Thursday, January 29, 2009

Reexamining Monetary Cause and Effect

Last November, I wrote an extensive article that raised some major questions about how our monetary/credit system really works. I circulated it among some economists and market professionals. Some found it very insightful, while others thought it was crazy.
One way or the other, I think it raises some very key points that you won't read anywhere else, so I am adapting its best elements to this blog. I have already discussed many, but not all, of the themes.

The rise of capital markets, foreign exchange and global trade has rendered traditional monetary tools ineffective, and at times, counterproductive.
Key themes:
• The last Fed tightening cycle may have increased liquidity rather than reducing it.
• New sources of credit have risen for the U.S. economy that established monetary policy does not contemplate: Foreigners investors, securitization and currency markets.
• Banks have declined in importance as lenders to the economy.
• Determined not to copy the Fed’s mistakes of the 1930s, policymakers are erroneously confident in low interest rates and fiscal stimulus as a means to solve the current crisis.
• The most effective solution may be to restore demand for spread-based credit products. One possible response would be the creation of a U.S. sovereign wealth fund, which could have the added long-term benefit of helping pay for Social Security and Medicare.

Funding entities such as Structured Investment Vehicles (SIV) channeled short-term money into long-term asset classes, undermining the Fed’s attempts to restrain credit growth in the 2004-2007 period. In the recent credit bubble, SIVs borrowed in the short-term by issuing commercial paper and invested their proceeds in longer dated credit instruments, mainly asset-backed securities (ABS) linked to home mortgages.
About six months after the Fed started raising interest rates in June 2004, money started flowing into asset-backed commercial paper (ABCP). The Fed steadily raised its rate for the next two years, from an original 1% to 5.25%. During that period, the amount of ABCP outstanding would grow $531bln, or about 80%, to $1.18 trillion.
Importantly, this amount peaked in July 2007 at the same time short-term interest rates reached their high. Three-month Treasury bills yielded 4.83 on July 20, 2007. As pressure mounted for the Federal Reserve to cut interest rates in August 2007, short-term yields dropped. This appears to have exacerbated the selling of ABCP, which was already under pressure as investors worried about its link to mortgage debt.
Between August 8, 2007 and October 15, 2008, the amount of ABCP fell $534bln, or 44%, to about $676bln. About $531bln flowed in as the Fed raised rates, and another $534bln left as the Fed cut interest rates back to 1%. This leveraging process matches the Fed’s interest rate moves closely.

The approximate $530bln figure represents 3.86% of 2007 GDP, 4.78% of total mortgage loans in the economy, and about 14% of ABS outstanding. Liquidating this large amount represented the opening round in the credit crunch.

The set of charts below highlights the correlation between higher rates and money in ABCP. I have never seen anyone else put this data together and think it merits further discussion.

SIVs would have unwound regardless of the Fed’s rate cuts. The important point is their structure caused them to directly oppose the Fed’s policy goals: They attracted money when short-term rates rose and lost money when rates fell. Because the same money was then recycled into credit securities, higher short-term rates had the unintended consequence of increasing risk appetite rather than reducing it.
Similarly, an inverted yield curve caused some investors to seek even higher yields to cover their own rising borrowing costs. Hedge funds, for instance, could borrow at a Libor-based rate when Libor was 2-3% and long-term corporates and ABS yielded 5-7%. (They probably borrowed at about Libor+100bp. The banks lending to them, like Goldman Sachs, were simultaneously funding themselves at about Libor+10-40bp.)
As Libor moved towards 5%, the universe of profitable investments shrank. Hedge funds responded by purchasing lower-quality assets, fueling huge growth for collateralized debt obligations (CDO) and leveraged loans. They had a similar effect as the SIVs, boosting demand for long-term (3yr+) credit securities as short-term rates rose.

The key message once again is that higher rates apparently encouraged, rather than discouraged, risk appetite. This precisely matched my own anecdotal experience as a reporter covering the bond market. Given this history, I am worried by the insistence of almost everyone in the market that lower rates are the answer.
Currency-based financing tools, such as the yen carry trade, had similar effects as SIVs and hedge funds -- probably on a larger scale.
The Fed’s constant interest-rate increases corresponded to a steady appreciation of the dollar against the yen. This allowed market participants to borrow yen at very low rates and to reinvest in higher yielding assets. (Many times it was reinvested in currencies other than the U.S. dollar.) The only risk in the carry trade is when the yen rises quickly, which increases the size of the investor’s liability. This inverse relationship between the yen and “risky” assets has been well established in recent years: Almost every day that stocks fall, the yen rallies.
The Fed gradually increased its rate from 1% to 5.25% between June 2004 and June 2006. Because the tightening was gradual and predictable, the dollar’s appreciation versus the yen was also steady, making investors comfortable selling yen. The dollar gained steadily against the yen as the credit bubble inflated between the start of 2005 and the middle of 2007. In today’s market, dollar strength versus the yen is equivalent to cutting interest rates because it facilitates borrowing, and vice versa.

Direct foreign capital flows into the U.S. made an unexpected and powerful contribution to asset-price appreciation.
Between June 1998 and May 2007, the U.S. credit market experienced a significant inflow of foreign capital that substantially increased the availability of funds for businesses and households. This resulted from a large growth in the trade deficit, which approached 6% of GDP in 2005 and 2006, compared with less than 1.5% in the 1990s.
These funds primarily flowed into an asset class the Treasury and Federal Reserve report as “corporate bonds,” which includes traditional corporate bonds and non-GSE securitizations(ABS). I call these “U.S. credit products.” The foreign money also flowed into GSE debt.
Over the period of inflows, foreigners bought more than $2 trillion dollars of U.S. credit products, pushing them past life insurers as the biggest holders. Credit products were also briefly foreign investors’ largest asset class in the U.S., surpassing stocks in Q2 2007, according to the Fed’s Flow of Funds report. (In Q3 2008, Treasuries retook the top spot.)
It should also be observed that money behaves differently when it originates in trade. If Americans had consumed products from their own country, most of the money would have been paid to Americans in wages and taxes. Only a small proportion would have filtered through to the capital market. In contrast, when the cash originates from trade, most of it is channeled into the capital market. From 2003-2007, $1.8 trillion, or 54% of the cumulativ U.S. trade deficit, was recycled back into U.S. credit products – excluding Treasuries.
This flow of overseas money into U.S. fixed-income assets was a major factor helping push borrowing costs lower for several years. (It is probably under appreciated because it was the first time foreign capital noticeably impacted the U.S. since before WWI.)

For more on the relationship between trade and credit excesses, see this blog entry.

Several sources of liquidity reached their apogee at the same time traditional corporate borrowers had the least need for funds. As discussed, these sources of liquidity were overseas investors, the yen-carry trade and short-term funding schemes such as SIVs.
Traditional corporate borrowers, such as telecom companies, had a declining need for debt capital because they had just completed a significant investment in new networks, etc. The period of the late 1990s experienced strong capital expenditure, resulting in a natural downturn afterwards.

Furthermore, early in the period of extreme capital-market liquidity, traditional mortgages lenders Fannie Mae and Freddie Mac reduced their activities due to accounting scandals. This means large amounts of money entered the market in 2004-6 at the same time traditional users of capital had much less need for funds.

The financial industry responded to this flood of money with a surge of private-label mortgage lending. Non-financial corporations reacted with record amounts of stock buybacks and acquisitions. Private-equity funds raised unprecedented amounts of capital they hoped to leverage using high-yield bonds.
The financial industry created new structured products, such as CDOs, which increased the demand for mortgage bonds. In the chart below, ABS issuance is compared with debt sales by traditional non-financial corporates. This surge captures the growth of subprime lending and highlights the true nature of the credit bubble. The key consideration is that the size of the bond market grew dramatically during the time span captured in the chart below, which makes the surge in ABS issuance even more important.

The bottom line: Excessive liquidity in the capital markets, intermediated by non-traditional
and unregulated lenders, drove home prices higher. Trade imbalances and novel sources
of leverage/funds created large pools of capital with nowhere to go. Wall Street
responded by “innovating” new products.

The crisis of September and October 2008 after the Lehman Brothers bankruptcy resulted from problems in the long-term debt market (capital market) rather than the interbank market.
A timeline of events:
Sept. 15: Lehman Brothers Ch. 11 filing
Sept. 16: Eurodollar deposits (Libor) rise from 3% to 3.2%
Sept. 17: General money-market funds, which hold corporate commercial paper, report
$220bln outflows over the preceding week. Another $220bln pours from the funds over
the following month.
Sept. 17: Financial sector bond prices fall 1-3 points. Eurodollar deposits rise to 3.75%.
Stocks plunge. The Reserve Fund money market falls below $1.
Sept. 18: Eurodollars rise to 5%.
Sept. 30: Eurodollars rise to 6%
What happened? Here’s my interpretation:
• Lehman Brothers failed.
• The Reserve Fund owned Lehman CP, which was now worth less than face value. This pushed its share price below $1.
• In panic, investors pulled money from all non-government money markets.
• Money market funds were forced to raise cash to meet these redemptions. They appear to have sold large amounts of short-term financial-sector bonds (due in 1-3 years).
• Lower prices pushed yields higher for short-term financial paper, causing the sector’s curve to invert.
• Many short-term financial bonds are tied to Libor. When their yields rose, Libor was forced higher. At the same time, financial panic pushed short-term Treasury rates to historic lows. Unlike in previous downturns, this time the fate of the financial sector and the “safe” government sector diverged.
• This is why the “TED spread” gapped wider. People said it resulted from a lack of confidence between the banks. Interestingly, the rates for actual commercial paper did not move higher until later in the period of liquidation in late September 2008. (People have come to describe the TED spread as a measure of panic or risk-aversion in the market. I think it's interesting that during the several years I covered the corporate-bond market, no one ever considered it worth mentioning.)

The problem wasn’t in the interbank market, it was in short-term (1-3 year)
financial bonds. I for one never understood all this talk about the interbank market, because during most of 2007, interbank debt represented less than 0.5% of bank liabilities. Their bond-market debts were 13 times bigger. This is why the FDIC's backing of bank bonds under the Temporary Liqudity Guarantee Program (TLGP) has been so beneficial. I am not an expert in banking, but all this talk about the interbank market always seemed like a red herring to me.

This chart shows how billions flowed out of money market funds the week ending Sept. 17 as Lehman failed. It continued in following periods.

Source: AMG Data Services

Yields for short-term financial-sector bonds rose as money market funds dumped them on the market. Notice in the chart below the yield on the 1-3yr financial paper (top line) rises before
anything else and pulls the TED spread higher:

Source: Merrill Lynch, Federal Reserve

The chart below shows the unpredented size of the price decline in short-term financial sector bonds. This is what drove their yields higher and forced Libor to increase:

Source: Merrill Lynch

Here I would like to offer a hypothethical scenario to explain. Say an investor had a line of credit at Citigroup that cost L+50bp. If Libor is 3%, his cost of funds is 3.5%. Say Citigroup's has 2-yr notes trading yielded about 3.25% in early September.

Then Lehman fails and money market funds unload those same Citi bonds, forcing them to drop to 90 cents on the dollar, and pushing their yield to say 4.25%. If Libor stays the same, the investor's cost of funds is still 3.50%, giving it the ability to earn 75bp of carry trade. Under this situation, the investor would borrow as much as possible to buy high-yielding Citi notes. This increased demand for funds would naturally push Libor higher.

That kind of easy money cannot exist for long in any financial market. Given the fact that you could replace the name of Citigroup with any other major bank, it's not hard to see why the lenders themselves pushed Libor higher. Don't forget, a committee of banks in London are the folks who set Libor in the first place.

At the same time this was happening, all of that money that exited the money markets, and exited the 2-yr Citi notes, went into US Treasury bills. This forced government rates extremely low at the same time that Libor was being pushed higher.

Of course, the scenario I describe above is only hypothetical. But it describes how the gaping TED spread resulted from developments in the corporate bond market, rather than a panic in the interbank market. There was an unusual, if not utterly unprecedented, divergence between Libor and Treasury yields. But it resulted from normal market dynamics of supply and demand. Again, this was a capital-market based crisis, not a normal banking crisis. Also, if it were a normal banking crisis, the problems would have started at commercial banks, rather than securities firms. This is why I take issue with academics like Nouriel Roubini who want to apply a Swedish nationalization model to our system, which is utterly different because it's based on an Anglo-Saxon capital market model. I don't think the world has ever seen a financial crisis like this one. We need to focus on the bond market, not normal loans.

The Fed Funds rate appears to have lost its efficacy starting in 2004. Using three-month
Treasury bills as a proxy for the Fed funds rate, I compare the effectiveness of various
tightening cycles:
June 1980-June 1982:
Short-term rates rose significantly (about 500bp from June 1980 to June 1982. During
that period, the growth of household borrowing slowed from 10-17% levels to 4-5%. This was the intention of Fed Chairman Paul Volcker, and it represented a successful use of the overnight rate to slow credit creation.
March 1988-March 1989:
Short-term rates started rising in March 1988 and peaked a year later. (Three-month
Treasury yields rose from 5.80% to 9.33%.)
Household borrowing growth slowed from over 9% in Q1 1988 to about 7.3% at the start of 1989 Rates peaked in March 1989 and fell for the rest of the year. This allowed household borrowing to reaccelerate, growing 11.23% in Q4 1989. Then the economy faced recession and the savings and loan crisis. Again in this case, short-term rate increases succeeded in discouraging credit growth.
March 1994-December 1994:

From March 1994-December 1994, short term rates rose from 3.33% to 5.84%.
Household borrowing fell with a small lag, dropping from 8.93% in Q4 of 1994 to 5.6% in Q4 1995. Short-term rates settled around 5% between April 1996 through September 1998, during which time household borrowing grew in the 6-8% range.
Again, it appears relatively tight monetary policy discouraged excessive household borrowing.
June 1999-May 2000:
This tightening phase was interrupted by worries about computer failures at the turn of the century. The overnight lending rate rose from 4.75 to 6.50%. As the increases were occurring, bank credit and household borrowing both increased. Soon after the increases peaked in May 2000, bank credit slowed. Household borrowing edged higher, growing in the 8-10% range quarter-on-quarter versus a 4-9% range previously. It’s hard to measure this period because it was followed by aggressive rate cuts, during which time household borrowing spiked higher.
This phase shows an unclear success of the Fed’s overnight rate in controlling credit growth in the economy.
June 2004-September 2006:
The Fed started a tightening phase in June 2004. Short-term rates would climb from 1% in May 2004 to about 5% in September 2006. They remained around 5% until July 2007. As the Fed raised rates between June 2004 and September 2006, household borrowing did not fall. It essentially remained in the 11% growth range. It appears that in this cycle, the Fed funds rate failed to restrain credit growth.

This was the great credit bubble that Alan Greenspan described as a “conundrum”. Borrowing broke loose from the Fed’s grasp. (Interestingly, and unlike before, almost all of the growth came from home mortgages rather than consumer credit.) The credit bubble formed as the Fed was raising rates.

Let’s consider rate-easing moves as well.
March 1989-July 1990:

Short-term rates fell from 9% to under 8%. No discernable improvement can be observed in bank credit, and household borrowing declines.
November 2000-February 2002:
Short-term rates fall from 6.36% to 1.76%. Household borrowing growth rises from about 8% to about 9%. This was a modest improvement, and was countered by the recession and stock market crash.
The Fed cuts again in June 2002 and rates remain extremely low for the next two years. During this period, the growth in household borrowing rises from about 9% to 12%, so the Fed easing did facilitate borrowing.
September 2007-October 2008:
The Fed undid more than two years of rate increases in half as much time. This time it’s done little to improve access to credit, and may have actually reduced liquidity, as I argue above.

Conclusions: Fed rate increases successfully reduced household borrowing 1980-2, 1988-89, 1994. In 2000, it had an unclear effect. Since 2004, the Fed has lost control over credit creation.

The final chart explains why this has happened: The bond market has taken over lending in the economy. Contrary to popular belief, the banks don't lend money. The bond market does.

The dotted line in this chart shows the rise of securities the Fed calls "corporate bonds," which include normal corporates, non-GSE securitizations and financial-sector bonds. It's important to emphasize that it excludes Fannie and Freddie bonds and Treasuries. Most of the debt growth has come from non-GSE securitized debt (ie, toxic assets) and bonds issued by banks to fund their own lending activities. This highlights again the importance of capital markets, rather than normal bank lending, in the recent credit bubble. While some issuance is improving in the corporate bond market and the FDIC is backing bank bonds, I fear these efforts are still secondary, when they should be the primary focus. See my previous blog entry for more.

Wednesday, January 28, 2009

Good Bank, Bad Bank: Who Cares?

Stocks rallied today as investors cheered reports the government would create a so-called "bad bank" to buy the troubled loans and securities that have rendered much of our financial sytem effectively insolvent. The hope would be to "cure" sick banks so that they can resume lending, allegedly allowing the rest of the economy to rebound. The idea has some credibility because it was used successfully in the U.S. and Sweeden in the 1987-1992 period.

Despite the optimism, I have some doubts, which I discuss in this blog entry. Fortunately, I see several ways the housing problem can be fixed. This article will conclude with specific policy recomendations.

Objection #1: If you create a true market for these toxic assets, the prices will be so low that the value of banks' entire portfolios will be in question. This could cause a panic and further shut down the credit markets.

Imagine you are trying to calm a patient whose femur is protruding from their leg. If they panic and move, it could slice their artery or cause worse injury. Do you tell them: "Wow, cool bone!" .. or do you say "It's okay, everything's going to be alright?" In dealing with any crisis, one major rule is to maintain calm, which means that sometimes ignorance is bliss. This was a theme I raised last year in this blog entry and this one. Just as shock can kill the patient, forcing a major bank to write down its assets by more than 50% can also be fatal.

Recently, people of much greater stature than myself have made similar observations:

"I'm strongly against forming a bad bank... If you have an asset only you own and only you carry, the history has been the banks carry them at inflated values ... If I bought that assert at fair value, you'd have to write that down... It's sort of robbing Peter to pay Paul. I don't think it gets you anywhere."
-Oppenheimer & Co. Banking Analyst Goddess Meredith Whitney on Maria Bartiromo's Wall Street Journal Report, 1/23/09

"I don't like it... I'm not alone. The original toxic relief program was never really implemented because the value of these [assets] is going to be dramatically enhanced by the government's presence. I don't see that as a good thing."
-CNBC bond market reporter Rick Santelli, giving a thumbs down to the "Bad Bank" on CNBC 1/28/09

Objection #2: The problem does not reside in the banks. It results from conditions in the credit market, which I have discussed at great length in previous blog entries such as this one, this one and this one about the decline of the banks.

Objection #3: Even if the "bad bank" successfully quarantines problem assets, that won't fix the problem: Falling home prices. The Case-Shiller Index shows that home prices are down 25% from their peak in July 2006 through November.

The worrisome thing is that the declines are accelerating: From from November 2007 to November 2008, Case-Shiller dropped a record 18%, compared 9-10% annual drops at the start of last year.

Mortgages are secured by houses and so ultimately derive their value from home prices. Most loans are repaid when people sell their homes rather than making monthly payments. When owners are "upside down," and owe more than your house is worth, the mortgage is by definition at risk. If money was lent assuming inflated value for the houses as was common in 2005-2007, the bank is almost certain to take a hit on the principal. If they foreclose on a house, a loss is even more likely.

First confined to some problem regions, home price declines are now becoming systemic. This has never happened on a sustained national scale before. The OFHEO Home Price Index goes back longer than Case-Shiller and looks at the entire country, rather than just 20 key cities, so I will use it for a longer-term view.
Looking at the period between the start of the index in 1975 and the first half of 2007, prices never fell for two consecutive quarters, or more than 0.4% at once.
This changed in the third quarter 2007, when the financial crisis began. Four of the last 5 readings have been negative.

Q3 2007: -0.5%

Q4 2007: +0.4%

Q1 2008: -0.2%

Q2 2008: -1.6%
Q3 2008: -2.7%

Given the lag in reporting, we can be pretty sure that Q4 of 2008 will also be negative. And, unless some kind of miracle transpires, the current quarter ending in March will also be a trainwreck. We're going to have at least five straight negative quarters of worsening losses, so if you think the recession is bad now, you ain't seen nothing yet.

Delving a little deeper into home prices: The OFHEO index rose from a base number of 61.04 in 1975 to a peak of 386.39 at the end of 2007. That's a change of 325.35 points. In technical analysis of price changes, it's common to use so-called Fibonacci retracement numbers. While they are very complicated and somewhat mystical in nature, they can prove uncannily accurate.

Fibonacci analysis expects that once a period of appreciation ends, prices should retrace either 23.6% or 38.2% of the move higher. (The latter number is more common.) This would suggest the OFHEO index needs to drop to 309.61 or 262.11, or 17-29%, from the level at the end of September. That would represent another $3.4 trillion to $6.2 trillion or so of wealth losses for U.S. households, and surely deepen the banks' financial crisis. This is why it's so important to arrest the declines, and why people need to consider the solutions I propose below.
I should highlight that Fibonacci is not normally used for this kind of pricing because we're not talking about a traded security like currencies and stocks. But it's still worth thinking about.

Home-price depreciation is becoming a national crisis. Everyone blithely thinks they will just stabilize at some point on their own. Aside from the Fibonacci analysis above, there are many other reasons to doubt things will just "get better."

First, home prices have risen dramatically for decades, outpacing inflation. This resulted from a self-reinforcing feedback loop of suburbanization, household formation, mass consumption and financial speculation. It also formed against the backdrop of a three-decade bull market in U.S. fixed-income assets, which had its own origins.

Source: Ofheo, BLS

Basically, the Fed's defeat of inflation in the early 1980s allowed it to cut interest rates steadily from a peak over 14%. This occured in a market dominated by so-called Bond Vigilantes, who were paranoid about inflation because of their experiences in the 1970s. Then came the 1980s, with falling oil prices, rising productivity, stagnant wages and cheap imports. As the inflation beast was tamed, vigilantes became believers. Just like in religion, converted bears become more zealous than those born bullish (usually because they are under-own the asset in question and must buy to catch up.) There was also a growing U.S. trade deficit, which left foreigners with huge stockpiles of dollars that were recycled into the U.S. bond market. Over time, these factors caused one of the greatest -- yet least appreciated -- bull markets in the history of financial markets. It channeled trillions of dollars of leverage into the U.S. economy, much of which found its way into the mortgage market. See this posting for more details. This bull market in fixed income has been coming undone over the past year or so, as I explain in this posting.

While I am a big fan of Reagan's tax cuts, their importance paled in comparison to the bull market in bonds unleased by the Fed's defeat of inflation. In many ways, the supply-siders owe more to the heroic actions of Paul Volcker, the Democrat appointed to run the Fed by Jimmy Carter, than to the Gipper himself.

Other things combined to drive home prices steadily higher in the decades following WWII, such as the baby-boom and suburbanization. The government promoted homeownership as a means of economic growth, giving tax subsidies, paying for roads and sewers, providing water to dry places like California and flood insurance for wet places like Florida. And, don't forget about institutions like Fannie Mae, Freddie Mac and the Federal Housing Authority (FHA), which built the modern-day mortgage industry. For instance, banks never dared to offer 30-year mortgages before the government was willing to back them.

Another major factor that drove the housing boom for decades was white flight from cities and a general decline of urban centers, especially as jobs exited en masse and drugs and crime arrived.

This process is now reversing itself and suburban areas are increasingly prone to crime -- especially as foreclosed homes invite squatters and troublemakers. This is only in its earliest stages, but a Google News search already turns up several stories across the country such as this one and this.

This reversal in the crime situation, while cities like New York continue to attract new people, highlights the severity of what's going on: A myriad of reasons combined to cause the homeowning boom of the last 60 years. It was systemic and self-reinforcing, making it hard to pin down a single cause.

But because the factors all fed into each other, many of those causes are now combining to move in the opposite direction. This is common in many kinds of human behavior -- especially after a bubble breaks. For instance, after the tech bubble burst in 2000, investors suddenly went mad for "real economy" companies like banks, retailers and homebuilders. (We know how that wound up.) After a bubble breaks, the bubble asset always becomes toxic. If it happened to tulips and tech stocks, it can also happen to townhouses.

So, even if government creates a "bad bank", it would only treat a symptom, and not the true disease. The reality is that the country is drowning in houses, and many of them poorly built at that. We need to accept they will never be purchased, or if they are, it will be at terribly depressed levels.

This is a disaster because it victimizes people who "didn't do anything wrong." Someone might have put down 20% and never used their home as an ATM, but that won't save them when other houses on their street lose value. It won't help their business get a needed loan from ailing firms like Bank of America. It won't prevent their town from raising property taxes to deal with revenue lost when neighbors are foreclosed on. It won't keep their insurance rates low when crime spreads in the neighborhood.

That person who did nothing wrong might get frustrated and decide they don't care about their house anymore and plan to leave the area, putting yet another house on the market. The next thing you know, it's South Chicago circa 1955. The schools will run into trouble and no one will ever want to live there again. This is how slums happen.

The problem could be even worse than in old industrial cities, where many people were tenants. When they left for "a better life" in the suburbs, their net worth didn't take a hit. They walked away and grew richer. This time, real harm will be done to their underlying personal wealth.

One final problem is that household formation could very well slow because it appears that large numbers of Latinos, who were driving much of the population boom, are leaving the country.

So to wrap it all up, George Soros spoke to Maria Bartiromo today in Davos. Speaking of the $100 billion or so being considered to finance this "bad bank":

"It will not be enough to turn it around."
George Soros on CNBC 1/28/09, referring to the "Bad Bank"

One final objection of mine to the Bad Bank idea is that it keeps the truly bad banks up and running. I would rather see the government and Fed encourage the creation of new banks, with new managements. The only justification for helping the big banks is that letting them fail would hurt the bigger economy. Why not allow new players emerge who could take their place, so they can die a just death?


So how to solve the problem?

1-Stop foreclosures. It might sound like a cavalier and simplistic idea, but foreclosure is a legal process requiring action by the local sheriff. Jim Traficant made a name for himself after refusing to kick people out of their homes in the early 1980s. More recently, at least one sheriff in Illinois took similar action. I know it's not as simple as I make it sound, but it would hardly be impossible if state governors and attorneys general put their minds to it.

2-Convert owners into tenants. Create a system whereby delinquent homeowners could remain in houses and pay rent. Even if they lose ownership of the home, they would be encouraged to remain in it.

3-Encourage investors rather than homeowners. The law is massively skewed in favor of owner-occupied houses. This sounds nice, but has caused many people to possess houses they never had the wherewithal to own. (If they had, banks never would have invented no-income verification loans.) The tax law and lending standards still favor owners. For instance, say I wanted to buy a house I think is cheap and try to rent it out. I would pay at least 1-2 percentage points more on the mortgage than if I lived in the home. In fact, I might not even be able to get a mortgage, which would be considered "Alt-A." This situation is the opposite of what you want to do if your intention is to get the market moving again. When there is too much supply, you should be trying to stimulate demand.

4-End the tax penalty for debt forgiveness. People talk willy-nilly about "reducing principal" on mortgages, but don't realize this can trigger a tax event. If your loan is reduced from $200,000 to $150,000, the government considers the $50,000 difference as taxable income. Not only do you lose your downpayment on the house and trash your credit score -- you also wind up owing income tax on the deal!

5-Identify certain areas that need to be condemned and dismantle the houses. Leave the roads and sewers so it can be restored later. It's key to get rid of extra inventory at this point, and would provide jobs.

6-Encourage investors in distressed mortgage debt. Why make the government buy these things when ordinary people can? I would suggest something like a deferment or outright elimination of income tax on certain kinds of securities. People know much of this stuff is worthless, but they'd be more willing to buy it if it's tax free. While it might sound like a giveaway, many of the parties who currently own this stuff, such as banks, probably would never pay any income tax on it anyway because they are bleeding red ink out of every orafice.

7-Have a government program to rebuild the securitization market. The government should say it will buy mortgage bonds that meet certain high standards, and provide specific price ranges. This would put a floor under the market and make private investors willing to buy. Obama should tap the knowledge and expertise of people like Janet Tavakoli, Meredith Whitney, Sean Egan -- all of whom were on the right side of this credit boondoggle. The rating agencies, partially responsible for this mess, should play only a small role in the new system -- at least in the beginning.

Under the Bad Bank paradigm, the government is forced to lick the wounds of the banks and inherit their lousy assets. Under my idea, including point #6 above, private investors would serve that role. That would restore the government to its rightful place as a leader, rather than nurse or nanny who must clean up after a spoiled child.

Sunday, January 25, 2009

Altruism vs. Profits

I don't have a lot of time, or want to dwell on this much... But I want to emphasize the huge differences between this recession and previous ones. I have discussed this a lot in previous posts, but need to emphasize it here quickly.

In times of distress, people forget about profits. They shouldn't, because it's the only way to maintain human activity over time. If people don't work for a profitable company, their jobs are not sustainable.

Bank of America's credit team comments in his latest report:

At this point in the credit cycle, while offering the surface short term appeal of expanding credit, mandated lending may lead to unintended consequences of expanding the bad asset problem offsetting these short term benefits. Simply put, throwing more credit at a problem whose root cause is too much credit cannot be a sustainable solution.

So far, our responses to the economic crisis have been charitable rather than profit based. We try to help struggling homeowners, rather than finding a way to make owning houses profitable again. Instead of trying to "keep people in their homes," the government should modify the tax code to make being a landlord more desirable. If houses are plunging in value and facing major financing risk, it makes zero sense for ordinary people to step in front of that train, but investors can. If they had a framework that encouaged them to buy up large numbers of houses, it would restore a functional market.

This is based on Ricardo's notion of competitive advantage, probably one of the few principles accepted by every economist. It's the idea that it's best for people to focus on what they're best at. Ordinary people are not good at being homeowners. They're good at taking care of their families and being good citizens.. they're even able to make monthly payments. But it's not in their interest to take the significant risk of owning homes now that are falling in value. (The whole purpose of buying a house is it holds its value or appreciates slightly.)

As it becomes clear to ordinary Americans that their homes are worth less, the entire economy will face bigger and bigger problems. This financial crisis started as a mere scratch on an extremity, but now has grown infected and is threatening more and more of the body. We can deny it all we want and talk about "time," but this disease is not going to just get better. It's going to devour the entire body if it's not tied off and amputated. This crisis needs to stop.

One way to do that is to get the market going for homes again, and the best way to do that is to give INVESTORS an incentive to come in and buy houses. I would suggest changing the mortgage rules to encourage investor loans (rather than conventional owner-occupied loans). Investors have the wherewithal and -- more importantly -- the risk profile to get this market moving again. We need to stop pretending we're going to get the limb back and accept that we're going to have a stub, but at least we'll still be alive. It might mean dismantling some houses and letting investors buy others. Perhaps we should even let some "upside-down" houses be sold directly to investors and convert the current owners into tenants.

But we need to shed the myth that homeownership is the only desirable outcome. It's a false religion that is turning into a major long-term threat to the economy.

Also regarding altruism: U.S. non-profits face a danger like never before. In coming years, higher education, hospitals, religious charities all face a major cash crunch. This is going to squeeze institutions that we always thought were beyond the reach of normal economic headwinds. It seems that one of the few kinds of charities that will continue to do well and grow are the newest group in our country: Islamic charities. The implications of this are unclear, and merit further research.

One other realization I had today in a conversation about why the government is likely to keep growing and spending money: Being a conservative in government is like being the CEO of a company who wants to liquidate its assets. All enterprises want to grow. This means the only way to keep government under control is to somehow prevent it from printing money (the greates virtue of the gold standard) or to let it get so big it collapses in a giant fiscal supernova such as Zimbabwe today or Peru in the early 1990s, when inflation ran over 7000%.

Thursday, January 22, 2009

Is More Debt the Answer?

Many Americans have probably never heard of Pimco, the giant mutual-fund complex based in Newport Beach, California. As one of the largest buyers of Treasury bonds in the world, it functions as the intermediary for millions of people globally between their need to save, and the government's need to borrow. This makes it one of the most important institutions in the economy.

Given that American households have ceased borrowing to pay for frivolous things like bigger houses and $6 lattes, Pimco economist and portfolio manager Paul McCulley thinks the government should now start throwing huge amounts of money around to revive activity. He spoke on CNBC today:

“What you have to have is the sovereign, Uncle Sam himself, lever up to soften the blow of the de-leveraging in the private sector. And, you’re seeing that with respect to the TARP .. The FDIC …. [ and ] the dramatic expansion of the Fed’s balance sheet. Essentially you have a private sector de-leveraging and de-risking, and a public sector going the other direction. And that is absolutely critical to avoid a cascading into depression. Washington is taking the right responses, meeting a de-levering force with a re-leveraging force.”

In many ways, this is classic "Keynsian" economics, the idea that the government should step in to counter swings in the business cycle. (I put Keynsian in quotes because I am not convinced that John Maynard Keynes would ever agree with some of the ideas emerging today in his name.)

While I have vast respect for Paul McCulley as an investor and economist, I have several objections to his argument:

1-Debt needs to be paid back. Americans are beginning a long process of paying back their debts after years of reckless spending and borrowing. We're going to pay this money back no matter what. If we allow the government to simply run off more debt, we'll have to pay it back a second time with either inflation or higher taxes.

2-All spending is not equal. It amazes me how apparently rational economists want the government to wantonly spend money regardless of the purpose. They seem to forget that money represents real resources, real wealth, real human labor, and real human spirit. As the government tries to find ways to spend, it will inevitably squander real resources, causing millions of people to spend billions of man-hours on unproductive activities. This debt-financed economic system has already proven a bad judge of allocating capital -- that's why we have millions of empty houses scattered across exurban America. When the government spends the money directly, it will be even less rational.

3-It won't work. The Congressional Budget Office says that less than $180bln of the $825bln sought by Barack Obama would be spent by the end of 2010. Rock-star bank-analyst Meredith Whitney sees about 10x that amount leaving the economy over the same period as credit-card issuers cope with losses and sell fewer bonds to finance people's balances. Furthermore, state and local governments are only now starting to take it on the chin, and will soon be forced to cut jobs and spending.

Years of covering earnings and economics has taught me that things change very slowly. Industries that have served one set of clients in the private sector for years will not simply just switch to the government. New business takes 2-3 years to really get moving, which means you'd be better off just waiting for the economy to rebound. By announcing big spending plans, you run the risk of delaying private-sector growth because people will wait to see how the government programs go. That means the recovery programs can actually prevent the recovery. (The problem is that, just like the stock market, people react what they know is coming, which I address right below with the mention of "static vs. dynamic.")

McCulley, known for discussing economics with his pet rabbit, argues that the combination of recession and bank failures will cause "debt deflation" a la the 1930s. The basic ideas is that as banks implode, they will cut lending and money will stop moving through the economy. As companies fail and workers lose their jobs, prices and wages will both drop. That makes it harder for everyone to pay their debts, resulting in more failures and more bad banks. (Imagine a store borrowed $1 million to stock up on merchandise for Christmas and expecting to bring in $2 million. Then every other retailer slashes prices and the store only earns say $1.5 million. That missing $500,000 comes right out of salaries, rent, etc.)

I completely agree with him about the danger of deflation, even though in an earlier post, I thought he was too nonplussed by rising prices. (That was before the failure of Lehman, which changed everything to me.)

However, I don't agree with McCulley's solution to the problem. The basic concept of "fighting deflation with inflation" makes sense purely on an academic level, divorced from reality. Like many ideas hatched in the 1930s, McCulley's argument is based on a completely static understanding of social behavior: Just replace private-sector spending with public-sector spending, and the economy will never know the difference... Kind of like changing a lightbulb or a sparkplug.

The truth is obviously different: Social behavior is dynamic. Private sector money tends to be spent by real people with real concerns, so it needs to be legitimately productive. Public sector money is spent by politicians interested in getting re-elected and transfering money to constituents. I believe that much of it will end up in private bank accounts and never be spent in "the real economy." The debt incurred, however, will be very real.

And, once money is spent by the government, interest groups and lobbyists proliferate -- much as sea worms cling to rocks miles beneath the ocean. They subsist on chemicals leaked from geothermal vents in a lifeless environment, much as trees thrive in oasis in the middle of the desert.

Sea Worm From Deep-Ocean Vent

McCulley's underlying argument fails to address the fact that behavior changes when money is spent. If you pay people to be unproductive and allocate energy wastefully, they will. That's how we wound up with a housing bubble in the first place: The government subsidized homeownership and mortgage lending for decades, and encouraged what we now know as sprawl as a way to deal with an economy that was producing too much stuff. (Much of this resulted from the two World Wars, when the U.S. supplied other countries with vast amounts of materiel.)

Government spending is a bit like suicide: It's a permanent solution to a temporary problem. It elevates a crisis to the level of national policy, and condemns the country to live in its wake for generations to come. This is is why we have such an inefficient health-insurance system, for instance; it allowed employers to dodge wage limits during the Second World War. Once it was enshrined in the tax code, an industry grew around it. Don't think the spending McCulley urges will be any different now. Because government is based on coercion rather than voluntary compliance, its programs last forever.

I once saw a show about people suffering tragic face-devouring tumors. I will spare readers the image, but you can follow the link. Needless to say, they make the worm above look like Clark Gable. One thing that struck me was that one patient had the opportunity to be cured after 10-20 years of this horrible ailment -- yet was reluctant because he had grown to identify with the disease. Similar cases can be found in some parts of the U.S., where welfare dependency was passed down from one generation to the next. Once people percieve themselves to be victims of something, and "in need," it becomes incredibly difficult to break free. This kind of "reflate the economy at all cost" thinking is no different. Such initiatives will perpetuate the state of crisis and make it the new normal, preventing any return to the old normal of healthy growth. Japan and Venezuela, which both had severe banking crises in the early 1990s, both exemplify this pattern.

When McCulley appeared on CNBC today, they put up a list of ideas he had for how the government could help the economy:
1-Sidestep banks and move to buying munis and commercial bonds over time
2-Set up aggregator bank to lift bad assets
3-Stimulus package to deal with shortage of demand

I am flattered to think that Paul McCulley may be reading this blog, because I have been harping about point #1 since early October.

One more point about Pimco is that it is staffed with a lot of very intelligent people. (I am also a huge fan of Mohammed El-Erian, whose understated manner is the polar opposite of the colorful McCulley.) I am not sure how much they consider the problems I have addressed in this posting, but they must be aware of them on some level.

The concern is that, as an institution, Pimco has a vested interest in the government borrowing as much money as possible. They run the world's biggest bond funds, and probably have more than half their total $700bln of assets in Treasuries. Because of their prominence and skills, the Fed has already tapped them to run some of its rescue programs.

I would almost say that Pimco is an adjunct of the government, but the truth is they do far too good of a job to ever be compared to the public sector. (My own 401(k) has directly benefitted from their wise management.)

Like all good businesses, Pimco inevitably wishes to see its market grow. The more Treasury issuance, the more money under management and the more fees they earn. I think anyone heeding their advice needs to remember that, like any organization, Pimco is responding to its own set of incentives. It's a bit like the ratings agencies, which had a clear incentive to grow the securitization market. The country paid the price for that. We should think hard about doing the same thing on a much bigger scale by "reflating the economy."

This is especially true because McCulley doesn't say what will come after the stimulus. Now that home prices and mortgage lending are both collapsing, I believe the consumer-based growth model is broken. It's not 1990 or 2000 when we can just count on going back to normal. And without a sense of what comes after "reflation," McCulley's argument is a bridge to nowhere -- except a future in hoc.


This chart show the long-term trends that are now coming unravelled.

Since the end of WWII, American households went on what was probably the most lasting and thorough borrowing spree in financial history. This largely drove the huge rise in non-government debt (see the green and red lines above), aided to a lesser extent by business borrowing. (Business borrowing is also a big problem, which I address in this blog entry.)

Interestingly, government debt is still quite small relative to GDP, meaning it has a lot of room to go up. (The data above includes state and local bonds and loans, but doesn't include most "entitlement" liabilities such as social security or pensions. All the borrowing discussed in this article would be at the federal level only.)

This raises the question of another trend I have noticed from my time covering credit: Problems tend to "work their way up a capital structure" over time. A company's equity is designed to absorb losses before lenders. That means stock prices get hit first, then bonds, then finally loans. Each category is progressively "more senior."

It's interesting that this financial crisis didn't begin with Lehman Brothers, or even Bear Stearns. It began in February 2007 with the bankruptcy of a subprime lender called New Century Financial. It fell first because it was closest to the bad assets. Since then, the problems have worked their way "up the capital structure," claiming bigger and more prominent institutions. (Bank of America, Citi) Even supposedly AAA borrowers like Fannie Mae and Freddie Mac are now essentially bankrupt. This leaves only the sovereign rating of the USA itself with any credit (or credit-ability). But, we're talking about burdening future generations with trillions of dollars in unnecessary debt. The mere fact it's the only thing to leverage doesn't mean we should.

To borrow an analogy understood by most elementary schoolers: Just because Paul McCulley says to jump off a building doesn't make it a good idea.


I'd like to end with one final criticism of the "reflation by government force" argument with a quote from "A Reason to Believe" off Bruce Springsteen's Nebraska album:

"Seen a man standin' over a dead dog, lyin' by the highway in a ditch,
He's lookin down kinda puzzled, pokin' that dog with a stick,
Got his car door flung open, he's standin out on highway 31,
Like if he stood there long enough, that dog'd get up and run ..."

The economic model we all know an love, the consumer, is the dog in the song -- D-E-A-D.. dead. After years of buying ever bigger houses, cars, stainless-steel refrigerators and aspirational handbags, he's lying in a ditch at the edge of the shopping mall parking lot, his guts smeared across the road by an $80,000 Hummer and a $30,000 credit card bill.

Home prices are falling, lending is contracting and an entire generation of Americans is learning about the dark side of debt the hard way. This is not 2000, when people still felt rich from the bull market of the 1990s. Ben Bernanke and Tim Geithner can poke and prod all they want, but this dog is not going to get up and run. They might get it to move by shocking it with a defibrillator, but that proves nothing. It's time to move on.


This is why I am calling for a new paradigm based on undoing some of the excesses of the last few decades. I believe if we're going to throw money around for anything, we should buy up/condemn entire subdivisions and pay unemployed construction workers to dismantle houses. They would leave the roads and sewers (and maybe slab foundations), and allow the land to return to wild. That way in 10-20 years, it could be redeveloped. But by removing the houses now, you will prevent major social problems that could likely result from large numbers of derelect structures.

Secondly, I think we need to promote a new urbanism. Our car-based suburban lifestyle is unsustainable on many levels -- mainly from a financial point of view. We already are going to have a major crisis in commercial real estate, so why not turn the problems into profits? I propose that we encourage investors to convert shopping malls into cities. Convert department stores into offices and industrial space. Once jobs are in place, some people will wish to live there. Allow other parts of the mall to become apartments, grocery stores, bars and gyms. Do stuff to encourage communities to develop, like opening up parts of the space to bands and plays, etc.

It could be a great way to live because you could still have a car left outside, when you need to travel. But, most people would probably find they use it rarely.

These are just primitive ideas, but I think they are of greater long-term utility to the economy than just throwing money at the problem. To me, it's important that any solutions be more than just bandages -- they need to offer the potential for profitable activity in the future. (This is why the 1930s model based on sprawl and the automobile worked -- becuse it was profitable.) If it's not based on long-term profits, it will wind up like welfare in the inner city, or the UK coal industry before Thatcher. I explain the problem with economic altruism in an earlier posting.

Tuesday, January 20, 2009

Obama to Disappoint?

I have little time, but it is about 130am before the Obama inauguration. I want to make a quick prediction.

He will give a stirring speech, but will guide down on the economy and expectations about the stimilus. He knows it will take time to fix the economy and knows it isn't in his interest to raise expectations now. Plus, he has less incentive to push hard on the economy because the electorare will associate the crisis with Bush -- just as the Great Depression was Hoover (things like Hoovervilles...)

Global stocks did poorly on MLK day Monday as fears spread about Barclays, RBS. The U.S. market had a false breakout early this month and have sold off since. If the S&P 500 consolidates below 865, I expect a new downtrend that will set new lows. I'd expect the index to fall to about 675.

The S&P 500 fell to the 800-900 range at three different times over the space of nine months in the 2002-3 period, each time rebounding from roughly the same low. This time we have stayed in the same range for more than three months straight. I don't think those lows will hold as lasting support.

One more I don't like: Apple. It may be forming a double bottom around 79.78, but may not bounce much. I heard some people saying bullish things about it, but expect to see resistence around 85. If it fails to break that, it's a short.
It makes sense fundamentally because the strong dollar will weaken the size of their global sales. Furthermore, I heard at least one analyst mention that Circuit City is causing deflation in compueter prices as it liquidates its inventory.
For a consumer already facing tough times, the Mac's premium price tag may suddenly become a problem.

I now like airlines because they have fixed their problems and will make tons of money from cheaper oil. One long shot crazy play might be to buy gun makers Ruger and Smith & Wesson. They are very small. Again, news reports indicate huge gun buying as people fear Obama will reduce availability of firearms. Even if he does, the stocks should bounce on any kind of good news. (None of which is reflected in the stock prices.)

Friday, January 16, 2009

Bin of America

“I do think we were doing the right thing for the country.” -- Ken Lewis, Bank of America CEO, on why he purchased Merrill Lynch, which has now destroyed his company.

This is one of the one outrageous things any executive of a publicly traded company can say, and should expose him to massive litigation from shareholders. I am not an expert in corporate law, but I don't think it says anything about serving the good of the country. Even if it's called Bank of America, it still belongs to shareholders. As their fiduciary agent, the CEO is legally bound to serve them -- even if it means hurting the national interest. (God knows that for the last 10 years few executives cited the "patriotism clause" when they shipped millions of jobs overseas.) Lewis's abdication of this duty for some vague sense of public good is a disgrace, and it should cost him the position of CEO.


I am increasingly worried by the growing number of business decisions, such as this one, that are made for altruistic purposes rather than self-interested ones. Despite some holes in her "philosophy," the libertarian writer Ayn Rand addressed this issue powerfully:

The irreducible primary of altruism, the basic absolute, is self-sacrifice—which means; self-immolation, self-abnegation, self-denial, self-destruction—which means: the self as a standard of evil, the selfless as a standard of the good.
... The issue is whether the need of others is the first mortgage on your life and the moral purpose of your existence. The issue is whether man is to be regarded as a sacrificial animal. Any man of self-esteem will answer: “No.” Altruism says: “Yes.” (Source)

Self-interest was also the driving force behind Adam Smith's concept of the "Invisible Hand." This was the idea that more wealth is generated when everyone serves his or her own interest rather than trying to help a larger group. As long as individuals are free, and their rights are respected, they are more productive when they can profit. The result is more and better food, clothing, technology, healthcare, etc.

The superiority of private enterprise has been proven repeatedly throughout history ... Perhaps most tellingly by Soviet Leader Vladimir Lenin, who embraced free enterprise under his "New Economic Policy" after an altruism-based system had driven agriculture and industry to the brink of collapse. The earliest experiences of Pilgrims in Massachusetts also highlight the failure altruism as an economic model: They originally shared all wealth, but quickly switched to private ownership after this system resulted in shortages and starvation.

While most people with any life experience understand free enterprise, Ken Lewis apparently missed that lecture in college. He either willfully ignored the lessons of Economics 101, didn't understand them, or didn't care. Maybe he's just a nice guy, and really wanted to "do the right thing for the country."

After all, he owned less than 0.5% of Bank of America, so why not be compassionate with it. Just like a politician, it's easy to be a nice guy when you're spending someone else's money. . As of Sept. 30, four huge mutual-fund companies combined owned 378 times more Bank of America stock than did Lewis: Barclays, State Street, Fidelity and Vanguard.

Now, these are clearly for-profit institutions, so maybe they deserved to lose money under the code of altruism. But, they were largely holding those funds for individuals, unions and state pension funds.

In the end, that's who will pay the price for Ken Lewis' magnaminity and kindness. They will be forced to reduce benefits and, in some cases, go bankrupt. If they are state pension funds, they'll have to raise taxes. I can't wait until we get a nationalized health system based on the same principles.

It was 234 years ago that Samuel Johnson famously said "Patriotism is the last refuge of scoundrels." I will not call Ken Lewis a scoundrel, because I am not saying he deliberately did anything wrong. In this case: "Patriotism is the last refuge of idiots." The media abounds with people who cheered deregulation and excessive risk-taking over the last 10 years as banks leveraged themselves to the hilt and polluted the financial system with toxic mortgages. Now they applaud patriotic bailouts and stimulus plans to make the demons go away.


While Ken Lewis didn't know what he was doing, John Thain did. He was the slick New York banker who unloaded the steaming pile of garbage known as Merrill Lynch on the half-witted Lewis.

A key detail in the entire affair is that John Thain almost recieved a $10 million bonus for successfully selling his company. He backed down for political reasons, but it was probably well deserved because, unlike Lewis, Thain actually did his job as CEO by getting top dollar for Merrill Lynch shareholders. Without him, they would have surely lost billions more.

One might argue that he merely passed the buck to Bank of America, which is true. But it cannot be denied he fulfilled his fiduciary responsibilities -- unlike Lewis.

Banks like Lehman Brothers and Merrill Lynch were doomed before the credit crunch began, while Bank of America was one of the country's most solid institutions. Starting in a position of strength, Lewis proceeded to squander it in a short time by purchasing Countrywide Financial and Merrill Lynch. Those two moves have now devastated B of A's balance sheet and driven it to the verge of failure.

You can say lots of bad things about people like Chuck Prince at Citi or Angelo Mozilo at Countrywide for creating the mortgage bubble -- but at least they were making money in the process. The problems at Bank of America result from investments Lewis has made once the financial meltdown was in full force. Ignoring examples of credit contagions throughout history, Lewis turned his company into the rubbish bin where others could dump their problems. Was he trying to grow his company? Help the country? Or just do something? In the end, I don't think even he knows the answer to those questions.

Thursday, January 15, 2009

The Despair of the Capitalists

Peter Drucker is well known for management books such as The Effective Executive and The Concept of the Corporation. Today I want to focus on his somewhat obscure first book, about the rise of fascism in Europe.

The End of Economic Man: The Origins of Totalitarianism, is a forgotten classic, despite being lauded by Winston Churchill after it was published in 1939. The second chapter is titled "The Despair of the Masses," which I adapted to the name of this blog entry.

Drucker makes several important points that are eerily reminiscent of the current economic situation. But, before I go any further, let me make it completely clear I am not comparing Barack Obama in any way to Mussolini or Hitler. But I do believe our society faces some similar moral and philosphical challenges as did Italy and Germany in the post-WWI period.

First, the Austrian-born Drucker stressed how the failure of Socialism created a dangerous vacuum in the German psyche. This is hard for Americans to understand because Socialism enjoyed only a brief spell of popularity in the USA before WWI. And, it was never as visionary or metaphysical as in Germany, where a substantial minority of the population actually believed in a coming socialist paradise.

"The appeal of socialism had not been based originally upon its promise to bring better bargaining conditions for unskilled workers. It owned its strength and its very existence as a creed to the promise to a new social order and to establish equality. Without this appeal the belief in socialism has no basis and disintegrates." (p 31-2).

When the Great War broke out, Socialists expected workers globally to unite and create a workers' utopia. Instead they aligned according to nation-states under the command of their bourgeois "oppressors" and marched off to kill each other. The final nail in the coffin of socialist thought was the Russian Revolution, which didn't cause the proletariat uprising in western Europe expected by Marx. On top of these specific failures of the Socialist cosmology, Drucker also observes how advanced industrialism produced a growing middle class of white-collar workers rather. This completely obliterated Marx's prediction that capitalism would produce widening disparities of wealth and worsening exploitation. Henry Ford's $5 day made the Soviet Union morally bankrupt four years before it came into existence.

Drucker argues that the collapse of this Marxist vision embraced by many Germans and Italians created a bitter sense of despair and cynicism during and after WWI. This was fertile ground for the growth of reactionary fascism.

Fast forward 80 years to the USA. Instead of socialist utopianism, you have a country that embraced the religion of consumer capitalism and financial markets until a few months ago. Years of rising prices for stocks and real estate have come to a sudden and jarring end, obliterating retirement plans, pensions and endowments. Citigroup and Bank of America -- the country's two largest banks -- are teetering on the edge of the abyss and tens of thousands of people who thought they "had it made now" face the prospect of unemployment late in their careers.

Many were ardent supporters of free-market capitalism, yet now speak hopefully of Barack Obama's stimulus plan. With a dreamy look in their eyes, they say "we'll get through this" and "the system will adjust" as they cheer each new slug of government money. I don't know what good can come from such a cynical embrace of government intervention in an industry based on private capital and self-interest. It reminds me of how disenchanted German and Italian socialists embraced fascism. (Many may not realize that Mussolini was a socialist journalist before inventing fascism.) German-born Sebastian Haffner addessed this in his brilliant 1939 book Defying Hitler: A Memoir , which is even better than Drucker's work:

… there was a process that might have taken place in mythical times when a beaten tribe abandoned its faithless god and accepted the god of the victorious tribe as its patron. Saint Marx, in whom one had always believed, had not helped. Saint Hitler was obviously more powerful. So let’s destroy the images of Saint Marx on the altars and replace them with images of Saint Hitler.

Today, one might add: Let's smash the images of Saint Free Markets and replace them with the images of Saint Government Capitalism.

Alan Greenspan recently engaged in this kind of idol-swapping when he said he was "shocked" to learn that deregulated markets might actually be exploited by one group of people to get rich at the expense of everyone else, rather than promoting broad social good. Greenspan's religious embrace of free-market ideas was actually quite similar to that of Germany's socialist utopian thinkers in the early 20th century. (And, judging by the massive contradictions in his own thought process -- such as abandoning the gold standard to become the Gutenberg of Greenbacks -- I am not sure he ever fully respected the nature of capitalism or money.)

Just as disheartened European leftists embraced fascism to fill the vacuum left by Marx, many financial professionals are now embracing big-government statism to fill holes in their portfolios. German socialists who once rejected the nation-state as a capitalist ploy to keep them oppressed suddenly became ardent supporters of nationalistic violence and imperialism. Now that the idol of free-market capitalism is leading to despair, its one-time supporters demand massive government intervention and stimulus. I won't quote anyone by name, but watch financial news for 30 minutes and you're sure to come across a portfolio manager, economist or strategist speaking hopefully about Obama's infrastructure spending. It's the new coming utopia for the capitalist class. "Money managers of the world unite! (around Nucor) You have nothing to lose but your losses!"

The despair of the "conservative" and free-market capitalists cannot be overstated at this time. Our entire financial system is running on the guarantees of the federal government, foreclosures continue to mount and bank-analyst goddess Meredith Whitney recently warned of further writedowns. She even said recently that earnings for Citigroup in 2009 are "highly unlikely."


Returning to Peter Drucker, on pages 66-7, he mentions how people faced new "demons" such as war and unemployment, which:
"...are all the more terrible because they are man-made. The demons of old were as natural as their manifestations in earthquakes or storms. The new demons, though no less inescapable, are unnatural. They can be released by man only, but once they have been turned loose, man has no control over them... The new demons are far more unbearable than the old ones ever were. A Kierkegaard, a Dostoevski, an isolated, consciously lonely poet or philosopher, might be able to look at them unflinchingly and yet remain sane. The average individual cannot bear the utter atomization, the unreality and the senselessness, the destruction of all order, of all society, of all rational individual existence through blind, incalculable, senseless forces created as a result of rationalization and mechanization. (emphasis added)

We might replace Drucker's demons with deleveraging, bank writedowns and hedge-fund redemptions. Just as his demons were created by man, today's crises result from our own policies and actions. After all, for the last 60-70 years, America embraced consumerism as the basis of capitalism. Facing a glut of cheap commodities and excess industrial capacity in the 1930s, the government subsidized suburban sprawl to encourage demand. It then proceeded to transfer hundreds of billions of dollars -- if not trillions in today's money -- from established industrial states in the northeast to less developed areas across the Sunbelt. This trapped millions of poor blacks in decaying inner cities, created a dependence on foreign oil and skewed growth towards less skilled professions such as construction.

We encouraged Americans to take on extra possessions -- cars, houses, refrigerators and TVs -- and told them to shoulder the growing debt loads. We continued to do this even after an increasing share of the products came from outside the country, so it could no longer even be argued that consumption provided jobs for other Americans. Faced with recession in 2001, our glorious leader told us to go out and spend money. The result was a massive trade deficit that helped inflate the credit and commodity bubbles.

Rising incomes, positive demographics and easy money allowed Americans to maintain this consumption binge for decades and establish a mythology of plenty. A constant inflow of cheap credit gave the appearance of financial stability, much as a valium drip into an IV line gives a patient the sensation of well-being. As this process now reaches its own ultimate climax, our government-managed "free market" capitalism is looking about as robust as did utopian socialism in the wake of WWI. The mythology of perpetual prosperity is now a nightmare haunted by demons of delayed retirements, lower standards of living and bleak career prospects.
Drucker mainly addressed Europe in the 1920s and 1930s, but his passages remind me strongly of what's going on now:

Every rigid legal system that tries to maintain an artificial society by outlawing violence, makes the eventual revolutionary break in legal continuity all the more violent. Just so does the vain attempt to outlaw war in order to maintain society increase the imminence of war by threatening to turn every local conflict into a world conflagration. p 69

One might easily exchange the idea of outlawing war for outlawing bank failure. One might also argue that attempts to ameliorate recession with increased consumer spending have now compressed 50 years of problems into a short period -- much as the tendency to appease Hitler only made him stronger. Efforts to prevent economic weakness have now compounded to threaten the entire economy. I for one am amazed that legitimate economists can argue in favor of cutting interest rates during a credit crunch. By definition, borrowing costs rise during a credit crunch -- they should. The entire Keynsian notion of using government force and central bank printing presses to fight the business cycle worked for a while, but it has created layers of unintended consequences and unproductive outcomes. (How many millions of man hours and trillions of wealth were devoted to building houses that will now stand empty in the outer reaches of places like Phoenix. Why weren't those resources spent on improving healthcare or education?) Fighting market forces never works. Imagine someone is distraught about being spurned in love or losing a job. Would any responsible person tell them to go and shoot up some heroin or snort cocaine to feel better about themselves? Yet that is the monetary philosophy espoused across Wall Street and at almost every academic institution in the land.

Drucker continues:

If we decide that we have to abolish or to curtail economic freedom as potentially demon-provoking, the danger is very great that we shall soon feel that all freedom threatens to release the demonic forces. Freedom ceases altogether, therefore, to be autonomous and supreme ... freedom cannot remain real and valid in a world which is ruled by demonic forces. p 78

In our case today, we are not losing political freedom -- we are losing economic self-interest as a way of allocating capital. The very basis of free enterprise is that two people enter into a transaction out of self interest. Banks are supposed to lend money because they hope to make a profit. Now we ask them to lend money out of patriotic duty. Is that sustainable? Can an altruistic bank ever attract new capital from anyone other than the government? (Instead, why are we not letting banks fail and encouraging the rise of new ones that WILL BE profitable? )

Again, let me emphasize that I am not making ANY comparison between leaders or saying that Obama is in any way like Hitler. He embodies neither the invectiveness nor the anger of Hitler. Furthermore, I think that the USA has always been blessed with the right leader at the right time, while Germany often wound up in just the oppositive situation. (We had people like FDR and Lincoln, while they had people like Hitler and Kaiser Wilhelm.) I personally am not a big Obama fan because I worry that his efforts to spread unionization ("card-check") will drive jobs from the country. I also don't think government stimulus will succeed because it will discourage private enterprise. And, while I fear deflation now, I worry that the ultimate result of his policies will be inflation and a possible loss of our country's AAA sovereign credit rating -- just like what happened to Japan.

The point of this blog entry is just to emphasize that the USA faces more than just economic challenges now. This isn't 1991 when things will "go back to normal." Unlike in any other post-WWII recession, home prices are falling and consumer credit is shrinking. The basic moral and philosophical assumptions that have guided our culture and economy for the last 70 years are collapsing. (There are actually two things coming undone: Consumer capitalism dates back 70 years, and deregulatory capitalism dates back 30 years.)

And, just like Germany in the 1930s, people are reacting to crisis out of reactionary and cynical despair, rather than a positive sense that it's the right thing to do. Something good might come out of this, but it would probably be a first in history.

(I for one proposed a more constructive solution in this blog entry. More recently I expanded this idea to saying the government should buy all kinds of debt securities such as ABS. Interestingly, policymakers have adopted many policies resembling my suggestions since I published them.)

Friday, January 9, 2009

More on the Global Nature of the Credit Bubble

You always have to know from whence you come... For months, I have stressed the global nature of the recent credit bubble, and emphasized that this history will make the future more difficult than many anticipate. My basic thesis is that a massive flow of undiscriminating foreign money into the U.S. credit market was one of the causes of the credit bubble that peaked in 2005-2007. This flow of money resulted from our own consuming habits, because Americans bought more products from abroad than at any other point in the post-WWII era.

In posts like this one I have argued that as Americans import fewer goods and send less money abroad, it will reduce our access to credit because it will mean less money flowing back into our bond market. This is why I see little reason to rejoice at falling oil prices, although I do agree over the longer term it will help the U.S. economy by keeping more money at home.

An important economist at a major brokerage/primary dealer recently scoffed at this theory of mine. (I won't name him because he didn't know he might appear on this blog.) Furthermore, the U.S. credit market has looked much better in December and so far in January, with borrowing costs inching lower and issuance rising.

Many experts have been arguing this bullish case of cheap gasoline and a stronger corporate-bond market (Larry Kudlow and his "mustard seeds" of hope for instance), but I reject that because the improvement results entirely from government action: Massive rate cuts and FDIC insurance on bank debt. This new AAA-rated governent-backed paper accounts for a substantial amount of the debt being sold (right now, I don't have hard data on this now, but the trend is clear with everyone from John Deere to JPMorgan getting in on the act.) Even Sovereign Bancorp, which was in danger of going under before being acquired by a Spanish bank, recently used the government guarrantee.

This is a bit like having a heart-attack patient on life support, with a machine pumping his heart and breathing for him. Would any competent doctor take the patient's pulse and say "it's going at 70 beats a minute -- sounds good to me" ?? (Economist Jim Bianco minces no words, calling it a "medicated market.")

The government has essentially pointed its entire nuclear arsenal at the head of the credit market and said "rally or else." Just like all the money in the world can't buy love, government force cannot restore health to a market based on free will and free choice. If a thug ties a woman to his bed tells her to love him, he might get his way with her a few nights. But one day she's going to find a way to kill him and run away. Financial markets are no different. (I worry that we're going to make deal flow dependent on government support rather than enlightened self-interest. After all, that's the foundation of capitalism -- the idea two people can wind up richer, each acting out of self-interest.)

This reminds me of what Georgetown University historian Carroll Quigley wrote about the 1920s in his brilliant book Tragedy and Hope:

As soon as the war was finished, governments began to turn their attention to the problem of restoring the prewar financial system. Since the essential element in that system was believed to be the gold standard with its stable exchanges, this movement was called "stabilization." Because of their eagerness to restore the prewar financial situation, the "experts" closed their eyes to the tremendous changes which had resulted from the war. These changes were so great in production, in commerce, and in financial habits that any effort to restore the prewar conditions or even stabilize on the gold standard was impossible and inadvisable.
Instead of seeking a financial system adapted to the new economic and commercial world which had emerged from the war, the experts tried to ignore this world, and established a financial system which looked, superficially, as much like the prewar system as possible. This system, however, was not the prewar system. Neither was it adapted to the new economic conditions. When the experts began to have vague glimmerings of this last fact, they did not begin to modify their goals, but insisted on the same goals, and voiced incantations and exhortations against the existing conditions which made the attainment of their goals impossible. p.320 (Emphasis added.)

WWI dealt a fatal body blow to the UK-based international money system because all the gold wound up stockpiled in the USA rather than London. The powers that be ignored this fact and tried to force a return to the old system, causing the flow of money to stop, which resulted in the Great Depression. This is why I cannot take heart in the jubilant words of many economists and observers who are excited about the credit market's apparent improvement over the last few months. We are now in a fictitious market the same way the global economy was in the 1920s, insisting that falsehood was truth. The Fed's success at driving Libor lower means nothing. The fact they had to use their coercive power to do it speaks volumes. Don't forget T in TLGP is for "temporary." What happens in June 30 when this program allegedly ends? Hint: It won't! It will be only slightly less temporary than farm subsidies in the 1930s.

The British financed modernity using the gold standard, and few countries benefiting more than the USA. (This was evident whenever that gold was withdrawn, such as in the "Panics" of 1837, 1857 and 1907.) When that model broke, the world changed.

Similarly, the American consumer has financed the global economy for the last 10-20 years. As he started running out of money early this decade, the rest of the world helped out by lending him some of his money back. According to my calculations, 54% of our trade deficit was plowed directly back into our market for corporate bonds and private label mortgage-backed securities (those were the stupid ones).

Just as it's erroneous to conclude all's well in the credit market because bond sales have risen on the back of government force, I maintain that the absence of foreign money flowing into our economy cannot ignored. I have heard a few economists touch slightly on this issue, but I believe it is significantly under-appreciated.

The data confirms my argument about the role of foreign capital played inflating the bubble: At the peak of the credit bubble in late 2006 through early 2007, foreign inflows to the U.S. credit market represented 3-5% of GDP.. That's an annual rate of $400-500bln, comparable to the entire economy of New Jersey or Ohio. (I am only looking at foreign flows into U.S. corporates, private label mortgage bonds and asset-backed securities. Bonds issued by the Treasury, Fannie Mae and Freddie Marc are not included.)

Since then, it has plummeted to essentially zero. Wall Street economists may scoff at my point, but I am sticking to my guns. The quick removal of this money from the bond market cannot be ignored as a major technical factor causing the credit crunch. This is why I fear the benefit of Americans saving more money might be eclipsed by the inability of companies and credit-card issuers from borrowing in the capital market.

After all, if Americans put their money into banks, they are essentially lending to the government. That's because banks have extremely small positions in Treasuries now, so they are far more likely to buy safe government bonds rather than make loans to companies. (I explain this at the bottom of this posting.) Before, Americans spent money and a lot of it came right back into our economy as credit. Now we're saving money, and it leaves the productive private-sector economy. How is this good??

I just wanted to end by bolstering my argument about the role of foreign capital with a few quotes from Dear Mr. Buffett, a new book worth reading by structured-finance guru Janet Tavakoli:

On pages 80-81, she describes a mortgage-backed bond offering in late 2006. It was more than 60% backed by loans from New Century Financial, which went backrupt the following spring. "The deal seemed targeted for foreign investors," Tavakoli notes.

On page 120, she observes that securitized bonds with AAA ratings in 2007 were cut to junk within months of being issued. "This is unprecedented," she wrote, adding that the most rotten apples came from 2005-2007.

While she doesn't emphasize the link to foreign capital flows, I will. This was the time that influx of money reached its lunatic peak, exceeding $300bln on an annualized basis for nine straight quarters. In the first half of 2007 alone, the money was coming at a $700bln clip. Based on that level alone, it would be the world's 16th largest economy!

Money of that size cannot be ignored. We can keep pretending we have an old fashioned bank-based financial system, but that would mean repeating the same mistakes as the monetary authorities pretending the gold standard was still viable after WWI. Things are different now.

This is a new era, and we need a new approach.