Tuesday, February 24, 2009

Black Swans for Breakfast

Yesterday, Bloomberg Television had a great interview with Nassim Taleb, the derivatives trader who has made a name for himself talking about so-called Black Swan Events -- unforeseeable random developments that can shake the world and its markets.
Some of his comments are worth quoting here:

"This crisis is not so much a Black Swan for me, because say you have a pilot who doesn’t know about storms, namely Bernanke and Greenspan, flying the plane. Of course, the first storm, they’re going to crash the plane. So that’s not too much of a Black Swan. It’s a grayish or white swan.
The Black Swan for me would be for us to emerge out of it unscathed and return to normalcy -- that would be the black swan. That would be the highly improbable event."

I obviously agree with him on this. On a deeper level, I think Taleb places too much emphasis on randomness to understand history. After all, he provides a pretty good systemic explanation of what happened in this crisis:

"The system is designed to blow up...
We helped them (banks) blow up late ...Greenspan did not allow them to blow up early.

He then says the Fed bailed them out after the incidents such as the Latin American debt crisis in the early 1980s. Taleb's argument is that by attempting to maintain stability, policymakers allowed problems to fester until they reach a devastating size. I think it's a bit like a water accumulating behind a dam, which eventually breaks. The man-made levee, not the natural rainfall, is the problem.

In an earlier blog entry, I quoted Peter Drucker's explanation of how war and economic dislocation cause greater chaos than something like an earthquake because they result from human actions rather than being random "Black Swan" events:
"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." -- Peter Drucker in The End of Economic Man: The Origins of Totalitarianism

Drucker was examining the calamity and economic turmoil that followed WWI to understand the rise of Hitler and Mussolini. He argued that man's embrace of rationalism had created a far less rational and more dangerous world: Tools of civilization intended to make life better, such as railroads and factories, were used to organize millions of men and the productive capacity of entire countries into killing machines. Throw in Weimar-era inflation, which undermined established power relations in the family and social classes, and the Germans were a rootless, drifting people, lacking the philosphical antibodies to fight off the the Fascist infection.

In the late 19th century, the Prussians invented a military model of massive and total mobilization, where millions of soldiers, along with their supplies and support units, would all converge on the field of battle. This was an enhanced version of Napoleon's concentration of force doctrine -- the idea that by rationally marshalling the resources of a modern nation state you could quickly overwhelm the enemy. The problem with this strategy is that once mobilization began, it couldn't be stopped. (A bit like deleveraging.) Millions of men expecting a glorious offensive victory were bogged down in a miserable defensive trenchwar, borrowing into the earth like worms as rats consumed their fallen comrades.
In the end, a military model designed to keep countries safe produced greater horrors than Europe had ever seen. When society's own defences turn against it, the resulting crisis can be much larger and insidious than expected because you don't have just a war or economic crisis to deal with, but a deeper existential crisis.
The same lesson could apply to our economy today because government policies to encourage homeownership have transformed into demons that haunt the finances of banks, insurance companies, households and municipalities. In every other crisis since the 1930s, the consumer and residential real estate remained strong, allowing a "return to normal." This time there may be no normal left.

For decades policymakers have embraced Keynesianism in an attempt to assure economic stability. This started in the fiscal and legal arenas in the 1930s and continued until the Reagan era as the government used taxes and spending to control the economy. (Through the late 1970s, the result was monopoly capitalism, high taxes and inflation.) Keynsianism then moved into the monetary sphere under the influence of Milton Friedman, a proponent of the modern-day Fed doctrine of raising interest rates when the economy is growing and cutting them when it's slowing.

Many experts would say I am wrong to lump Friedman and Keynes together. I do this because both supported counter-cyclical measures and argued against reality in favor of a government-endorsed economic outcome. For instance, how does it make any kind of economic sense to lower interest rates during a credit crunch? Credit was somehow too cheap and people used too much of it. If an ordinary company or person borrows too much and faces bankruptcy, they're forced to pay higher rates to borrow. Somehow when we move from the singular level of the individual or business to the plural of the entire society, people like Milton Friedman and Alan Greenspan think the rules should no longer apply.

In fact, almost everyone in the world of economics and finance embrace this theory today. I hear almost no one on CNBC or Bloomberg arguing in favor of higher interest rates. The thing I find most distressing is that none of the journalists ever ask the follow-on question: What comes after you cut rates to 0%?


This problem is simply ignored, but to me is an underlying reason why the Japanese stock market is still miles below where it was 20 years ago: Low interest rates become a curse because they are impossible to ever raise again. This is why I argued for rate hikes in the summer of 2007 so that banks would attract more deposits and the Fed would have the ability to cut rates once the inevitable recession came. Instead, they cut rates right off the bat and triggered both an inflationary spiral and a wider credit crunch. (Again, most people probably think the Fed's rate cuts helped ease the crisis. They should read this blog entry.)

I fear low interest rates will cause much more harm than good because people know they can't go any lower. One of the most basic ways to value equities is to compare the "earnings yield" to the yield on a benchmark like the 10-year Treasury bond. (Earnings yield is EPS/Price -- the inverse of P/E ratio.) This is often called the "Fed Model," and essentially dictates that falling interest rates are positive for stocks. Most market watchers understand this implicitly.

In many ways the stock market's strength in the 1981-2007 period resulted from a steady decline in interest rates. This pushed borrowing costs lower, allowing companies to cheaply buy each other and consumers to buy more stuff.

Rather than the absolute level of interest rates, the key factor is direction. For instance, you want to buy a house and can afford to pay $2000 a month in payments. If interest rates are 20%, you can borrow roughly $120,000. Assuming you put 20% down, you can afford a $150,000 home.

If the interest rate falls to 10%, you can now support about $230,000 in debt, and afford a $287,000 home. This is not rocket science.

Low interest rates are bad because they destroy dynamism in the market. Once they can't go any lower, why should I even bother to buy a house, or buy stocks?

(Of course some people will argue that you shouldn't buy a house based on speculation, and that it's "a good thing" to see houses go from being speculative assets back to normal "use" assets. The problem is that the period of speculation leaves an overhang of supply that will drag on the economy and society for years. Furthermore, if you take the speculation out of houses, it makes more sense for many people to rent in the first place. Don't forget the government had to subsidize homeownership for a reason -- namely it didn't make any sense for the average American, when you consider all the financial and legal risk involved. See this and my Vatter quote below for more.)

Again, policies put in place to ease economic cycles and prevent distress cause the economy to work less efficiently because it allows bad activities to keep going longer:

"Whatever breaks is fragile, whatever doesn’t break survives, and then that’s capitalism. Capitalism is: You let what is breakable break fast. Now we’re letting things break late, but odds are they’re going to break anyway." -- Nassim Taleb

Taleb's version of history is that banks have made money steadily for years and convinced people they were conservative and low risk. This allows them to grow so large that all of society is dependent on them, which creates a new kind of risk and forces the government to bail them out when they fail. That means "we are sponsoring the asymmetric risktaking on the part of banks. Everything was geared to building up a deferred blowup scheme."

I think Taleb should take it even further. This wasn't just about bailing out the banks. It was the result of a 60-year secular bull market in the U.S. consumer and his house. The government fed that process by subsidizing homeownership and transferring wealth from cities to suburbia. It was part of a larger Keynesian plan to build a mass-consuming society that could keep the factories going and maintain full employment.

It began with direct expenditures such as highway building and defense spending in the South. The government also provided preferential loans to develop suburban areas. Here's a quote from economic historian Harold Vatter on page 22 of his edited book History of the U.S. Economy Since World War II:

"By the beginning of the 1950s the whole system of housing credit was substantially underwritten by the government..."

Vatter then quotes a 1950 report from the Council of Economic Advisors: "The credit policies and programs of Government played an indespensible part in the expansion of the market demand for homes. This expansion depended on low interest rates, small or nominal down payments and long periods of amortization. Without public assurances, the policies of private investment institutions could not have been extended far enough to permit this type of financing."

The subsidization of sprawl started in the 1950s with explicit government spending (highway building, defense spending) and gradually morphed into a quasi-state lending scheme under Fannie Mae and Freddie Mac. This second stage really took off in the late 1980s when Fannie and Freddie became widely held stocks and pursued aggressive growth. Despite what some people claim, these organizations were never private and always relied on the credit of the U.S. government. (That's why the government is now backing them. There was actually a quiet debate in central banking circles for years about the safety of their bonds, which concluded that they were more or less the same of soveriegn debt. That's why foreigners bought so many of them in the first place, and why they could be considered AAA. It's also why the Federal Reserve in its Flow of Funds report has always treated them separately from other banks.)

This androgynous public/private status was hugely successful for a long time, giving them access to unnaturually low interest rates. Their share prices rocketed higher for most of the 1990s as they grew into giant lenders.

It was great for the economy because, instead of citizens being taxed to pay for their neighbors' houses, the expense was concealed by GSEs borrowing in the name of the public. It wasn't that different from the practices of General Motors, which mortgaged its own future to sell cars at steep discounts. This also allowed the company to "maintain full employment" and to pay workers sitting idle in the jobs bank.

In the end, the Keynsianism road ends at a corruption of capitalism because resources are "invested" for political purposes rather than for profit. Whether you're looking at the Fed or Fannie Mae, both were designed to deny natural economic and financial reality. In the long run, this rewarded bad behavior and caused a huge misallocation of capital. That's why we have millions of homes standing unsold across the country. Even more tragically, we encouraged millions of human beings to engage in unsustainable economic activity such as construction and retail. Those people gave up precious years of their lives when they could have been learning new skills or developing new sources of income. The wasted human capacity is the real tragedy.

I'd like to end this blog entry comparing the growth of GSE debt and private financial-sector debt, most of which was securitized. The majority of the debt underlying both lines is linked to home mortgages.

GSEs led the surge in mortgage lending for more than a decade before they retrenched and were replaced by players like Countrywide and Bear Stearns. While the private sector drove the movement to its final, insane peak, it only came after decades of the government building the bubble.

This is not a crisis of capitalism. This is a crisis of Keynesianism.

Sunday, February 22, 2009

Are Experts to Blame?

I was discussing the financial crisis with some people tonight when someone asked why things are different now in previous crises, such as during the 19th century. My immediate answer was that the banking industry was much less centralized then. The country at large was susceptible to gold outflows, but there was no unified bond market, securitization or national real-estate market.

I also suspect the gold standard helped in the past. If you had real bullion, you were ok no matter what happened in New York. Now, you might hold your savings in stocks or mortgage bonds. When they fall for one person, they fall for everyone. Because money is no longer rooted in real gold, it seems to follow trends in the financial markets, which themselves have none of the safety of gold. Many people complain about derivatives, but they forget that common stock is also a derivative -- especially when a company has a lot of debt.

Just now, I thought of an even better explanation about why events like the Great Depression or the Second Great Depression (i.e. Bernanke/Obama/Geithner Depression) seem so much worse than events in the 19th century. It's precisely because people like Bernanke, Obama and Geithner are "in charge." Just by offering to "help," they are prolonging the crisis. This marks a change from the 1800s, when hundreds of settlements sprung up across the frontier only to fail and wind up as ghost towns. If that happened today, people would be asking for bailouts and rescue packages instead of moving on to other endeavors.

I suspect that the presence of policymakers to "fix things" has caused an entirely new kind of problem because it makes people hope for someone else to solve their problems. Instead of just abandoning the ghost town and moving on, people stay, asking for the authorities to subsidize the the local businesses and help them stay in their homes. This dynamic is most visible in Michigan, where millions of people have been trapped by the failing auto industry and the promises of organized labor. A century ago, they would have been long gone for greener pastures. But why should they do that when the union had arranged "job banks" to keep them on the payroll?

The cruelest irony of all is that the same people who have been paid not to work for the last 10 years could have spent that time establishing themselves in different professions. Now that the overall economy is collapsing, it's the worst possible time to seek a completely new career path. The union, intended to protect, wound up a prison.

I think another problem that has yet to be seriously addressed by anyone other than myself is the country's unhealthy education bubble. During my entire life I have watched universities create "degrees" in subjects like "restaurant management" and "criminal justice." I have seen certification programs like the CFA grow exponentially. Few people question the value of this designation, even after its disciples led the credit system over the cliff -- guided by their models.

The problem with academia is that it's a false environment. It exists in its own bubble, independent of the real world, untroubled by profits or managing costs. The government is to blame for much of this because it has subsidized the system for decades -- much as it has supported mortgage lending.

"Experts" emerge from this environment, supercharged with a shaman-like aura of power that was created in the false world of the seminar and classroom. The typical academic setting simply gives people grades on tests, but doesn't make them manage a portfolio, study technical analysis or tear into a company's balance sheet. The certification process gives them a bogus sense of confidence.

In my own experience as a reporter, I have been amazed at how many people ignore facts directly before their eyes in favor of "theories." They worship ideas like "fundamental analysis" of stocks, focusing on fictional concepts such as "earnings" in order to determine "proper valuations." (I personally believe in enterprise value and EBITDA over market cap and earnings.) They assume the market is like a football game where a referee is going to come out and say "you should be trading at a multiple of 15x, not 8x" and magically push it higher. They ignore the very clear reality that stocks go up when people buy them and down when they sell them. Many factors can cause people to buy or sell that has nothing whatever to do with intrinsic value.

I often think that having a "theory" to fall back on increases moral hazard and the pro-cyclicality of a crisis because it makes everyone do the same thing. For instance, one analyst said that U.S. banks should be buying AAA-rated German bunds rather than Treasuries. He might be right that they are safer, but I told him that's not how people think institutionally. If everyone in the world buys Treasuries and it winds up being a bad decision, no one is going to get fired for owning them. But if you buy Bunds and the trade goes against you, you're at risk of getting fired because you took such an outside-the-box move. Accepted theory/expertise herds people together... much as barbed wire and landmines are used on the field of battle to channel attackers into a narrow space to be cut down by machine gun fire...

That's why some portfolio managers kept buying Lehman Brothers all the way to zero, saying "it's really cheap on a valuation basis." They were following the same model as "experts" like Ben Bernanke, Tim Geithner and Larry Summers, who ignore that today's world is controlled by forces like capital markets and international money flows. Instead, they nostalgically pretend they're still the bank-dominated system of their youths. See this posting for more. And because they are men "of reputation" and "power," no one challenges them openly or seriously.

Anyone wanting to understand the proper place of academia should look no further than its origins in ancient Athens. It was an exclusive and closed environment where people like Plato sat around contemplating things. They had no deadlines or budgets to meet, nor many explicit responsibilities. It wasn't very different from the GM worker getting paid to sit and watch TV in the "jobs bank." Yet, we've given them control over our economy. This is why I called for the creation of a new power junta of established market professionals in this posting.

Because they're not in the real world, the academic mindset doesn't appreciate how things really work. They don't understand that economics is a bit like love or friendship. Things just work or don't work. (There is no General Theory, as Keynes tries to find.) Instead of people having chemistry between each other, companies and customers find each other and keep coming back out of their own free will. These relationships evolve organically over time, and are held together by everyone's individual sense of self-interest. (Friedrich Hayek won a Nobel Prize for arguing that the links are too complex and dynamic to be managed by a central authority.) Furthermore, places like ancient Rome had economic cycles, and they didn't have a Fed or M2. Keynes' ideas existed at one moment in time and are based upon an army of assumptions that may or may not be valid today. I am not sure even he would approve of how his theories are being used today. I say this because of his persipacious warning against the UK returning to the gold standard in the 1920s. I think unlike most of his alleged followers today, Keynes himself would appreciate that we now live in a capital-markets based world. He would know better than to do things like cutting interest rates close to 0%, which are like poison in the veins for the financial system. (See this posting for more.) He would probably also realize that a lot of this mess resulted from government policies that created the housing bubble (Fannie Mae/Freddie Mac, FHA, highway building, defense spending. For more on the role of military contracting, see pages 157-160 of this book). Unlike today's Keynesians, Sir John Maynard was able to think outside the box.

When the government gets involved in the economy, it can only use force. Occasionally this works. For instance during and after WWII, the government successfully expanded the country's industrial base and promoted a new kind of consumer-based growth model that lasted decades. (Until a few months ago.) This worked because companies like GM were eager to convert from military to civilian production, so it was like forcing a bunch of teenagers to go to a dance at gunpoint. Even if it's against their will at first, some will wind up making out before the night is through.

Unfortunately, it seldom turns out so well. At its most benign, the government resembles a scene in My Big Fat Greek Wedding when the father tries to match the main character with a series of unappealing men. At its worst, government "aid" resembles a forced marriage or a violent enslavement.

Compared to the 19th century, our fiat money system might prolong the crisis now. Since the government "can never run out of money," there is no limit on the stupid things it might do. This is just an idea I wish to record briefly. I am not sure how much it's worth dwelling upon.

One final criticism of the experts and academics: They all keep assuring us we're not in another Great Depression. (Their main explanation is that today we have "policy response." To me this makes as much sense as saying a patient with a bullet in his head will survive because he's been given antibiotics.) To me there are four big similarities between now and the early 1930s, but the academic mindset has blinded people from the stark reality:

1-The secular story today is broken. In the 1930s, it resulted from oversupply of steel, grain, oil and labor following WWI. Today, it results from an oversupply of houses and a lack of things consumers need.

2-We have a financial crisis. The Fed thinks it's easing credit when in reality they are squelching it. Determined not to repeat the exact same mistake of the Fed in the early 1930s, Ben Bernanke is making the same mistake of taking actions that reduce financial intermediation. Then, the culprit was higher rates. Today, it's falling home prices and artificially low interest rates.

3-We have an intellectual crisis. The paradigms that have brought us to this point have stopped working. Our leaders are mortgaging our futures trying to bring back the past. See point #2.

4-Deflation: Despite a gain in CPI last month, CPI fell by at least 1% the last three months of 2008. The last time that happened consecutively? December 1930 through February 1931.

Friday, February 20, 2009

Whitney's Reality Check

Continuing to break down some recent comments on CNBC....

Steve Auth is Chief Investment Officer at Federated Investments. From everything I can ascertain, he's a very smart and successful asset allocator. I have chosen to "pick on him" a little bit because he appeared on CNBC and made some very mainstream and conventional comments. For 99% of financial history, everything Auth said would have been true, so he reflects the traditional thinking I wish to critique. We're at a major inflection point now and these ideas need to be questioned.

Steve Auth on CNBC 2/20/09

Auth says "we are not in a great depression scenario" and argues that our current monetary system will save us from the deflationary cycle caused the gold standard in the early 1930s. I attack this assumption in this blog entry and in this one.

During the Great Depression "there were no dollars in circulation in some places in the country and things were very, very tight ... the policy response here has been completely different ... The fiscal stimululus plan hasn't been completely stimulative, and in a lot of people's minds, it isn't a plan, but we're getting there, and at least we're addressing the issues."

Let's compare this perspective with the views of Meredith Whitney, who has emerged as one of the shining stars of this financial crisis. (I hope she doesn't mind me setting her up in this ficticious debate with Steve Auth.) She spoke Thursday night to CNBC's afternoon anchor Maria Bartiromo:

"You've got years and years worth loans underwritten with faulty assumptions. Those are car loans, credit-card loans, auto loans, and obviously mortgage loans. And those have to work through the system. There has to be a group of consumers that lose credit and a lot of consumers will lose access to some of their credit."

I consider Whitney's comments as a rebuttal to Auth's point about how things are different than the early years of the Great Depression. In the early 1930s, banks in some parts of the country couldn't lend because they lacked physical gold. Today, some banks cannot lend because they are insolvent. Just as certain geographical areas were affected in the 1930s, today the problems revolve around certain kinds of loans... Whitney lists these as auto loans, credit cards and mortgages.

Auth also says "... the policy response here has been completely different ... " than during the Great Depression.

I am not sure how Whitney would respond to this, but I think it's wrong in spirit. Auth is correct on the surface: During the early 1930s, policymakers "tightened" credit and exacerbated the problem, while today we have "loosened" credit and "stimulated" the economy.


My point is that, just like in the early 1930s, policymakers have responded by embracing convention, despite evidence that new kinds of thinking are needed. For instance, our traditional policy tools are designed for a financial system dominated by banks rather than capital markets. That's why the Fed's earliest actions were interest-rates cuts and liquidity facilities. They viewed the problem as existing on bank balance sheets, when in reality it was to be found in the capital markets. Thanks to securitization, globalization and deregulation, banks had become adjuncts of the bond market. Everyone knows that banks stopped holding loans on their balance sheets, but no one asked "what does this mean for the way we approach problems?"

I have been arguing this point since the crisis took root in October. For instance, home mortgages represented 65% of bank deposits in the U.S. in 1974. People were borrowing money that someone else had saved. By 2007, home mortgage debt had ballooned to 160% of bank deposits. Now people were borrowing money that came from somewhere else ... the bond market. During the intervening years, Fannie Mae, Freddie Mac and private-label mortgage issuers -- all of which rely on the bond market -- developed a lending system independent of banks. Yet in the years 2007 and 2008, the Fed was still using policytools developed in the 1970s and earlier.

Yes, the Fed has managed to affect some improvements in the capital markets. Corporate debt issuance surged to a record level in January. But I believe if you look at the underlying causes, they still support my thesis.

First, when the Fed cut interest rates to 0.25%, it caused Treasury yields to fall so dramatically that corporate yields had to follow them lower. The same thing applies to the various and conflicting rumors about how the government wants to buy mortgage-backed securities and drive rates below 5%. These trends caused an improvement in the capital market by pushing rates lower.

Secondly, the FDIC is now insuring bank bonds under the Temporary Liquidity Guarantee Program (TLGP). Many experts celebrate the fact that these government-backed deals represented less than 10% of all issuance in January. Yes, this is positive, but I maintain that few of them would have priced without the TLGP. Why? Because without the government's support, Bank of America and Citigroup would have both collapsed by now and the credit market would be in utter disarray. The TLGP allowed the bond market to remain functional. Again, the policy succeeded because it fixed a problem in the capital market.

Importantly, Whitney and I seem to be on the same page regarding the importance of capital markets. She's been predicting a broad contraction in lending since last year because of the collapse of securitization. I quoted her and Jim Bianco on these points in this blog entry.

In the 1930s, the conventional thinking was based on the 19th-century gold standard. Faced with a credit crunch, the rules said to raise interest rates because that would attract gold, against which the banks could lend. Unfortunately, this doctrine had failed to adapt itself to the changes of WWI, when the gold standard essentially died.

Today, the conventional thinking is based on the 1970s model, ruled by bank balance sheets. Faced with a credit crunch, the rules say to cut interest rates because that would make it easier to lend. Unfortunately, this doctrine has failed to adapt itself to the changes resulting from globalization, securitization, deregulation and the rise of capital markets. For instance, I personally suspect that the Fed's rate cuts in September 2007 unleashed the credit crunch as we know it because it caused many "leveraged investors" such as SIVs and hedge funds to sell riskier assets. I know this is a very unorthodox view, but some evidence does exist to support it. See this posting for more.

In other words: In the early 1930s and today, the Fed did the conventional, accepted thing to deal with a credit crunch. In both cases, this had the opposite effect of what was expected because the ground had shifted beneath their feet and the intellectual tools had not yet caught up with the new reality.

Again, I am not sure how much Meredith Whitney would agree with how far I take some of these points. Let me make very clear that my comparisons between now and the Great Depression are my idea alone.

Returning to my ficticious debate, Steve Auth says:

"The fiscal stimululus plan hasn't been completely stimulative and in a lot of people's minds it isn't a plan, but we're getting there, and at least we're addressing the issues."

Whitney responds..."So many people were so hopeful about this administration really making a difference, and put so much faith into the administration. What I thought was a mistake of this proposal was it underestimated the intelligence of of the American people because it was built up obviously to be this great saving grace. Somebody set those expectations and then there was nothing behind it."

I think in many ways the Obama administration's response to this financial crisis has been similar to Lyndon Johnson's persecution of the Vietnam War. He always viewed it through the lens of Congressional politics, rather than war. In his world, you could always make a deal go through by adding a little pork for one legislator here or giving a nod to another legislator there. Compromise is the mothers milk of making a bill into law. That approach didn't work as well in a real war and caused him to make some fatal compromises, such as refusing to invade the North. A politics-based worldview kept Johnson from understanding the problem correctly, costing millions on both sides their lives. Tim Geithner seems to resemble Johnson's Defence Secretary Robert McNamara, who apparently said that loyalty to Johnson was his main guiding principle. Just like McNamara's Vietnam policy, Geithner's rescue plan and Obama's stimulus package seem to be much more based on the dynamics of American politics than on the actual problems on the ground.

As Whitney says:

"We will get to the bottom when we address all the issues. But some of the obvious issues have still not been addressed, and that's what makes me still nervous."

Sometimes, I think this blog should be renamed the official Meredith Whitney Fan Club because I cite her so frequently and with such admiration. However, I don't agree with her on everything. She supports the rise of new smaller lenders to replace the Citigroups and Bank of Americas of the world. While I agree with this in principle, I think it will take years to work. Instead, I think the government should hire Whitney, Janet Tavakoli and Sean Egan to write new rules on how securitization "should work."

The New Junta?

They are fine analysts who have proven their competence. (It would be a welcome improvement over the rating agencies, which are conflicted by their reliance on debt issuance to generate revenue. See this post for more on that.) Once they have completed their work, the government would simply buy asset-backed securities and mortgage-backed securities that follow the new rules.

While it might sound revolutionary, this is how Fannie Mae transformed the home-mortgage industry and mandated many of the standards we now consider "normal," such as 20% down and 30-year terms. Once the government has established new standards for securization, private capital will return to the asset class and debt origination will resume. Most Americans already do business with companies like Bank of America and Citigroup, thanks to decades of franchise building by those lenders. I don't think Whitney is giving enough weight to the immense complication and diffulty involved with tens of millions of people changing banks at the same time that many have lost their jobs and face huge losses in the stock market. In a crisis like this, you want to focus on as few issues at any given moment in time. After all, that's precisely why the government has propped up the biggest banks -- because so many people depend on them for so much.

My capital markets-based plan would use the infrastructure of the moribund megabanks to keep credit flowing in the economy. I know it's a bit of a gruesome analogy, but imagine a pregnant woman has an accident that renders her brain dead. The husband chooses to keep her on life support until the child can be born. That's essentially what we need to do with Citi and B of A.

Another concern with Whitney's plan is that she wants the government to "supercharge" small banks with capital so they can expand into big national banks. She says this money should be "nonpunitive," which leaves many unanswered questions. Would Harry Reid and Nancy Pelosi allow executives to earn more than $500,000 a year? Would they be allowed to have corporate jets? What is the future for any financial that relies on public money? So far, government capital injections have proven the kiss of death for banks. Given the political climate now, this could be more of a hindrance than a help.

Under my capital markets-based plan, the government could hold asset-backed debt securities without disrupting the market and sell them when conditions improve. Furthermore, the government would profit from the measure because the bonds would always be priced at a level above the Treasury's cost of funds. This is called "positive carry." (One idea that should be considered is the abolition of LIBOR in favor of T-bills as a benchmark for short-term floating rate debt. I am not sure it's a good idea, but I think it should be discussed.)

My idea also recognizes that in today's world, capital markets run the show. All assets will try to price themselves against the largest and most liquid market, so that is where attention should be focused. Fixed-income money all is more or less or the same thing under most circumstances -- except during a crisis like now. If Treasury yields fall, junk bond yields will follow. Investors know they have to tolerate less liquidity and corporate defaults, so they simply demand extra yield to compensate.

Whitney makes a few more important observations about how the weakening consumer and falling home prices are keeping banks on the ropes:

"Consumer loans ... were underwritten with false assumptions [ and ] diminish on a daily basis as the consumer gets increasingly strapped ... Peak to trough house price expectations... started the summer 2007 [ forecasting ] a 10% [ decline ], now gone up to 30% Now it looks like it will be closer to 40%, so they have to keep paying cash up, keep boosting reserves. And, their own earnings power is diminished, which means they are not earning capital and they can't make more loans. So, they have to keep shrinking their assets."

Since early October, I have argued that this financial crisis will continue as long as home prices continue to drop. Unfortunately we have entered a vicious cycle where the financial crisis is also causing home prices to drop because people can't get mortgages and are losing their jobs. Policymakers must focus attention on the houses because they are the collateral behind mortgages. As long as they continue to lose value, the banks that lent against them will keep getting squeezed. Today is different from previous blowups, such as the S&L debacle. The consumer economy was still going strong as consumer credit and home prices both rose steadily throughout the entire crisis. Despite a temporary glut in commercial real estate, most of the properties were sold off at a profit.

Today, the problem is much more severe because consumer credit and home prices are both plunging. This situation is truly reminiscent of the Great Depression, which was the last time the economy truly had too much stuff, and not enough demand for all the stuff.

Auth the Mark on Money

Listening to CNBC over the last 24 hours has given me huge amounts to write about. One big money manager made a comment that I can't help but criticize:

"We are not in a great depression scenario ... When you had the market crash in 1929, the next three years you were on the gold standard, and you actually tightened the money supply."

--Steve Auth, Chief Investment Officer, Federated Investors on CNBC 2/20/09

I have recently been arguing that our financial system has stealthily moved itself onto a mutated version of the gold standard in recent years, but people have yet to recognize the dynamic at work. Instead of gold bullion, the value of real estate has served as the basis for our money: As homes appreciated in value, more credit was extended. It's the same thing as 100 years ago when banks' ability to lend was directly tied to the presence of physical gold in their vaults.

Of course, this notion is nowhere to be found in text books, but it is scattered throughout the economic data and financial news over the last several years.

For instance, a New York Times article from Jan. 14, 2005, spoke of consumers' suprising ability to keep spending:

...Feeling on solid ground, consumers have taken advantage of cheap money to borrow. They have bought cars on credit and taken out home equity loans to refurbish their homes. In the third quarter, total household debt grew more than 9 percent. And the personal savings rate has plummeted to merely 0.3 percent of disposable income in November - virtually nothing...

Stories such as this were extremely common in the 2003-2006 period as people kept chorusing: "The consumer isn't dead yet!"

Here is a brief summary of how real estate came to resemble gold as a source of credit in the economy:

As home prices rose, people had more money. This is why the Fed was unable to halt the growth of credit using traditional monetary tools like the overnight lending rate, causing Alan Greenspan to complain about a conundrum.

On one side, residential real-estate was an asset class. Despite regional differences, it was united by the same sources of financing, the same tax treatment and more or less the same demographic trends. This caused a secular bull market for years as people moved to suburbia and babyboomers had families in the post-WWII period. (See this posting and this posting for more.)

On the other side, you had increasingly sophisticated financing mechanisms that learned to work their way around traditional controls such as the Fed's tightening policies or shortages of domestic savings. The new money machine subsisted on securitization, a globalization of capital flows, a surge in financial wizardry and hedge-fund speculation. Topping it all off was a 28-year bull market in U.S. bonds, one of the most important, yet least appreciated, trends in financial history. (It contributed to or caused two junk-bond bubbles, two LBO bubbles, an emerging market bubble and the housing bubble.) See this posting and this posting for more.

All bubbles are built on solid foundations. That causes people to trust the asset itself -- whether it be houses, stocks, oil or tulips -- and ignore the fundamentals. Once they come to believe the asset can only go up, complacency takes root and the cultural basis for a bubble is established.

Residential real estate in the U.S. was no different. It began on extremely solid footing, with equity representing 80% of total real-estate value in 1952. In comparison, an individual home mortgage is considered "well capitalized" at just 20% today. That national level dropped into the 65% range by the mid-60s, and remained there until the late 1980s. Salomon Brothers had just started securitizing mortgages and Fannie Mae was an increasingly active player in the market. (Its shares would rise more than 80-fold over the next 15 years. From 1985-2001, the mortgage pools of government-sponsored lenders like Fannie and Freddie Mac rose from $289bln to $2.8 trillion -- a factor of 10x. Meanwhile, GDP rose just 2.5x, from $4 trillion to $10 trillion. After 2002, Fannie and Freddie actually backed off and were replaced by non-government subprime lenders, who drove the system to calamity.)

As mortgage debt proliferated, less and less home value backed the loans, squeezing "cushion" out of the asset class. The ratio plunged when the lending boom hit a fever pitch as the housing bubble peaked. It will continue to fall as long as home prices continue to drop because debt remains fixed until it is written off, while houses will keep getting cheaper.

The only way to reverse the trend is to reduce mortgage debt, which is exactly what's happening now. Unfortunately, this will stand as a huge obstacle to increased mortgage lending.

Less mortgage lending translates into less demand for houses. (If people can't get a mortgage, or can't borrow very much, they can buy less house.) When demand falls, prices also fall. Of course, there are two ways to fix this situation: Reduce supply or increase demand. That is why I proposed three simple policy suggestions at the end of this blog posting. They are:

1-Stop foreclosures (reduce supply of houses on the market)

2-Dismantle houses (reduce supply of houses on the market)

3-Encourage more real-estate investors and end the unnatural preference for owner-occupancy (increase demand for houses)

I am not an expert on houses per se, but I understand markets. They all follow the same principles. Maybe my specific ideas won't work, but we need something that will attack the same issues.

The next chart shows this same dynamic at work. The top line is the value of household real-estate in billions, and the bottom line is the overall amount of household debt, most of which is related to real-estate. It shows how the household as an enterprise/industry leveraged itself over time. As the purple line approaches the blue line, more households become insolvent.

It's hard to deny the relationship between home prices and the availability of credit in the economy. As I argued in a previous blog entry, real estate assumed the same role as gold in the 19th-century financial system. The problem is that financial systems are slow moving animals that evolve over decades, not months or years. The accompanying economic paradigm -- "the consumer story" -- took shape over a similar amount of time.

The thing that worries me now is our credit system is linked to a socio-economic process (consumer spending/home prices), which is not going to rebound anytime soon. In essence, our ability to borrow is tied to the value of an asset class that is plunging in value because of the factors I describe above. It's a process of decline that's going to last for years.

This is much worse than life on the gold standard, when a country merely had to raise interest rates to attract new money. By trying to make everyone a homeowner, have our politicians tied a ball and chain to our economy? Is that weight called home prices?

Tuesday, February 17, 2009

Some notable quotes

I was just heard some good experts make some important comments to Yahoo's Tech Ticker. Below I include their key points:


"There's a permanent change (in the U.S. consumer), and the worst is yet to come.... People are going to be in survival mode.... Everything you see in the mall, they're buying less of.
Our supermarket clients are telling us that the most popular items are not brands, they're private label, because that sells for less....

Prices are going to continue to come down dramatically...
When you take something like apparel, 70% off is the new 50% off...
At the end of the day in apparel you're going to have prices way down, 30-40% down from where they were, or the consumer simply won't buy them. The consumer will wait out the retailer. They won't buy.
What will happen is you'll have more private label goods, which will sell at lower prices, and that will attract the consumer."
--Howard Davidowitz, speaking in two interviews on Yahoo Finance's Tech Ticker 2/17/09

I liked these quotes from Davidowitz because they support things I have been arguing for a while on this blog. I have also asserted that the drop in home prices will become a prolonged drag on the U.S. economy, although I tend to take it a step further than Davidowitz.
I also like his argument about falling prices, because I have been warning about deflation for a while now. Finally, he mentions the rise of private-label consumer goods two separate times. I gave a historical and somewhat philosphical explanation of this phenomenon in an earlier blog posting.


"They're trying to preserve and restore the old market. They're trying to restore the securitization market ...
What they're trying to still do at the Treasury is go back to the future. And, I think the more basic question we have to ask is, what are we going to have to say to investors that's going to be credible? -- That's going to stabilize expectations for the future? Because his proposal right now is not dealing with that." (Emphasis added.)

I like Whalen's comments because they support this an argument I made in this blog entry. This is why I have argued in recent weeks about the need to restore the profit motive and normal financial behavior to the market, so that reforms are sustainable. Even if it means making significant superficial changes -- like letting Citi and Bank of America fail -- this would be better than trying to find ways to make it look like the old system is still working. (Such as by insuring their bond issuances and making capital injections.)

To properly frame this argument, I'd like to return to my roots as a social anthropologist and draw some inspiration from German thinker Max Weber, who spent a lot of time examining how people look at the world. In his most famous book, The Protestant Ethic and the Spirit of Capitalism, Weber argued religious convictions like predestination and a disdain for idleness helped drive modern industrialism. A key subtext about Weber's argument is the accidental nature of this religious influence. People didn't say, "I want to be rich, so I will embrace Calvinism." They embraced it as a religious faith, which then had unintended consequences. This is essential for anyone who wants to truly understand history. (Most people who examine their own lives will find the most important things are unplanned or unintended.)

For instance, some people say the U.S. fought the Civil War to "end slavery," which is simply untrue. Washington waged war to maintain the Union. In 1862, Abraham Lincoln issued the Emancipation Proclamation to strengthen his position in that conflict. The move solidified his standing with increasingly important Anti-Slave forces and gave the North a moral upper hand in the eyes of the world, preventing the UK and France from supporting the Confederacy.
In other words, the North didn't fight the Civil War to free the slaves. The North freed the slaves to win the Civil War! It might seem like an inconsequential point now, but it shows the importance of understanding why and how people do things because history is often the result of unintended consequences. A good leader will always focus on winning, even if it means changing the goal to exploit the opportunities that present themselves. The great man doesn't ask "what do I want?", but "what is possible?"

You know that neither Tim Geithner nor Ben Bernanke are great men because they are trying to do the impossible. Instead of focusing on halting home price declines and restoring some semblance of reality to the credit market, they have implemented countless band-aid measures that will leave the patient dysfunctional for years to come.

Many crises in history result from people trying to do what's established and traditional when reality has changed and different actions are needed. This was true in WWI, when European military commanders ignored the lessons of the American Civil War lost millions of men on hopeless frontal assaults. Our economic generals at the Fed and Treasury also misunderstand reality with amazing regularity.

I highlighted the points from Whalen above because it reminded me of a passage from the Georgetown University's Carroll Quigley which I quoted in the blog posting referenced above. Quigley, a brilliant historian and economic expert, placed heavy emphasis on the intellectual paralysis before the Great Depression as politicians and central bankers refused to appreciate how much the Great War had changed the global financial system.

He says that after WWI ended, policymakers tried to force a return to the pre-war 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...
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."

He also mentions that, even as policymakers tried to restore the gold standard, they also tried to hoard bullion -- undermining the free flow of gold the gold standard required. This reminds me of our current credit market, where the Fed and Treasury have extended a confusing mishmash of guarrantees and supports while pushing rates to insultingly low levels. (I have opposed Fed rate cuts from the moment they began in the summer of 2007.)
Just as the sterilization of gold and big war debts prevented the old money system from working in the 1920s, today's mountain of ad hoc measures rules undermine the transparency and individual profit motive necessary for the credit market to function. Instead of saving the system, they are slowly killing it. The patient is has a gangrenous leg. A sensible doctor would cut it off to save the life. Ben Bernanke is ignoring the severity of the infection because he doesn't want to be the guy who cuts off someone's leg. His squeamishness will cost the patient his life.

In the case of the Civil War, the intention was the save the Union. The end of slavery was an unintended consequence (and obviously a good one.) An even more interesting way to look at the situation is to ask why the South even tried to secede? It wasn't to keep their slaves, because only the most radical and marginalized absolutionists spoke in favor of ending slavery before the war began. I believe Southerners fought out of a commitment to states' rights, a sense of inferiority towards the North, a sense of self-doubt because of slavery (after all, if you "fight for freedom" it helps you delude yourself into thinking you stand for liberty) and their own desire to re-enact the American Revolution. The South also had a proud citizen-soldier tradition and many men grew up hearing stories of the victory over Mexico. (For more, see Why Confederates Fought by Aaron Charles Sheehan-Dean. Link) These factors all combined to make them want to fight, but have been lost to history. All we know now is they fought to defend slavery and lost. (Another, even more interesting point is that, if they hadn't fought, who knows when slavery would have ended? Their stupidity and eagerness to fight did more to end slavery than did Northern heroism.)

My point is that history doesn't care what you mean to do. It only looks at what happens and that will become your legacy. Say I am a news reporter going to a press conference on credit ratings, and instead learn of a hugely important merger. I can chose to stick to my original story, or I can adapt to the new reality and break the takeover story. In the end, no one will care that my intention was to cover a boring credit-rating seminar. I would be judged by the merger story.

Likewise today, history won't care that Bernanke/Geithner are trying to restore the old financial system. It will only judge them by the consequences of actions. (That's why we snicker at the Fed's decision to raise interest rates at the start of the Great Depression, not realizing that it made a lot of sense when they did it. Today, we just call them stupid for removing credit at the start of a Depression.)

Just like 78 years ago, the authorities are ignoring the new realities at hand: unending declines in home prices, the unprecedented role of securitization and speculation in this crisis, or the failure of interest-rate cuts to fix the problems. (See this blog posting and this one for more.) This is why Whalen's quote was so salient to me.

Finally, I want to comment briefly on today's trading, which was shockingly bad. The S&P 500 made a huge gap lower. I am not sure whether it will try to rally back to fill this gap at least partially in coming days, but the momentum is clearly to the downside. The S&P500 took out the key support level at 800. Furthermore, the oscillators are looking bad. My slow stochastics has shown a cross below the 20% line. That has happened five times since November 2007, and each instance was followed by significant downside.

The night of Feb 9, I correctly called a top for the market, arguing that money would flow back to Treasuries and away from stocks. This is now happening. Despite all the talk about deficits, etc, Treasuries offer major value at these levels -- especially at the longer end of the yield curve. I expect to see money flowing out of stocks and back into the 10-30 year space. As I have been thinking all along, the "reflation trade" was a perverse thought by equity managers with too much cash on their hands. (Idleness might be the devil's workshop, but "dry powder" runs a close second...)

I have been predicting a 480 level on the S&P500 since November. I am sticking by that call.

Sunday, February 15, 2009

The Curse of Real Estate

I want to delve deeper into something I mentioned in an earlier blog posting because its importance is growing clear to me: THE REAL-ESTATE MONEY STANDARD.

It's key to understand that our monetary system has quietly undergone a major change during the last century, evolving from a solid gold-based currency into a pure "fiat system." While these innovations had few immediate impacts, they gradually allowed major distortions to occur. That's why I've been arguing it will take decades for the U.S. to recover from this crisis, which is closely linked to the collapse of home prices. Additionally, the inability of policymakers and politicians to understand the true nature of our problem will worsen the crisis, which is exactly what happened during the Great Depression. (See the Carroll Quigley quote in this post for more on that.)

Under a traditional gold-based money system, the demand for credit follows a natural balance between supply and demand. An economy with a strong growth potential but a lack of investment can pay high interest rates. Investors will respond by lending to profit from the high rates. That allows investment to occur, which results in growth and income. The economy in question grows, allowing people and companies save money. This results in more capital accumulation, which causes interest rates to fall. Investors then look to another country, or another industry that needs money and is capable of earning a higher rate of return, and the cycle begins anew.

This is classic credit market theory 101. Just like any other market, the supply/demand dynamic maintains an equilibrium over the long term. It determines an economy will get the right amount of credit it needs, when it needs it. Money is like a migrant day laborer who washes dishes, delivers Chinese takeout, or builds houses, depending on what pays best at any given moment.

In recent years, a very different system emerged that prevented these mechanisms of supply and demand from functioning correctly. These were related to the U.S.'s stature in the world, a speculative bull market in home prices, the nature of our regulatory system and the abandonment of the gold standard.

Banks were comfortable making home loans because "houses never lose value." Thanks to securitization and a steady decline in interest rates, mortgage lending increased steadily. As the lending grew easier, home prices continuously rose. Higher prices in turn allowed people to refinance mortgages with bigger principals, resulting in even larger amounts of debt. Homeowners spent that money by taking cash directly at closing or by saving less money because they were "building equity" in their homes.

Americans also purchased more goods from abroad as consumption rose. This caused foreigners to amass trillions of dollars in savings, which they lent back to us by purchasing corporate bonds and residential mortgage-backed securities/asset-backed securities (RMBS/ABS). This provided even more credit to homebuyers, driving prices higher again. See this posting for more.

The tendency of foreigners to invest a large portion of their money into the US credit market was a statutory factor. This is a new concept I would like to introduce. A statutory factor is one that's based on rules and cultural preference rather than market forces. For instance, Chinese factories made toys and sneakers for Wal-Mart under long-term contracts denominated in U.S. dollars. (These contracts were always in U.S. dollars, as the 10-K of any major importing company will demonstrate.)

China wanted to make as much stuff like this as possible to employ its impoverished masses. This quickly produced a glut of greenbacks that had to be managed. If the Chinese authorities allowed the dollars to be converted into yuan, it would have caused their currency to appreciate and ultimately made their exports more expensive. Secondly, it would have flooded their own economy with money and caused inflation.

In response, China forced banks to keep some of that money in the form of dollars. (This is reminiscent of the process of "sterilizing gold," when one country's government would take gold out of circulation to prevent currency appreciation and credit growth. It's worth noting that European and the U.S. countries began sterilizing, or hoarding gold, after WWI. This contributed to the financial paralysis we call the Great Depression.)

China's preference for U.S. fixed-income assets resulted from an explicit government policy, making this a statutory factor. It was not the result of normal supply/demand factors. Large amounts of money also flowed into the U.S. credit market from oil-producing states via London.

Furthermore, the U.S. dollar has been the global reserve currency since the end of WWII, serving the same role as gold in the 19th century. That also created a huge artificial international statutory demand for dollar assets like U.S. mortgage-backed securities.

Within this world of dollar assets, other statutory factors were at work. First, there was the belief that home prices could not systemically fall in value. It was never an official law, but it was the assumption of every credit model used by Moody's or S&P when they rated trillions of dollars in mortgage-backed securities. And, the rating agencies did have statutory power: The Securities & Exchange Commission dubbed them "Nationally Recognized Statistical Rating Organizations," while their opinions were used heavily by bank and insurance regulators to set capital adequacy ratios. (Also see Table 6 in this Fed report for an idea of it works.)

Another major statutory factor was the government's indiscriminate encouragement of home ownership. This took shape over decades as roadbuilding was subsidized and government-backed organizations like Fannie Mae supported owner occupancy. For instance, if you own a house as a landlord and rent it out, your mortgage is "non-conforming" and your rate will be higher. If you own an apartment building, the politicians would never dream of subsidizing your loan. This determination is written directly into the lending guidelines. Investors are just considered to be riskier, regardless of their financial strength.

These statutory factors forced capital unnaturally into certain kinds of investment. Now we must pay the price for creating such a distortion. It's like a restaurant locking a wage laborer in a kitchen and paying him less than he'd get from building houses down the road. When he finally breaks free, that restaurant will never be able to get him back again -- no matter how big the pile of dishes in the back.

Also contributing to the mess was the rise of hedge funds and "leveraged players" in the credit market, such as structured investment vehicles (SIVs). These folks added hundreds of billions if debt to the system, often borrowing in yen or swiss francs to fund their activities. That's why both currencies have been surging higher as investors scramble to pay back those loans. This posting explores the phenomenon in greater depth.

In sum, a long history of rising home prices, recycled trade dollars, "financial innovation" and statutory factors drove a self-reinforcing feedback loop: Houses kept getting more expensive and more credit kept getting created. It was a monetary perpetual-motion machine that made everyone richer until it stopped. At some point, all bubbles come to an end.

In the old system, money was fundamentally linked to the supply of gold and silver. When the Spanish stole precious metals from the Americas in the 1600s, it increased the amount of money in Europe and caused inflation. Inversely, financial panics in 1837, 1857 and 1907 each resulted from a physical removal of gold from the U.S. economy. For instance, the SS Central America, sunk with 30,000 pounds of gold on board in 1857. In 1907, gold flowed out of New York banks as insurance companies paid claims resulting from the massive San Francisco earthquake and fire.)

Today places like Las Vegas, Miami and Phoenix are having the same impact on our credit system. Under our recent bubble system, money was based on home prices. Now that they're falling, it's the same thing as a shortage of gold in the 19th century.

Each of these previous crises was severe, but relatively short as bullion flowed back into circulation. Even in the age of steamships, precious metals move more quickly than home prices. Given the likely slummification of suburban America and long history of appreciation, I fear we now face the equivalent of a long, gradual shipwreck. (For more, look at my discussion of Fibonacci analysis on the OFHEO index in this posting. I see prices dropping another 17-29%, which would represent another $3-6 trillion of wealth destruction.)

Instead of a sudden crisis, it will be a steady bleed on the economy for years to come. Even though it was never in the textbooks, our modern money system was based on rising home prices just as much as the old money system was based on physical gold. That's one reason why the Fed was unable to stop the price gains by raising the overnight lending rate. It was a bull market with its own momentum. Houses were appreciating as an asset class, generating new wealth and new credit in the process.

Now that houses are getting cheaper, it's harder to originate new loans. I first predicted this late last year, and it was confirmed in a recent article from CNBC:

With mortgage rates at 25-year lows, refinancing applications have reached record levels in the last two months. But homeowners who bought during the boom years are getting squeezed out of refinancing because the value of their home has plummeted...
For homeowners, many lenders don't have an incentive to refinance a home that's valued lower than the original price. "Unfortunately, we run into that a lot," says Steve Habetz, CEO of Threshold Mortgage. "People call us to refinance that don't have enough equity and we have to say no. We try our best, but you can't force a bank to refinance them."
In the boom times of real estate, home appraisals helped create what some say were higher than actual price values. But now experts say appraisers are taking a different more realistic approach that's actually hurting some refinancing. "My own opinion is that appraisers were under pressure to submit higher prices," says Ent Credit Union's Paukovich. "But now appraisers are more conservative. The purchasers of the mortgages want them to be conservative and much more thorough."


Bubbles usually follow years of steady price increases, which lead people to trust the asset in question: Tulip bulbs appreciated steadily for decades before reaching a fever pitch and collapsing in 1637. U.S. stock prices had risen steadily for over a decade, and proven their mettle by rebounding after the October 1987 crash. That kind of resiliency was an essential component of the bubble that finally broke in March 2000.

The thing that makes a bubble a bubble is that nothing, and no one, can stop it. Like a plague striking a new population, an economy's defences are impotent against it. (This is what makes it a bubble.) In many cases, the regulatory structures themselves are co-opted by the fever, just as a virus takes over cells in the body to reproduce. (For instance, the SEC allowed more leverage, and the rating agencies promoted securitization.) Things that once protected the host economy, such as rules of credit analysis and concepts of safe lending, were exploited by the illness.

In the late Middle Ages, rising farm productivity and widening trade allowed the rise of towns and cities. People lived longer, had more access to information and more economic opportunity. It all all sounded great, until the Bubonic Plague came in 1346 and flourished precisely because of concentrated population centers and transportation networks. If it hadn't been for Europe's relative wealth and success over previous centuries, people would have still been living in isolated villages. The plague wouldn't have swept the continent like fire through a dry forest.

Similarly, without decades of successful mortgage lending in the U.S., the housing bubble never would have hit the U.S. economy. Despite economic crashes in 1981, 1989 and 2001, home prices kept going up nationally. (The OFHEO home price index never fell more than one quarter in a row, or dropped more than 0.4% at once until 2007. In Q2 of 2008, an unprecedented phase of declines began. I fear it will last for years.) That made the credit system trust home lending, laying the cultural basis for the bubble.

Rising home prices begot more credit, which in turn pushed home prices higher and allowed more lending and consumption. As I argued above, none of the checks and balances present in the self-correcting model were present in the housing boom.

I want to conclude with a few thoughts on inflation. Many people expect some kind of runaway inflation in the U.S. because of all the "stimulus" and "bailout money." I think we're actually going to get deflation because these same actions will prevent economic recovery and keep the credit market in a kind of medicated coma.

The inflation hawks point to places like Weimar Germany and Zimbabwe, where the government literally printed huge amounts of money. I would also include the cases of the United States during the War of Independence and the Confederate States during their failed bid at seccession. Both suffered runaway inflation after printing worthless paper money. In all of these cases, the supply of money increased faster than the supply of goods and services.

In our current situation, we're seeing an opposite situation, where the supply of stuff is going up along with the new money being created. Based on the pace of home sales (months of inventory), we now have more houses than at any point on record. We also have so much oil that full tankers wait at sea, millions of workers stand idle while factory utilization plunges. All the data suggests we have too much stuff right now, not too little. For instance, the last GDP report was artificially inflated by excessive inventory building. (This is another similar characteristic we share with the Great Depression.)

Our situation is completely different from previous bouts of inflation. The potential for price gains does exist in the future, but it will probably result from a collapse of the dollar and economic growth outside the U.S., which could drive prices higher for commodities and merchandise. That will probably happen at some point, but it will take a lot longer than people think. After all, the global economy is dependent on the U.S. consumer. The people of China and India will eventually pick up the slack, but it will take years.

Few things have attracted as many passionate debates as the causes of inflation. Thanks to Milton Friedman, many economists rely on confusing strings of Greek letters to explain the dynamic between prices and money:

(Friedman's "Quantity Theory of Money". See this for more.)

I won't pretend to understand what this formula means, but I know Friedman's most famous dictum: "inflation is always and everywhere a monetary phenomenon." I think it's best to avoid using the word always when you're dealing with groups of people. After all, many were convinced "home prices always go up." Markets frequently do all kinds of crazy things few people expect or immediately understand. (That's why they're so much fun.) As we saw with bubbles and plagues, systems often sow the seeds of their own destruction.

Friedman was famous for embracing human freedom. If he were still alive, I would ask him: If people shouldn't be constrained by a conscription or a monopolistic public school system, why should prices be restrained by the actions of a government or central bank?

In reality, they're not. Like everything else in economics, it all comes down to supply and demand. If people want stuff and are able to pay for it, prices rise. If producers make too much stuff, or people stop buying the stuff, the price goes down. Sometimes -- but not always -- the government's creation of money corresponds to more demand for stuff. This is often true during war, which consumes huge amounts of materiel. But, it wasn't true for Japan over the last 15 years, and it's not true for the U.S. now.

That's why the current moment is such a challenge. To borrow the analogy of the tree falling in the forest, if the Fed prints money and no one uses it, does it create inflation? Right now they are trying to replace money destroyed because homes lost value. Unlike printing money to pay for a war, this process doesn't result in real demand for anything, or real purchases. No human being is putting in extra hours of work to built a fighter plane or tank. Fuel and steel isn't being diverted from the consumer economy to a war effort. Abstract concepts like "money supply" or M1/M2 don't explain what's happening, because all of those concepts simply assume that money created by a central bank will actually be used. As Ayn Rand constantly said: "Check your premises." In this case, the premises of the inflation hawks are completely wrong.

This is the paradigm I use to understand the inflation of the late 1970s: Too many people wanted stuff, but there wasn't enough to go around. The Vietnam War and devaluation of the dollar started the price increases in the early 1970s, and were followed by the oil shocks. But, the icing on the cake was the maturation of the baby-boom generation. Millions of people born after WWII became major consumers as they started families and bought extra cars, bigger houses and washing machines .... more of everything. The U.S. economy was also much more self-contained, with oil as the only major import. In 1974, the trade deficit was just 0.05% of GDP, compared with more than 5% when the credit bubble peaked in the 2005-2007 period. That allowed domestic producers to control prices in a way that doesn't exist in today's world of global supply chains.

John Kenneth Galbraith described this in his classic book Money: Whence it Came, Where it Went:

The market power of corporations and unions ... could keep prices going up ... Everywhere the less privileged were asserting more strongly their claims to some part of the consumption that previously had been thought the natural right of only the privileged... The tendency for the claims of consumers to press ever more insouciantly on the capacity to supply them -- and the associated and by no means unnatural reluctance of governments to limit these claims -- was one cause of inflation in the industrial countries. (Excepted from pages 348 and 355-6 of the 1975 paperback edition.)

This only ended when Fed Chairman Paul Volcker caused a recession by raising the overnight lending rate to 20% in 1981, which halted the rise in oil prices and broke the back of inflation. Importantly, consumer discretionary items like apparel and durable goods kept getting more expensive despite the recession because they were still largely manufactured in the U.S., with high labor costs. In subsequent decades, these same industries would attract major foreign competition. Many of the jobs moved to Asia, which made the merchandise cheaper than ever. (This also caused the trade boom, which eventually fueled the housing bubble, as I explained above.)


Energy: -10.4%

Housing: +30%

Apparel: +14.8%

Consumer Durables: +22.5%

Services: +42%

All Inflation: +27.1%

(To replicate my data query, begin here.)

Again, inflation is all about supply and demand!

Wednesday, February 11, 2009

The Baltic LIE Index?

SUMMARY: The recent rise in the Baltic Dry Index may result from a glut of unused oil rather than reflect economic strength. It may be sending a false bullish signal.

In recent years, a new measure of economic activity has gained popularity: The Baltic Dry Index, which measures the price of shipping raw materials by sea. It climbed during the global growth period of 2003-2007 as China's surging economy consumed huge amounts of iron ore, soybeans, etc.

When the economy hit the wall in September and October of 2008, the Baltic Dry Index plunged as well. Since mid-January, it has rebounded sharply, causing many optimists to view it as a bullish leading indicator. They dreamily speak of a "reflation trade," dismissing stark deflationary warning lights flashing across virtually every economic report.

While I believe thoroughly in data and study charts, I always try to ask: "Does this make any sense?" In this case, my answer is emphatically NO. That's why I am warning people not to be lulled into a false sense of bullishness by the Baltic Dry Index. It might be a lie.

Here's why:

Thanks to the global economic slowdown, oil prices have completely collapsed. Many people who paid $50-60 a barrel (or more!) last year now face the prospect of selling it into a market priced in the mid-30s. So, they are holding on to it in hopes of selling it later at a higher price. On-land storage tanks are already full. (For readers with more knowledge of the market, this results from "contango" in the crude oil curve.)

This is from a recent report in the Calgary Herald:

Inventories at the storage hub at Cushing, Okla.--the delivery point for U.S. crude futures--have surged a whop-ping 139 per cent to near the available capacity since early October, as sliding energy demand makes holding oil more profitable than refining it.

Energy analyst Stephen Shork recently summed it up on on Bloomberg Radio: "You can't swing a cat without hitting a barrel of crude oil in the United States."

Because there is so much extra crude around, people are leaving it on oil tankers at sea. This is apparently removing tanker capacity from the system and driving up shipping rates. (Despite its name, the Baltic Dry Index also covers shipping rates for liquid cargoes.)

In other words, the weak global economy has depressed oil prices so much that people are holding crude hoping for better prices down the road. This is creating an artificial demand for shipping. As Shork further explained:

"Every trader who wants to buy oil now will buy oil, put it into tanks and sell the much more expensive contract down the road. It's actually an incentive to build storage."

I have been suspecting this for several weeks and have not yet seen anyone put the pieces together. At first, I thought I was just missing something, but today my suspicions were validated. I was attending a meeting of market analysts and asked this exact question. One of the moderators, who is well known and respected, dismissed my question out of hand as "too complicated" to worry about. "We're just trying to make money," he said, shrugging off my inquiry.

As a journalist, I have learned that the most important questions are often those that people don't want to answer, so I thought I was on to something. Immediately after the meeting, a fellow who identified himself as a hedge-fund consultant came up to me and praised my question. I don't remember the number he gave me, but he told me that I had hit the nail on the head and that the recent rise in the Baltic Dry Index reflected little more than all the tanker capacity getting tied up at sea.


My argument remains the same: We are in the early stages of another Great Depression. The first depression ultimately resulted from the inability of the global economy to absorb all the productive capacity of the U.S. economy, which had DOUBLED in size during the World War I.

It was also caused by less global trade, which resulted from the collapse of the British gold standard. For more than a century, the world's economy grew as gold seamlessly flowed from one country to another. That abruptly ended in 1914. Is it any surprise the whole global economy shut down as a result?

This time, the global economy has grown on the back of the U.S. consumer. Instead of a gold standard, we had a real-estate standard. Credit growth was ultimately based on the value of U.S. home prices. It was a perverse cycle that most people are still not fully aware of: Houses never lost value, so banks gladly lent against them. That helped drive prices higher, which in turn made Americans richer. This allowed them to buy more consumer products.

Because of globalization, an increasing number of those products came from abroad. The more we bought from overseas, the more dollars foreigners had. Instead of exhanging their dollars for rupees, yuan or dinars, they invested those dollars back into the U.S. bond market. This resulted in a credit bubble, which in turn pushed home prices even higher. (See this blog entry and this one for more.)

In sum, credit creation was based on the value of U.S. home prices, which in turn drove the global economy. (The U.S. consumer was the one buying all those items coming out of China, and the U.S. consumer got his money from his house.)

This was a sick and bizarre non-system that was destined to crash at some point. Most people would probably think I am crazy to make these these points. But most people just 18-24 months ago would have thought Ben Bernanke crazy for talking about providing several trillion dollars of extra liquidity, or pushing rates close to zero. Most traditional-thinking economists would also think it's crazy that we can print money at such a pace without triggering runaway inflation. But, that's exactly what Japan did and what we're doing now.

(While I cannot help but fear we'll get inflation at some point, I am increasingly convinced we're going to experience significant price declines first. Inflation fell by at least 1% in the last three months of 2008. The last time that happened was Dec. 1930-Feb. 1931! It's time to stop pussy-footing about and accept this reality. The Depression is here.)

I suspect this distorted house-based money standard results from our abandonment of the gold standard over the course of the previous century. In days of old, countries needed to possess actual gold bullion in order to create money, providing a natural brake on credit growth. I think that something like this was bound to happen, given the gradual rise of a completely fiat-based money system. A frenzy of unchecked lending, fueled by a global trade bubble and the alchemical cult of securitization, fueled the construction of millions of extra houses and a surge in productive capacity around the world to fill them with flat-screen TVs, furniture and clothing.

Previously, money was "priced" in gold, not the other way around. You needed more actual gold to have more money. It was a one-way street. Under the real-estate money standard, houses were priced in money and money was derived from real-estate values. More lending pushed home prices higher, which begot more credit. It was a monetary perpetual-motion machine.

(Another point on monetary economics is the recent strength in gold and silver. People are buying these metals expecting a long-term paper-money crisis. This is a nascent trend, but could be hugely important. This is a different kind of bull market for gold than we saw in the 2003-2007 period, when it served as a hedge against inflation and a falling dollar.)

This is reminicent of what happened during WWI, when JP Morgan Jr.'s decision to prop up the UK and France perpetuated a conflict that killed millions of people and gave a false stimulus to the U.S. economy, which in turn ushered in the Great Depression.

Eighty years ago, the U.S. provided ammunition, meat and fuel to the Allied war effort. This time, China provided everything from sneakers, pharmacueticals and wallboard to the American consumption effort. Now we have too many houses to live in, and they have too many factories and workers to provide our economy.

This is only going to get worse as home prices continue to fall, as I argue in this posting and this posting.


Readers might be tempted to dismiss my fears about the economy as too dire. But I am in the very best company. Heavy hitters at Pimco are essentially arguing the same points. For instance, I have not heard Pimco CEO Mohamed El-Erian say a single positive word on CNBC or Bloomberg in months. Don't just take my word for it, check out his last appearance:

"I think the employment number is very concerning. The acceleration of job losses is of particular concern... We are in the midst of something very different. It's more than just a synchronized and severe global recession. It's more than just a banking system that's not functioning... Even those who can spend are not spending."

Of course, El-Erian is extremely pleasant and gives this grim news with a smile. Don't be fooled. He's both extremely bearish and one of the smartest people alive.

Now Pimco's Asian head of credit research, Koyo Ozeki, is weighing in. This guy, who seems to know the Japanese crisis inside and out, tells us what we have coming:

He says that the government cannot stop asset prices (real estate prices) from falling, which could trigger 3+ years of deflation. Declining prices and falling employment will cause more companies to go out of business. Looking to Japan...

"The slump in share prices was even greater in this second wave. In the present global turmoil, a similar second-wave crisis is likely, and it is unclear whether capital injections of the current magnitude can counter such an impact."

And, as I have warned in previous postings, the lower home prices could impair a huge chunk of the loans on banks' balance sheets for years to come. (Mortgages are paid back when people sell their houses. If homes lose too much value over time, all the loans will be impaired. People don't have to go delinquent for this to happen.)

Ozeki concludes:
...the economic setback is still in its early stages, and any further decline in housing prices could accelerate the downturn, intensifying the pernicious feedback loop and possibly leading to a second wave in the financial crisis in the next 6–12 months.