Volume X, No. VI

Let's face it. We live in Crisis World. Everyone uses the "C" word for everything these days. The family's in crisis; our kids are in crisis; education's in crisis. We've got an oil crisis, an economic crisis, a religious crisis and endless government and political crises.

Is there anything or anyone not in crisis out there? Help!

We're bringing all this up because we ended our last letter saying we'd talk about exactly how to assess what's going on now -- along with what we can expect in the coming months and years. And, let's face it, you can't talk about exactly what's going on without recognizing that we're in -- you guessed it -- a crisis.

But instead of just generating more anxiety (doesn't the word "crisis" make you feel a bit on edge?) we'll start with a simple definition of "crisis": a crisis is a turning point, for better or for worse. It's a decisive moment -- or a time when decisive change is impending.

At least we know what we're talking about now. That's not too bad, is it? Feeling a bit calmer now? Okay, with that out of the way, we're going to look our current crisis straight in the eye and find out:

• The Incredibly Simple Reason Most Experts Don't and Simply Can't Get It
• Why the Experts Kept Believing It Really IS Different This Time
• How the Real Estate Bubble Pushed Us Into Crisis
• Six Reasons Why Our Leaders Either Missed or Ignored All the Danger Signals

Oh, and we'll even finish off what we started last month with our assessment of

• Why Real Estate Hasn't Bottomed Yet…and When It Might

Let's kick things off with…

Why the extremes from the "experts" out there? On the one hand we've got the cheerleaders who keep telling us we're just one more tax break -- or was that one more bailout package -- away from getting back to business as usual. America's ready to rumble - if only the government would just do more…or maybe that's do less.

On the other, there are the cave-dwellers: It doesn't matter what anyone does. Find a cave to stash some freeze-dried food, guns ‘n ammo and, maybe a little pile of gold.

What's going on? We've never seen such extreme differences. Are all these guys just making it up as they go along? How do we tell who's right?

To find out, we'll turn to Carmen M. Reinhart & Kenneth S. Rogoff and their recent book This Time Is Different. While we usually don't delve into the details of books we read, this time is going to be, well, different. As it turns out, our authors point out that most experts and commentators on the current crisis use data that only goes back to around 1980.

Think about it. If you use data that started in 1980 -- the start of the greatest stock and bond bull markets in American history -- is there any reason to be surprised when the cheerleaders keep finding examples of how things kept getting better and better after every crisis?

On the other hand, knowing this, why be surprised if the cave-dwellers tell us to ignore the data and just write off all the cheerleaders. The party's over. Head for the hills.

That's why our authors compiled and organized the available data from crises dating back 800 years or so. And that's why we've chosen Reinhardt and Rogoff to help us understand what the heck is really going on.

It turns out when you look back on 800 years worth of crises, you'll find five varieties:

• Banking Crises
• Domestic sovereign debt defaults
• Foreign debt defaults
• Currency crashes
• Inflation outbursts

Let's take a quick look at the first type -- the banking crisis. If we all knew that banks had written enormous amounts of sub-prime mortgages, and that hundreds of millions of dollars worth of those mortgages were defaulting in 2007, why did current Fed Chairman Ben Bernanke assure us that the sub-prime crisis was not a big deal and would quickly evaporate. How could he be so wrong? And why did so many people believe him?

More specifically, how did the vast majority of economists miss not only the warning signs of the crisis, but even the crisis itself until it practically ate us all alive?

Our authors claim to have identified a kind of "syndrome" that helps explain this. They call it the This Time Is Different syndrome and it infected the vast majority of the experts out there. The syndrome goes like this:

They even break out six specific reasons why our leaders missed the danger signals -- which we'll get to in a moment.

For now, though, let's think about how this "syndrome" infected so many otherwise intelligent, rational minds. You can understand Wall Street spewing this nonsense. After all, they just want to keep us happy and upbeat so we'll buy stuff from them. But remember, prominent economists, responsible government officials, even seemingly bright academic types took this seriously until only a couple of years ago.

Frankly, it's shocking how many people even now ignore the stark reality of the massive "credit bubble" that blew up over the course of decades, as well as with how much it will have to deflate before we get anywhere near a somewhat "normal" economy. Reinhardt and Rogoff make a heroic effort over about 400 pages trying to straighten us out by showing how crises unfolded in the past and how they were eventually resolved. We'll focus on our current crisis, specifically where we're at right now and what we can expect in the months and years to come.

Since we discussed real estate last month, let's start our discussion there.

The current U.S. financial crisis is firmly rooted in the bubble in real estate fueled by massive increases in housing prices. How did houses get so expensive? Cheap credit. But how did credit (mortgages) get so cheap?

The authors identify a "massive influx of cheap foreign capital resulting from record trade balance and current account deficits and increasingly permissive regulatory policy."

Simply put, we in the U.S. bought lots of foreign-made stuff. We paid for the stuff with U.S. dollars. When people in, let's say, China got dollars in exchange for the stuff they sold us, they had to "convert" the dollars into their local currency. (Just like we use U.S. dollars to buy stuff here, they use their own currency to buy stuff in their own countries.)

Now where did they go to exchange dollars for their local currency? The bank (just like you might if you had some leftover euros in your pocket from the last time you traveled in Europe). What did the banks do with the dollars? They went to the central bank to exchange them for local currency -- and gave their customer the local currency. What did the central bank do with the U.S. dollars? They invested them -- mostly in U.S. Treasuries.

We don't have time now to get into why they invested them in Treasuries. Let's just say that was their best choice at the time. The point is, the dollars found their way back here when the foreign government bought the U.S. Treasuries -- with those dollars. And those dollars were available then for our banks to loan. (Remember this was before the crisis, when banks were still lending money to any and all takers.)

But where did we get all that money in the first place that we used to buy all that foreign stuff? Ah, that's where the whole credit bubble started blowing up like crazy. You see, lots of that money we spent was borrowed money. We used our credit cards. And when we maxed out the credit cards, we borrowed against the equity in our homes. All along, banks were happily lending us the money (banks own credit card companies; banks provide home equity lines).

That explains the "massive influx of cheap foreign capital resulting from record trade balance and current account deficits." But what about the "permissive regulatory policy"?

Well, our authors correctly note that the regulatory agencies -- for example the Federal Reserve and the SEC -- did nothing to stop or at least slow down the bubble. Of course, the regulators claim they didn't notice anything. But how realistic is that? Data certainly existed that could at least force them to take notice. Take, for example the Case-Shiller Housing Index.

This index provides a clear overview of, among other things, housing prices relative to historical averages. Since 1891, no housing price boom has been comparable in terms of sheer magnitude and duration to the one recorded in the years culminating in the 2007 sub-prime mortgage fiasco. Between 1996 and 2006 (when prices peaked), the cumulative price increase was 96 percent, more than three times the 27 percent cumulative increase from 1890 to 1996.

And with all that, neither Alan Greenspan (former Federal Reserve Chairman) nor Ben Bernanke (current Federal Reserve Chairman) noticed anything disturbing? None of the other regulatory agencies that oversaw the banks and the Wall Street firms noticed anything strange going on?

Then again, we can't be surprised. After all, banks who issued sub-prime and other questionable types of mortgages were making fortunes. Wall Street firms who "packaged" these questionable mortgages into new securities like CDO's were making double-fortunes. Why upset the apple cart?

Then came 2007 and a sharp rise in sub-prime mortgage defaults in the U.S. provided the spark that ignited a full-blown global financial panic. Why global? Among other reasons, the junk securities (e.g. CDO's) that started to blow up when the sub-prime mortgages began defaulting were bought and held by foreign banks. Oops. Now the genie was out of the bottle. And many commentators -- including Greenspan (Fed Chairman at the time) -- called this a "bolt out of the blue." Why?

Right off the bat, Reinhardt and Rogoff note that the Fed could have paid more attention to the rise in asset prices in the face of a relentless increase in household debt and declining personal savings -- along with previous studies showing that housing booms are accompanied by a sharp rise in debt.

From there, the authors conclude there was a "conceit" at play here. The conceit was that the financial and regulatory system could withstand massive capital inflows on a sustained basis without crisis.

They then identify six reasons why our financial and regulatory leaders were completely oblivious to what should have seemed obvious:

• The US, with the world's most reliable system of financial regulation, the most innovative financial system, a strong political system, and the world's largest and most liquid capital markets, was special. It could withstand huge capital inflows without worry.
• In addition to its other strengths, the US has superior monetary institutions and monetary policy makers.
• New financial instruments were allowing many new borrowers to enter mortgage markets.
• All that was happening was just a further deepening of financial globalization thanks to innovation and should not be a great source of worry.

Our comment: Can you see what's going on here? Look carefully and we think you'll find a combination of greed along with an exaggerated confidence (to put it mildly) born of the belief that the "best and brightest" who lead our financial system had finally found some sort of "Philosopher's Stone" that could -- and did -- change all the rules of economics, money and risk.

For those of you who've forgotten or possibly never cared for history, medieval alchemists believed that something they called the Philosopher's Stone could turn lead or other base metals into gold. The mythical substance didn't exist of course. And in spite of all their efforts, they never discovered or created it.

We all know greed will always be with us. But wouldn't you think smart people would not so easily get sucked into believing in a modern Philosopher's Stone -- letting their decisions and actions be driven by attitudes and beliefs born of wishful thinking, pride, and arrogance?

We'll have to continue our discussion next month, since we're running out of time now. But before we wrap up, let's finish up with real estate and what may lie ahead there.

Last month we focused on the individual home owner and tried to provide some reasonable guidelines on how to value a specific house. Now, though, we look at the price of houses in light of the ongoing crisis and whether it at all makes sense to think that housing has "bottomed."

Let's first remember that the government's "tax credit" program did cause some buyers to finalize their purchase plans; house purchases steadied until the tax credit expired at the end of April. So what about now?

For example, what happened to all that debt that drove up the price of housing as described above. Where did it all go? Well, it's still around -- and waiting to pounce. In addition to the sub-prime mortgages that began defaulting in earnest in 2007, a whole wave of "Alt-A" and "Option Arm" mortgages (forms of adjustable rate mortgages) will re-set their rates this year and next year. Defaults have already started on these. Will the coming waves overwhelm the market and dump millions more homes on an already saturated market? Well, one positive note here is that mortgage rates are at historic lows, so re-sets may not be quite as bad as they might have been. But mortgage rates aren't the whole story.

The headwinds facing a recovering housing market include: demand, price level, inventory, REO's, unemployment and wages.

Demand remains weak, exacerbated by the simple fact that banks aren't liberally granting mortgages anymore.

Price levels are still above historical averages (hard to believe, isn't it?). When an item is dramatically overpriced for a long time (as houses have been), it doesn't just correct down to the average. It shoots below, usually far below average, before it stabilizes. We're not there yet.

Inventory, which includes REO's (real estate owned by banks from defaulted mortgages), continues to grow. Unwanted and abandoned homes sit unsold with few making offers. How bad is the problem? One indication of how severe the problem is: appraisals are taking a lot longer to complete. "Comparable sales" are so few that the appraiser can't find enough references to use for comparison when coming up with a reasonable price. So banks make appraisers scout around for more homes in ever-widening geographical areas -- sometimes leading to price appraisals that really have little to do with an individual home in a specific neighborhood.

Unemployment stubbornly refuses to budge. Wages are stagnant now and have been for at least the last decade.

The picture for housing is simply not improving. Prices must revert to a sustainable level. Why some economists and other commentators claim otherwise remains a mystery. The facts are there for anyone to see.

Just as real estate started the crisis in 2007, so it's now keeping the ball rolling through 2010 and beyond. Next month we'll continue with how and when we can expect to resolve this crisis.

For now, let's take a look back at another crisis -- one that eventually was resolved happily.

Our Founding Fathers signed the Declaration of Independence to resolve a crisis - a crisis that started with the passage of the Stamp Act on March 22, 1765. When the British Parliament in London imposed the Stamp Act on the American colonies, it kicked off years of debate -- some peaceful, some violent -- about "taxation without representation." Over time, more and more American colonists resented being taxed by a legislative body in which they had no representation. But the taxes kept coming.

The crisis intensified. After a decade of debate without resolution, the shooting started. Finally, on July 4th 1776, the Declaration of Independence drew the line in the sand. The debate was over. The Americans would be British citizens no more. Their separation from Britain would be irrevocable.

Perhaps it's unfair, but you can't help but compare the way our first leaders resolved their crisis with our current leadership's efforts to resolve ours. For example, when our leaders today pass legislation -- well-intentioned though it may be -- they're spending other people's money. Contrast this with our Founding Fathers who put themselves on the line. Just read the last sentence of the Declaration of Independence:

A radically different approach, wouldn't you say? And remember they had no "career" prospects to advance, no promise of lucrative jobs when they left office, no vast profits to skim from the inevitable war that would follow -- a war that few others around them believed they could win.

They pledged their lives, their fortunes and their sacred honor. They understood that each and every one of them would be held accountable for their actions, if caught by the British.

No promises of entitlements to their "constituencies," no massive bailouts with money they didn't have - just commitment driven by character, something we could use a lot more of today.

Happy Fourth of July!

P.S. -- While I was putting the finishing touches on this letter, the stock market started sending some disturbing signals. For more on this, you can check out rickesposito.blogspot.com. Right now we're in the middle of a mini-series focusing on Warren Buffet's Seven Most Important Characteristics of Wise Investing. (Why Seven? Check it out here.)

Richard S. Esposito, ChFC
Lighthouse Wealth Management LLC
405 Lexington Avenue, 26th Floor
New York, NY 10174
Tel: 212-907-6583/Fax: 866-924-1952

Email: resposito@lighthousewm.com