Filed under: Consumer experience, Money and Finance This day, Economic data, Personal finance, Recession

Reuters reports that consumer confidence has hit a 28-year low. That should not come as a surprise. After all, between 2000 and 2007 the median income has dropped from $61,000 to $60,500. But prices have skyrocketed. And with growth slowing — the prospect of layoffs looms large while consumers expect prices to keep rising.

There’s something called the Federal Reserve. And it’s supposed to keep those inflationary expectations under control by raising interest rates to strengthen the currency and keep credit use from going haywire. But the Fed got confused. It thought that by cutting rates from 5.25% to 2%, it could revive a frozen credit market without boosting inflation. Whoops! Now the credit markets remain frozen but actual inflation and expectations for future inflation are both skyrocketing.

Those expectations are rising fast. One-year inflation expectations surged to 5.2% — the highest since February 1982 — from 4.8% in April. Worse yet, five-year inflation expectations jumped to 3.4%, the highest since April 1995. In April this year they were at 3.2%. If there’s any good news it’s this — if the Fed raised interest rates, the dollar would strengthen, oil prices — which are denominated in dollars — would fall, and investors would pour back into U.S. stocks.

The extra investment might actually provide the capital to fuel corporate expansion and create new jobs and income growth. One thing seems certain to me — it’s hazardous to build an economy on a foundation of debt. If the Fed raises rates, maybe we’ll be able to rebuild it on equity instead.

Peter Cohan is President of Peter S. Cohan & Associates. He also instructs management at Babson College and edits The Cohan Letter.

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Filed under: Earnings reports, SEC filings, Market matters, Money and Finance Today

Recent bank earnings reports suggest that the costs of uncertain values of Level 3 assets — those hard-to-value financial instruments with no active trading market — could sink our financial system. By my estimates, the eight largest banks had a total of $517 billion in level 3 assets at the end of 2007, up 13% from the third quarter. And these assets represented 91% of those bank’s capital at the end of 2007, a rise from their 78% share of capital in the third quarter.

Why does this matter? First, because banks are taking big write-offs of these level 3 assets. Bloomberg News reported that Investors are wary of banks and brokerages with difficult-to-sell securities on their books as $232 billion of write-downs and credit losses from the collapse of the subprime mortgage market have crippled earnings. And Bloomberg points out that more assets have become difficult to value in the last three months as investors shunned a wider array of credit, reducing trading.

Secondly, the way these assets are valued is almost totally at the discretion of management. According to a Wall Street analyst I interviewed who covers the banking industry, many of the assets are very unique and each company really does appear to develop its own methodologies accordingly. The analyst asked a senior auditor at one of the big accounting firms whether they tried to impose any sort of conformity on the valuation processes used by companies they audit and the answer was no, even when one auditor handles several directly comparable firms.

The analyst continued, “And there is clearly no attempt among the auditors to get together to develop standards to be applied across all financial companies. So while I am sure the companies do make an honest attempt to do things that are intellectually supportable, in case the Fed or the SEC decide to drill down, the fact is that two different firms could value the same asset completely differently.”

This means that the biggest banks on Wall Street are resting on a sliver of capital that could be wiped out if they were forced to apply a common standard of how to value their bloated level 3 holdings. It amazes me that anyone would want to invest in a black box whose value is so hard to pin down.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter .

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