Perhaps some analysts and pundits breathed a big sigh of relief when equities rebounded after a huger sell-off on Wednesday to close higher. No relief was in sight today as the Dow dropped more than 500 points and the S&P 500 dropped 55 pushing both indexes into the red for 2011. 

We see two possible explanations: fundamental and technical. First perhaps investors and the rest of the world where a bit shaken that a significant portion of our elected leaders would take us to the brink of default to prove a point. Basically that they would not be the first to blink.

 How much confidence can you have in an economy with such recklessness in high places going on? We pointed out last week that the debt ceiling debate was having real consequences. People and markets were working in a chance of a default — albeit a slight one — into their risk models. Margins rose and haircuts on Treasuries were increased. That meant funds had to be diverted from other things to cover that small downgrade in collateral.

That being said, the markets did seem a little toppy and last week’s sell-off pushed the indexes to some significant support levels that were taken out. So while you listen to blame get tossed around the next couple of days remember this move may be mostly technical.

More on this shortly.

While interesting, what perplexed us given the scope of government and Federal Reserve activity over recent years, is how the mechanics of such a transaction would play out. While minor fluctuations in this CDS could be hedged and traded, if a real default becomes likely it is doubtful the markets would be allowed to decide.

 And while most analysts discount an actual default happening, many also point out that going into default is not the only thing that can cause damage to our economy and U.S. standing. In fact damage is accruing the closer we come to the ledge without a resolution. In our futuremag.com poll we are asking what is likely to happen with the debt ceiling debate. The overwhelming response has been that there will be a deal but not before the market throws a scare into the politicians. We may be seeing the first signs of such a scare as the CME Group raised margins on Treasury futures and yesterday announced that they were increasing the “haircuts” given to Treasury products used as collateral at the CME clearinghouse.

While in both cases, CME pointed out that the move was part of a “normal review of market volatility to ensure adequate collateral coverage,” what they are reviewing is volatility in the market, which is subject to fundamentals such as if the U.S. government defaults on its obligations.

As of today’s close the Dow Jones Industrial Average is down nearly 400 points for the week. While it is always dubious to try and apply cause to market activity, it is a fair bet that the market is watching this debate.  

 And the fact that a significant political faction is pushing the matter — and even appear to be rooting for default — has to worry folks counting on the solidness and security of U.S. government debt. And it is still the gold standard. The dollar has been weakened for more than a decade but when things begin to look very bleak there continues to be a flight to quality towards U.S. assets. How long will that last when a portion of our political leadership see a technical default as a positive?

If there is a downgrade, that only makes matters worse. It will decrease our options not increase them.

Higher capital requirements could force end users to lighten positions as it takes more capital to back those positions.

An interesting blog post yesterday in Naked Capitalism pointed out that at one point in 2007 AAA rated collateralized debt obligations (CDOs) and asset backed securities (ABSs) were highly regarded forms of collateral and received minimal (2%-4%) haircuts from clearinghouses. When those products were exposed in 2008, they could no longer be used for collateral and that helped cause a huge exodus from the markets. I can’t see a scenario where the haircuts on U.S. Treasuries go to 95% as was the case with AAA CDOs, but every increase in the haircuts has an affect. It pulls capital from other sources. As we mentioned, damage is accruing.

This comes on the heels of a possible Moody’s downgrade announcement a day prior. “Moody’s Investors Service has placed the Aaa bond rating of the government of the United States on review for possible downgrade given the rising possibility that the statutory debt limit will not be raised on a timely basis, leading to a default on U.S. Treasury debt obligations.”

S&Ps CreditWatch indicates a substantial likelihood of taking rating action in the next 90 days.

It is ironic because what brought this to a head is the credit crisis and resulting great recession, which is ongoing despite technically being out of it for more than a year. And while there were many culprits, right at the top of the list has to be the aforementioned credit ratings agencies. It was them who chose to slap AAA ratings on massive amount of collateralized debt obligations (CDOs) and other mortgage backed securities. It is them who were compensated by the very investment banks that were creating these products as quickly as mortgage lenders could write bad loans and sell them off to be bundled in various mortgage backed securities. The shocking conflicts of interest of how these ratings agencies operate is arguably public enemy #1 in the crisis.

The very nature of most of these products—subprime mortgages—meant they were higher risk products. Nothing wrong with that if they were labeled as such but they were not, and they were not because the banks who created the products needed the AAA ratings to sell their CDOs to the widest group of investors, many of whom are restricted from investing in things not rated as investment grade.

Bottom line is the banks paid for the ratings.

As noted here at the onset of the crisis all the way back in August 2007, the fact that high risk investments were rated as low risk investments is extremely dangerous because entities used these products as collateral and leveraged off of them as if they were AAA government debt.  

In an upcoming Futures interview with Securities and Exchange Commission (SEC) Chairman Mary Schapiro, the SEC chief talks about the conflicts of interests with ratings agencies and steps she is taking to address it.

Frankly, given there complicity in the crisis, I am surprised the ratings agencies are still around.

This is not to say the Federal government should not get debt under control. The growth path of entitlement programs made the conversation we are having today  on debt inevitable, the financial crisis just moved things forward a bit. However, in the last week I have seen stories from ratings agencies and the heads of several investment banks talking about what the government needs to do. These are the folks that got us into this mess and seemingly got off scot-free.

Don’t know why the government doesn’t just  do what the banks did and pay for their ratings.

Bernanke looked more comfortable in this second soiree with journalist, even if he didn’t let much slip concerning timelines the FOMC is looking at. It’s still a good idea to hear what the head of the Central Bank is thinking. Below is the webcast from the conference.

What questions were you hoping Bernanke would address? How does your outlook for the economy change as a result of what Bernanke says here? Be sure to check out our Mid-Year Economic Outlook that will be published in the July issue of Fututres on June 27.

Broadcasting Live with Ustream.TV

In our July issue (being published on June 27), we spend some time looking at the housing market in our mid-year economic outlook. Let me sum it up: It’s not good. Housing prices are falling and those lower prices are not spurring increased buying. Nationally, house prices fell in April to their 2002 levels and earlier today we saw existing home sales fall in May 3.8% to only 4.81 million, a six-month low.

Analysts declared the housing market was in a “double dip” last month after the S&P Case-Shiller Home Price Index showed prices dropping below the bottom put in place last year. Pretty much every analyst has equated last year’s uptick in housing sales to the short-term first-time homebuyer tax credit. As soon as that expired, home sales and prices started working their way back down again. So much for that quick straw house.

While taken as a whole, the U.S. housing market still is in for a rough rest of 2011 and probably 2012, there are some patches that are beginning to turn around. According to a Wall Street Journal article, some areas are beginning to recover from the five-year-and-counting housing recession. The article points to three things that are indicators that housing may be turning around in any particular area: Jobs, rent prices and foreclosures.

None of those are that great of a surprise. If people can’t get jobs, then they can’t borrow money for a house, and job creation has been dismal with June non-farm payroll showing only 54,000 jobs created in May. Considering the millions of people that lost jobs, that number doesn’t even put a dent in the unemployment figure, which rose to 9.2%.

Still, one of the greatest drags on housing prices is the glut of foreclosures still flooding the market that are forcing traditional sellers to lower their asking price just to compete. Those foreclosures need to be purged from the system before a recovery can take place. Further, there is a huge shadow market of homebuyers waiting to sell their homes as soon as there is any uptick in the market.

It is ironic to think the very things that spurred the housing bubble are the things depressing a recovery. The buying frenzy created the huge glut of inventory and that buying was fueled by low lending standards, something that has tightened as the pool of buyers has shrunk.

Depending on where you fall, there are two ways of looking at recent housing data. If you are a homeowner hoping to sell, it has to be discouraging. If you are a homeowner that plans to stay put for a while, it is neutral with a potential upside that now is a great time to get your home reassessed to lower your tax bill. For homebuyers, it’s hard to imagine much better news than prices falling and mortgage available around the 4.25% mark.

The U.S. housing market is looking for that solid foundation to begin a recovery upon. While things still look to be on the downside nationally, there are patches beginning to climb out. That is the important thing to focus on, recovery is happening, it’s just taking a little longer in some areas than others. The housing market is not just a factor in the Great Recession, the Great Recession is tied to the housing market. A number of analysts have said there can be no recovery in the economy at large until the housing market turns around.

Be sure to read our mid-year economic outlook in our July issue to see what analysts are expecting, it will be published on June 27.

What do you think? What needs to happen to see a recovery in housing? Would another homebuyer tax credit help to stimulate buying?

Jackson cities the recent bankruptcy of Borders as an example, asking, “Why do you need to go to Barnes & Noble? Buy an iPad and download your newspaper, download your book, download your magazine.” He goes on to practically call it an abomination that Chicago State University’s plans to create a “textbookless” campus by giving incoming freshman students iPads.

It’s nice to see a congressman worried about unemployment, now he just needs to direct that frustration into the right channels. Obviously the publishing industry has changed. That change was started long before the iPad, though, just think Amazon. To say that one new electronic device that has only been on the market a little over a year is responsible for the loss of thousands of American jobs is ridiculous.

Jackson’s speech is below. What do you think?  Banning iPad’s probably isn’t going to help the American employment situation, but what would?

“The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done. If we accept this notion, it will happen again…. It falls to us to make different choices if we want different results.”

These are the words of the task force that wrote the Financial Crisis Inquiry Report released in January. These 10 commissioners were tasked by Congress to determine what caused the 2008 financial meltdown. After hearing about possible exemptions of certain firms from the Dodd-Frank Act by those in Congress, I read this report. It irks me that some of those responsible are the loudest naysayers of reform. Even the task force notes: “Some on Wall Street and in Washington with a stake in the status quo may be tempted to wipe from memory the events of this crisis….” So let’s have at it…what were the group’s main conclusions?

1) The financial crisis was avoidable. “The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public.” The main instigator? The Federal Reserve Bank and “its pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards.”

2) Widespread failure in financial regulation and supervision. “The sentries were not at their posts…more than 30 years of deregulation and reliance on self-regulation by financial institutions, championed by former Federal Reserve Chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the financial industry at every turn, had stripped away key safeguards, which could have helped avoid the catastrophe.” Regulators highlighted for sleeping on the job: Securities and Exchange Commission, Federal Reserve Bank of New York and those keeping an eye on the mortgage industry. One suggestion on how it was weakened: The financial industry spent about $4 billion in lobbying and campaign contributions from 1999 to 2008.

3) Failure of corporate governance and risk management at key financial institutions. “Too many of these institutions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding.” Further, compensation focusing on short-term gain added to the long-term problems.

4) A combination of excessive borrowing, risky investments and lack of transparency led to the crisis. Everyone was overleveraged, especially Fannie Mae and Freddie Mac. Both Wall Street and Main Street incurred debt levels unseen before.

5) The government was ill-prepared and its inconsistent response added to the uncertainty and panic. They rescued Bear Stearns, then put Fannie and Freddie into conservatorship, then let Lehman fail and then bailed out AIG.

6) There was a systematic breakdown in accountability and ethics. You think?

7) Contributing to the meltdown was a collapse of mortgage-lending standards, unchecked OTC derivatives and credit rating agencies that didn’t do their jobs.

My synopsis just skims the report; this group dug in and even got philosophical. “These conclusions must be viewed in the context of human nature and individual and societal responsibility…. It was a failure to account for human weakness that is relevant to this crisis.” It does hold accountable public officials, specifically in the Clinton and W. Bush administrations, and sort of blames us for allowing these officials to do what they did to the system. So what’s the takeaway? Learn from the past, heal thyself, and blame Alan Greenspan.

Never mind that the Middle East dust-ups have had little effect on domestic crude oil supplies. Ignore that U.S. energy companies are reporting huge profits (one to-remain-nameless company had NET PROFIT over $9 billion in its 4th quarter alone). And forgive the media for swallowing the analysts’ trick of implying cause-and-effect with statements like “Gas prices soar as the Middle East smolders.” True, but the inference of economic connection needs critical review.

 No, the talk about releasing oil reserves relates to gas prices lurching toward $5 a gallon regardless of why. So, I ask the Energy Department to do some simple math:

First, determine the average price that the Government paid for the crude oil in the strategic reserve. If it substantially below current market prices, then

Second, sell it to refiners for 5% above cost, creating a taxpayer profit.

Third, allow the refiners to sell the gas to outlets at 5% over their cost, more profit.

Fourth, let the filling stations mark their cost up 5%, more profit.

Then, if the cost to motorists is significantly below current levels, everyone wins.

Otherwise, leave the reserves alone. Sure beats providing cheap oil to some of the planet’s biggest companies to enhance their already remarkable bottom lines.

Move over, George Soros, Glenn Beck has a new commie to bludgeon.

A group of experts who spent two years on the problem and produced the report “Choosing the Nation’s Fiscal Future” have agreed to  some serious points on the deficit: A) it is unsustainable and will limit our flexibility the longer it is not seriously addressed and B) the size and scope of it is too large to solve simply through an increase in revenue or spending cuts. The cuts would be too deep and painful even for the most conservative and the tax increases too punitive for the most liberal.

The conclusions the debt commission appointed by President Obama offers a similar dire scenario if we do not address the problem. 

This brings us to the recent compromise between the White House and Congress over extending the Bush era tax cuts. As you know the President wanted to extend the tax cuts to everyone except those earning more than $250,000. The tax cut for the top tier earners has been estimated to cost $2 trillion over the next decade. Republicans stated on numerous occasions that they would fight letting those tax cuts expire, even allowing the tax cuts expire for everyone. The administration agreed to extend the cuts even for the wealthy in exchange for extending jobless benefits out to 99 weeks. This begs the question when does unemployment insurance stop and welfare begin. The extraordinary nature of the economy downturn justified extending these benefits, which has happened several times but can they go on indefinitely?  

While this may seem like a reasonable compromise to some, from a budgetary standpoint it is simply a capitulation as both sides agreed to spend more in order to retain a program dear to them. The compromise is estimated to add nearly $1 trillion to the deficit in the next two years.

If deficit reduction is the priority politicians’ claim it is, then the sacrifice offered should benefit that goal. If there was an appropriate compromise it would have been to let the tax cut expire for the top bracket and let unemployment benefits run out or find a way to pay for them by cutting something else. That was the discipline imparted on the system that allowed for a balanced budget less than a decade ago. And since that discipline was squandered in the name of tax cuts by the GOP, it is particularly disturbing hearing them spout off about the deficit without contributing to the solution. It is simple: if you add a spending program you need to cut something else or increase taxes; if you cut taxes, you have to eliminate some spending those revenue would have supported. The notion that tax cuts pay for themselves is a kinard. If it were true, we woudn’t be in this mess.

A story titled “The era of deficit denial is over” accompanied the President’s bipartisan fiscal commission report.

Less than a week later the tax compromise was struck proving that we are still in denial. A compromise would involve each side altering their position in a way that would reduce the deficit not each side agreeing to increase the deficit to save their own spending.

Apparently we will need another shock before we get serious. It may be coming shortly.