-->Tapping Equity

The Daily Reckoning

Paris, France

Thursday, 20 March 2003

---------------------

*** War! Will the Iraqis take a dive? Will the stock market
take a leap? More questions...

*** Making history...the costs of war...gas down, refis
up...history back in business.

*** Lumps for the lumpen...information age revisited...a
moral world, after all...and more!


The bombs have begun falling over Baghdad and the whole
world holds its breath.

Will the war be short and sweet, as people believe? Reports
from Iraq tell of surprisingly little preparation for war.
Did they not believe it? Did they not care? The Iraqis went
about their business like a man whose wife was sitting down
with lawyers to write up the divorce papers. A new stage of
their national life is coming, they must think to
themselves...but not necessarily a worse one.

Who knows, maybe the fix is in. Maybe the Iraqi leadership
has decided to take a dive early in the fight. Maybe
they've made a secret deal with the CIA and loaded up on
call options and dollar futures. We don't know. Anything
could happen.

Investors pushed stocks up yesterday in a pre-war rally;
they think the conflict will be followed by a boom, as was
the last war with Iraq. Will it? We don't know. Anything
could happen.

But some things are more likely than others. The U.S.
military has such an overwhelming, butt-kicking superiority
advantage...and such a good idea of what to expect from the
one-legged Iraqi forces...it is unlikely that they will not
be able to flatten their adversaries easily. The question
marks pop up later. What will happen after the war is over?
Will the world be a safer place...or a more dangerous one?
What will the U.S. do with Iraq once it is conquered? How
much will the war cost? Where will the money come from? How
will U.S. markets...and the U.S. economy react? We don't
know. And neither does anyone else.

All we know, and even we are getting tired of hearing us
say so, is that stocks are still very expensive. Most
likely, they're going to get less expensive. But a post-war
rally could drive them up long enough and far enough to
make people forget the major trend.

We also know that history is not made by individuals going
about their business, making reasonable decisions on the
basis of what they actually know. It's made by groups of
people caught up in absurd episodes of madness, which are
rarely evident to those in the middle of them. A tech-stock
buyer in '99 could no more see he was acting madly than a
piece of pork fat can see it is part of a sausage. But both
are devoured in subsequent events.

After the fall of the Berlin Wall and the end of the 'Cold
War', Francis Fukuyama worried that history might have come
to an end. But here we are, only a dozen years later, and
not only is history back in business, but her stock is
rising. America is making history with the most ambitious
foreign policy program since the end of WWII (The war
against Iraq alone is estimated to cost somewhere between
$27 billion and $1.92 trillion!!). She is also making
history with the most fantastic program of debt financing
ever...with public deficits"as far as the eye can see",
record house refinancings, and record current account
deficits.

Never before has so much paper money been taken up by so
many people with so few doubts about it. And never before
has a nation that owed so much to so many been able to go
so long without settling up.

We don't know where any of this leads...but we continue to
give you our annoying thoughts...below...

Eric?

------------

Eric Fry in New York...

- U.S. troops have their toes to the Iraqi border like
homesteaders waiting to jump the Oklahoma line, moments
before the Cherokee Strip Land Run of 1893. And whenever
George W. fires off the starter's pistol, U.S. forces will
charge across the"prairies" of Iraq to claim their prize.

- Investors are giddy with anticipation. If the Pre-
invasion Rally can add 700 points to the Dow Jones
Industrial Average, just imagine what the Invasion Rally
will do! The lumpeninvestoriat have so thoroughly convinced
themselves that war is bullish - and that the one-sided war
they anticipate is particularly bullish - that they
continue bidding up share prices. Yesterday, the Dow gained
71 points to 8,265, while the Nasdaq slipped 3 points to
1,397. The greenback, which is also enjoying a brisk pre-
invasion rally, gained ground for the sixth straight
session and now stands at $1.0560 per euro.

- Meanwhile, investors cannot seem to imagine any reason
whatsoever to buy oil. Crude futures dropped $1.79 to
$29.88 a barrel - the lowest close for oil since early
January. For a while there, we thought the gooey, black
stuff might be in short supply. But soon we will control
Iraq, and that place has got plenty of oil to keep our SUVs
flying down the road. Besides, it's so much more
environmentally friendly - for us - to yank oil out of the
Iraqi dessert than to drill it out of the pristine Alaskan
wilderness. Perhaps it is no coincidence that the US Senate
voted yesterday to reject oil drilling in the Alaska
wildlife refuge.

- But even if Iraq and all of its oil were to become the
51st state, our economic difficulties would continue to
mount. That's because America,"land of the free and home
of the brave", has become the"land of underfunded pension
plans and home of soaring government deficits". The net
effect of these two trends is to impede capitalism and
encourage a de-facto socialism.

- One consequence of America's three-year bear market is a
soaring national pension liability - both in the private
sector and in the public sector. Because of this increasing
liability, we must devote an ever-growing share of
corporate cash flows to pay pensioners rather than reward
workers and investors (shareholders). That's not a healthy
combination. Nothing against pensioners; it's just that
this"closet socialism" discourages investment and hinders
productivity. We doubt that this trend is bullish for
stocks. All else being equal, large pension obligations cut
into corporate profits and drain cash flow away from
productive endeavors.

-"We're talking to companies about cutting capital
expenditures and hiring in order to have sufficient cash to
fund pension deficits," says Kevin Wagner, retirement
practice director for Watson Wyatt Worldwide, a pension
consulting firm."These cuts will cause a definite ding in
the U.S. economy." And it's a fair bet that owners of
certain high-profile American stocks will feel like ding-
dongs for ignoring these massive pension liabilities.

- Meanwhile, government borrowing is soaring. The two
trends may not be unrelated."Four states are considering
the unusual step of borrowing money to meet their
obligations to future retirees," the Mobile Register
reported recently."Among the worst off is Illinois, where
Gov. Rod Blagojevich wants to float a $10 billion bond
issue to help cover a massive pension shortfall. More than
half of state pension systems are underfunded, according to
a study by Wilshire Associates Inc. The study also pointed
out that in Nevada, West Virginia, Oklahoma and Oregon, the
dollar amount of long-term pension liabilities exceeded the
entire state budget."

- In a healthy economy, private companies and private
citizens do most of the borrowing and investing, while the
government feeds itself like a tickbird in the mouth of a
rhinoceros. In a sickly economy, the government is the
rhino."The state and local government sector's 11.4%
increase in debt [last year] was the first double-digit
growth since 1987," observes the Prudent Bear's Doug
Noland."At the same time, last year's 1.3% expansion in
Corporate borrowings was the weakest performance since
1992."

- These are not healthy trends.

- [Editor's note: Working in tandem with Apogee Research,
Eric Fry has conducted some groundbreaking research into
the pension crisis, subsequently picked up by Barron's and
Washington Insight. For ideas on protecting your own
retirement, why not check out Apogee yourself? Click here:

Apogee Research
http://www.agora-inc.com/reports/APG/ToSeeMore/

------------

Back in Paris...

***"Your editors at The Daily Reckoning, observers of the
Old School," began James Davidson's essay, which appeared
in this space the day before yesterday,"think the
prospects of economic expansion are negligible because of
heavy debt and a moral requirement that investors be
punished for the 'excess returns' of the 1990s by a
'regression towards the mean'.

"In other words, they think it is impossible for the
returns on investment to increase substantially over time.
In effect, they posit a kind of 'steady state' of economic
potential, as if some law of physics with the potency of
gravity ordained that profits wear lead boots. But I know
of no such law of physics. To the contrary. The possible
rate of return on investment is clearly variable. It is a
function of the rate of economic growth..."

We do not usually comment on the other opinions in the
Daily Reckoning. But this one seemed to crack a dam in our
thinking...we found ourselves flooded with thoughts.

Paul Krugman, writing in the New York Times, made a similar
attack on the Daily Reckoning - even before it came into
existence. In the early '90s, he ridiculed what he called
the 'hangover' school of economics...the Old School in
which economists believed investors really were punished
for their mistakes.

Of course, we have no idea what rate of return investors
might get. But by the late '90s, it became obvious to us
that they weren't getting it. Investors were paying high
prices for companies that not only were not producing
extraordinarily high profits, but were actually not
producing profits at all. They weren't producing profits
because the source of their supposed profitability -
information technology - was a sham.

Information doesn't make people rich. In fact, it is
worthless...or worse than worthless...outside of the
refined, nuanced and evolved system that gives it value.

Information's value depends upon what is done with it. And
that depends not on digits, but on wisdom, rules, and
principles. These things take more than information to
produce. They take time and experience. What makes them
valuable is that they are the lessons of many
generations...many years spent in the Old School...through
bull markets and bear markets...and many passes through the
sausage grinder of history.

What do the Old School rules tell us? They tell us to buy
low/sell high, for example. If the tech stocks of the
bubble years really had been able to produce higher rates
of profit, we would have been delighted. But it still
wouldn't have made sense to pay more for them than they
were worth - 8 to 15 times real earnings. Those who made
more were punished. As Emerson put it, 'all the world is
moral' after all.

***"What really gets the public," says Old School crank
capitalist, Warren Buffett,"are CEOs that get very rich
and stay very rich [while shareholders] get very poor."
But there are few real capitalists like Buffett left. In
our modern consumer capitalist system, the
lumpeninvestoriat may be annoyed by corporate parasites,
but what can it do about them? Like lumpenvoters, the small
investors take their lumps and say 'thank you'.

*** People were not particularly unhappy under the Roman
Empire...nor the Ottoman Empire...nor the Austro-Hungarian
Empire...nor the British Empire. In almost every case, they
were wealthier and healthier than they were under the
regimes that followed. Empires tends to be civilized and
peaceful. Arguably, independent states with populist
leanings, by contrast, tend to raise taxes and fight with
one another.

For the benefit of new readers, here at the Daily
Reckoning, we see nothing wrong with empire. We neither
support it nor oppose it. We merely wonder how we will
afford it...and write about it to prepare you for the next
stage in world history. Whether it wants to or not, we
think America is headed towards an imperial role. Will it
be a good thing? A bad thing? Will it be a new form of
empire all together, maybe a sort of Empire Lite? We cannot
say. But we aim to enjoy it.

To read more on the subject...an interesting article
someone sent us:

The Madness of Empire
http://www.dailyreckoning.com/body_headline.cfm?id=3024


The Daily Reckoning PRESENTS: It's not so much that
consumers are taking advantage of lower rates to refinance
their homes that has Strategic Investment's David Tice
concerned. Rather, it's what Johnny Q. does with the money,
the dough, the fric, the cash...after he gets his mitts on
it.


TAPPING EQUITY
by David Tice

I never would have pictured Alan Greenspan with a 0%-
financed-Ford Explorer in the front yard and a home-equity-
loan-funded-Jacuzzi in the back. But he sure sounds like
the typical American consumer. After all, in his February
testimony to Congress, the Fed Chairman told us to forget
about the loan balance; it was the monthly payment that
mattered. The finance man at the dealership couldn't have
said it better himself.

Here are the facts: by the Fed's measure of mortgage and
consumer credit, household debt-to-income has reached a
record high. Typically, consumers pare down debt in an
economic slowdown. In 1991, for example, Americans cut non-
mortgage debt by $11 billion. But last year, consumer
installment borrowing increased a whopping $110 billion.
With three quarters of data in, consumers are on a pace to
have borrowed $70 billion in 2002.

In his February testimony, Chairman Greenspan admitted that
consumer debt relative to income was high. However, he
chose to focus on the cost of servicing that debt, noting
that debt service costs as a percent of income"do not
appear to be a significant cause for concern at this time".

We would not be concerned either, if we thought the
skyrocketing bankruptcies of the late 1980s were a swell
thing. But the '80s were hardly a frugal period. By the
Fed's own measure, the consumer's debt-servicing burden is
bumping against records set in the mid-to-late 1980s.
That's despite ultra-low interest rates and five mortgage
refinance booms in eight years.

Certainly, lower interest rates have enabled consumers to
maintain higher debt burdens. But the consumer has also
extended maturities. This combination has allowed the
consumer debt-service burden to"only" reach levels of the
late '80s without surpassing them.

In our view, the consumer's debt situation will crimp
spending even under a"best-case scenario" - an environment
with no crash in home prices and no spike in interest
rates. Why? Consumers are stretched.

At least, that's what a loan officer would infer, given the
consumer's willingness to take out six-year car loans.
According to Dealer Magazine, six-year car loans account
for 21% of new car and truck financing.

A closer look at the variables behind new car loans
illustrates how monthly payments stayed down while
borrowing skyrocketed: according to the Fed's numbers, auto
finance companies now loan an average 96.71% of the cost of
a new car. The average maturity is now 57.51 months. That
compares to 91% and 51.3 months in 1985. Thanks to lower
interest rates, the monthly payments work out to be
slightly lower on the average loan today. But because the
amount financed has jumped to $26,647 from $9,965, the
average car loan as a percent of per capita income has
jumped from 77% to 96%. The result is a higher debt burden
without higher monthly payments.

As you might expect, with more consumers opting for longer
maturities, more are"upside down" on their trade-in. A car
dealer in the Dallas area estimated that 75% of his
applicants for new car loans are upside down. So far, the
financial engineers are keeping consumers in the game by
making loans in excess of the value of their new car!

But unless lenders start giving away principal, consumers
eventually will be forced either to trade cars less or cut
back elsewhere.

Home equity loans, mortgage refinancing and equity lines of
credit have made it easy for consumers to swap home equity
for cash. According to a study by CIBC World Markets, home
equity withdrawals accounted for almost one-third of the
increase in consumer spending last year. Although real
estate bulls argue that rising home prices will continue to
bail out borrowers (by giving them more and more to borrow
against), we would argue that even real estate prices can't
go up forever. Again, according to CIBC World Markets, home
prices rose 32% in real terms since 1995. That's about
twice the gain in prior housing booms. Past performance may
not be an indicator of future results.

For an idea of how enthusiastically homeowners have chosen
cash over equity, consider that home equity as a percent of
market value stayed in the 65-70% range from the mid-1960s
to the mid-1980s. That ratio is closer to 56% today. How
low can it go?

Even if interest rates stay low and home prices stay flat,
new rules from Fannie Mae and Freddie Mac could cut down on
the number of cash-out financings. Borrowers could soon be
paying an extra one-eighth of a percent for the privilege
of taking cash out in a refinancing. Fewer cash-out
refinancings means fewer new decks, new cars, and new
kitchens.

From October 2001 through year-end, consumers have driven
the savings rate up from 0.3% to 4.1% of disposable income.
During this period, consumer spending as measured by real
personal expenditures has advanced at a below-average rate.
This was also the case in the last two periods of rising
savings rates. If this newfound frugality continues as we
expect, we would also expect below-average spending to
continue for some time.

Despite last year's refinance boom, personal bankruptcy
filings hit a record last year, up 6% from 2001. The
American Bankruptcy Institute expects a repeat performance
in 2003. So far, they are on the mark. Weekly bankruptcy
filings jumped to 32,223, up 9% for the week ending Feb. 7.
That's the highest level since early November.

While bankruptcies are rising, spending is already slowing.
Retail sales rose just 3.4% last year, the smallest gain
since 1993. And consumer borrowing is dropping. Consumer
credit outstanding fell in December on the heels of a
decline in November that was the first since January 1998.
For all of last year, non-mortgage consumer credit grew
just over 3.2% ($55 billion), less than the increase in
income. But because mortgage growth continues to surge, we
can't really make the case that consumers have stopped
borrowing. We can venture, however, that the refinance boom
won't last forever, and that mortgage purchases will wane.
Already, the number of mortgage purchase applications
appears to have peaked and is rolling over.

The ability of consumers to service their debt as"easily"
as they did in the mid-'80s is hardly a bullish prospect.
Going forward, it's difficult to see how the construction,
remodeling, and auto industries can reproduce the results
of the last few years.

Typically, these areas are engines of growth in a recovery,
but they are quickly running out of gas. Given that last
year's weak performance was fueled by a refinance boom, we
wonder what consumer spending will look like without such a
boost. In our view, it is just such a level of post-bubble
spending that truly will be"cause for concern".


Warm regards,

David Tice,
for The Daily Reckoning