It is way, way too early to form even a provisional judgment on what is, in fact, the most crucially important of all questions for the future, long-term course of the global economy. All we are beginning to see is typical early recession behavior of the American consumer. This has consisted, thus far, in a contraction in the rate of consumer borrowing, declining purchases of houses and durable goods, and contractionary indications in consumer spending for discretionary items. Even a further acceleration in these trends as a downturn unfolds and intensifies would not necessarily constitute a structural change in consumer behavior manifesting any fundamental change in consumer psychology.

Having said this, if the current economic weakening does indeed fulfill its promise of visiting a level of pain on the average American homeowner/worker/consumer which appears rather likely, the enduring consumer psychology of borrow, spend, borrow more, and spend more could begin to come into question. The chances of such a development are enhanced substantially by the unprecedented (post World War II) bear market in house prices, and by the accompanying credit contraction. Much will depend upon the DURATION AND FUTURE SEVERITY of these trends.

For the third time over the past 3 months we are getting the feeling that we are in a raft which is on the rapids. On each previous occasion the raft was able to make it to shore. The last time around there was, fortunately, a doctor in the house. One doctor named: Dr. Ben Bernanke.

We do NOT try to prognosticate the market. We are simply recording our feeling and our worries. We wonder what might happen if we do not make it to shore at some point down the road, as the rapids accelerate. Without attempting to draw any analogies, we would note that rapids sometimes culminate in another type of natural phenomena.

This AM the store "where America shops" reported same store sales of UP .5% for January. Including fuel, same store sales were UP .9%. After adjusting for inflation, these numbers show a real negative in the 2-3% range.

One of the factors contributing to this disturbingly poor showing was the redemption of gift cards. Wal Mart noted a slower than expected exercise of gift cards. The company also noted that a large percentage of the gift cards which were exercised were used for FOOD PURCHASES (a lower margin item for the store chain).

The average American, who does indeed do his shopping primarily at Wal Mart, is, in plain English, using his/her CHRISTMAS GIFT TO BUY FOOD.

This, we believe, SPEAKS VOLUMES.

In life, there is frequently little, or even NO, relationship between the OSTENSIBLE problem and the REAL problem. This, we believe, is the case with regard to the FED's dilemma.

Before we address the issue of what constitutes the TRUE dilemma which may confront the FED shortly, we want to make one point: At this time the FED does not confront any dilemma, OSTENSIBLE OR REAL. However, the FED may confront an extremely difficult -- and possibly insoluble dilemma -- as it proceeds with an aggressive program of liquidity creation.

Prospects for a full-fledged bailout of the banking system and a comprehensive effort to halt the decline in residential real estate prices are dimming as election year politics moves to center stage. There is strong anti-bailout sentiment among important sectors of public opinion. The probable Republican presidential nominee, Senator McCain, has signaled strong opposition to a full-fledged bailout. The Democratic contenders, for their part, are outdoing each other in offering what are really small measures of relief for the besieged, bewildered, and terrified mortgagee class.

None of the likely candidates are interested in proposing a serious bailout. The reasons are both political and a consequence of superficial "analysis" on the part of said would-be candidates. It is still unpopular to advocate bailout. The demonology of American politics, resentment toward "Wall Street" and banks, irritation at those who got into houses "the easy way" --i.e., without working hard and saving diligently -- remain strong obstacles.

Affirmative.

We have now seen, and the market has responded to, the FED's dramatic policy change, manifested in the extraordinary 75 basis point (bp) inter-meeting FED FUNDS rate cut, followed barely a week later by another substantial reduction. (50bps).

This response has fallen far short of the spectacular signal a new bull market normally gives when the FED initiates a drastic rate-cutting program, and the equity market has already priced in the unfolding economic downturn. Indeed, the rally off of the intraday low in the 11,500 area looked to us more like a bear market rally than the beginning of a bull market, or the signal of the end of a bull market "correction." We must now discard our prior bullish stance vis-a-vis the equity market, and conclude that if it walks like a duck, talks like a duck, and acts like a duck, it is a duck. (Read: BEAR).

It remains to be seen whether or not further dramatic FED rate cuts and energetic re-liquefying efforts by the FED, in conjunction, hopefully, with a comprehensive and decisive bail-out program by Uncle Sam, will contain the economic downturn within traditional, post World War II limits. We would expect to receive an early signal from the equity market.

Regrettably, we believe this to be the case.

Forthcoming hits to the banking system are, in our judgment, likely to be as follows:

1. Commercial mortgage-backed securities. (CMBS). The bear market in commercial real estate, which we have predicted for some time, is now solidly underway, in our judgment. Prices have started to decline from their current stratospheric levels -- from where they receive grossly inadequate support from the rental income generated by the underlying properties. The market value and salability of commercial mortgage-backeds is poised to sink -- possibly severely -- with attendant damage to bank balance sheets and the banking system's lendable capital. Multiplying signs of distress among multi-billion dollar borrowers among real estate moguls is suggestive of the developing downward pressure on commerical property prices. The contraction of lendable bank capital -- attributable to other factors -- constricts the availability, and raises the cost of bank capital still extendable to commercial real estate property owners. The price of CMBS will follow the price trend of the more familiar, now well-hated, bear trend in the price of residential mortgage-backeds, we judge.

We are quite impressed with the intensity of the inflationary obsession among the generality of economists, Wall Street "sages," financial market commentators, and "informed opinion," as refracted via the general media. We would note, passim, that there is one very notable institution ABSENT from the persisting inflationary fixation. That institution is the Federal Reserve. It would appear that the FED has finally taken the point, albeit very, very late in the game.

Up until very recently, when the gravity of the crisis in the banking system finally began to achieve at least a portion of the recognition it demands, the inflationary obsession focussed on fears of excessive growth (ha,ha), surging commodity prices, the seemingly endless upward march of oil prices, deficit spending, the trillion dollar war, etc etc. Today, the bulwarks of the inflation-phobic opinion-makers have shifted: now the focus is on the alleged "inflationary" impact of a FED-inspired reflation via very low interest rates and a forthcoming flood of liquidity (which, if truth be told, we have YET TO SEE). Additionally, there is mucho concern that fiscal stimulus and -- horror of horrors, relief for the besieged mortgagee class -- will produce the DEMON INFLATION!

Well folks, we thought we had seen it all. Turns out we haven't. All of which goes to show one thing: while things may indeed be getting curiouser and curiouser, there are apparently NO LIMITS TO HOW CURIOUS THINGS CAN ULTIMATELY GET. Another way of putting it might be this: our financial institutions make magicians, witchcraft, and voodoo look sane and rational by comparison with their antics.

We refer here to the truly astounding maneuvers surrounding the current intense efforts to bail out the muni bond insurers. The situation, as we have been able to unravel it, appears to be roughly the following:
1. Muni bond insurers, who had a great thing going insuring, and collecting premiums for insuring securities which would probably never require an insurance payout (i.e., municipal bonds) got greedy and gravitated toward insuring ultra-risky mortgage-backed bonds. Those whose bread and butter consists in properly evaluating risk bought rating agency gilt-edged ratings of iron pyrite mortage-backeds hook, line, and sinker;
2. When the inevitable blow-up occurred, and those financially incapable of making usurious interest rate payments on their mortgages stopped paying, the mortgage-backeds went into their inevitable tailspin;

The prospective condition of state and municipal finances in this country gives cause for serious concern in the current contractionary environment. Obviously, income flows to states and, particularly, to cities and other municipalities are poised to decline significantly. The major source of this prospect is, of course, the housing depression. Each house which is abandoned by a mortgagee unable to meet his monthly payments constitutes a loss of tax revenue to the municipality. Each notch down for house prices in general translates ultimately into downward revisions of house value tax assessments, and a deterioration in the overall revenue stream for municipalities. Each step down in the quantity of new houses under construction translates into future real estate tax payments which will NOT materialize.

There are two additional factors pressuring municipal revenues. The first is the ripple effect of falling house prices on overall local economies, which produces further downward pressure on house prices, new home construction, and, consequently, lost tax revenue to the municipalities. The second is the RISING COST OF MUNICIPAL BORROWINGS.