t been following the government’s latest cash-burning project, hands multi-thousand dollar vouchers to people who drive old cars as incentive to upgrade their vehicles.

Proponents argue that it will give a much-needed jolt to America’s moribund auto industry. The greens will be happy with cleaner, newer cars on the road, they say, and consumer spending will jump when those stimulus-mobiles roll off the production line.

Put aside for the moment the fact that the government does not have $3 billion to fund the program, a somewhat insurmountable problem for those who failed Lesson 1, above. Forget too that it will artificially prop up dying players of an industry in desperate need of the free market machete. Instead, spare a thought for the myriad other businesses, those that couldn’t afford lobbyists in Washington, who might have survived had that consumer cash been deployed for their goods and services. When they go under, as many will, they will be able to thank Uncle Sam for tempting consumer dollars away from their doors to GM and Ford.

It reminds us of a comment the barber made to us last week, back in New York.

“Would you like a shave too, sir?” he inquired after finishing the cut. Puzzled, we replied that we had only just shaved that very morning.

“I can see that,” the old fellow nodded. “But it’s a recession…we need the business.”

America might be in the early stages of a depression, but they need the business of economists like a straight razor to the throat.

In today’s column, our resident short selling expert, Dan Amoss, takes his own scalpel to some decidedly malignant accounting tumors in the nation’s banks. Enjoy the operation…

— Strategic Short Report $1 One-Month Trial Offer —

Urgent Report: The man who called Lehman’s collapse five months early — showing his readers how to play the bankruptcy for as much as a $200,000 profit, now says…

“On Monday the 24th at Noon I’ll reveal the next major Bank Stock set to CRASH.”

— Dan Amoss

With a 192 year old history and 37,000 employees, its crash would drop like an A-bomb on unsuspecting shareholders…

And Now, You Can Be On Dan’s Exclusive Email List When This Next Bomb Drops For Just $1. Here’s How.

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Bank Accounting: Extend and Pretend
By Dan Amoss

Investors often assume dangerous, unnecessary risks by owning stocks on the basis of sloppy economic and financial analysis. For each stock you own, you should frequently reassess the reasons for owning it. Also, you need to remain on the lookout for signals that the future operating environment for a particular stock has changed.

Right now, the market has priced bank stocks for perfection, but the earnings outlook remains bleak. Investors are excited about the wide yield curve that’s enabling banks to borrow at ultra low rates and lend at much higher rates. But starting a few years ago — and going forward a few more years — losses on loans made during the bubble will matter more than the wide yield curve. More bank failures, capital shortfalls, dividend cuts and shareholder dilution are in the cards for most bank stock fans.

Because bank stocks usually act as a canary in the coal mine, a continued bear market in banks translates into a continued bear market in most other stocks. The evidence tells me we’re experiencing a bear market rally, not a new bull market. The promoters of the idea that this is a new bull market are ignoring one of the worst enemies of stocks: uncertainty. Right now, especially considering aggressive government policies, uncertainty about the future business environment is very high.

As readers will know, the government’s land grab is going to make things worse. It seems that there’s no end to the threats facing corporate profits, which will make corporate loans that much harder to pay back. This is not a garden-variety recession. It’s more like a depression, so the so-called economists parroting the “recession is over” message will have a rude awakening soon enough.

Let’s briefly consider the sentiment toward overall market. Aside from the investor sentiment polls, you can tell how bullish investors are by the multiples they are willing to pay for stocks. And right now, after the sharpest 5-month rally since the 1930s, the market is trading at valuations that require a strong economic recovery, and a return to credit bubble conditions. The rally was powered entirely by P/E multiple expansion, not earnings growth. That sort of rally would be justifiable if corporate revenues and earnings were about to soar, but they’re not. Most earnings surprises were due to cost cutting, rather than top-line growth, which is like burning your furniture to stay warm.

The market is not even that cheap when you consider how artificially inflated earnings were at the 2007 peak. Financial earnings made up 18% of the S&P 500’s earnings in 2007 — much more if you add the “earnings” from the finance divisions of industrial conglomerates like GE and GM. Any claims that the S&P 500 is cheap because 2007 somehow represents “normalized earnings power” are bogus. The corporate profit margins and earnings won’t return to that level for many years.

The talking heads are getting more creative in their rationale for owning stocks right now. Most money managers seem to be thinking: “I don’t believe in this rally, but I’ll ride it until it looks like it’s over, and then I’ll sell.” This is the type of dangerous crowd psychology that consumes most people during bubbles. When enough investors share this Ponzi sentiment, and nobody’s investing on the basis of sober, rational fundamental analysis, the result is sometimes a crash.

This brings us to the poor quality of earnings, particularly at commercial banks. Accounting — especially the accounting that produces income statements at banks — is more art than science. It’s as much opinion as it is fact. Bank executives have a lot of leeway in how and when they recognize credit losses. As you’d imagine, some of them have more creative imaginations than others. Some are actively engaging in “extend and pretend,” a practice in which banks refinance deadbeat borrowers to avoid reporting loan losses.

Banks make loans expecting to receive interest and principal payments in a timely fashion. Banks book revenues, expected credit and operating costs, and profits associated with every loan upfront. But as we’ve discovered, the credit costs, or losses, often wind up being much larger than originally expected. When this happens, banks must dramatically ramp up their “loan loss provision” expense, which cuts into earnings, often pushing earnings into the red.

So the ultimate credit costs associated with bank revenues often take a year or more to be reflected in earnings and capital cushions. That’s why regulators require banks to maintain an “allowance for loan losses.” This allowance is a contra account on the asset side of a bank’s balance sheet, and its purpose is to absorb credit losses from loans as they run through the default and recovery phases. Loan losses, net of recoveries, deplete the allowance. Banks can rebuild their loan loss allowance by booking larger provision expenses, but this process cuts directly into earnings.

The chart below shows how under-reserved banks are right now, so they still have a ways to go in accounting for the losses on loans made during the bubble. These numbers are the combined figures for over 7,000 U.S. commercial banks insured by the FDIC. In grey, you see that noncurrent loans — the raw material for credit losses — had soared to $200 billion by the end of 2008, and are still climbing sharply. As a rule of thumb, to remain well capitalized, and to prevent their allowance from shrinking to dangerously low levels, banks should book provision expenses in line with the increase in noncurrent loans.

But since the credit crisis began, this has not been happening. As the yellow line shows, the ratio of loss allowance to noncurrent loans for the entire banking system has fallen below 100%. To rebuild the industry wide loss allowance back up to an adequate level, provision expenses will have to rise faster than delinquencies. Some banks can only catch up by raising new capital from investors. Those banks that are too far behind, and cannot raise capital, will be taken over by the FDIC. All of this translates into a strong headwind for bank earnings over the next few years.

Recall that bank executives have lots of control over the timing of loss recognition. Evidence that banks are delaying loss recognition is springing up all over the place. For instance, some banks that provided unsecured revolving lines of credit to highly indebted REITs have waived some restrictive loan covenants. In residential mortgages, we’ve seen lots of instances where banks are stringing along underwater homeowners with modifications that do little more than kick the can down the road.

It would make more sense to restructure mortgages on underwater properties where the bank receives a property appreciation right in exchange for a large reduction in mortgage principle. This makes more sense from a societal perspective, and would help accelerate the return to a healthier, less “zombified” banking system. But this idea is not popular among bankers, because doing so would force the bank to immediately recognize lots of losses, which could cut heavily into the bank’s capital.

This state of bank accounting is not limited to the U.S. In fact, in some instances, the accounting at some foreign banks is even more detached from reality than it is in the U.S. For readers of Strategic Short Report, I recently uncovered a non-U.S. bank that’s been especially tardy in disclosing its credit losses. It’s a very attractive short sale right now, especially because the market loves this bank, and is totally ignoring the wave of credit losses to come in the near future. You can read more in the special report below…

Joel’s Note: On Monday 24^th, Dan will announce the name of a bank he’s been investigating for some time now…a bank he says have cooked their books to a cinder. When this bank’s shoddy accounting practices come to light, disaster will ensue…but not for those who are ahead of the news. In fact, a lucky few will walk away all the richer for it.

As an Executive Series reader, we’ve secured you a select $1, one-month trial of Dan’s Strategic Short Report (usually $1,995 per year). To ensure your spot is reserved ahead of Dan’s announcement, grab your $1 trial today right here.

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[Rude Endnote: We’ve run a bit over length today, so we’ll have to wrap it up there. Check in again this time tomorrow for our regular weekend wrap.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

Laguna Beach, California

• Distressed properties continue to flood bleeding markets,
• One super-charged way to play the commercial real estate collapse,
• The empty house shuffle in Laguna Beach and plenty more…

Eric Fry, reporting from Laguna Beach, California…

“What did you do last night?” Your editor asked one of his 17-year-old son’s close friends.

“Nothing much,” the friend smiled. “I was just chillin’ up at Rick’s house. And before that I was at Jeremy’s house.”

“Oh yeah?” Your editor pretended to care. “So how was that?”

“I don’t know, alright I guess,” the young man matter-of-factly admitted. “Sometimes I wonder why I just drive around from house to house with all the same people. We left Rick’s house to go Jeremy’s house. I mean what’s the point? Why didn’t we just stay at Rick’s house? It makes no sense.”

“Yeah,” your editor agreed. “Maybe you should just hang out at the first house and call it a night.”

“I know, right?” the kid laughed. “But we just go from doing nothing in one empty house to do nothing in the next one.”

Such are the (very) lazy days of summer life for some of the (very) lazy adolescents of Laguna Beach, California. To be fair, this particular adolescent works a 40-hour work week and only spends part of his time “doing nothing.” The empty houses in which he and his friends “do nothing” aren’t actually empty, of course; they are merely devoid of adult supervision for some period of time.

But there are plenty of empty houses here in Laguna Beach that are actually empty. They are empty because the former residents could no longer afford to make their mortgage payments. Even here in this affluent beachside hamlet, the signs of financial distress are GROWING…not diminishing. The number of houses in foreclosure or “pre-foreclosure” has jumped more than 50% during the last twelve months.

And as a result of these “distressed properties” flooding into the local real estate market, the median sales price of a Laguna Beach home has slumped to $1.1 million – down 35% from a peak of $1.7 million in late 2007. In other words, the spirit of economic recovery that so many investors believe is sweeping across the nation, is sweeping across Laguna Beach like an Angel of Death.

The ashen hue of California’s residential real estate market is, of course, an old story. The only new part of the story is that there’s nothing new. The residential real estate market still stinks. The stench might not be getting any worse, but it’s certainly not getting any better. Meanwhile, over in the commercial real estate market, the new-new thing is a very bad thing. Occupancy rates are plummeting, which means that property values are plummeting, which means that delinquencies are turning into defaults.

Even so, foreclosures remain relatively rare events. The nation’s lenders, as a group, still prefer to play around with phony valuations and nonsensical forbearance gimmicks, rather than to acknowledge actual losses. “Extend and pretend” remains the modus operandi of most commercial real estate lenders.

Just yesterday, Maguire Properties Inc., (NYSE: MPG) one of the largest commercial landlords here in Orange County, California, surrendered seven large office buildings to its lenders. Unable to service the $1.06 billion debt outstanding against these properties, Maguire opted to “hand back the keys.” But don’t weep for Maguire; it will not declare bankruptcy.

“We are not considering bankruptcy,” the company’s CEO announced, “and we feel the course we’re on is a far better course of action.”

If “better course of action” means unloading troubled properties on lenders, the CEO is undoubtedly correct. The vacancy rates at the properties Maguire surrendered increased about 20% year-over-year, while asking prices for rents slumped about 20%.

Investors greeted the announcement by boosting Maguire’s share price from 89 cents all to $1.04. Apparently, when it comes to leveraged commercial real estate in Southern California, less is more. Maguire’s maneuver is just the latest hint that commercial real estate faces challenging times… just as our colleague, Dan Amoss, predicted in several recent editions of the Rude Awakening.

Dan, whose Strategic Short Report helps investors to profit when stocks FALL, has been focusing much of his attention on problems in the commercial real estate market and has been trying to identify the finance companies who have the most to lose.

Back on July 15, in a column entitled, “Sell REITs”, Dan remarked, “Out in the real world of plummeting demand for commercial space and constricting access to credit, commercial real estate is facing a very tough time. And that means the seemingly inexpensive shares of many REITs are not cheap at all. REITs are still in the early stages of a huge deleveraging cycle that will last for years, which means that the REITs that concentrate on commercial real estate may be a deceptively dangerous asset class.”

A few days later, in “Sell REITs, Part II,” Dan wrote: “Investors in common stocks tend to ignore warning signs coming from the credit markets…Right now, the credit markets are broadcasting the following warning: The equity of overleveraged REITs is at risk of elimination or permanent impairment.”

Since Dan issued these warnings, the REIT sector has continued to maintain a bullish bias. REIT stocks are not falling. Not yet. But today, Dan returns with some fresh thoughts on the commercial real estate sector – thoughts that do not inspire confidence!

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How can that be possible?

Give me the next four minutes and I’ll show you how…

——————————————

Sell REITs Some More
By Dan Amoss

Economic distress is metastasizing throughout the commercial real estate market.

As I mentioned last week, Kilroy Realty’s (KRC) earnings were ugly. The stock soared anyway. Apparently, investors are focusing on hope rather than substance. Kilroy’s conference call after the earnings announcement did not provide any evidence of a turnaround, only hopes and wishes. CEO John Kilroy describes his hopes for recovery in profitable rental activity on the call:

“Certainly there’s some pent-up demand. We’ve seen a lot of folks that had been close to signing an LOI and then backtracked and decided to stay and do a one-year lease in their existing space. So we do think there’s some pent-up demand with regard to improving people’s facility structures, but there clearly has been a wait and see attitude, as Jeff mentioned, amongst the broad number of tenants throughout Southern California, given the economic conditions.”

That wait-and-see attitude will be around for a long time. “LOI” stands for letter of intent, and it’s an early stage, non-binding agreement about the terms of a potential lease deal. Kilroy management is trying to paint a bullish picture about “pent-up demand” for office space, but this is a ridiculous notion. Potential tenants are just testing the water, and very few of Kilory’s LOIs will be converted into signed leases.

Consider that Kilroy’s core San Diego market is now over 20% vacant. Why on earth would any potential tenant be in a rush to sign a new lease? The signs of a turnaround in demand for commercial real estate are as bogus as the “green shoots,” and are only being temporarily boosted by the government’s destructive fiscal and monetary policies.

We are very far from seeing capacity utilization in office space stabilize, let alone turn back up — especially in Southern California. The analyst covering Kilroy at Stifel Nicolaus hit the nail on the head with this comment in a post-conference call note:

“The primary issue is large tenant move-outs in small tenant markets: Accredited Home Mortgage vacating roughly 182,000 square feet, Epicore moving out of 173,000 square feet, Boeing out of 113,000 square feet of Orange County industrial and Boeing on the fence for 290,000 square feet of El Segundo office space in mid 2010.”

Meanwhile, the only way to explain the recent moon shot in all REIT stocks is short-covering.

According to Goldman Sachs Research, U.S.-listed REITs have raised roughly $13 billion in capital year to date; yet they still need an estimated $40 to $60 billion, even without further reduction in REIT values. There simply is not this amount of dedicated REIT mutual fund money in existence. Those REITs who can raise new equity will keep doing so, flooding the market with new, dilutive shares.

The number of REIT shares outstanding is soaring at a time when property values are plummeting. The MIT Center for Real Estate maintains databases on property values. You can find the data at this link. The estimates of supply and demand for each type of commercial property paint a very bleak picture for rents. MIT notes that the second quarter of 2009 saw an 18% sequential decline in commercial property prices — not year-over-year, but quarter over quarter.

Distressed sellers are pushing down comparable prices, which marks to market every REIT’s portfolio. Furthermore, crashing rental yields are becoming less reliable as indicators of property value. Prospective property buyers — real investors, not the momentum traders chasing after REITs in recent weeks — will adjust rents downward by anywhere from 20% to 30% over the next year or two to factor in the massive excess capacity in commercial space. Finally, the REIT stocks have not even begun to discount the bearish impact of higher Treasury bond yields, which will increase their cost of future refinancing.

Despite the mountains of bearish evidence, the REIT index continues to rally. This has the feel of a blow-off top. I did not expect something like this to happen – a situation in which money would start to flow into the REIT sector, setting off a short squeeze. But I continue to recommend shorting REIT stocks (as well as the lenders who hold large quantities of commercial real estate loans). Specifically, I like SRS, the UltraShort Real Estate ProShares ETF (NYSE: SRS. Current price $11.63) as a way to profit from weakness in the REIT sector. But fasten your seatbelt! SRS is volatile. It delivers twice the INVESE return of the Dow Jones U.S. Real Estate index. In other words, when REITs fall, this ETF goes up a lot. But when REITs rise, this ETF falls a lot.

This ETF isn’t for everyone, just for those investors who believe the commercial real estate sector is ripe for a fall.

Joel’s Note: As we write to you this morning, our publishers in Baltimore are working to put together a rather incredible trial offer for Dan’s Strategic Short Report. We can’t reveal too many details at this stage, other than that, as an Executive Series reader, you’ll be the first to hear of it. Astute short sellers and green shoot skeptics, watch this space…

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[Rude Endnote: We’re throwing together some reader mail for issues later in the week so, if you’d like to have your say on any Rude-related matter, shoot us your thoughts at the address below.

In the meantime, we’ve got some serious jetlag to sleep off.

Until we wake up…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

Taipei, Taiwan

• Credit markets broadcast the following warning…
• When is a falling asset price a rising one?
• Insolvency, meet illiquidity, and plenty more…

Joel Bowman, reporting from Taipei, Taiwan…

Pattern-seeking creatures that we are, the human species will happily settle for a quack theory over no theory at all. Worse still, however, is our propensity to favor “warm and fuzzy” explanations over “cold and prickly” ones…even if the former variety fails to exhibit one iota of actual truth.

A falling asset price, for example, is never a rising one. Never. Ever.

By the same token, a job lost is not equal to a job gained; a dollar spent is not the same as a dollar saved; a unit consumed is never the same as one produced.

And yet, as we thumb through our virtual newspapers every day, we find bad news passed off as good more often than not. We see editors dress sinning facts in saint’s halos to parade them out in front of their congregation.

“GE earnings down, but better than expected,” announces CNNMoney from the financial pulpit this morning.

“Bank of America Profit Drops Less Than Expected on Fee Income,” choruses a Bloomberg headline below.

Let’s quickly review our premises before continuing here:

1) Something cannot fall and rise simultaneously relative to the same fixed point.

2) Falling earnings are bad.

So, now that we know falling earnings ARE NOT rising earnings, and that falling earnings are bad…how are the above headlines positive for the economy again?

It is this warped preference for rainbow-coated explanations over reality-coated ones that too often lead us to interpret otherwise terrible data points as cause for champagne by the pool.

According to the Bloomberg story, net income over at BofA fell 5.5% to $3.22 billion, or 33 cents per diluted share, from $3.41 billion, or 72 cents, from a year earlier. Whether that number was more or less than “the average estimate of 21 analysts surveyed” is as irrelevant as those analysts’ numbers are in the first place. What if the average analyst estimate had been much better, say 40 cents? Would the EXACT SAME BofA result now a “more bad” one merely because the expectation from a group of terminally incorrect economists was different?

Last month, 80 such economists were asked to predict how many employees were sacked during the previous 30 days. They were off by 100,000. Even more disturbing, the range between what can only be referred to as their “guesswork” was almost as big as the actual job loss number itself. (Low estimate, 150,000; high estimate, 500,000; actual number lost 365,000.)

We know instinctively that 365,000 lost jobs is a bad thing…but what if those same economists had predicted we would lose 400,000…or a million? Should we now celebrate an annualized job loss rate of 4.4 million simply because it is not 5 million or more?

For better or worse, truth is utterly unconcerned with and unaffected by our petty wish thinking. The intelligent investor usually makes a point of separating the two.

In today’s edition of the Rude Awakening, Dan Amoss, the mind behind the Strategic Short Report, delivers the second and final part of his insightful analysis of the commercial real estate sector. Hint: he is not bullish. Please enjoy…

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Sell REITs, Part II
By Dan Amoss

Investors in common stocks tend to ignore warning signs coming from the credit markets, often at their peril. Right now, the credit markets are broadcasting the following warning: The equity of overleveraged REITs is at risk of elimination or permanent impairment.

Yet the stocks of real estate investment trusts (REITs), which are popular among income-oriented retail investors, are still trading at high enough levels that discount just a garden-variety recession in commercial real estate. REITs were designed to invest in portfolios of rental properties, and generally pay no corporate income taxes if they distribute at least 90% of their profits as dividends to their shareholders.

REITs were designed to thrive in an environment of steadily rising property values and rents. But in this ice age for commercial real estate, the REIT business model will cease to function properly; a REIT’s tax-free status doesn’t allow it to retain much excess capital during lean times. Since REITs pay out all their earnings, they cannot grow without taking on more debt. During the boom, a REIT strategy encompassing growth, leverage, and acquisitions was a virtuous cycle that led to juicy dividends and soaring stocks. But in this bust phase, the REIT business model has morphed into a vicious cycle of dividend cuts, dilutive equity offerings, debt offerings at double-digit interest rates, and bankruptcies.

The REITs that levered up and grew too fast at the peak will go to zero in bankruptcy. Others could fall into the low single digits by year-end as the market anticipates that creditors will take title to many properties in 2009 and 2010. These developments would push the value of the REIT Index dramatically lower.

The REIT sector is woefully undercapitalized — just as the big banks were last year. If you mark the value of commercial real estate to market, it tells you that REIT debt in all its forms — commercial mortgages, unsecured notes, secured lines of credit – is much too burdensome. Equity cushions that seemed adequate at the commercial property market peak are now thin. REITs don’t have to mark their assets to market each quarter like investment banks. But you can be sure that before committing a single penny to a secondary offering of REIT stock, institutional investors will mark property portfolios to market.

Marking property to market will result in many underwater commercial properties. This is critically important because the combination of underwater properties (insolvency) and imminent debt maturities (illiquidity) tends to wipe out equity. The maturities over the next five years are staggering, and these debts were sloppily underwritten near the peak of the credit bubble. According to Goldman Sachs research, roughly $1.6 trillion in commercial real estate debt is coming due 2009-2013.

Lenders will not be willing to refinance mortgages in situations where mortgage debt exceeds the value of the property — so-called “underwater” properties. In order for all of these $1.6 trillion in loans to qualify for refinancing, hundreds of billions in new equity will need to be injected into properties. This much new equity capital dedicated to commercial property ownership will not exist in the investing environment of 2009-2013. So many of these loans will default.

In a scenario of paying off staggering debt loads under stress, the claims of common shareholders are either diluted or wiped out completely. This is the scenario facing General Growth Properties, for example, and shareholders will be lucky to recover anything. You can find shades of the General Growth saga throughout the REIT space.

Bulls argue that REIT stocks are cheap enough to buy. After all, they’ve declined to the point that you’d be buying ownership stakes in commercial real estate at prices well below peak values. Also, the high dividend yields already reflect plenty of pessimism.

What is the credit market’s response to REIT bulls? Creditors will take title to many properties in bankruptcy, and dividends will be paid mostly in new shares of REIT stock, rather than cash. I side with the credit markets.

A review of the aggregate REIT balance sheet — and the delusional commercial real estate purchases during the 2006-2007 peak — will tell you that this won’t be a garden-variety bear market in REITs. Supply of retail, office, hotel, and industrial space will greatly exceed demand for several years. In most cases, tenants will have the upper hand in lease renegotiations. This bear market, which is still in its early stages, will go down as the worst REIT bear market in history.

So will the TALF come to the rescue? Wasn’t the Federal Reserve’s “term asset-backed securities loan facility” (TALF) designed in part to mitigate the systemic damage from the time bombs ticking inside of CMBS? A primary reason for the recent rally in REIT shares is hope that the TALF will help restore value to equity of the most-indebted REITs by loosening up lending for commercial mortgages. The Dow Jones U.S. real estate index rallied from an intraday low of 80 in early March to a recent 130. But this REIT rally is based on hope, rather than strong fundamental evidence.

The Fed does not restore equity value to leveraged financial companies sitting on toxic assets; it merely tries to prevent stressed borrowers from unwinding positions too quickly. Look at how little equity value the Fed’s unprecedented lending facilities salvaged for Citigroup shareholders. TALF will do little to preserve equity value for highly indebted REITs. The Fed did not eat the losses on Lehman Bros.’ garbage securities, nor will the Fed or the Treasury eat losses that must be first absorbed by shareholders of overleveraged REITs.

Plus, potential limits on executive pay could limit interest in TALF participation. Special Inspector General Neil Barofsky said in a recently published report that executives involved with the TALF program “could be subject to the executive compensation restrictions.” Whether or not compensation restrictions are enacted as part of TALF, the mere threat of capricious rule changes and taxes imposed by Congress and the administration will scare many potential managers away from TALF.

While there are certainly opportunities to be had in this market, as I see it, REITs aren’t one of them.

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[Rude Endnote: Finally today…Did you hear? Goldman Sachs is in talks to acquire the Treasury! Well, not really…but this story is pretty funny anyway.

That will have to do for today as we’re a bit over time. We’ll return tomorrow with our usual weekly wrap-up. If you have any thoughts or comments in the meantime, please shoot them over to us at the address below.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

Laguna Beach, California

• The looming option-ARM crisis and acid rain on Manhattan’s elite,
• Dissecting the mess over in the commercial real estate market,
• Following your pig through the sausage machine and plenty more…

Eric Fry, reporting from Laguna Beach, California…

Continuing our recent series of religio-economic analyses, we shift our attention from the Gospel of Mark to the Gospel of Matthew. In the fifth chapter of Matthew, which details the Sermon on the Mount, the writer observes that rain falls on both “the righteous and the unrighteous.”

“The rain [also] falls on the rich and the poor,” as we observed in the January 8, 2007 edition of the Rude Awakening, “Bonus Envy.” But the story does not end there. Many of the rich are pretty good at siphoning rain away from the poor, or at drilling horizontal water wells under the poor’s property. That’s just the way of the world.

But if it is any comfort to the poor of the earth, acid rain also falls on the rich and poor alike. Of course, the rich possess better defenses against acid rain than the poor. But these defenses are not always foolproof.

Sometimes the acid rain of economic adversity burns a hole right through these defenses and erodes some or all of the wealth that the rich have amassed for themselves. The housing bust, for example, has victimized nearly every home-owning individual in the country, even those individuals who own homes in the Hamptons – the posh summertime playground of Manhattan’s rich (or formerly rich) Wall Streeters.

High-end homes everywhere are taking a beating. As home prices slide, many high-end homeowners – like so many of their subprime counterparts – find themselves hopelessly upside down in their mortgages.

Once the value of a home falls well below the size of the mortgage against it, the homeowner loses the incentive to continue making payments. The calculus is approximately the same, no matter whether the mortgage be $100,000 or $1,000,000.

That said, the truly rich would not go into foreclosure, no matter how disadvantageous that mortgage math might become. The truly rich possess other assets that could be liquidated to satisfy their mortgages.

But many, many of the theoretically rich individuals of the late great housing bubble were never really very rich at all. They were simply “credit-worthy.” They earned enough money to qualify for a monster mortgage. As long as nothing changed, paying the mortgage was doable. But if anything changed – anything at all – paying the mortgage was absolutely non-doable.

Something changed.

Lots of big-ticket employees lost their jobs; home prices tanked and credit disappeared. When you add all this up, you get lots of pain and suffering, even in “rich” households. And you also get an alarming rise in delinquencies and foreclosures within the “prime” and “near-prime” loan categories. Big-ticket mortgages are the new sub-prime. For three straight months, option adjustable-rate mortgages (“option-ARMs”) – a preferred product of many formerly rich homeowners – have generated proportionally more delinquencies and foreclosures than subprime mortgages.

“Wells Fargo ‘acquired’ $115 billion of these things (i.e., Option-ARMs) when it bought Wachovia,” blogger Karl Denninger observes. “[Wells] claims they’re worth $93 billion. Oh really? A bunch of loans that were mostly at or near 100% loan-to-value (that is, near zero equity) when originally written, in markets where prices have declined by half? Oh, and in May, [Wells] said 51% of the balances out [on these loans] were being paid only on the minimum due. That is, [these loans] were still negatively amortizing even as house prices fell! Talk about double-screwed!”

In other words, the housing-bust-cum-credit-crisis might not be over just yet. Meanwhile, the commercial-real-estate-bust-cum-credit-crisis is just getting started. Dan Amoss, the mind behind the Strategic Short Alert provides the details below…

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Sell REITs
By Dan Amoss

Like bank stocks one year ago, REITs look cheap on paper…but very expensive on pavement.

Out in the real world of plummeting demand for commercial space and constricting access to credit, commercial real estate is facing a very tough time. And that means the seemingly inexpensive shares of many REITs are not cheap at all.

REITs are still in the early stages of a huge deleveraging cycle that will last for years, which means that the REITs that concentrate on commercial real estate may be a deceptively dangerous asset class.

Our story begins with the massive credit bubble – and related housing bubble – of the last several years. These twin bubbles powered a dramatic rise in consumer spending. Some significant portion of commercial real estate sprouted up to serve and satisfy this artificial demand. From the top to bottom of the U.S. economy, easy access to credit during the last several years powered excess consumption – and a frenzy of knock-on commercial ventures.

Accordingly, shopping boutiques popped up everywhere, along with restaurants, real estate offices, home-furnishing stores, art galleries, etc. All of these enterprises unwittingly relied on credit-fueled demand, and believed that this demand was “normal.”

But now that credit has disappeared from the U.S. economy, thousands of businesses are discovering that they cannot survive the new normal – the one that relies on actual paychecks and savings, NOT credit. And so, one by one, business doors are closing and the empty commercial spaces are piling up.

“The severity of the recession is turning some malls that were once viewed as viable into potential casualties,” the Wall Street Journal recently observed. “‘Any mall that’s sitting on life support is probably going to get its plug pulled as the economy stalls,’ says Michael Glimcher, chairman and CEO of Glimcher Realty Trust, which owns 23 U.S. properties, including Eastland Mall in Charlotte.”

The distress in the commercial real estate market would be serious, even if credit were still flowing freely. But credit is contracting, which means that commercial real estate is in especially dire circumstances. Refinancing commercial properties has become an extremely difficult task. Without the ability to refinance – or to sell at a profitable level – properties will continue to stumble into foreclosure and liquidation, which will put continuous pressure on property values.

Owners of underwater properties will have to either default and hand the title over to the lender, or they’ll have to inject an impractically large amount of new equity into the property to qualify for refinancing. And in these cases, we are talking about face-to-face negotiations between borrowers and lenders. In the modern “securitized” economy, face-to-face negotiations have become as rare and quaint a concept as the corner malt shop. In the modern economy, most mortgages are sliced and diced into unrecognizable portions of various mortgage-backed securities (MBS).

Think of securitization this way: Image your pet pig ran away from home and stumbled into a sausage factory. If you searched for your pig at the end of the sausage production line, you probably couldn’t find him. He’d be there alright, but not in a form you would recognize. He is there; but he is now everywhere. So is your mortgage.

Securitization is, therefore, a very toxic aspect of this particular commercial real estate bust. Simply stated, securitized mortgage structures are not designed to function in our current environment — one with falling collateral values and soaring defaults. Let me highlight the loan restructuring challenge ahead for troubled commercial property owners and their lenders.

Take just one example of evaporating equity in commercial properties. It shows why stressed property owners cannot easily renegotiate terms with their lenders. A few weeks ago, Sunstone Hotel Investors Inc. defaulted on its mortgage on W San Diego hotel. Sunstone bought the W for $96 million in 2006. The transaction was financed by a $65 million mortgage that was sliced, diced, and sold into the commercial mortgage-backed security (CMBS) market. The W’s value is now below the face amount of the mortgage, so Sunstone will likely write its equity down to zero and turn the deed for the W (i.e., the mortgage collateral) over to creditors in order to eliminate its mortgage obligation.

Sunstone defaulted when it skipped its June 1 payment on the W hotel’s mortgage. Thus, Sunstone basically invited its servicer, Centerline Servicing, to foreclose on the hotel. Centerline represents the interests of the lenders, who are spread throughout the ownership structure of CMBS. Without the chance to renegotiate, the only real option is for lenders to foreclose and auction off collateral. Even worse, if Centerline were to approach the lenders about restructuring the mortgage, the lenders would have different objectives — some would want to liquidate collateral to get paid, while others would prefer to renegotiate and hope for a rebound in collateral value. This is known in the securitization business as “tranche warfare.”

From a legal standpoint, borrowers are too far away from ultimate lenders. The complex legal structure of CMBS practically guarantees that sensible loan restructurings, including debt-for-equity swaps, are very difficult.

Now apply this situation to hundreds of other properties around the U.S., and you can see how securitization (CMBS) practically eliminates the potential for property owners to meet with their creditors and renegotiate. Private sector creditors who want to participate in fire sales and in very attractive loans are waiting for property to fall to more reasonable levels first. Banks are not going to refinance commercial mortgages coming due on properties that are down 50% from peak values, and no equity is left. This means that the foreclosure market will dominate the overall market, pushing values for every comparable property down even more.

There will not be any legitimate bottom in the REIT market until there is a bottom in the prices of commercial real estate mortgages. The smart institutional money will initiate its investment in real estate by buying the distressed mortgages of attractive properties, NOT by buying REIT shares. These investors will want to buy claims on commercial property market that are high up in the capital structure, not gamble on equity in properties, which may be worth a fraction of peak values — or zero. That’s why I’m monitoring transactions in the commercial real estate debt markets, looking for signs of a true bottom.

The “bottom” we saw in early March was almost entirely due to the Fed’s extraordinary commitment to print money in an attempt to prop up old bubbles. This caused a temporary rally in CMBS and REITs. The most stressed REITs used this as an opportunity to de-lever their balance sheets just a smidge by flooding the market with new shares. With the window for REIT secondary offerings closing, by fall we should see another leg down in the Dow Jones U.S. Real Estate Index.

The real buyers for CMBS and commercial property are professional investors – not the Fed or taxpayers. By and large, these professionals are waiting for bargains, with bids far below the current market.

So should you.

Joel’s Note: WARNING! Green Shoot Enthusiasts Look Away Now!

No, we don’t have a report for you in this space today; Just a 90-day trial for Dan’s Strategic Short Report. This Link goes straight to the order page. If you like what you see, it’s two grand for the year. If not, we’ll refund your cash, no worries. The offer is for serious investors only.

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Yet, they also name seven “Super Shields” you can use to safeguard against further losses… plus at least five surprising “long” plays you can still use — even now — to get very rich. Read On Here.

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[Rude Endnote: Markets across Europe and Asia seemed to be squeezing the last bit of juice out of Wall Street’s fading rally overnight.

Here in Asia Hong Kong’s Hang Seng managed to stack on another 2.1% by today’s close after earlier in the week falling to a near two-month low. The Aussies too rallied 1.5%. Japan’s Nikkei 225, however, remained relatively unchanged on the day.

Last we checked Europe’s major measures were all up around the 1% mark with Germany’s DAX leading the way with around 1.2% gains for the session. France’s CAC and London’s FTSE were higher by around 0.9 and 0.8% respectively.

Over in the commodity pits, crude jumped a buck overnight to reclaim the $60 per barrel threshold. Gold, marching higher in recent days, added another couple of dollars and was sitting around $927 per ounce last we looked.

We’ll be back with more Rude views tomorrow.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

Laguna Beach, California

• REITs in big trouble – two stocks for your short shortlist,
• A bull market in delinquencies, a closer look at that “stress test,”
• Plus, green shoots or premature celebration? Have your say below…

Eric Fry, reporting from Laguna Beach, California…

“Success is never final. But failure can be,” Bill Parcels, the former NFL coach, once observed. Investors in real estate investment rusts (REITs) might want to pay particular attention to this truism.

REITs, as the name suggests, invest in real estate of various types. But what the name does not suggest is that REITs usually utilize leverage in their pursuit of investment returns. Leverage, as many investors learned during the last 12 months, is fun on the way up, but potentially fatal on the way down (unless you happen to be one of America’s 19 largest financial institutions).

At the moment, the REIT industry finds itself squarely in the middle of the “way down” phase – both because asset values are plummeting and because interest rates are climbing. Just yesterday, the yield on 10-year Treasury notes kissed 4%, which means that the 10-year yield has nearly doubled since the start of this year!

When long-term interest rates rise this dramatically and rapidly, many different industries suffer. But few industries suffer as much as the commercial real estate industry. Even in the best of times, rising interest rates increases the cost of capital, while also undermining the value of commercial real estate assets. In the worst of times – or even in less-good times – rising rates can produce catastrophic consequences.

Today’s commercial real estate market was distressed, even before rates starting rising. The problem, in a nutshell, was excess capacity. During the last several years, America constructed shopping malls and office buildings to satisfy the excess, phony demand that easy credit produced. But now that home equity loans and other readily available forms of credit have disappeared, so has the phony demand.

The unfortunate result: a glut of shopping malls, office buildings and hotel/motel properties.

“Vacancies are definitely rising across the commercial real estate market,” observed hedge fund manager, Jason Stock, at last month’s Value Investing Congress in Pasadena, California. “You’ve got office vacancies well over 15%. We think those are going to approach 25% before this is over.”

Stock and his partner, Will Waller, oversee the M3 Fund, a hedge fund that invests solely in the banking sector. Stock and Waller claim they are finding a number of attractive stocks to buy. Nevertheless, they remain very anxious about the health of the overall banking sector. In particular, they fear that commercial loan defaults will skyrocket from current levels, causing a large number of banks to fail during the next two years.

“So far this year there’s been just over 30 bank failures,” Stock reported in early May. “We expect they’ll be roughly 150 bank failures by the end of the year. And we would actually expect that number should be significantly higher.

Stock continued:

“Every Friday night (we jokingly call it ‘death watch,’ because that’s when you get the notices of the banks that have failed [from the FDIC]), when we look at the banks that are coming across as failures, we’ll say to ourselves, ‘Geez, that bank is a lot better off than 20, 30, 40 banks that we can think of. The regulators right now are completely overwhelmed. You have to have people to close down banks. And it’s not a very quick and easy process. It takes a fair bit of manpower. So if the regulators had the staffing to do it, there are definitely 50 to 100 banks that you could say, ‘This Friday we are going to go in and close all these banks down.’ So it’ll just be a matter of time before that pace picks up.”

In last month’s letter to their investors, Stock and Waller reiterated their skeptical outlook:

“The Government’s release of the ‘stress test’ results on May 7th was a key driver of the rally in large bank stocks. The results indicated that nine of the 19 firms have adequate capital under the test’s most adverse scenario…In our opinion, this ‘stress test’ was in no way stressful and could more accurately be compared to a beach vacation in Hawaii where the weather forecast had a 10% chance of afternoon showers.

“The ‘worst case’ scenarios that the Government utilized in this test included unemployment reaching 8.9% in 2009 and 10.3% in 2010 (as of May 31, 2009 the unemployment rate was 9.4%), and GDP growth of .50% in 2010. We believe unemployment could easily exceed 10.3% and that it is absurd to use a positive number as a worst case scenario for GDP in 2010. This ‘stress test’ created a false sense of stability in the banking sector and created a historic opportunity for banks to raise capital at significantly inflated valuations…While extremely beneficial to the banks, we believe the investors who participated in these offerings will be choking on these investments over the upcoming months.”

Contradicting the sanguine conclusions of the stress tests, Stock and Waller point out, “The Federal Reserve chimed in with an alarming report on first quarter loan delinquency rates at commercial banks. Total loan and lease delinquencies increased by 96 basis points, a 20.7% increase in only one quarter (from 4.6% to 5.6%)…We maintain our bearish outlook…we believe this bear market rally is unsustainable and that fundamental trends for banks are negative…”

Your California editor concurs, which is why he does not hesitate to say that most bank stocks are better sold than bought at their new and improved “recovery prices.” Similarly, most REITs are better sold than bought. Dan Amoss, editor of the Strategic Short Report provides a bit of color (mostly red) in today’s edition of the Rude Awakening…

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Real Estate Investment (Dis)Trusts
By Dan Amoss

I’m confident that the trend for REITs will be down through the end of 2009. That’s why I suggest buying the UltaShort Real Estate ProShares ETF (NYSE: SRS. Current price $18.52) as a way to profit from weakness in the REIT sector. But fasten your seatbelt! SRS will be volatile!

REITs may appear cheap, but they are very dangerous to hold right now. A basic tenet of corporate finance is that a company or a sector is only creating value for shareholders if its return on invested capital (ROIC) exceeds its weighted average cost of capital (WACC). If its WACC exceeds its ROIC, it is destroying value. This describes the situation facing the REIT sector for the next few years.

Most REITs cannot float unsecured debt at anything less than 10% or 12%, so their cost of capital is high and rising. At the same time, due to the glut of supply in commercial real estate supply, and waning demand from stressed tenants, the returns on incremental investment in new capacity are very low — possibly negative.

Summing it all up: REITs will be destroying shareholder value until supply and demand for commercial real estate reaches equilibrium. The free market is screaming as loudly as it can that millions of square feet of capacity need to be absorbed or eliminated over the next several years in order for the surviving REITs to have a chance at generating respectable returns on capital.

This process has barely even begun, after the biggest lending binge in the history of commercial real estate. It will last a long time. The lending binge ensured that a large swathe of REITs will not make it to see the next commercial real estate up-cycle, which is still several years away at minimum. The title to many properties will go back to creditors in bankruptcy, and auctions will bring down asset values across the sector until they are cheap enough to earn respectable returns in a weak rental environment.

Another example of stress surfaced earlier this week. The auction to settle credit default swaps related to the General Growth Properties bankruptcy indicates serious pain to come for mall REIT owners: GGP’s senior loans effectively liquidated for 44 cents on the dollar! This means that lenders are demanding extreme discounts and high yields to hold debts secured by mall collateral. This isn’t good news for peers like Kimco (NYSE: KIM) and Simon Property Group (NYSE: SPG).

Another argument I’ve seen lately is that REITs will be a good inflation hedge if you buy them at these prices. This is an overly simplistic view of Fed-created inflation and its ultimate symptoms.

Fed Chairman Bernanke can debase the dollar all he wants, but most of the new dollars will act to push up the prices of goods and services in sectors with relatively tight capacity. Mostly, this translates into lower living standards for the average American — an echo of the 1970s, only without the real estate appreciation.

The Fed’s inflation will find its way into tangible assets like gold and silver, oil and gas, uranium ore, farmland, potash mines, and any other commodity China needs to import. Conversely, the fed’s inflation will NOT find its way into the pricing of American shopping malls, which arre in a condition of extreme oversupply.

Over time, the capacity to supply light, sweet oil to the global economy will be far tighter than the capacity to supply American retailers with real estate in malls. Demand for oil will be far more resilient than the U.S.-centric consensus expects, while demand for discretionary items — like “Color Fiend Neon Green Hair Spray” at Hot Topic (this product actually exists) — will fluctuate up and down, but generally head lower. Rising prices for several necessary goods and services will crowd out discretionary spending in many family budgets.

Inflation does not re-inflate old bubbles — especially in the case of residential and commercial real estate. It will only slow the previously violent deleveraging process.

On a related note, it was a breath of fresh air to hear Howard Davidowitz of Davidowitz & Associates interviewed on Bloomberg Radio recently. (You can find a link to download an mp3 of the 17-minute interview here). Davidowitz has decades of in-the-trenches experience in retail consulting and analysis. Rarely do you find an industry analyst express an informed opinion so forcefully in the mainstream financial media. I highly recommend listening to the interview for an overview of how the retail and commercial real estate business will evolve in the coming quarters.

A preview: It ain’t good.

[Joel’s Note: Faithful readers may remember Dan for being way out front on calling the implosion of Lehman Bros. last year. That play handed his Strategic Short Report readers a chance at bagging over 400%…and that was in the face of everyone who said “the worst is over” after Bear Stearns’ collapse a few months earlier.

Now, those same people are shouting “green shoots” and telling you that the worst is over (again). Meanwhile, the guy who actually got it right is warning of more trouble to come. Hmm…what’s an investor to do?

Well, you can catch the other guys on television every night…or, you can grab a risk-free, 90-day trial of Dan’s Strategic Short Report Right Here.

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[Rude Endnote: Finally today, we’d like to know your thoughts on the whole green shoots vs. premature celebration debate. Specifically, how do things look from where you sit? Is the property market in your neighborhood booming or busting? Are they building new strip malls, or tearing old ones down?

How about the job market? Are more or less of your friends employed…taking pay cuts…out on their behinds?

And what’s your outlook for the days and months ahead? Are stocks going to add or subtract a thousand points…gold go to $2,000 or $200…oil at $100 or back to $40?

Okay, you get the drift. We’ll publish your boots-on-ground analysis and anecdotes in upcoming editions. Just send them to the address below and stay tuned.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com