Tuesday, December 30, 2008

Rationing Credit

Yes, the government has managed to force mortgage rates ever lower in their bid for 4.5% home loans. They'll get it there even if they have to destroy the entire financial system in the process.

To me, this is beyond farcical. Yes, we know that if the government puts its massive force behind something, it can will just about anything into existence. But there are always unintended consequences... these in a moment...

The big worry to me is that despite the government's best efforts, we have yet to see the follow through in actual mortgage origination. The same goes for corporate bonds... Yields have fallen sharply in the last 2 months, from over 9.5% to about 8% for Baa credits. But issuance has yet to follow suit.

The truth is that when the government sets a price for something artificially low, we shouldn't be surprised to see less of it. Unless the government itself is willing to lend the money in the mortgage market, there will never be enough capital to fund these loans.

We're headed towards a world where the "official" mortgage rate is 4.5%, but it will be close to impossible to get them. The richest people with the best credit scores will manage to refinance loans, but I am predicting now that the average person won't see the slightest benefit from this process. If anything, it might have the unintended consequence of inducing lots of Americans to seek refinancings, only to find a rude surprise when the appraisal comes. Just like we learned with the original TARP, sometimes ignorance is bliss.

Even if "appraisal shock" doesn't emerge as a major theme, what good is refinancing mortgages? It will only help the richest people who don't need help -- just like we see in the case of things like farm subsidies and public school, that's normally the way government works in this country.

How does letting the richest people refinance their mortgages prevent foreclosures for marginal borrowers? (Answer: it doesn't.) Who does benefit? (Answer: the banks, which are positively salivating at the prospect of earning fees from the whole process. In the early 1990s, Alan Greenspan deliberately caused a steep yield curve to help banks "rebuild their balance sheets." Some commentators elevated him to an Atlas-like stature for this policy, which put the country's monetary policy at the service of its lenders. This time cutting rates isn't doing much good, so the powers that be will find a way to help the banks make money somewhere -- anywhere. Never forget who the Ben Bernanke actually works for: the banks.)

We're headed to a situation where official mortgage rates are 4.5%, but no one can get them. It will be like buying gasoline by lottery in the 1970s, or going shopping in the Soviet Union, when the shelves were full of cheap merchandise that only existed on paper.

Whenever the government tries to overrule the basic laws of supply and demand, black markets develop. This is why I fear something much more sinister could emerge from these artificially low interest rates. I think it will be so hard to actually get the money that we'll see the rise of personal connections and politics play a role in getting a home loan. Given the President Elect's established ties to groups like ACORN, I fear the day when they gain control of the mortgage lending system.

It's disturbingly likely given the way things are playing out. First, we'll see some mortgage lending done at 4.5%, but only the richest peple will benefit. Then the media and Congress will express outrage (and somewhat rightly) that so many people are being "excluded"... After all, if the government's doing it, it should be for everyone. There will then be some kind of political pressure to extend loans to "minorities" etc. The next thing you know, groups like ACORN will be all over the mortgage market. Of course, it won't play out exactly like that... But the basic dynamics are there.

It's almost 2009. We are not learning capitalism, or seeing mistakes made for the first time. History teems with examples of politicians who tried to make the free market (ie, free people) do what was against their free will. Sometimes, such experiences end in violence. Often, they end in more poverty. But, they always end up as failures.

Monday, December 22, 2008

new thoughts for a new era

I have totally neglected this blog for various reasons, but feel the need to put some stuff in writing now...

First, I have been watching Larry Kudlow talk about how low gasoline prices will help the economy. This to me is unlikely because lower oil prices mean less money leaving our country in the form of trade, which means less money coming back in the form of capital-market flows. For the last 5-10 years our economy grew dependent on securitization as the spigot of credit for our economy. Evidence of this is massive in the data, which I don't have time to gather now... It's also apparent in the way the system broke down. We had a credit bubble because the underwriting and lending processes were separated... Fly-by-night mortgage brokers did the underwriting, and were essentially paid to manufacture mortgages, while Saudis, Chinese and Russians lent to us from the massive stockpiles of dollars they had accumulated selling us stuff.

Now that they're selling us less, they going to lend to us less.

People might say: great, Americans will now save. That's all well and good, and they have been saving largely by piling money into bank accounts. Twenty years ago, this would have been fine and dandy because banks actually lent money. Now, however, banks have simply become intermediaries between borrowers and the capital market. They have spent the last 5 years becoming less local and more massively corporate. While Meredith Whitney is brilliant, her recent recommendation that the country needs to go back to a local-banking model is economic suicide.

Now that securitization is moribund, banks have lost the ability to lend. This is why banks are sitting on vast piles of cash, uncapable of lending.

My expectation is that the Fed is going to keep spewing money into the economy, it's like putting gasoline into a diesel engine. Until securization returns, the economy is dead in the water.

This is remarkably similar to events in the 1920s and early 1930s... In 1925, for instance, Churchill (then Chancellor of the Exchequer) put Britain back on the gold standard, over the objections of John Maynard Keynes. The resulting deflation put the UK into the Great Depression five years before the rest of the world.

In the early 1930s, the Fed raised interest rates believing this would support lending in the economy. After all, that was the standard operating procedure during the gold-standard period in the 19th century. Even though the USA was still on the gold standard at that time, it was essentially dead because it had been abandoned by England, and almost every other country. Unlike Keynes, the Fed failed to recognize a new era had begun.

And in Germany about the same time, Heinrich Bruning tightened credit controls as the Great Depression began, following the belief that austerity would fix the economy. (This was apparently such a pervasive cultural value in the period that FDR actually ran on a small-government, budget-balancing ticket.) Bruning's policies proved even more disasterous in the long run than the Fed's, as history clearly showed. (Guess who soon succeeded him as Germany's leader?)

Just as balanced budgets and small government were the established beliefs in the early 1930s, allegedly Keynsian "stimulus" is the creed today. Just as most leaders failed to recognize the new economic realities of the post-WWI world, not a single policymaker today seems to understand how different the world is today from a few decades ago. (For more, read this posting.)

My contention is that we have entered a new world where established rules of monetary economics are breaking down. We had ample evidence of this in 2004-5 when the Fed's interest rate increases corresponded to an acceleration of mortgage lending. It was clear then that something wasn't working as it should. The rules never contemplated securization or the impact of unregulated borrowing mechanisms such as the yen carry trade.

The question is: will our policymakers ignore the new realities, just as Churchill, Bruning and the Fed of the 1930s did? So far, the answer appears to be yes.

My expectation is that credit will continue to contract and deflation will worsen. Home prices will keep falling, foreclosures will snap back in January and jobs will continue to disappear. The Fed's low interest rate policy will worsen the situation by harming repos and money-market funds, while doing nothing to spur lending. Securitization will remain close to non-existent and consumers will lose access to credit cards. State and local governments will run out of money and be forced to lay off workers, worsening the economic slump. (I am still not sure how anyone can be bullish on infrastructure stocks in this environment. If state and local governments can't afford to pay their workers, I'm not sure how they're going to pay for roads and asphalt.)

My recommendation remains the same: We need to stop thinking about the Fed funds rate and create a spectrum of spreads at which the government will buy various credit securities. (It should set the levels for different risk levels, and possibly nationalize the credit-ratings firms in the process.)

The evidence is overwhelming that capital markets have replaced banks as the source of credit in the economy. We can embrace this new reality -- this new market primacy -- or we can fight it. But we cannot change it.

No one doubts we're in a new era. It's time to starting thinking that way.

Friday, December 12, 2008

Detroit's Just End

The Senate just failed to "bail out" the U.S. auto industry. The real blame falls at the feet of the United Auto Workers who refused to accept pay cuts as part of the deal.

This is the just end for an industry that has enjoyed too much power in our country for far too long. Ever since the 1930s, the vast bulk of our public building and planning have revolved around the automobile. Cities were neglected and trillions of dollars in wealth were transferred from rich northern cities to poor areas across the Sunbelt in particular. This process not only contributed to urban blight and impoverishment during the 1970s and 1980s, it also caused Americans to become completely addicted to expensive, inefficient and irrational life styles. It made use voracious consumers of fuel, building materials and -- most importantly -- capital.

With their multiple vehicles, hunting lodges and high-income life styles, Michigan auto workers were perhaps the clearest example of this phenomenon. Furthermore, the culture of entitlement fostered by the union has, in many ways, spread throughout our country. For years, they won ever-rising salaries and benefits, even though many of them never went to college or did anything significant to upgrade their skills. They simply expected the money to be there, regardless of the competition, the quality of their vehicles or the financial strength of their company. They were even paid for not working.

This actually should come as no surprise. One of the great innovations of the auto industry was to pay workers high salaries to make them into a consuming class of customers. This basic economic paradigm, often called Fordism, dominated our society from the 1940s until -- roughly -- now. Of course, incomes have not done terribly well over the last decade or so, but the economy grew ever more dependent on the consumer.

The dark side of this paradigm was debt. General Motors displaced Ford as the top automaker in the 1920s because it aggressively used financing to sell its cars. The dirty secret about our entire post-WWII society is that consumer debt grew a few percentage points faster than GDP almost every year. By the final end last year, debt was all that was driving the economy.

In many ways, GM is a microcasm for our entire country. GM was once a proud AAA rated company, with vast assets, enviable profit margins and a relatively small debt load. Everyone flocked to Detroit for jobs, making the UAW into a political force and a nexus of power and money. The organization bloated into a massive bureaucracy, with more committees, sub-committees and petty commissars than the Soviet Union. Factories sprawled across the Upper Midwest and pretty soon all of the brands were cannabalizing each others' sales.

Between all of its employees, executives and retirees, GM had many mouths to feed. Rather than downsize rationally, they chose to keep growing. The only problem is the Japanese had gotten really good and were now major competitors. The best way to move product and keep things going was to pay customers to buy their cars. Pretty soon, GM was offering 0% financing, or close to it, on their vehicles. Where did they get the money? They mortgaged their entire company.

Given their massive size, and helped by cheap oil in the late 1990s, they were able to keep squeezing more value out of their capital structure for about 25 years. Finally they are at the end of that road.

Now I listen to people talking about the USA. "We can afford a trillion dollars of stimulus," say some. "We have a better balance sheet than European countries," say others. While these statements are true, they reflect the basic problem with all credit-based investing: It's inherently backward looking and insufficiently aware of human culture and behavior. Credit investors only look at assets and liabilities. Unlike equity investors, they are seldom good at seeing where a company is going.

When I hear all of the loose talk about stimulus now, it reminds me a lot about the kind of thinking that ruled for decades at GM. "GM has plenty of money," said the union leaders. For decades, they were right. As a result, they developed a culture of waste and negligence. And, as a result of that, today the opposite is true. GM has almost no money.

The question is whether we will learn from Detroit. Profligate spending never made anyone richer. As Washington gets ready to hurl vast amounts of cash at the US economy in coming quarters, it's almost inevitable that decisions will be made as poorly as they were made in Detroit over the past years.

One last point about waste: Is there any reason why a 150-pound person needs to transport 2000 pounds of steel and fiberglass with them everywhere they go? Would you design a system where ordinary people are exposed to the legal liability of operating such a machine, and forced to pay for maintenance and insurance? Is it logical to borrow money to buy something that loses value the second you own it? Is there any reason why we must live at the end of suburban cul-de-sacs, in giant homes that consume even more energy than our vehicles? Is it healthy to spend several hours everyday in a vehicle, not exercising, earning money or learning new skills?

When you look at it from the big picture, none of it makes very much sense. The car culture is wasteful and, in the long run, unsustainable. But even more important, it draws on the worst in people rather than the best. It doesn't draw out the best in people, but the worst. It doesn't make us aspire to greatness, foster a better sense of community or more productivity. It's rooted in our crassest and most base tendencies.

Nothing embodies that more than the UAW, with its job bank and its calcified culture of entitlement.

When GM finally goes bankrupt, the blood will be on the union's hand. In the end, the truth always comes out.

Tuesday, December 9, 2008

Unintended Consequences

I have woefully neglected this blog. I want to get things going again with some quotes from interviews today on Bloomberg Radio and a story on Market Watch.

Mohamed El Arian, co-head of Pimco
What surprises you?
“The extent to which liquidations are still ongoing and more generally the deleveraging."
What do you want to buy in this environment?
“The sectors we envisage as under the umbrella of government action. You're looking at the mortgage market and the debt securities issued by the large banks. Those in our view offer the best risk adjusted returns."
Michael Darda, Chief Economist at MKM Partners
"This economy is (growing) far below potential.. That's probably going to be the case through the entirety of 2009."
“We looking at the fall of next year as the earliest the economy will bottom.”
Just for good measure, Darda added the unemployment may peak at a level "substantially higher" than his official forecast of 8.2%. He doesn't expect employment to show signs of improvement until 2010.

Roel Campos, Former SEC Commissioner & Obama Advisor

"We're looking for disclosure of positions, with a small delay, after a short sale is made."
Campos is seeking to have the next SEC chairman introduce new rules requiring short sellers to publicly disclose their positions in a manner that is similar to how equity investors are required to reveal their equity stakes.
(This according to MarketWatch.)

What it Means

These quotes illustrate points I have made earlier, but they are worth repeating.

First, as El-Arian says, the liquidation of fixed income assets remains a major problem. My contention has been that the entire credit market has entered an outright bear market. After years of complacency, it's swung in the opposite direction to utter paranoia and fear. People are more willing to earn 0% or slightly less in "risk-free" Treasury securities than investment-grade corporate bonds or mortgage-backed securities that are trading at such cheap levels that they're worth the risk.

My worst fear, as expressed in this blog entry, is that the overall credit market would enter a state of liquidation when everything gets sold. You might say "so, what, I don't own bonds ... I only own stocks." But stocks are equity securities that represent the "residual value" of a company. Once the creditors are paid back, shareholders get everything that's left.

That's great when asset prices are rising and credit is easy. Now that we're in a period of credit contraction, it will be increasingly difficult for companies and consumers to roll over debt. And, unlike stocks, debts come due. Companies have to pay back specific amounts of money at a certain point in time. If they can't borrow it again, they get liquidated or are forced to sell new shares. Both options are terrible for stock investors.

El-Arian's second comment is equally distressing. He says the best place to invest now is in areas guaranteed by the government. It should send a chill through anyone who believes in free-market capitalism that one of the great investors of our time doesn't want to buy any asset classes many people now claim are "cheap," such as mortgage-backed securities or investment-grade corporate bonds.

Both of these comments substantiate observations I have been making over the previous few months. Basically, we are in critical danger of the credit market bifurcating into a class of "touchable" and "untouchable" assets. Investors will gravitate solely to debt sponsored by the government and shun everything else. That will eviscerate seemingly healthy companies that need to refinance maturing debt, forcing them to sell assets, raise capital or seek bankruptcy protection in the midst of an already terrible environment.

This is a problem I raised personally with El-Erian colleague Paul McCulley as soon as the government said it would use the FDIC to insure financial-sector debt in October. At the time, McCulley agreed with my concern. El-Erian validated it today: “Every time the government intervenes in a certain sector, another sector gets destabilized because it hasn’t been included," he told Bloomberg.

In other words, we're looking at an environment where the only the government -- or its favored clients -- can borrow money. (Since the FDIC backstop has been put in place, lenders such as Citi, Bank of America and even KeyBank have utilized the it to issue tens of billions of dollars in debt. One might add it's terribly unfair that the companies that made the biggest mistakes now enjoy government guarantees, while those that "did nothing wrong" are forced into bankruptcy.)

Darda advances this point by saying the economy will expand below its potential growth rate. In other words, the private sector will contract, forcing the government to step in and employ people, factories and offices. (Factories and offices, after all, need to eat, too. Just like people, they have debts to pay.)

My concern is that as the private sector goes into cardiac arrest, people will increasingly look to the government as the ultimate consumer in the economy.

To sum it up, we're facing a situation where the government is the only party that can borrow. That means pretty soon, it will be the only party that can spend and hire. In other words, it will be an economy by the government, of the government and for the government. It won't take long before resources are misallocated and politics, rather than economic considerations, drive the decision-making process.

The Accidental Statist

If Americans wanted socialism, they would have elected Ralph Nader president. One of the great ironies of the current situation is that so-called conservatives in the Bush Administration and Bernanke Fed are clumsily nationalizing the entire financial system.

Where does this leave us going forward? The comments by Campos about disclosing short positions might seem innocuous enough. He wants to disclose short-selling positions. What's wrong with that?

1-It will be viewed as an attack on short sellers.

2-It won't accomplish anything except scaring people away from the market. There are many problems with the U.S. financial system, but short selling isn't one of them. A much better use his time might be to address how the SEC allowed such large amounts of financial instruments to be churned out like sausages over the last decade. First it was tech stocks, then it was off-label mortgage-backed securities and collateralized debt obligations.

3-It's a wholly political move. Short-sellers didn't cause the banks to fail, or make people default on their mortgages. Banks and regulators are responsible for that mess. Short-sellers were right about the industry's problems, and they shouldn't be punished for their perspicacity.

4-How will it work? Many traders sell a stock short and cover their position the same day. How do you account for them? What happens if they use other ways to bet against stocks, such as buying inverse ETFs that move in the opposite direction as share prices?

This kind of disclosure would do little more than drive more trading outside of the USA and undermine our financial system. Shooting the messenger is never a good idea. If short sellers are right or wrong, the market will reward or punish them. The SEC has dropped the ball for a long time in this country. There are many more productive places they can spend their time.