djr-musings

starting over for real this time, but not from scratch

2010-01-03T14:29:00.007-05:00

I haven't posted on this blog for a long time, but will probably post ideas from time to time -- especially more spiritually oriented things.
The year 2010 is off to an interesting start. Several people I know had their New Year's Eve plans foiled, either by needless quarrelling, illness or simple miscommunication. I don't consider this a bad omen at all, but rather an indication of what the year will be like. It will be a year of challenge and obstacles, but also a year of triumph. Unlike in previous times when things fell together so easily in my life or the nation's economy, we are in a new era where we must carve out a new future and new circumstances. It will be fraught with some difficulty, but also great joys as we embrace aspects of ourselves we always knew existed but didn't use. Talents and strengths built in other endeavors will be used in completely new ways.
For the past 60 years, our country and culture have fallen back on the comfortable institutions born out of WWII: housing, higher education, highways and mass consumption. They served their purpose, but have become false idols that must now be replaced. Just as religions need periods of revival when they return to their real message and purge corruption and distraction, we as a country and economy must get back to the real messages of freedom and prosperity.
These cannot come from more government, which by definition can only act by taking people's liberty and/or wealth. (Think of any government action: All require as a philosphical necessity telling people what to do, or taking people's money. Taking liberty or taking wealth.)
With spirituality relegated to the privacy of individual lives, we have embraced government as the new religion. While few would place absolute faith in the actions of another human being such as a neighbor or even a spouse, our current policial philosophy requires complete and utter faith in the cumulative actions of all them.
People have sought out new absolutes: houses never lose value, a college education is always good, America will never default. We have built entire industries and financial systems around these beliefs, and millions of people have realigned their lives based on these principles. The housing bubble collapse should serve as a stark warning to everyone that these shared public morals are little more than mantras and slogans. They are built upon the sand of a country that had a massive savings glut and consumption shortage at the end of a great war. This false trinity of beliefs in housing + consumption, higher education and big government can traced to specific socio-economic realities in the 1940s that are no longer true.

Instead of embracing the sand of a bygone era, it's time to turn back to the real principles. In the metaphor of building on sand, the sand itself my not be permanent, but gravity is. In our economy, housing and education might not eternal, but profit is. For many years, profits could be made simply by building houses. It was a very solidly packed sand we mistook for bedrock. But it was still sand, and now it's coming lose.

In our own lives, we must avoid the temptation to deny reality. We must avoid the temptation to pretend the sand is bedrock. We must avoid the false comfort of repeating something that used to be true as if though it's eternally true.

The more I study economics or any other human endeavor, I realize there are only two absolute truths:
1-We're all going to die
2-Jesus loves you

It's not always true that low interest rates help the economy, or that a higher education is always good. We need to put aside this foolish and childish bromides and embrace the new reality of the 21st century.
The important thing to remember is that in 1850, a century before the post-WWII era began, there were no academics who argued for the merits of housing or higher education. These things grew out of the reality of 19th and early 20th century America, based on natural interests. There WAS a time when higher education was highly beneficial, and there WAS a time when the promotion of housing was an intelligent way to drive the economy.
But that time has passed. As an economy, we must raise interest rates so the bad banks fail and their mispriced assets are thrown onto the open market. Entire cities and municipalities must go bankrupt and hundreds of thousands of underproductive public-sector workers must lose their jobs. We must face the reality of the 21st century at a time of our chosing, or that reality will one day face us at a time of its chosing. Like an enemy that's allowed to rebuild after a defeat or a tumor that's ignored, this reality will fester and grow into a mighty wave of governmental dysfunction and public-sector insolvency that will destroy all liberty and all society. It must be stopped now before the inevitable happens and the United States defaults on its debts and money ceases to exist.
As individuals, we must stop embracing the convenient. We must stop taking emotional solace in superficial pleasures and those things that have sustained us in times when we were out of touch with our own hearts. We must find that pillar of iron within each of us, that innate core that we never wished to compromise. Instead of ignoring what really matters, we must embrace it and grow in a new direction based upon it. The old directions, like housing and higher education, are well travelled and putrid. We need newness based on the fundamental, just as Baudelaire described modernity.
This brings me to the weekend's heavy emphasis on Isaiah and Matthew:

Arise, shine for your light has come, and the glory of the LORD has risen upon you.
For behold, darkness shall cover the earth, and thick darkness the peoples; but the LORD will arise upon you, and his glory will be seen upon you.
And nations shall come to your light, and kings to the brightness of your rising.
Lift up your eyes round about, and see; they all gather together, they come to you; your sons shall come from afar and your daughters shall be carried in their arms.

In Matthew 2, we read of the wise men visiting the Baby Jesus. Kings from afar come to pay homage to the light. Mighty men of power of wealth subordinating themselves to a poor child in a stable.

So it will be in politics, economics and our own lives. In economics, light of real truth (profits) will cast out the darkness of government-imposed temporary truths (housing and higher education)... So it will be our own lives: The light of real faith and real values will cast out the darkness of convenience and habit. And so it will be in politics, where the eternal truth of the constitution will cast out the darkness of statism and unthinking government fiat.

We have lived as children for the past 60 years in this country. We trusted in simple truths like housing, higher education, big government (which implicitly means the USA can never default). We used collective definitions of value to avoid thinking: If you don't know what else to do, build a subdivision and a strip mall. If you don't know what else to do, get more education. If you don't know what else to do, buy Treasuries.

These beliefs kept us like children who don't have to fend for themselves because their parents are always there to help them... always there to kiss their scraped knees when they fall, or to pump trillions of dollars of "liquidity" into the financial system to "avert crisis."

How many parents want their kids to come back to them when they are 15, 25, and 35 asking for more bandaids? Indulging a child at age 8 is one thing, but coddling millionaires in fancy suits is downright immoral. It's equally wrong to treat adults as children, assuming they need someone else to provide them with food stamps, healthcare and unemployment benefits.

As St. Paul wrote in 1 Corinthians: "When I was a child, I talked like a child, I thought like a child, I reasoned like a child. When I became a man, I put childish ways behind me."

Bromides such as "economic stimulus," low interest rates and stimulus programs designed to keep state and local government employees in their jobs are childish things. It is not compassionate to treat adults as children, and it is not moral to shield grownups from the consequences of their own actions. Trillions of dollars worth of capital were misallocated in this economy. The people who did this must face the consequences of their actions.

They have been fleeing this reality for decades as government regulators and Fed officials coddled them with regulatory forbearance and easy money, licking their wounds with kindness rather than making them live in the reality inhabited by everyone else.

But truth cannot be avoided. It's time to put aside false gods and to draw upon the ultimate reality we carry within. It's time to stop doing the convenient and easy and to do what's true.

I pray to be a bearer of light in 2010. Like the mishaps of new year's eve, it won't always be convenient. But the truth is now clear in my heart. We are no longer children. It's time to retake our lives, our economy and our country from the forces of darkness. There will be setbacks and failings along the way, but I am now clear what must be done. I pray for all those who share with me, and for my enemies. So many of them are trapped in darkness. Let us be humble, honest and free of rancor as we strive to set them free.

"The people of darkness have seen a great light.
The Lord of our longing has conquered the night."

And so shall we.

New Home for My Writings

2009-03-15T23:20:00.001-04:00

I will be posting much less on this blog going forward to focus on writing columns for greenfaucet. My articles will now be available at:

http://www.greenfaucet.com/more-exclusives/86188?user_id=838

A Hidden Tax on Banks

2009-03-10T02:08:00.008-04:00

Yet again, the government's policies are proving procyclical and seem to be making problems worse. This time it turns out the FDIC is making banks pay through the nose to insure their deposits, according to William Dunkelberg, the chief economist for small business group NFIB and the executive of a small bank. Today on Bloomberg Radio, he was asked whether the rising fees are hurting banks:

"It truly is. When we saw the proposals for this year we were astounded at the huge cost . It basically puts a real hole in the profitability of the bank ... If you don't have earnings, you can't raise new capital effectively, and that means you can't grow, you can't make the loans and you can't capitalize yourself the way the people in Washington are tyring to tell us we should do..."

Dunkelberg then notes that many healthy banks are being forced to pay for the messes created by defunct lenders such as Washington Mutual. Again, where are the priorities on the bailout bill? Why don't we budget extra money for the FDIC instead of punishing innocent banks? I would like to know what happened during the S&L crisis, which caused a huge fiscal deficit. Was the taxpayer ultimately on the hook in that case?

Dunkelberg says his bank's rate rose from 7 cents per $100 in deposits to 14 cents to 16 cents. And now there is also a new 20 cent "assessment" in the autumn. All of that will consume 80% of his company's expected profits for the year. He also notes that the Fed's recent rate cutting has punished his bank by forcing down the "prime rate," which is essentially 3 percentage points more than Fed Funds. (Another unintended, credit-ruining implication of the Fed's reckless and irresponsible policy of monetary easing.)

"The government keeps taking all my money." -- William Dunkelberg.

PONDERING THE VIX

I have a second, vaguely related point about insurance. At Monday's meeting of the Market Technicians' Association in New York, some questions were asked about why the VIX volatility index has remained relatively low even though the stock market has continued to make new lows.

One possible explanation offered was that the VIX is consolidating above the 44 range, which was more or less the top for the index in the 2000-3 bear market. That would make it a simple case of resistence becoming support and be consistent with a bullish uptrend for volatility.

I want to throw out a second possibility purely as a theory and am yet not sure whether it has any merit: The reduced market cap of the S&P500 has resulted in a situation where there are fewer assets to insure against downside. That means the system has extra capacity to insure against loss. More people are selling protection than people need to buy it. Imagine what would happen, for instance, to auto insurance rates if suddenly a third of the drivers in a state decided to get rid of their cars. Insurance would get cheaper.

Anyway, just an idea.

Black Swans for Breakfast

2009-02-24T07:13:00.049-05:00

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.

DRUCKER'S DEMONS

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.

GREENSPAN THE KEYNESIAN

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%?

IS CHEAP MONEY GOOD?

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.)

GETTING BACK TO CAPITALISM

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.

Are Experts to Blame?

2009-02-22T22:01:00.012-05:00

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.

Whitney's Reality Check

2009-02-20T16:39:00.032-05:00

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.

RETHINKING THE RULES

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

2009-02-20T10:33:00.025-05:00

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?

Some notable quotes

2009-02-17T22:59:00.010-05:00

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

RETAIL EXPERT HOWARD DAVIDOWITZ

"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.

CREDIT-RISK EXPERT CHRISTOPHER WHALENS

"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.

The Curse of Real Estate

2009-02-15T21:45:00.029-05:00

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."

TALKING TULIPS

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.)

PRICE CHANGES OF SELECTED ITEMS 1981-86:

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!

The Baltic LIE Index?

2009-02-11T21:46:00.020-05:00

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.

GREAT DEPRESSION 2.0

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.

PIMCO'S VIEW

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.

Treasuring the Moment

2009-02-10T02:18:00.004-05:00

I want to add a very quick note about the stock and bond markets. Everyone has been talking about how we've entered a bear market for Treasuries. I think this is starting to happen, but I don't buy it yet.
The yield on the 10yr note has risen more than 80 basis points in less than a month. (Yields go up when prices go down.)
This represents a big selloff, coming after a massive run that traces its days back to the early 1980s when Paul Volcker raised interests rates to slay the inflation dragon. During that time, yields fell from more than 15% to barely over 2%.
In my opinion, this is the most significant bull market in history. It provided enough liquidity to fuel two private-equity bubbles, a stock market bubble, a hedge fund bubble, a telecom bubble and a life-transforming housing bubble.
A bull market like this in Treasuries doesn't just meekly go away. It will come back. That's why I remain bearish on stocks. I think pretty soon, investors are going to look at the rising Treasury yields and remember how bad the economy is. They're going to realize that prices are falling in the economy... CPI is at -1%, the lowest sustained rates since the 1930s. That boosts the "real return" on Treasuries. Money will come back into Treasuries and leave stocks.
This week the government is selling an obscene amount of debt, more than $100bln. But the normal pattern after these auctions is for yields to fall. I have heard this from countless people on CNBC recently. Furthermore, I heard one commentator on CNBC say that every stock manager is buying heavily so he doesn't miss a rally and look like a fool. I also heard that the put/call ratio of stocks is now quite low, showing that pessimism is waning.
To me, this is rubbish. When sentiment is better, it's bearish because it means that all of them can potentially become sellers.
I have been bearish for a while and frustrated by the selloff that hasn't come yet. But, the market is still failing to do anything bullish so far. The S&P 500 remains stalled at its 50-day moving average. If it doesn't break out of this range soon, I think stocks have to move south.

Safe as Houses?

2009-02-09T20:58:00.021-05:00

For centuries the British have used the expression "safe as houses," to denote a general sense of security and well-being. Needless to say, that saying is probably headed to extinction as a centuries-old obsession with homeownership inflicts massive financial harm on the English-speaking people of Europe and the United States.

This blog entry will argue that U.S. home prices have much further to fall, and will probably remain in descent for the next 5-10 years -- longer than any of the "experts" are predicting. This threatens to leave an open wound across much of the country and decimate wealth, turning the post-war American dream into into a 21st-century nightmare. I will conclude with three specific proposals that need to be considered by anyone seriously interested in fixing the problem.

Bank of America economist Mickey Levy was recently on Bloomberg Radio. Asked whether home prices will stop falling soon, he responded with a long "noooo...."

"The reason I can say that -- unfortunately emphatically --is we still have this yawning gap between supply and demand in housing. That is, we have a huge inventory of unsold homes, and until we close that gap, either by increasing demand or by reducing supply there's going to be downward pressure on home prices."

Levy also observes how the declines have ac.celerated recently and adds that overall home prices will be "materially lower than now" by mid-2009.

One of the troubling things about the current discouse in the general financial media is that everyone just assumes house prices are going to just magically stop falling. But, no one explains how or why this will happen. I for one am going on the record and predicting home prices will continue to drop for years and that much more significant action is needed.

The first reason is the curse of the bubble. A price bubble occurs when the price of some kind of asset goes up for a prolonged period of time based on speculation rather than underlying supply and demand. Price bubbles defy the naysayers by proving them wrong. In the process skeptics are turned into believers and join the stampede. In the process, everyone comes to trust that the bubble asset can never lose value and is inherently safe. ("Safe as houses?")

Another aspect of bubbles is that prices keep going up despite new supply of the asset in question. In the housing boom, for instance, home construction surged and inventories started piling up unsold for about a year before prices started falling.

Bubbles often result from easy credit for the asset in question, or from some kind of government endorsement. For instance, the 1920s stock market bubble resulted from aggressive margin lending by banks. The 1990s bubble resulted in many ways from the rise of 401(k) plans, which gave people a tax incentive to buy stocks.

The housing bubble had both: a reckless and aggressive lending environment, plus countless government programs to encourage homeownership and real-estate development. I will discuss these later. For now, I just want to demonstrate we're dealing with a classic bubble phenomenon.

The key thing about bubbles is that once they break, the asset in question becomes worthless and stays that way for a long time. For instance, Japanese stocks continued to fall for 13 years after the bubble broke in 1990, and now stand 80% below their highs. The Nasdaq only approached 60% of its previous bubble-peak in late 2007 before the latest bear market struck. Other bubble assets, such as the 1970s' darlings gold and oil, fell by similar amounts in the 1980s and 1990s.

Just as the bubble drives prices up to utterly "irrational" levels, they then fall to equally irrational levels after it breaks. Just as people are conditioned to buy the bubble asset on dips on the way up, they then learn to sell it on any kind of rally after it's broken. While home prices don't "rally" like stocks, as soon as the market firms up, loads of houses will be listed for sale by people who have been waiting for a better market.

Just as a cuckholded man might despise his unfaithful wife, love also turns to hate in the world of finance when people feel betrayed. They stop trusting the bubble asset.

George Packer, a reporter for New Yorker magazine, recently appeared on the radio program On Point to discuss an article he'd written about subdivisions near Tampa, FL:

"The slums of the future are visible in some of the driveways and houses in some of these places...
Lehigh Acres was a very good and successful working class and lower middle class development

.. and now alot of driveways have weeds growing up in the pavement and the yards are unkempt and it doesnt look like the kind of place where new familes would want to relocate to."

The New York Times apparently piggy-backed on Packer's work in this article over the weekend.

The prospect of slumification is the most worrisome thing facing American suburbs. I grew up near Bridgeport, CT, and was amazed at how the former paper and tool making city had devolved into one of the the most violent and crime-ridden places in the country by the early 1990s.

It really sunk in when I went to college and wound up surrounded by fellow white kids from Westchester County, suburban Chicago, Philadelphia, St. Louis or Birmingham. I realized I had more in common with those kids than I did with poor blacks who'd grown up less than 20 miles from me. It became clear to me that a new kind of sectionalism had swept our land, the division between city and suburb (or exurb). This has been an obsession to me ever since and I have researched it extensively.

As I studied the division of urban and exurban, I came to realize that it resulted from a series of long-term factors, most of which dated back to the 1930s, if not earlier. Urban decay involved several self-reinforcing processes that formed a vicious cycle of job loss, property price declines, lost tax revenue, worsening schools and rising crime.

In many ways, much of the economic growth enjoyed in the post-WWII period was little more than a transfer of wealth from cities such as Bridgeport, which had teemed with life for more than a century, to towns like Trumbull and Westport, which barely existed 60 years prior. The same story played out on a national scale as factories sprawled across old farmland while plants shut down in cities like Pittsburgh and Erie, PA.

I will now sum up the major factors that fueled this process. For more details, see this lengthy article from my college days as an Anthropology student in London. The key takeaway from all of this is that most of these processes have now either halted or are reversing themselves.

The rise of the automobile: No secret here. For decades, suburbia grew as America remade itself to accomodate motor vehicles. Americans bought cars like crazy, and run up huge debts in the process. Automobiles are the ultimate consumer discretionary item. I believe that going forward, people will drive less and come to favor communities that don't require frequent use of cars. As I explain in this blog posting, owning a car makes little sense financially, environmentally or health-wise. Why must people commit themselves to $100-300 a month in car payments and another $30-200 in insurance payments just to get around? Why must a 150-pound person transport 10x their weight in steel and fiberglass just to go to the store? Why must Americans spend 1-2 hours a day behind the wheel, getting fat and listening to the radio when they could be working out, spending time with family or improving their skills? I know it sounds very abstract, but these are real quality of life issues I hear from people now. Furthermore, consumer credit to buy cars is not going to just magically reappear on the other side of this financial crisis. Even if it did, I think millions of Americans have been so burned by debt that they'll be much less willing to take on car payments.

Home price speculation: Houses were never just a place to live. Even when prices were going up very modestly, they were always an investment. As I explained with the post-bubble phenomenon above, the belief home prices always go up is broken forever. (Or at least for a generation or two.)

Education: The quality of schools has always been a key factor determining property values. City schools lagged for years as their tax bases dropped. That is going to change going forward as suburban municipalities grapple with plunging property values and mounting foreclosures. Cities now appear to be on the vanguard of change for education.

A recent report showed huge improvements on Advanced Placement test scores for New York public school students. Most importantly, minority groups that previously struggled showed the biggest gains. Here's a graphic from the New York Post article:

So far a handful of cities like New York and Washington have implemented free-market reforms. Because they have lots of kids and lots of schools in one place, it's a perfect environment for competition between schools. Even if it's not the model for the future, cities are going to close the education gap with suburbia, which will attract families and give them fewer reasons to chose a life at the end of a cul-de-sac. This will be a direct threat to the attractiveness and relative value of the suburban life.

Racial exclusion: People in suburbs never liked to admit it, but they benefited from a de facto system of apartheid. Many of them were liberals who supported the Civil Rights Movement. When they sought "a better life" on Long Island or in Westchester in the 1960s or 70s, they implicitly diverted resources and jobs from blacks who had recently migrated to the old industrial centers. The flow of educated white people away from cities channeled more money and purchasing power into suburban real estate. Now that line of distinction is fading as many middle-class families move to cities while suburbs attract more minorities with relatively low levels of education and income. The money is no longer moving in just one direction, which will be a negative for suburban home prices.

Mortgage lending: For years, Washington pushed home loans. The Federal Housing Administation was founded in 1934 to guarantee mortgages, followed by Fannie Mae in 1938. These companies got banks to make 30 year loans, when previously they would only lend for periods of about five years. Their goal was to expand lending, but they were too successful. (The federal government also enforced racial segregation using the FHA until 1968.)

Home loans peaked at a ridiculous level not very long ago. Now much of the U.S. banking system is insolvent as a result and the economy faces what could prove to be something like another Great Depression. The chart above says it all. (It's interesting that by trying to make something like homeownership "normal," the government has destroyed it. There's a lot to think about in that, especially for proponents of nationalized healthcare.)

Crime: As property values fall and homes become empty, crime will inevitably spread. Insurance rates will rise, cars will get broken into and people will move away. This is what happened in countless inner cities across the country, and now it's starting to happen in suburbia.

For decades, the factors above supported the value of suburban real estate relative to urban. Now they're all reversing and cities are going to enjoy a renewal after decades of decline.

Given that suburbia benefited from this systemic pattern for more than 50 years , it's seems reasonable to expect the process to go in reverse for at least 10-20 years.

One more thing: The USA is going to attract fewer immigrants in the future as the economy generates fewer jobs. Population growth will slow, also reducing demand for houses.

As suburban areas and houses decay, they will bring down everyone's net worth and cause large geographical parts of the country to become slums. (Suburbs cover many more square miles than did the old inner cities.)

I see three immediate courses of action the government should pursue to manage this problem:

1-Organize a concerted effort to halt foreclosures. Foreclosures are devastating to home prices. It's a bizarre irony that local authorities are using their own laws to screw over their own citizens and taxpayers. Given that foreclosures are legal proceedings carried out by a local sheriff, I don't see why governors, the Federal Reserve and FDIC can't somehow reach an agreement to stop home seizures. Now that the government is taking ownership of the banks and their vast holdings of "toxic mortgages," does it make any sense to foreclose on anyone? There have been isolated instances of local officials halting foreclosures, so it can be done.

(I see this as a truly exceptional event, and should be done under a program with a clear expiration date. Under "normal" circumstances with a functioning resale market, foreclosures are fine. In a situation like we have now, they hurt borrower and lender alike.)

2-Dismantle houses: Do a national study of the worst-affected areas and hire unemployed construction workers to dismantle entire subdivisions. Leave the roads, sewers and maybe slab foundations. If they could uproot entire neighborhoods to build the Cross Bronx Expressway, they can do it in the suburbs too.

This would help reduce house inventories. More importantly, it would prevent suburbs from turning into dilapidated, crime-ridden slums that will haunt the country for years to come.

It might sound like this isn't a productive use of human labor, but it's common for companis to spend billions of dollars in "restructuring charges" to exit a bad business. Freeing oneself from a debilitating legacy is an investment in the future. The company winds up with lower costs and can focus on more profitable activities. In the long run, it's often a good thing for a company's stock price.

The same logic should apply to fixing housing. If something's a problem that's only going to haunt you, it's best to take your lumps and move on. Otherwise, you live in crisis for years. It's a bit like cutting off an infected limb to prevent dying of blood poisoning. We have seen slums take shape before. It's a process we understand and need to prevent.

3-Encourage investors to take over houses. For 70-80 years the government has encouraged home-ownership. That means owner-occupancy.
Generally, when the government wants to "encourage" something, it means the activity in question is economically unfeasible. I say that if homeownership wasn't already a common thing, there was probably a good reason for it. (I think some of that is now becoming obvious. A certain percentage of the population is simply not suited for owning and caring for a structure costing $200-400k, or more.)

We should make a new legal system so that investors can buy houses and convert the current owners into tenants. There could be some kind of rule about allowing the tenant to live their guaranteed for 5-10 years, or perpetuity, etc. The homeowner might lose their downpayment and the bank would probably have to take a haircut, but it would reestablish an economically viable ownership model.

Mickey Levy of Bank of America, cited above, called for a new tax credit for home purchases, saying it will put a floor under home prices. I think this is essentially right in theory, but still misses the point I am making. Many people shouldn't own homes. We need to stop thinking that home ownership is an a priori, unquestioned good thing. People have rented residences for millenia (like in ancient Rome) because it often makes more sense. We need to cast aside the notion that home ownership is always the right thing.

Many aspects of the lending rules and other laws also discriminate against landlords. We need to rethink all of this.

One more idea, which is geared to the financial side: We need to encourage private investors to get back into the market for mortgage-backed securities. I think the government should outline a new series of standards for the bonds and buy them at a certain spreads. This will make private investors more willing to purchase them. There could also be tax benefits to buying distressed assets.
If the government gave people a complete tax holiday for buying these assets, it might seem like a big tax giveaway. (After all, many of these yield 20-30%.) But, they are currently on the books of banks, which are suffering huge losses. Those banks are now costing the taxpayers money already, so they will never pay tax on the income. So, in my view, making them tax-free instruments would cost the government nothing. And, it would help get them off bank balance sheets.

Cycles of Decay: Post-War Urban Decline and Social Division

2009-02-09T19:43:00.005-05:00

[ I have decided to post a college paper of mine from March 1996 on this blog. It focuses on the decline of U.S. cities in the post-WWII era, placing heavy blame on the Federal Government and so-called "progressive" policies. I am including this because the paper contains lots of good facts and I would like to use it as a reference.
I hope my readers will forgive its academic style and Marxist overtones. Reading my blog's eager support of profit and free enterprise, this Marxism might come as a surprise.
First, I want to categorically assert that I am not a Marxist. The two thinkers of greatest impact on me were Max Weber and Edmund Husserl -- both of whom accept human freedom in a way Marx could never have understood.
But there is some usefulness in Marxism as a meta-narrative tool. First of all, I think anyone who takes him seriously has to conclude with an embrace of free-market capitalism. Most of Marx's critiques had more to do with the abuse of government and religious authority by those in positions of power than with the concept of capitalism itself. In fact, he applauded capitalists for creating modernity at the same time he called for their liquidation. (No one ever said Marx was sane.)
Something else about Marx I like is his recognition that culture, religion and economics can form a self-reinforcing feedback loop -- the so-called social superstructure. It has some flaws, and is overly conspiratorial in nature, but can be a useful narrative tool. (Like many 19th century thinkers, Marx assumes a teleology and fails to demonstrate that the actors deliberately did things like design religion in order to keep people pacified. This is why I am a Weberian at heart, for he never fails to explain causation.)
This paper draws on these two observations of Marx to describe the process by which North American cities degenerated from a position of economic vitality to backwardness at the same time that the country at large grew richer. It also discusses the seldom-explained historical paradox of how black people grew poorer and more disadvantaged at the same time the Civil Rights movement was underway.
I also want to add that since writing this, my regard for Reagan has increased -- especially for his foreign-policy decisions. Furthermore, in the 13 years since I wrote this paper, it has become clear that the new post-industrial economy is increasingly favorable to urban centers over suburbia. I now expect that most of the factors I credit in this paper for supporting sprawl have now gone into reverse as the housing bubble breaks.
Finally, the footnotes do not work, so please scroll to the bottom of the essay for attribution. ]

"Cycles of Decay: Post-War Urban Decline and Social Division"

In our February 22nd seminar, we ran through a varied list of indisputably appalling social indicators for American cities. They describe a general array of material poverty, including hunger, inadequate housing, and lack of medical care. These conditions reflect how, in less than fifty years, the traditional urban centres of the Northeast and Midwest have gone from being economically and socially significant, sporting a wealth of manufacturing, residence, and financial services to being economic wastelands and social backwaters enduring Third World social conditions.
How could this happen during the nation's greatest economic boom ever? Why, in the midst of broad national economic expansion, did cities regress, becoming peripheral and socially-segregated within America? I shall proceed to explain these paradoxes as inherent to the specific nature of post-war American national development: Various economic, social, and political factors interacted to engender a general structure of national development. One way to interpret this development is as a processual condition, derived, on one hand, from convergent historical factors, while assuming, on the other hand, a specific trajectory with its own logic and character. Its specific character--including its own economic, social, and political aspects--in turn was initially inherited from pre-existing circumstances, but then grew integral to the system itself.
As an implication of a systemic process, urban decline resulted from specific structural biases inherent to that process--namely, biases against established, manufacturing-based central cities that had developed well before the Second World War. The factors that converged to produce this structurally anti-urban process were multiple and varied: Many, such as sundry actions by the Federal Government, were essentially accidents of history never explicitly intended to harm urban areas. Other factors, such as the economic importance of consumption, race, and settlement patterns were inter-related and self-perpetuating. Regardless of their origins, they all had a devastating combined effect on the United States' established urban centres and populations that is best understood as a self-perpetuating and marginalising cycle inevitable given the particular direction of post-war American history.
Analysis of this period requires a look at economics, politics, and general social trends--including shifting income and occupational patterns, racial relations, and cultural values affecting the public's relationship with different levels of government. Historians and sociologists generally refer to approximately the first thirty years of this era as "modernist", and the last twenty years as more or less "post-modernist". These titles entail broad generalisations of categories ranging from architecture and film to economics and politics. An intensive examination of these developments is beyond the scope of this essay; what instead pertains to my argument is the more visible and concrete consequences of this larger shift. The driving forces that existed within political and social modernism, particularly a general trend of "destructive creation"[1], will surely be visible in this discussion. Even more obvious will be the ambivalent nature of this destructive creation, especially in the field of state intervention into the "private sector" seeking to promote a specific ideal social model, leading one to ask, "development for whom?" and "by whom?". Such uncertainties and their implicit ideological biases were an important aspect of a general continuity that systematically produced profound discontinuities, such as yawning social differentiation along racial, economic, and spatial lines. Political economy and culture interacted in this highly dynamic phase of national reshuffling, making urban marginalisation a matter of economic and social shifts. Due to the inter-connectedness of factors generative of post-war development, one cannot isolate any specific issues without missing the larger picture. Hence, certain points will repeatedly enter my discussion, though I have done my best to minimalise redundancy. But, some is necessary to establish the structural nature of post-war national growth and its related urban decay.
After the Second World War emerged a specific modernistic form of political economy, "Fordist-Keynesianism". It was a synthesis of various pre-existing values and practices that quickly became dominant and influenced American society. Characterised by mass-production and mass-consumption, the Fordist-Keynsian model was a highly-rationalistic vision of a society in which semi-skilled factory workers organised into large-scale production manufactured a broad range of consumer durables. Unlike in earlier industrial production which sought to exploit labour with low wages, these workers received relatively high wages so that they could, in turn, become mass-consumers of these new goods.
Fordist-Keynesianism, however, was not merely a static cycle of production and consumption. Rather, it relied upon particular dynamisms that would ironically grow dominant to slowly render the system obsolete. Expansion was perhaps the most significant: Firms thrived by intensive re-investment of profits that ever increased their productive capacities. Accompanying this indefinitely swelling production were growing markets which firms actively sought to maintain through advertising and planned obsolescence. Another necessary dynamism contained within the Fordist-Keynesian paradigm was improved productivity. A single firm can earn profits by simply lowering its production costs in relation to its competitors. But, industry's need for a well-paid work-force and pro-labour government regulation prevented firms from simply cutting wages, so they maximised their production efficiency in two inter-related fashions. One was an intensive rationalisation of industry, demanding ever more efficient production arrangements, including assembly line organisation and plant relocations in search of cheaper transport and operating costs.[2] Relocations, in particular, as we shall see, were especially devastating to established urban centres. Linked to rationally lowering costs amid rising wages was the need for technological inputs that increased the productivity of labour. Together with a growing consumer market, these expansive aspects of industrial production made Fordist-Keynsianism grow into a self-perpetuating economic system that was to re-shape American society.
Before turning to its social impacts, however, I must emphasise that the Fordist-Keynesian cycle was by no means a self-contained private sector phenomenon. Both previous and continuing historical and political developments prepared the state to play a central role in the new system. The combined effects of the Great Depression, the Second World War, and the nascent Cold War all converged to give the Federal government a new political paradigm: Modernism. The Depression experience and Roosevelt Administrations had re-defined the state's responsibilities to American society. Adopting the demand-led economic theories of Sir John Maynard Keynes and prevailing popular demands to assist the nation's poor, the American state assumed the authority to maintain wage levels, hence supporting large national markets of mass-consuming workers. It also sought to provide jobs through national modernisation programs, such as the building of infrastructure and power stations. During and after the war, these programs, especially highway construction, were actually expanded, despite the rapid fall in unemployment. Destined to reshuffle the spatial organisation of American society and industry, road transport and a rapid increase in reliance upon automobile transport were fundamental to post-war development--a factor that can scarcely be overstated and will re-emerge several times throughout this essay.[3]
The growth of the defense industry during both World War II and the Cold War also had a profound impact. First of all, Second World War industrial production was entirely Fordist in nature, well-paid and rational.[4] Secondly, the war-effort created an enormous fixed capital accumulation of factories which were quickly converted to civilian production, while War Bonds provided American consumers with large savings to spend.[5] And, even with a decline in arms manufacturing immediately following the War, the defense industry regained lost ground in the 1950's in the midst of the Cold War and the perceived Soviet threat.
The Cold War, and its related defense industry, is an oft-neglected component in the decline of established American cities, but it produced an undeniable spatial re-configuration of American society detrimental to established urban centres. Put simply, government spending during the Cold War served essentially to subsidise the rapid expansion of previously insignificant regions at the expense of older areas--In 1981, northeastern states paid $70b in taxes going directly to defense, but received only $44b in local defense industries.[6] Given the perceived threat of Soviet aggression, it was natural for Washington to build bases throughout the nation's entire territory and to scatter strategically-important arms manufacturers. Furthermore, given the relative novelty of most new Cold War-era weapons, there were no pre-existing factories so that their manufacturers could locate virtually anywhere. The "Sunbelt" proved a perfect choice. Consisting of the general South, the South-West, and Southern California, this broad region offered several advantages to established Northeastern and Midwestern cities. For one, many of the western states contained great expanses of desert ideal for testing and designing the new weapons like jet fighters and missiles. Secondly, most state and local governments in the Sunbelt actively courted large corporations with low taxes and right-to-work laws (effectively anti-union legislation). Finally, the national expansion of Interstate Highways (initiated in 1956) made the Sunbelt suddenly much more attractive for a myriad of inter-related reasons. By depending an infrastructural spine consisting only of belt-ways, highways, and roads, Sunbelt cities were highly flexible production areas; it was no longer necessary to locate in more expensive central zones with established transport nodes such as railroads and canals. The reliance upon personal cars for transport also rendered unnecessary public transport, permitting lower taxes. And, perhaps most importantly, personal automobiles made possible a new way of life for the workers in these newly-developing urban areas such as Houston, Dallas, or Phoenix: Mass-consuming suburban life.[7]
Suburbanisation was a staggeringly broad and national phenomenon not confined to the Sunbelt--the Sunbelt cities merely had the privilege, or curse, of being totally suburban in nature. Obviously dependent upon the car, the rise of suburbia after the war was an integral aspect of the Fordist-Keynesian system. Not only did suburbs generate massive demand for automobiles, but they also became the primary market for all consumer goods--seen in the virtually infinite number of appliances perceived necessary to run a home: electric washers, toasters, and, of course, televisions. These commodities were indispensable to the new life-style. A case in point is the air-conditioner. Though banal, the air-conditioner was completely necessary to accommodate the northerners pouring into the Sunbelt and spurring the region's rapid growth.[8] Hence the mass-market crucial to Fordist-Keynesianism had emerged and promised to remain, if not grow.[9]
Suburbanisation, or ex-urban movement of people and economic activity, had actually begun long before the Second World War. It simply became dominant in the post-war era and was completely designed around automobile transport, unlike earlier exurban movement based upon rails and streetcars. Although one must be cautious when generalising about these suburban areas due to their great economic and social diversity, we can discern specific unifying characteristics. Most important is that, like urbanisation itself, their development both reflects and supports the nation's economic structure. As products of capitalism, they are totally intertwined with the unending search for more profitable production, so that when technological improvements in transport made possible suburban production cheaper, capital seized upon it--especially in areas like the Sunbelt which also offered lower taxes and living costs. Their residential characteristics were likewise dependent upon nuances of capitalism. Residential suburban growth shares with industry a dependence upon transport technology and industrial capacity--suburban houses, for example, were constructed from mass-produced pre-fabricated commodities only available after the war. And suburban residential patterns are also highly influenced by the nation's financial structure, as we shall see. Finally, their growth generates, as David Harvey (1975) notes, strong "multiplier effects" in specific sectors of the economy at large, generating greater demand central to Fordist-Keynesiansm, but also spurring their own indefinite expansion so that suburbanisation becomes a self-perpetuating cycle of destructive creation. Unfortunately for cities and many of their residents, they saw more of the former than the latter; suburbs and suburban cities were created at the expense of established cities. Thus, while a cycle beneficial to some, suburbanisation augmented certain pre-existing social divisions, placing them in a new, and possibly more confining, social and economic context. In some cases, especially with residential patterns, exurban growth actually depended upon these divisions for its continuation. Given the United States' unique forms of local government and education, suburbanisation galvinised and required specific forms of economic and social exclusion.
Exclusion and inclusion are components of any creative act. Just as a painter or student must discriminate between features to include in a painting or essay, residential suburban development, influenced by legislation, banks, and private citizens, "selected" only specific features as desirable. On one level, these were characteristics that Miller[10] recognises as part of mass-consumption in general: Purchased commodities all fit into processes of social life and meaning. Offering greater space for living, the freedom afforded by a private car, and commoditised modernity, suburbs and all of the purchased commodities of suburban life were appropriated to construct the individual suburbanite's self-image. Suburbia also consisted predominantly of single-family detached homes, helping to objectify familial relations and concern for one's children. Hence, sizable lots and public education are still highly prized in the suburban house market. On another level, inclusion and exclusion of specific housing patterns and social groups became an economic consideration--if not necessity--for individual families.
But before turning to residential suburbanisation and its economic features, it is necessary to examine the process at large. Suburbs, or cities essentially suburban in nature, characterised by outward sprawl requiring personal automobiles and new infrastructure designed for the subsequently heavy traffic, have now become dominant in the United States. When considering the impact on older urban centres, it scarcely matters whether they are relatively new, as in the case of Phoenix, which was scarcely a city at all just a half-century ago, or whether they grew up around existing metropolises such as Chicago. The spatial re-arrangement of urban areas had basically the same effects on almost every old central city: Employment, income, property values, and tax bases all declined, while, in turn, newer "exurban" areas enjoyed higher incomes and massive employment growth. Industrial relocation, it should be noted, was not a new process in American urban areas; as early as the 1920's established cities such as Chicago were experiencing rapid outward expansion into cheaper areas. What was so significant in the post-war era was the use of highways for transport which allowed a far greater decentralisation than early forms of urban transport such as streetcars while requiring personal ownership of an expensive commodity.
During the first ten years following the war, an irreversible process of industrial relocation from central city areas to suburbia was underway. Chicago, for instance, during this period saw 591 of its industries move to suburbia, which also received 528 new firms. While Chicago itself did receive 533 new firms, they tended to locate outside of the traditional central areas. A trend was clearly underway and is visible in the case of most other older cities whose SMSA's gained manufacturing establishments at the same time that their central areas lost firms.[11] Also damaging to traditional urban areas was the Sunbelt's awesome expansion, which grew 112.3% between 1940 and 1960, plus another 44.1% between 1960 and 1980. The Northeast, in contrast, grew by a comparatively meager 41.9% and 11.4% respectively, both far below overall national urbanisation figures for either period.[12] And, even worse for older cities was the fact that, not only were they funding much of the Sunbelt's economy through federal taxes, but most migrants to the Sunbelt were highly-skilled white-collar workers with high income, creating a general drain of wealth and skills.
Social and economic characteristics like education, racial composition, and income levels also differentiated older cities from their suburbs. During the 1950's, for instance, blacks' percentage of central city population consistently grew while remaining stable at minor levels in suburbia. Suburbanites simultaneously had proportionately more white-collar workers and High School graduates.[13] By 1960, the suburbs surrounding every single older city had higher family incomes, High School completion rates, and proportion of white-collar workers.[14] Suburbs did vary in their economic activities, being either industrial, residential, or intermediate. Their racial composition, however, unified the three types, being well below 10% non-white for each in 1960.[15] From Christian (1975), it is clear that the industrial relocation to suburbs that gave many formerly black unskilled or semi-skilled jobs to white suburbanites was simply an accidental social implication of capitalist firms' natural search for cheaper production. The integration of racial difference into residential and social division also began largely as accident of history, but, once established, became a recurring product of the financial structure perpetuated by intentional discrimination.
The nation's financial structure (including tax laws), strongly favoured (and still does) residential suburban growth for specific Americans. As was the case with the federal government's role in the Fordist-Keynsian system, these pro-suburbanisation conditions (and a complimentary urban decline) resulted from a mix of various factors, most of which are related to Federal actions. For one thing various anti-monopoly laws that had been passed periodically over the previous fifty years produced a highly diverse financial system suited to mortgage lending. Furthermore, ever since the first national income tax in 1913, home mortgage payments could be written off as tax deductions (actually following a precedent dating to the 1860's), granting homeowners a subsidy unavailable to tenants, which most urban dwellers were. (In 1973, this amounted to a $6b concession.[16]) But, most important of all was the Roosevelt Administrations' encouragement of private home-ownership as an anti-Depression policy. (It was hoped to stabilise property markets and to spur the construction industry.) Following a highly modernistic model with specific inherent priorities, Federal programs were both instrumental to suburbanisation and determinative of specific features that the process was to assume. Federal Savings and Loans institutions, specially designed to provide home mortgages, were created during the Depression and after the war grew into the single most important source of credit for the new suburban dwellers.[17] In addition to S&L's, the Federal Homeowners' Administration (FHA), designed to insure private mortgages, acted upon an obvious bias that sought disproportionately to develop low-density suburban areas that openly excluded lower-income groups and blacks. (In St. Louis, for example, despite roughly equivalent amounts of construction in the city and the county between 1934 and 1960, the FHA provided five times more mortgage capital to the county, and more than twice as much for home repair.[18]) By lowering interest rates and extending loan periods, the FHA produced an enormous growth in private home-ownership that followed the Administration's normative criteria. This growing suburban market would engender among private financial institutions and homeowners a long-term developmental biases against established urban areas in favour of wealthier and white suburbs: Given that the FHA created a market for specific types of development, financial institutions and private homeowners alike were inclined to follow its guidelines. And, worst of all for cities, these programs proved economically viable; by the early 1950's the FHA had pushed monthly mortgage payments for a suburban owner-occupied house lower than the rent paid by a middle-income family in central urban areas. Suburban home-ownership, in other words, became cheaper than urban renting for middle-class white families. (see Jackson on Levittown for the racial exclusion inherent to suburbs.)
Partially because of the FHA's criteria, a great social and economic divergence was implicit in exurban growth. Race became, almost immediately, a salient issue and category along which a largely economic division grew. Having migrated to northern cities throughout the 1920's and 1930's, urban blacks quickly suffered under the changing conditions for two clearly discernible aspects of the post-war urban reshuffling. First was the simple effects of industrial re-location from their areas. Blacks lived mainly in central city manufacturing nieghbourhoods. Between 1965 and 1971, for example, these areas in Chicago lost over half their job opportunities, and in most cases, these jobs relocated directly to white, suburban zones.
The second major problem for urban blacks was the fact that they were themselves unable to move with their jobs. Transportation was a basic obstacle. Being urban and relatively poor, few had cars at a moment in history when automobiles were becoming indispensable for personal transport. Furthermore, even when an exurban zone was served by public transport the long commute from the city tended to be economically unfeasible. It should be noted that Washington's utter bias in favour of Interstates over public transit clearly augmented this problem, directing 75% of all transport-related expenditures towards Interstates and 1% towards public transport over the entire post-war period. [19]Complimenting this was a complex socio-economic phenomenon usually popularly known as "discrimination" which kept blacks in the declining central cities. While a lot of American popular sentiment tends to describe residential discrimination as sheer racial hatred, it was just as much of an economic issue and owed much of its force to the FHA.
The most important factor that made race a significant issue in suburbia was the widespread increase in home-ownership and residence-related debt, making suburban residents much more personally interested in their homes' market values. During the 1950's alone, mortgage debts doubled in aggregate terms, underpinning an equal expansion of per capita debt as a percentage of personal disposable income. Over a longer period the change was even more dramatic, in aggregate expanding more than eight-fold between 1950 and 1973.[20] This aspect of the suburbanisation process conditioned a great potential for economic and social division. For one thing, even the U.S. Congress found that suburban owner-occupancy was an economically rational option for only middle- and upper-income groups, injecting a wealth differential into the suburban-urban divide. (Most suburban homes were owner-occupied.) And, with an increased personal stake in their homes as an investment, suburbanites universally sought to protect, if not stimulate, local property values--especially since capital gains from real estate sales were often tax-exempt, making family homes a potentially profitable investment.
This suburban synthesis of entrepeunership and residence led Sonstelie and Portney to liken suburban communities to private firms that do everything within its power to maximise property values as a firm would maximise profits. (1975: 50-1) But, rather than relocating plants or intensifying capital inputs, suburbia increases its "profits" through zoning legislation and education that have a positive effect on property values. As most suburbs surrounding older urban centres were legally separate municipalities with the power to stipulate building patterns, they tended to prohibit high-density rented housing suitable for poorer citizens in favour of low density detached owner-occupied dwellings--very much following the FHA's original directives.[21] Furthermore, each municipality tends have and fund its own distinct school district, producing two divisive effects. First, suburban communities would court higher-income populations with better educational facilities, which have always been a key factor determining a town's property values. Second, suburban schools, enjoying a proportionately larger tax base because of its residents' greater incomes, would improve as the suburbs grew richer, attracting more out-migrants from the cities, whose flight in turn lowered urban tax bases and subsequently their educational standards. Public education, ironically a state service intended to equalise all citizens' opportunities, thus became an important component in an exclusive social system.
This socio-economic cycle began in the 1950's with blacks in a highly disadvantageous position. Non-racist profit-seeking industrial relocations into areas that had income-related factors precluding black populations' movements were the most important general problem. Within suburban communities, however, the economic reality of home-ownership did favour the growth of outright racial discrimination. Put simply, white suburban homeowners sought to exclude lower-income blacks from both their towns and schools. Although exclusionary zoning was technically restricted to building regulations, it has been widely recognised as racially-motivated. Unfortunately for blacks, its strictly de facto segregating effects--as opposed to Southern de jure segregation--has maintained its constitutionality.[22] Seeking to maintain for their schools a "good" image, suburban municipalities have also staunchly defended their local school districts and prevented urban blacks' attendance. While racist school district gerrymandering within a city was ruled unconstitutional in 1972, the traditional correspondence between municipal boundaries and school districts remains legal and contentious to this day. (e.g. Connecticut's Sheff v. O'Niel)
It is, of course, impossible to reduce this pattern to either racism or economics because the two have interacted in the context of post-war social re-ordering. Once the bias against blacks was in place, it was destined to continue: Burdened with a large, long-term mortgage debt and knowing that other homeowners, or potential homeowners, will be in the same situation, each suburban owner-occupant-investor would inevitably fear blacks entering the area. The old axiom of perceptions being 90% of the market rings true.
The cyclical effects of such perceptions have been highly detrimental to blacks, confining them to economically declining city nieghbourhoods. For one thing, they clearly encourage people to fear black neighbours. Linked to this prejudice and perhaps even more discouraging, the financial structure has deliberately discriminated against black borrowers. A good example is David Harvey's study of Baltimore where all financial institutions denied mortgage credit to even well-off blacks. As capitalist, profit-oriented enterprises, it can scarcely be argued that they wished to deny blacks access to better housing simply for the sake of being racist. Banks did, after all, happily lend to white speculators, knowing full-well that they would, in turn, develop the land specifically for the same black population. As was the case with protective homeowners, surely thinking of the long-term security of their homes as investments and anticipating long-term costs such as sending their children to higher education, these were a rational business decisions--albeit influenced by what we would probably see as an irrational business climate. The financial conditions engendered by a particular combination of historical factors that initially situated people differently grew into a system that categorised blacks for essentially economic reasons.[23] In sum, therefore, exurban growth was a divisive process that drew jobs and wealthier citizens away from established urban centres. A myriad of historical factors converged to give suburbs a great economic appeal--lower taxes, and a possible investment opportunity. In conjunction with their cultural appeal as a consumer good, especially as a site of familial appropriation, it was almost pre-ordained that suburbanisation would sweep the land, given the widespread prosperity of the post-war era and Washington's political support. But, suburbanisation's dark side was considerable. As an industrial site, manufacturing firms relocated to exurban areas, creating growing unemployment in central cities. As a residential area, its growth was exclusive of blacks and lower-income groups, two categories that became increasingly equivalent as jobs left black areas. And, their mere presence prevented serious private sector investment in urban areas, discouraging the entrance of higher income groups, cutting urban tax bases, which in turn worsened public services like education. With poor education and unpromising property markets, not only were urbanites at a disadvantage for improving their own economic prospects, cities failed to attract wealthier citizens seeking to buy homes.
Running through this process, complete with all of its exclusion and selective privileges, is the federal government and its policies. But in this lies an irony, for, in the 1960's, the Federal government enacted an entire Civil Rights program, including measures aimed at both Desegregation and urban renewal. Riding a large wave of popular support, these programs categorically failed to help cities in the long run. Why? How could there be such a contradiction as a government economically supporting exclusive suburbanisation while rhetorically endorsing racial equality and justice? The explanation is the cruelest irony of all: The co-existence and interdependence of profit-oriented media needing to attract audiences and popular democracy have produced a political discourse dramatically divorced from reality. The discussion of political issues, especially those not affecting voters (as urban dilemmas do not affect suburbanites), are inherently superficial, appealing more on symbolic than pragmatic grounds. Such were the 1960's well-celebrated, yet half-baked, social movements and related federal legislation. Desegregation, for example, was very popular because Segregation was so obviously--in a symbolic sense--unfair. Laws forcing blacks onto the rear of buses, banning them with large conspicuous signs from public facilities, and hooded red-neck Klansmen raping and lynching by night all provided easy targets for popular outrage. More subtle problems, such as exclusionary zoning and structural racism, had much less symbolic appeal and, by not mobilising popular passions, never merited Washington's attention.
Desegregation did succeed in the South, probably because Segregation was not thoroughly imbedded in financial structures. Urban renewal programs, on the other hand, universally failed, largely because they were more symbolically-inspired than intelligently designed to work correctly.[24] Given their own inadequacies and the uninterrupted continuation of the patterns I have already discussed, this was really no surprise, especially when one considers the great political success of interests groups benefiting from suburbanisation, such as the powerful Interstate lobby of the 1950's, which consisted of automobile manufacturers and road builders.[25] One scholar noted that, given the structured formalised economic and social patterns of selective economic growth, only a well-funded, intelligent, and long-term federal policy could affect urban rebirth.[26] This would have required an unlikely mass-excitement over boring issues such as zoning laws and financial institutions. Furthermore, any popular interest in the structural inequalities of American society would force suburbanites to hold themselves at least partially responsible for urban populations' misfortune. What sort of capitalist newspaper would dare to so accuse its readers? What kind of politician, relying upon the media to present his platforms, would therefore even consider such an option politically expedient? Given this bias in the political-media discourse, it was natural for Washington to do nothing constructive about urban blight. When the idea was popular, simply doing something symbolically was sufficient; no matter if these actions were futile or even damaging, as was the 1968 FHA Act.[27] And, when the issue failed to stimulate popular subscription, which is exactly what happened throughout the 1970's, it could be disregarded outright. Hence, the 1980 Presidential election.[28]
From Ronald Reagan's 1980 Presidential victory onwards, the federal government has essentially abandoned any attempts at urban renewal.[29] Reagan himself started a pattern of opposing cities' interests by endorsing tax reforms that favoured rich suburbanites while cutting various social programs.[30] This unprecedented assault on urban centres and their people augmented the general anti-urban structural conditions that I have already described, undoubtedly accelerating cities' decline to the conditions in which one finds them today.
Three coexisting aspects of the United States politics, economy, and culture have interacted to permit these developments. The capitalist media was most important, engendering a certain type of discourse that prefers image and superficial appeal to substance and thoughtful action. As a Reagan press aide put it, "...Reagan fundamentally understands that politics is communication with leadership, and he probably puts communication above substance," while Carter was just the opposite, putting "...substance above politics."[31]. Reagan's dependence upon superficial imagery was almost total; not surprisingly, a highly-trained and intelligent P.R. team made him into a political success by carefully managing his statements and appearance.[32] This team was quick to exploit the general empathy and uncertainty that characterised the national press in the late 1970's and early 1980's. Knowing that most Americans were generally disenchanted with Washington and politics in general, the press was cautious and consistently refused to confront Reagan--he was too nice of a personality to challenge. They were, therefore, quick to elevate him to hero status, even though many of his programs directly opposed Americans' own desires.[33] Events like the end of the hostage crisis and an attempt on his life were especially romanticised. They also blindly approved of his Cold War policy, despite the fact that even Reagan's own advisors often recognised it to be utterly impractical and unacceptable to the Soviets. (e.g. Hertsberger ch 12; Dallek ch 5) Reality, it would seem, was not allowed to ruin a good image.
Conditioned by this particular political-media discourse were two other factors permitting Reagan to directly oppose urban welfare. One was the obvious spatial separation between cities and the rest of America. As the main beneficiaries of Reagan's economic programs, exurban people were particularly happy with Reagan, and had no reason therefore to be interested in the subsequent harm to cities. Whether they were simply richer suburbanites or Sunbelt dwellers, Reagan's tax cuts and increases in defense spending were all good news to them. This spatial division, with all of its coincident economic and social differences, has increasingly shaped American politics. Both parties have now turned their interests away from cities[34], de-emphasising federal programs designed to provide for cities what their own local economies cannot: educational funds, medical programs, welfare, etc. Living in a totally different America than do poor urbanites, exurban peoples are far enough removed from cities to quickly embrace the entire moral system associated with Reagan: self-help and independence from government charity.[35] These same people, of course, are simultaneously unwilling to see themselves, especially those working for defense contractors and private home-owners, as perhaps the largest federal hand-out recipients in the nation. So, the press need not bother to make issue of it and no one has to worry.
The second factor relevant to urban decline was a general economic transformation of the nation at large. For about thirty years, Fordist-Keynsianism had prospered, but certain aspects of the system grew dominant by the 1970's, creating a strange hybrid, flexible accumulation. Maintaining the same quest for profit, flexible accumulation borrowed and emphasised aspects of Ford-Keynsianism to function in a radically different way. Rational business decisions, such as seeking cheap production, continued, as did a dependence upon technological inputs. But they articulate completely differently: Firms use information technology to orchestrate decentralised production, rather than simply depending upon industrial technology that raises the productivity of labour. (Not surprisingly, much of this improved information technology resulted from Cold War defense spending.) Subcontracting and sweatshops have proliferated as they work for several firms that require highly flexible production. The days of intensive re-investment, large inventories, and large fixed capital costs are over. Firms have also turned increasingly towards other forms of profit-earning, such as the management of fictitious capital and corporate mergers so that a large and homogenous domestic mass-market is no longer necessary.
The rise of flexible accumulation has had both an economic and cultural effect upon cities. For one, it has rendered obsolete centralised manufacturing establishments, even those located in exurban areas. Now, major firms simply manage global manufacturing lines, rationally dividing production between different nations and areas in search of the lowest possible cost. Well-paid semi-skilled factory jobs are decreasingly common, but that does not threaten to cut firms' profits because a of the lesser importance of a large mass-consuming market.
Unlike in the 1960's when people at least responded positively to the idea of government altruism and an enactment of social justice, the American public today has come to accept the rhetorical morality of Reaganomics: self-interest and individualism. This cultural change, while inherent to the general rise of post-modernism, is linked to the socio-economic implications of flexible accumulation. Given the fall in well-paid mass-employment, most Americans have experienced a constant income contraction since 1973. This process was fundamental to the economic stagnation of the late 1970's that aided Reagan's rise to power, and now prevents politicians from proposing new spending and social programs, especially with a soon-to-be bankrupt social security apparatus and a massive debt to service. This legacy of the Reagan years still haunts America, and its treatment by the press reveals the truly unnerving superficiality of the entire political-media discourse. This growth of this ludicrous debt was, after all, made possible by the press's consistent failure to challenging Reagan's 1980's budgets. (e.g. Hertsberger 105) And now, as the press continues to seek simplistic and appealing headlines, the debt can be elevated to such a symbolic level that Representative Newt Gingrich could challenge and embarrass President Clinton over a relatively minor issue concerning deficit-reduction. Given the division between cities and the rest of America and widespread economic stagnation, it is only natural that Americans would similarly respond to such symbolic policies concerning cities. No longer enjoying a continuous improvement in their quality of life as they did in the 1950's and 1960's, the bulk of non-urban Americans chose to perceive inner-city people as the classic underclass, absorbing public funds indefinitely while simultaneously participating in gang violence and other conduct that embodies even farther their detestability and undeserving status. (e.g. Davis 33-7) Hence, social conditions including spatial division and economic stagnation, it is easy to think this way, making urban renewal into a non-issue.
The co-existence and historical interaction between the issues I have discussed has therefore grown into a structured process. Long-term patterns of economic and social development have produced a divided society--split along economic and social lines. The American state has been crucial in this general process of societal division, conditioning the social consequences of economic differentiation. Augmenting the general economic and social marginalisation of older urban areas that was inherent to post-war national development is a national economy now stagnant for most Americans. And, given the capitalist media's superficial representation of political issues, it is almost structurally-determined that the Federal government shall continue to neglect cities and their peoples.
[1]see Harvey 1989, he calls it creative desctruction
[2]Harvey 1989: ch 8
[3]see Jackson 183-4 on trucks and 248-51 for a brief history of the political and economic forces favouring Interstate construction.
[4](Harvey 1989: 136)
[5]$26b worth of new factories had been built, $20b of which were easily converted to civilian production. $147b worth of Savings Bonds were held. Bryson 1994: 299-300
[6]One can only assume that this direct transfer payment, which went almost exclusively to the Sunbelt, was previously even GREATER when the Sunbelt was first developing with defence contractors. Rice and Bernary 12-3
[7]Rice and Bernard 14-7
[8]Rice and Bernary 198
[9]see Harvey 1975: 134-5
[10]see Miller 1987: 190-6; or Miller 1995
[11]see Christian 1975: 223
[12]Measured by Statistical Metropolitian Social Area and thus including even Northeastern suburbs Rice and Bernard 1-4
[13]Farley 94-5, see also Christian 220
[14]Schnore 42-3
[15]Schnore 1972: 104-6
[16]Harvey 1975
[17]Harvey 1973: 129-33
[18]Jackson 203-9
[19]Jackson 250
[20]During the 1950's alone, total mortgage debts nearly trebled from $54.9b to $161.6b. By 1973, it would grow to a staggering $470.7b--more an an eightfold expansion in just twenty-three years. During the same period, per capita debt, as a percentage of personal disposable income rose from 26.7 percent to 53.5 percent. Harvey 1973: 135-7
[21]Jacobs 30-1
[22]Jacobs 151
[23]Harvey 1975: 144-6
[24]Hambleton 142-7
[25]Jackson 248-9
[26]Johnston 165
[27]see Harvey 1975: 133
[28]Jacobs 115, ch 8
[29]Davis 11-3
[30]Jacobs 116-23
[31]quoted in Hertsberger 38
[32]Hertsberger 5-9
[33]Harvey 1989: 329-30
[34]Davis 18
[35]Dallek ch 1

Blaming the Bankers

2009-02-07T22:19:00.021-05:00

Many conspiracy theories revolve around people like JP Morgan, John D Rockefeller and Andrew Carnegie. Some people point to the foundations the endowed, claiming they engineered everything from the collapse of the constitution,to the Russian Revolution, gay rights, animal rights, environmentalism and the creation of the United Nations.

My problem with these kinds of conspiracy theories is that these men loomed so large in history and spent so much money on so many causes that you can link them to just about anything. They are like oil tankers on a small pond, leaving a flood of money, decisions and philanthropic endeavors in their wake.

So instead of another conspiracy theory that cites obscure meetings or letters from a century ago, I would like to offer a different narrative based on commonly accepted facts. It is my own unique interpretion of well established history.

First, I would like to blame the current mess in the economy on JP Morgan Jr., who died in 1943 -- 65 years before the collapse of Lehman Brothers. That might sound like a long time, but I actually trace the mistake even further back, to 1915.

Here's the sequence of events:

At the start of WWI, France and Britain hired JP Morgan as their purchasing agent for war materiel in the USA.
Secretary of State William Jennings Bryan resigned in protest of the U.S.'s implicit support of the Allies in June 1915. He was replaced by State Dept lawyer Robert Lansing, who wanted the U.S. to support trade with and lend to the Allies.
By August 1915, France and Britain were running out of money.
In October JP Morgan syndicated a $500mln loan so they could keep fighting and continue buying America's guns and butter.
The U.S. economy enjoyed massive growth supplying the Allied war effort, doubling in nominal terms in just four years.
By early 1917, millions of men had been killed, but France and Germany were again on the brink of defeat. By now their debt to JP Morgan had trebled to $1.5bln. If they had defaulted, it would have represented about 3% of U.S. GDP -- a big enough loss to trigger financial crisis.
In April 1917, the U.S. declared war on Germany and immediately lent hundreds of millions of dollars to France and Britain, which promptly used the money to repay the Morgan loan.

Most of the historical information referenced here comes from Ferdinand Lundberg's 1937 book America's 60 Families. I own the original, but the key chapter is replicated online here. For correspondence by some of the officials involved, see this link.

Many people have argued that the U.S. went to war to save JP Morgan. This may or may not be true, but it's not the kind of historical finger-pointing/conspiracy theory that interests me.

My concern is about how resources get allocated. I believe that when loans and investments are made "improperly," bad things inevitably happen.

Before WWI, the global financial system relied on the British gold standard. Countries needed to have possession of physical gold in order to print paper money. When one country spent too much money on imports, it lost gold and thus lost money. This would then force its interest rates higher, which in turn would attract gold from abroad in the form of loans.

This system worked remarkably well for over a century. All currencies were valued in ounces of gold, and you could bring your paper money to the government and get physical gold in return.

One of the best best things about the gold standard is it limited the ability of countries to wage war. During war, a country devotes money to fighting, rather than producing goods and services. As was the case with Britain and France, they needed to import large amounts of materiel from the U.S. Germany, on the other hand, was in a much stronger position. Europe's biggest economy, it had a diverse industrial base, large population and short supply lines. It was much less dependent on foreign trade to survive.

As a result, the war drained gold from Britain and France. If it hadn't been for JP Morgan Jr.'s original $500mln loan, they would have been forced to sue for peace sometime during 1915. (They knew very well the lessons of the 17th and 18th centuries, when war bankrupted Spain and France.)

My key point is that, when Morgan made that loan, it marked the end of the old gold-standard system. He gave them the loan despite their ability to repay it. While this has never been established historically, I think it is safe to say that he always knew that the U.S. would eventually enter on the Allies' side to bail him out. After all, President Woodrow Wilson and Sec. of State Lansing had already endorsed the policies of providing loans and armaments. Furthermore, Morgan's investors included some major figures of American society, such as Andrew Carnegie (steel magnate), George F. Baker (banker who endowed Harvard business school), Samuel Untermyer (prominent corporate lawyer and Democratic party insider), along with many of Morgan's corporate clients.

He also knew that the war effort would enrich the American business community and entwine the country's economy in the war. By 1917, if Britain and France had surrendered and reneged on their debts, it would have caused financial crisis in the U.S. The chart below, based on data from measuringworth.org, shows the change in nominal GDP during the war years:

The U.S. and Morgan essentially "broke the rules" of the global gold standard by allowing a loan that could not be repaid. I posit that Morgan always knew he'd get "bailed out" if the war effort went against him. (He was, in fact, bailed out, as I mention above.)

Morgan lent money to Britain and France, despite their inability to score any major victories against the Germans. He then continued to lend even more as they continued to lose on the field of battle. If there was ever an instance of throwing "good money after bad," this was it. There is simply no way he did this without an implicit sense that Washington would come to his rescue.

My key point is that this was an "improper" loan. It wasn't based on the established rules of banking or credit analysis. It was made with the knowledge a bailout was probable, allowing Morgan to engage in excessive risk-taking. Sound familiar? To borrow an expression from today, his profits were privatized while the losses were socialized.

This shows the perils of having the government bail out anyone, or providing any kind of support to something that doesn't make sense economically. It inevitably creates distortions, which in turn cause even bigger problems.

It's also worth noting that JP Morgan Jr. acted with the potency of a public official even though he never worked for the government. His father had financed much of the American industrial revolution and single-handedly saved the financial system in 1907. The younger Morgan was instrumental in the creation of the Federal Reserve in 1913 stood at the crossroads of the banking system and securities industry. Some people have also credited the Morgan group with with Wilson's victory in the 1912 election. (Morgan financed Teddy Roosevelt's Bull Moose campaign, which split the Republican ticket.)

It's safe to say that Morgan was one of the most powerful men in the world. He knew he was too big to fail, and that he had the influence to get his money back somehow. (Again, don't forget that, before we sent a single soldier to Europe, Morgan started getting paid back by the U.S. taxpayer.)

I want to take it a step further. If JP Morgan hadn't arranged this loan in 1915, history would have been very different:

The war would have fizzled out in about 18 months sometime in 1915. Instead it lasted for another three years.

Millions of men would have lived.

The German Kaiser and Russian Czar would have stayed in power.

There would have been no Hitler, no Soviet Union, and probably no Mussolini.

There would have been no Holocaust and no United Nations.

The U.S. economy would never have enjoyed such a large and unnatural growth spurt, meaning there never would have been a post-war deflation.

There would have been no Dustbowl, and no Great Depression.

There would have been no Cold War.

To go even further, without a Great Depression, the government never would have needed to encourage suburban sprawl and mass consumption as a way to absorb all the extra capacity. (The government built roads, subsidized mortgages and basically paid people to live in them.) Without the sprawl and consumption, we never would have had a subprime mortgage crisis, and the modern-day JPMorgan Chase & Co. never would have been forced to take a government capital injection with Hank Paulson holding a gun to its head.

While all it might seem a bit extreme to blame on one man and one loan, it's hard to dispute these were consequences of WWI. And, anyone looking at the sequence of events would surely conclude that the war could have ended sometime in 1915 without Morgan's money.

Morgan was a master of financial innovation and trickery rather than good, sound lending. He allocated capital -- another word for human life -- in a reckless manner because he knew he'd be bailed out. When people of such importance, controlling so much captital, make mistakes like that, the results are catastophic for everyone.

The same lesson applies to the recent credit bubble, when loan officers with "no skin in the game" originated hundreds of billions of dollars in mortgages that were securitized. Just like JP Morgan Jr., these bankers had no incentive to make good loans because they knew they'd get paid no matter what. Another good example is Bank of America's recent decision to throw itself on the pyre of the American financial system, much like the widow in a traditional Hindu funeral. Ken Lewis thought he was doing the right thing for the country and that he'd be bailed out, so he sacrificied one of the world's biggest lenders without a shard of due diligence or skepticism.

The problem was never too much profit. It was complacency by bankers who reponded to the real incentives facing them. Each time, we have tried to fix the problem by giving more money and extending more credit, when we should be doing the opposite.

Whenever crisis hits, people panic and try to suspend the rules of capitalism in favor of patriotism and altruism. At a time like this, we need to fight that urge and stick by the rules more than ever. After all, it's easy to do the right thing when everything's going well. From the very start of the credit crisis in the summer of 2007, I was critical of policymakers' state-of-seige thinking. In private emails, I correctly argued rate cuts would stoke inflation and do nothing to fix the credit market. Since then, I have argued that the rate cuts actually accelerated the credit crunch by triggering a mass liquidation of mortgage backed securities.

This is why I have criticized the tendencies of altruism and patriotism in our response to the credit crisis. These values meant nothing during the boom times. These same banks that now take hundreds of billions of dollars in taxpayer money gladly financed the rise of factories in Asia that "took American jobs" and were intimately involved in every stage of the gloablization movement.

They were just following the rules of capitalism. But now that their backs are to the wall, those rules should still apply. This is why the Fed never should not have cut interest rates at the onset of the crisis cuts, and why it would be better to let all banks fail and simultaneously encourage the creation of new ones. There is no lack of private money willing to capitalize new banks. But as long as the government is so intricately involved in "fixing the sector," it will never happen. We're doing everything just right if our intention is to perpetuate this state of crisis for the next 5-10 years. This is also why the various solutions proposed on this blog, like at the end of this entry, are all based on the profit model. Furthermore, the post-WWII boom was so successful because it created opportunities for private-sector firms to profit from things like road building, house construction and mass consumption. That's why the process succeeded and became self-perpetuating even though it was originally founded on government fiat. For more, see this blog entry.

Of course, JP Morgan Jr. never intended to cause massive imbalances in the global financial system, the Russian Revolution, the rise of Fascism or WWII. He was just trying to make money the best way he knew -- just like any other normal human being.

The episode teaches us the unintended consequences of mixing free-market practices with the Leviathan powers of the state and the money-printing capacity of the Fed. At times like this, it is more important than ever to play by the rules.

An Ursine Secular Age

2009-02-04T21:49:00.012-05:00

We live in an ursine secular age. Not only is the economy imploding in the wake of the credit crunch. Just about every industry where you'd normally want to park your money is undergoing major historic problems. Even if the economy were growing, many would be doing badly on a secular basis. Today, I will take a look at these directly.

First, I will define some words.

"Ursine:" for those readers without a penchant for Latin, means "relating to bears," coming from the word urso for the animal. In the world of finance, bears are evil spirits that destroy the value of your investment portfolios. I for one believe the market will only turn around when we install a bear statue on Wall Street to compliment the bull statue. Angry ursine spirits haunting the market need to be honored.

"Secular:" This refers to long-term worldly movements. For instance, the rise of computers and digital cameras were secular trends that devastated the markets for typewriters and film. No matter how much the economy grows, they're not coming back.

"Cyclical:" This deals with the "business cycle." When the economy is growing and people are making more money, they buy new cars and spend more on items like travel and stainless steel refrigerators. That's why stocks like GM, Delta and Whirlpool are all considered cyclical, while companies like Kraft are not. People don't buy more macaroni and cheese just because they have more money... or so it seems.

Kraft's what we call a consumer staple, so let's start with them.

CONSUMER STAPLES: In the 2001 recession, companies like Kraft and Procter & Gamble were safe havens. This time things aren't working so well. Late last month, P&G warned of slowing sales and said it's only getting growth from raising prices -- not selling more products. Today, Kraft and Sara Lee followed with similar news.

Overall, these are very expensive stocks. Kraft and P&G both have an enterprise value/EBITDA ratio over 9x, compared with levels of 4-6x for the rest of the market. Traditionally, investors drool over consumer staple companies because of customers' brand loyalties. They spent billions of dollars and millions of hours building and maintaining the image of products like Tide and Kool-Aid. To understand how the business really works, a quick history lesson is useful:

Executives at these companies are following a model developed late in the 19th century by James Buchanan Duke, who built American Tobacco Co. before it was broken up as an illegal monopoly in 1907.

Duke invented what business historian Alfred Chandler called the "integrated industrial company." As I discuss at length at the end of this blog posting and this one this kind of business put marketing and production under one roof. Previously, manufacturers of things like clothing sold products to middle-men known as jobbers who then sold them to small retailers. The jobbers worked for themselves and had no loyalty individual factory owners, which made it hard for manufactures to control how much they sold. Without a reliable stream of revenue coming in, it was hard to build a truly large and efficient organization. So, even though many factories in the 19th century were using modern technology such as steam power and mass production, their marketing remained literally medieval.

Duke changed everything by uniting factory with sales and distribution. His marketing executives were organized geographically to push his brands only. Duke's people provided advertising and displays. They also took back unsold cigarettes, ensuring quality and making the merchant more willing to carry the products. This was a big improvement over dealing with less organized tobacco companies. This made local merchants more willing to carry Duke's products. And, when just being a nice guy didn't work, he also used rebates and other heavy handed methods to build market share, just like other trusts of the era such as Standard Oil.

Once these "distribution channels" were solid, Duke could count on a certain critical mass of sales every month. This allowed him to invest in larger production facilities to lower costs and widen profit margings. It also allowed him to raise capital and keep growing. In sum, customers had products they could trust, giving rise to brand loyalty. Retailers' lives were easier because they knew that as long as they carried American Tobacco's cigarettes, there would always be loyal buyers. Both were winners thanks to Duke. He made a fortune, endowed a major university and invented a business model that would remake American society.

This paradigm worked extremely over the following century and was drove the booming stock market of the 1920s. (Examples include GE, GM, IBM, Standard Oil, P&G, Campbell Soup etc.)

These integrated companies had a sustained advantage because they understood the market for their products. With thousands, if not millions, of customers, they became the nexus of information about sales and markets. This data was analyzed to produce new and better products and to minimize production costs. For instance, it was cheaper to purchase raw materials like tobacco and wheat etc in bulk. This arrangement created a virtuous cycle of even more growth and profits. In the process, it fed the rise of a new class of educated white-collar office workers. And, its need for publicity and marketing fed the growth of media and advertising. A big chunk of modern American culture as we know it all resulted from the cleverness of an impoverished Confederate veteran with a supply of tobacco and a rolling machine.

So, where's the bear? At the heart of Duke's model was information. Big integrated consumer companies monopolized information and used it to their advantage. Until recently, that required a standing army of army of clerks and sales representatives. It consumed huge amounts of paper, travel and long-distance phone calls. Any small competitor that tried to fight their way onto the shelves of stores found itself locked out by the Krafts or Pepsis of the world, which had strong relationships with retailers.

The Internet and other cheap forms of communications (such as viral marketing) change all of that. Despite decades building these sales organizations, I believe their intrinsic value are now declining as the competitive advantage of being big and corporate wanes. Furthermore, they were built on a big national economy/culture/society. They existed in a symbiosis with big media outlets like TV/radio/newspapers and big cultural events like NFL/MLB etc. They would sponsor these key events and capture a big slab of the country's attention. A relatively small number of institutions dominated the marketplace of ideas and cultural values. Only huge national organizations like Budweiser, Chevy and Coke could buy access. Their size allowed them to dominate.

Now culture is fragmented, with an ever growing multiplicity forums and outlets. For instance, I often watch youtube or Netflix instead of television and read news from any number of websites. Instead of reaching me by advertising on a small number of key outlets, a company like P&G can't even find me anymore.

These companies were once big fish in a small bond. But now they are getting washed downriver into a massive ocean where their earlier advantages count for less and less.

This same cheaper access to information will allow generic brands to better serve customers' needs. Instead of just churning out quasi-edible cheap junk, the generics are increasingly boosting the quality of their products. And, now the retailers will turn against the big integrated consumer product companies because the private-label items are often sold at wider profit margins than the name brands. (When you buy the name brand, you are basically paying for all the executives and advertising.) Throw in the rise of the local food movement, farmers markets and agricultural co-ops, and big food companies like P&G and Kraft face a long journey downward.

Getting back to this from a market point of view, investors have long been willing to pay a premium for these large "consumer staple" companies because of their solid market positions. That means they are heavily owned, and will be steadily sold as people realize they are both expensive and low growth. It's a bit like the newspapers, which once had premium valuations, with enterprise/EBITDA values of 12-13x because they had built "strong franchises." But now they're valued at about 6x. When the sands of the economy shift beneath the market's feet, the biggest castles fall the hardest.

Media & Publishing: As I just discussed, the rise of the Internet and online advertising is devastating to traditional media such as television, radio and newspapers. They face a double whammy of shrinking audiences -- especially newspapers -- as the number of competing media outlets proliferate like rabbits. It hasn't happened yet, but I am just waiting for someone to release the first Youtube-based sitcom or serial program. It's just a matter of time. And, as people increasingly watch video on phones, video quality will necessarily decline, reducing the need for expensive production techniques. Again, that will be one more competitive advantage that big-budget television will lose. And, even if newspapers are successful on line, the advertising rates are much lower compared with the old full-page spreads and classifieds.

Even worse than rising competition for viewers, TV/radio/newspapers face much stiffer competition for advertiser dollars. Previously, newspapers were packed with ads from companies like Macy's and other retailers. TV stations carried ads for all kinds of consumer products. Perhaps one in 10 or 20 readers or viewers would be interested in the women's sweaters, jewelry or soft drinks in question.

It was a bit like shooting a fly with a shotgun: expensive and wasteful. Furthermore, because most of the products didn't interest the viewer at any one moment in time, there was naturally an antagonistic relationship between audience and advertiser. Forcing people to sit through ads is confrontational and intrusive. Of course, when there was only TV to watch or only a handful of newspapers, people tolerated it.

One immediate danger to this model is the rise of digital video recording devices such as Tivo, which allow people to skip over ads. (For more on this trend, this article is worth reading.)

The much bigger problem is Google and the Internet. Now advertisers can reach customers directly based on what they're searching for on line. Web retailers like Amazon and Youtube can suggest things you might like because they track you purchases and searches. (I recently discovered a remarkable Janis Joplin video this way.)

This is the polar opposite of being intrusive and obnoxious. It makes advertising helpful and timely.

No longer must advertisers paying the salaries of journalists and athletes. No longer must they support expensive printing presses and foot the bill for tons of newsprint and gallons of ink just to reach one in 20 potential customers. Now they pay a much smaller amount and Google finds them a large number of people who are much more likely to want their product.

The next big danger to traditional media is wireless advertising. As I wrote in this blog entry last year, I anticipate a future when stores link their inventory to Google and ordinary people keep a list of things they want to buy. When you move within a certain proximity of a merchant carrying an item you want, your smartphone will tell you. This would be paradise for buyers and sellers alike.

Of course, these are all big pie in the sky ideas -- almost metaphical in nature. Let's look at the companies themselves to see if it's affecting them yet ...

New York Times Co.: Ad sales down 18%, the Gray Lady goes hat in hand to Mexico's Carlos Slim to help it pay back debt.

Viacom: The parent of Nickelodeon and MTV cut its profit forecast in October. Even though the company blamed the weak economy (a cyclical factor), its margins were eroding before this, revealing the deeper secular nature of its difficulties. This company was separated from CBS due to its allegedly better growth prospects, but equity investors never really got on board with the idea. Viacom also complained about falling DVD sales, which are haunted the Magic Kingdom as well:

Disney: The Associated Press had a good article on Disney's last earnings release that captured the key points well:
An aging DVD format and a proliferation of viewing options hurt home-video revenue in ways that could not be blamed solely on economic decline, [CEO Bob] Iger said. Studio revenue fell 26 percent from a year ago.
"The average U.S. DVD household owns about 80 DVDs already," Iger said. "That suggests that, economy or not, going forward people potentially will be more selective about what they buy."
He said that the abundance of viewing choices had also hurt the ABC broadcast television unit "and may have a long-term potential impact on the DVD business."
Analyst Anthony DiClemente of Barclays Capital said it was the first time Iger publicly acknowledged that the consumer shift from physical media consumption to digital was beginning to affect Disney's businesses. The shift has already plagued the newspaper and recorded music industries.
"The fundamental trends are on a slippery slope to the downside," DiClemente said after the call.
Analyst Alan Gould of Nataxis Bleichroeder Inc. echoed the concern.
"Those comments are a bit scary, frankly," Gould said. "DVDs, for the last 10 years, have been such an integral part of the profit stream of a movie. If you have DVD sales slowing down dramatically on a secular basis, that changes the whole economic structure of the motion picture business."
(Emphasis added. Click here for the source.)

Furthermore, Disney's credit ratings are now under pressure because of its big capital expenditure plans. Another problem facing the media industry is that most of these are old-fashioned companies with traditional pension funds that are now under pressure.

And, don't forget about companies like Young Broadcasting, which is now bankrupt, and yellow-pages companies like RH Donnelly, which is one step from the grave. More than a century of hard work by media executives is collapsing before our very eyes.

Retail / Consumer Discretionary: I don't think I even need to elaborate on this. Whether it's department stores or companies like Whirlpool, which earn most of their margin by slapping stainless steel on commoditized machinery, they're all in big trouble.

Utilities: This is traditionally a "safe haven" area, but I am still seeing bears. For one reason, they're all highly leveraged businesses that constantly need to borrow money. Even though I expect they'll be able to keep rolling over their debts, one cannot ignore the fact the credit market is uber-ursine. At some point the rising yields will push up their interest costs and squeeze profits. And, think about it like this: What happens to house prices when interest rates rise? Home prices typically would fall. What happens to the value of your utility operations when the cost of owning it (borrowing costs) go up? Moody's, for instance, recently cut Ameren's outlook from positive to stable because of its reliance on bank lines as lenders tighten credit. It's not a big danger, but the trend is moving in the wrong direction.

Furthermore, I believe we are entering a period of true deflation. Most people praise how the Fed is pumping liqudity into the economy, but I think their interventions will have the unintended consequence of poisoning the credit market with altruism and unintended consequences. See this posting for more on this subject. As the economy weakens and prices fall, utility revenues will get squeezed while expenses like interest payments will remain fixed.

Another problem for utilities is that they recently spent a lot of money on capital expenditures. Con Ed's capex rose 30% between 2005 and 2007, Public Service Enterprise Group's rose 32% Excelon's rose 51%, and PG&E's rose 53% -- to name a few. When companies spend money on things like upgrading transmission lines and towers, they spread the cost over several years using an accounting method called depreciation. Just like interest payments, this is going to be another fixed cost dragging on earnings at the same time people buy less electricity.

Utilities are also valued for their high dividends relative to other stocks. But now they must compete with rising interest rates on Treasuries and higher rates on various other bonds.

And, of course you have the weakening economy. We now face the real prospect of factories and shopping centers going dark. This caused Moody's to recently cut the rating on American Electric Power (AEP), a conglomerate with operations in struggling areas such as Michigan and Ohio.

One final concern is the future of coal-fired plants under a Democratic Congress and White House. This is less clear, but requires some awareness.

Aerospace / Defense: I don't know much about this industry, but know that it's been on fire for a long time and the country is facing big budget deficits. Lockheed Martin and Northrup Grumman, for instance, have cut their forecasts. Again, the Democratic control of Congress is a concern. And, the weak economy and slowdowns in emerging markets -- recently big plane buyers -- are also obvious headwinds.

Healthcare: This is a mixed bag. Biotech always has some kind of big winning story, so there are good secular things going on. One story I think that has been badly neglected is the complete collapse of hospital stocks like Health Management Associates and Tenet Healthcare because of their huge debt loads. These companies' ready willingness to borrow in search of higher shareholder returns was a sad and ignored consequence of the recent credit bubble. We also don't know what will happen to them under some kind of nationalized health system.

Another concern is Pfizer's purchase of Wyeth. We can assume the Pfizer has almost unlimited information on the industry, yet CEO Jeff Kindler was unable to find any small biotech company worth buying. Of course, he might just be a bad executive. But if Pfizer, with an insider's view of the industry, couldn't find any company worth buying, does the sector deserve any of your money?

Tech: This is the one area that everyone is talking about. I can see the positive case because many of these companies are much better run than they were in the late 1990s. But, I still see an industry that has reached maturity in many ways. Instead of seeking ever more powerful computers, consumers are now opting for less expensive "netbook" computers for using the Internet or doing word processing. Companies like Dell are trading close to liquidation value, and it seems like more and more of the semiconductor industry is getting totally commoditized. However, some names like Apple and Research in Motion seem to have positive secular stories underway.

Mining: These stocks are also a mixed bag. Gold is enjoying a completely new kind of bull market. Previously people bought gold as a way to bet against the dollar. Now both are rising together. I think we're seeing the ominous early signs that people are seriously questioning the long-term existence of the monetary system as we know it. But mining stocks themselves seem to be in a bad spot right now cylically because they spent a lot of money for expansion and now need to scale back. Secularly it's hard to determine whether they are worth buying. On one hand, if the global economy recovers and middle-class consumption grows in emerging markets as people expect, they'll prosper. An alternate vision is that the collapse of the U.S. housing market will cause another Great Depression because, in many ways, the global economy is just an extension of the American consumer. I personally think house prices will keep falling for another 5-10 years, as I explain in this posting. I think we've already entered another Great Depression because the Fed has waged guerilla war on the credit market, as I explain in this posting.

Financials: This is obviously an industry in a terrible place secularly. U.S. fixed income and credit -- Treasuries, corporates and asset-backed -- have flourished for almost three decades as the country's debt levels ballooned. It was probably the greatest bull market in the history of finance, and made possible surging prices for stocks and real estate. We obviously already know about the credit crunch and all the writedowns. It's hard to bet against a lot of these stocks right now because of the government's involvement. But I am comfortable saying that the financial bubble is broken, no matter how hard Ben Bernanke and Tim Geithner might huff and puff to reinflate it.

The Gray Lady Got Mugged

2009-02-03T00:29:00.006-05:00

"A conservative is a liberal who got mugged." -- Ex Philadelphia mayor and police chief Frank Rizzo.

The New York Times, a bastion of the liberal establishment, is feeling like someone took its wallet. In a somewhat stunning article, the gray lady is feeling let down by Barack Obama, and uncharacteristically calling him to task for his quick abandonment of integrity in government:

WASHINGTON — During almost two years on the campaign trail, Barack Obama vowed to slay the demons of Washington, bar lobbyists from his administration and usher in what he would later call in his Inaugural Address a “new era of responsibility.” What he did not talk much about were the asterisks.
The exceptions that went unmentioned now include a pair of cabinet nominees who did not pay all of their taxes. Then there is the lobbyist for a military contractor who is now slated to become the No. 2 official in the Pentagon. And there are the others brought into government from the influence industry even if not formally registered as lobbyists. (Emphasis added.)

The article documents how Tim Geither failed to pay his taxes, even after being warned, and still got to be Treasury Secretary. Tom Daschle dodged an even bigger tax liability and is still on track to become Secretary of Health and Human Services. And, former Raytheon lobbyist William J Lynn III was appointed deputy Defense Secretary, to name a few.

This comes not only after Obama imposed allegedly sweeping ethics reform. It also follows campaign promises repeated ad nauseum about change and a new era of accountability in Washington.

One question the New York Times does not attempt to answer is "how do we hold a politician accountable after such an obvious bait and switch?" I think that unless he starts changing his stripes, the paper should seriously consider publishing an apology for endorsing Obama -- much as they issued an apology for swallowing George W Bush's case for war in Iraq hook line and sinker.

Until we as a people start to punish politicians for breaking their promises, these problems will haunt us. As Alexis DeTocqueville said: "The people get the government they deserve."

We all know and lament how dishonesty and double-talk have run amok in Washington. We all know it has cost the country dearly for years, and now has left us rudderless when we most need solid leadership. I almost thought the New York Times was starting to get it, until I read this paragraph near the end:

Bill Clinton promised “the most ethical administration in history” and then endured the most independent counsel investigations in history. Mr. Bush vowed a new era of responsibility only to be accused of selling out to energy and military industries.

Nowhere do they mention the fact that Clinton was not only impeached, but also had his law license suspended and voluntarily gave up the right to argue before the U.S. Supreme Court in 2001. During the entirety of the late 1990s, the New York Times looked the other way as Clinton opened the White House to lobbyists across the full spectrum of business and other special interest groups. By glossing over his misdeeds, the paper gives a free pass to all politicians, letting them rest easily knowing they'll never really be called to task.

I am a financial journalist, comfortable with hard facts such as earnings numbers and GDP reports. Coming from this background, I sometimes feel that the culture of dishonesty didn't begin in Washington, but at 620 Eighth Avenue, where that New York Times is based. They have given politicians a free pass for years because they agreed with them. They did the same thing when the Supreme Court made outrageous intepretations of the constitution -- as long as the Times' liberal news staff agreed with the decisions, they were just fine.

Because politicians have been allowed to operate in this culture of non-accountability for so long, it's little surprise that Obama thought he could promise change, and then deliver more of the same.

This whole thing was a bit like a subprime home loan made during the credit bubble in 2006, when mortgages were written dishonestly based on fancy and fable. The watchmen at the banks let down their guard, and abuse became rampant. Now we're paying the price for it.

I fear that news outlets such as the New York Times -- our watchmen as voters -- let us down the same way. Instead of failing to verify the existence of income, they failed to verify the existence of a plan to fix the country. Instead of accepting no money down, they accepted a thin gruel of bromides and catchy phrases in the place of real ideas. Instead of ignoring the borrower's limited and potentially troubling credit background, they disregarded the candidate's diminuitive resume and history of being influnced by people like Saul Alinsky, Jeremiah Wright and William Ayers. Instead of allowing a subprime mortgage loan to be made, they allowed a subprime candidate to become president.

Thank you, New York Times. Now that the trouble has come to your backyard, it's nice of you to notice.

AP's Ugly Nativism

2009-02-01T17:11:00.012-05:00

The Associated Press is getting desperate. Despite making a big push to expand business reporting, the newswire has failed to break any significant news on the credit crunch and is now grasping for straws:

SANTA CLARA, Calif. (AP) -- Banks collecting billions of dollars in federal bailout money sought government permission to bring thousands of foreign workers to the U.S. for high-paying jobs, according to an Associated Press review of visa applications.

The story then reports how the 12 largest banks that have recieved government bailout money have sought H-1B visas to hire 21,800 foreign workers over the last six years. This appears to be a second-rate attempt to match stories such as John Thain's $1.2 million decorating bill or Merrill Lynch's big bonuses. It's a crude attempt to stir envy and nativist sentiment among Americans who are losing their jobs. In reality it's an utter non-story that was never fit to print.

Why?

First of all, we don't even know how many visas were granted. The entire quota was filled in the first two months of the year in fiscal 2007, so it's clear that the majority of applications are denied. Big corporations with giant HR offices probably made a huge number of requests as part of a shot-gun approach to filling vacancies.

Second, the math alone is less than impressive. The total translates into 3,633 applications a year, in total, or 302 per bank annually. That comes out to 0.12% of Bank of America's entire workforce or 0.18% of Well Fargo total workforce. If 3,600 jobs disappeared or were created in a single week in the entire economy -- for instance in the jobless claims -- it would have no impact on anything. Stretch them out over an entire year and you're talking about something less than statitically irrelevant.

Third, AP says the jobs would have paid an average salary of $90,721, and then highlights how that's "nearly twice the median income for all American households." At first, that might conjure up notions of envy and class warfare. But, a journalist with half a brain economically would quickly realize that it's good to create high-paying jobs in the USA. Not only does it raise the country's income level and add extra tax revenue. It also means more demand for a house, a housepainter, personal trainer or any number of other jobs that native-born Americans might fulfill. High-income foreign workers live in the country, spend their money here and add an educated diversity to our schools and communities -- unlike many illegal immigrants who perform unskilled labor, live on the margins of society and send much of their earnings home in the form of remittances.

Fourth, AP tries to wrap a class-conspiracy bow around the entire story with this final line:
"Foreigners are attractive hires because companies have found ways to pay them less than American workers."
Not only is this assertion completely unattributed, it's also at odds with the earlier statement about how the foreigners are paid twice as much as average Americans. Obviously, we know they mean that for the kinds of jobs -- skilled positions such as accountants and lawyers -- foreign workers are paid less than Americans. Even if this is true, it doesn't make much sense. Even if all these 21,800 jobs were given to Angolan accountants, Laotian lawyers and Thai traders, they would be way too small a proportion of the banks' workforce as to make any impact on total costs. And, don't forget the added legal cost and hassle of making such a hire -- plus the fact employers need to prove no qualified Americans can perform the job in question. I simply cannot believe a bank would chose to jump through all the hoops needed for an H-1B visa just to save $5-10,000 in salary.

Fifth, would AP rather see the banks avoid the visa problem entirely by instead hiring people in Ireland or India?

The AP should be ashamed of itself for ever allowing such a thinly reported and ill-concieved story to pass for news.

I suspect it resulted from a last-minute attempt to piggy-back on Barack Obama's comments about "shameful" bonuses on Wall Street. In fact, it's worth making a quick observation about how the Democrats have attempted to exploit class envy. They have about as much heart as actors flatly reciting their lines after taking a scene for the 50th time straight. Has the political establishment become so entrenched with special interests and plutocracy that it can do no better than propose limiting Wall Street pay at $400,000? (At the suggestion of Democratic Sen. Claire McCaskill.) Never mind the fact it probably won't happen. Never mind the fact that this is pathetic and meek compared with previous greats in the party such as Williams Jenning Bryan.

For one thing, it shows McCaskill's own political tin ear: Thanks to AP, we know that the average American earns something around $45-50,000. Do you really want to remind them that the executives taking their money will be earning something like nine times their pay? Or is it better to just leave well enough alone?

Secondly, if comp were limited to $400,000, all the best talent -- including many people who made the messes at these banks and are somewhat needed to clean them up -- will leave. It's like a big sign telling the best and brightest not to apply, which will delay these banks' return to solvency and keep them in a zombie state even longer at the taxpayers's expense.

Maybe at the end of all this, the key message is that the Democrats don't care because they don't pay taxes -- that is unless they're appointed to public office, such as Mr. Geithner and Mr. Daschle.

On one final piece of class warfare, Mary Schapiro, the new head of the SEC, will recieve up to $25mln in severance pay from Finra -- the very same people she will be regulating. Much like Mr. Geithner, her main qualification for fixing the mess on Wall Street is apparently that she helped create it.

I have tried to steer clear of partisan politics on this blog, but the conduct of the new administration is unfolding exactly as I had feared. I expected little more than bromides and a superficial change in policy from the Bush presidency. Aside from politically charged issues such as subsidizing overseas abortions and closing Guantanamo Bay, this administration is a continuation of business as usual -- just as little changed when Bush came to office. (All the Wall Street abuses of the dot-com era happened under Clinton's watch.)

Now Obama and Geithner plan to come up with a big mega plan to fix the credit market. Needless to say, it will be some kind of politically concocted grab-bag of subsidies, pork and class envy. At some point along this process, the market will realize nothing is going to get fixed and break out to the downside. It's about time to make the new lows I have been expecting. (I have been targetting 680 on the S&P 500 by the end of March.) If you want some real solutions on actually fixing the problem, read this. Interestingly, mega bond fund Pimco appears to have gotten on board with my argument from late last year that the problem needs to be fixed in the capital markets rather than the interbank market. For a more in-depth analysis, read this.

It's time for Americans to wake up and start seeing the real bubble threatening our country. It's not the housing bubble, the credit bubble or the now ailing Treasury bubble. It's a government bubble that largely traces its roots back to the 1930s, when Americans threw the constitution out the window and let Washington take over a country that spanned six time zones and thousands of miles. Our constitution was designed two centuries ago to solve a handful of problems, yet our politicians have hammered it into a system that tries to manage the smallest details of our economic, political, cultural and legal lives. We have endured decades of of middling results, trillions of dollars in waste, millions of lives ruined by welfare, inner-city decay and the war on crime, and tens of thousands killed in undeclared wars around the globe -- all because of politics. It's time to realize the problem is a government that's out of control because we let it get out of control.

There is no liberal or conservative, no Democrat or Republican. Most Americans agree on 80-90% of issues, and only fight over cheap symbolic issues such as abortion, evolution and prayer in school. It's important to realize that all of these result from the nationalization of politics. They have us battling each other the same way the British kept their enemies in India and Europe weak by getting them to kill each other. Our country has been carved up into political districts to serve the needs of the elected rather than the electors. We're split the same way General Motors and Ford once shared the auto market. Divided, we are easily ruled.

Like all bubbles, the time is approaching for this one to burst. (This article about the coming bear market in US Treasuries could be an early sign this is starting because if Washington can't pay for itself, how long can it keep growing?) We need to return power to the states where it belongs. They are more fiscally responsible and politically responsive. Just as happened in the early progressive period in the second half of the 19th century, states can compete against each other to solve health care, improve education and promote economic growth. There is a never a single answer to any problem, so why pretend we need single policies for 300mln people? It's a question of diversity versus dictatorship.

The answer isn't more government or less government. It's better government -- limited, constitutional government. That's the only kind of change you can truly believe in.

Reexamining Monetary Cause and Effect

2009-01-29T10:36:00.021-05:00

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.

Hypothesis:
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.

OBSERVATION #1:
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.

OBSERVATION #2:
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.

OBSERVATION #3:
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.

OBSERVATION #4:
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.

OBSERVATION #5:
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.

OBSERVATION #6:
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.

Good Bank, Bad Bank: Who Cares?

2009-01-28T08:50:00.036-05:00

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.
INFLEXION POINT

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?

SOLUTIONS

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.

Altruism vs. Profits

2009-01-25T23:09:00.008-05:00

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%.

Is More Debt the Answer?

2009-01-22T20:06:00.021-05:00

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.

BREAKING DOWN THE DEBT

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.

A REASON TO BELIEVE?

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.

PROFIT PROPHESY

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.

Obama to Disappoint?

2009-01-20T01:26:00.002-05:00

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.)

Bin of America

2009-01-16T13:31:00.013-05:00

“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.

THE PRICE OF ALTRUISM

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.

THE REAL WINNER

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.

The Despair of the Capitalists

2009-01-15T23:39:00.024-05:00

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."

WALL STREET'S DEMONS

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.)

More on the Global Nature of the Credit Bubble

2009-01-09T09:20:00.011-05:00

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.

Now vs. the 1930s

2009-01-08T11:48:00.009-05:00

Almost everyone I listen to on CNBC and Bloomberg are so convinced the current economic crisis won't be nearly as bad as the Great Depression. It is clearly different, but in some ways I see reasons why it could be even worse...

Mainly, few industries or sectors offer clear prospects for growth.

1- In the 1930s, most Americans didn't own a car and a large minority didn't have electricity. Merely by improving these conditions with things like road building and the Tennesee Valley Authority, government programs made a positive contribution.

2- In the 1930s, the economic system often called "Fordist-Keynsianism" was emerging as the new economic paradigm. Based Henry Ford's $5 day, this model focused on rising the living standards of workers and transforming them into a consuming middle class. It emphasized rising incomes and consumption. This model started coming apart with the inflation of the 1970s. Since then, corporate America has waged full-scale war on the Fordist-Keynsian model by shipping jobs overseas and scaling back benefits such as pensions.

3- In the 1930s, the modern integrated industrial corporation was still relatively new as a way to organize production. Modern integrated corporations include companies like IBM, GM, GE, AT&T, Procter & Gamble, etc. In the 19th century, technological progress was the name of the game -- things like electricity, railroads, higher crop yields, steel, etc.

This movement reached its peak during WWI, when the USA was expanded production to supply the allies with guns and butter. After the war, the country wound up with too much capacity, causing nasty deflation. By the mid-1920s, the agricultural sector was already in a depression and other primary industries like steel struggled. This was great for companies like GE and GM because it reduced their raw-material costs, making them massively profitable.

The key strength of integrated industrial corporations was much less their mastery of technology and much more their mastery of markets. They created brand identities and carefully managed sales and distribution, unlike textile and steel companies in the 19th century that relied on middle men to sell their products. (There were no brands back then.)

These integrated companies were centers of knowledge and information: It's where all the data about sales, production and finance intersected. This gave rise to a new class of white-collar middle-class workers, which would dominate American life for the next 70-80 years.

The problem now is that information is getting commoditized like never before. That means the same industries that benefited in the 1920s because they could monopolize knowledge are now facing a major threat.

Media is a perfect example. It grew in the 1920s and did pretty well even during the great depression. Today, it is being decimated by its own lack of creativity and the Internet. It started with the record companies in the late 1990s, spread to the newspaper companies starting in about 2005 and now is decimating television ... One mid-level executive at a major network recently told me "we're not planning to open any new television stations again."

(I think that even without the Internet or this recession, the established media companies were at the end of the road... That's why they resorted to growth via leverage and consolidation in the late 1990s.)

I covered the credit market as a reporter for several years. During that period, it was commonly stated that U.S. companies were "in great shape" financially. They were making tons of money and their debt levels were relatively low.

Since then I have become more skeptical and uncovered some data that casts major doubts on these assertions:

Unlike the chart in my previous posting, this chart looks at the debt of all businesses -- big corporations and small businesses. One of the reasons why companies appeared to be in better shape in the last few years was that companies enjoyed a massive profit bubble, with pre-tax earnings rising from 2% of GDP to 9% between the end of 2001 and late 2006. I believe at least three factors caused this bubble:

1-Companies benefited from significant capex in the late 1990s, which allowed them to produce more for less. It also allowed them to get by spending less on plant and equipment.

2-Globalization allowed companies to outsource many activities. As they purchased more from China, they experienced a situation like the 1920s -- only this time instead of benefiting from falling prices for food and steel, they enjoyed cheaper merchandise from China etc.

3-Cheap credit allowed companies to refinance debt to lower levels. It also let the U.S. consumer borrow excessively, making demand grow faster than it should have.

Now that the economy is going into retraction, profits are getting crushed. We've seen this across the entire retail space, and it will become increasingly common for industrial companies. So far, we've heard from Alcoa and Lenovo (not American, but still a good indicator of things to come in the USA).

That means debt burdens will actually go up, even if companies don't borrow money. Imagine you earn $5000 a month and have a $1500 mortgage payment. It takes up 30% of your "free cash flow." Now, imagine your pay drops to $4000 a month because your company loses a customer, or something like that. Now your debt payments absorb 37.5% of your money. The entirety of corporate America is facing this on a massive scale.

Another obligation that's going to get even bigger are corporate pensions.

On Dec. 23, S&P says companies in the S&P 500 index are now at least $257 billion underfunded.

On Jan. 7, BNY Mellon Asset Management said the liabilities of the average pension plan rose 31.5% last year. This was partially because of falling stock prices, which reduced assets and will require bigger contributions from sponsors. But most of the decline came from the Fed muscling bond yields lower, which reduces the ability of pension plans to earn income. Another unintended consequence of the Fed's heavy hand in free markets.

On Jan. 8, Mercer said pension funds were $409 billion short.

Based on all this information, it's clear the established corporation as we know it faces big problems. Their liabilities are going to get bigger over the coming year, putting even more pressure on employment.

Another looming issue is problems in the loan market. UBS is predicting that about $54bln of loans could get put up for sale this year as collateralized loan obligations (CLOs) and hedge funds dump assets. Amazingly, these two categories of investors control more than $240bln of the $370bln market for leveraged loans. (This demonstrates the huge decline of banks in the economy that I highlighted in this posting.) Do you think the average American knew that largely unregulated lenders account for such a large portion of the US loan market? CLOs are like mortgage-backed securities that hold big corporate loans instead of home mortgages. Both CLOs and hedge funds owe huge amounts of money at any one moment in time, so vulnerage to quick liquidations when things go against them.

This just demonstrates how hard it's going to be for debt-laden companies this year.

One final observation, which UBS took from the Bank of International Settlements. This table shows bonds outstanding as a percentage of GDP in several countries:

USA 219%
Japan 207%
Italy 199%
Germany 155%
UK 142%
Brazil 77%
China 51%

Debt is clearly a first world, developed country problem. This is going to hang like a ball and chain around the neck of our country for years to come, especially after politicians throw money at the economy in hope it will rebound. It's like throwing a cow's ear to your dog. When he's a puppy, he loves it.. over time, he's less and less excited about it. Now the dog is blind and arthiritic. He's lucky if he can walk 20 feet across the room. The trick won't work anymore.

At this point, the best thing we could do would be to find a way to replicate the economic experience of WWII, when people were essentially forced to build a nest egg of savings. This is what unleased the consumer boom that is finally ending now. It should be complemented with a rational dismantling and re-engineering of shopping centers and suburban subdivisions. The only problem is that that Wall Street can't make any money under that scenario, so I doubt it will happen!

Where'd All the Money Go?

2009-01-05T21:30:00.032-05:00

"The biggest issue the credit markets have is the loss of the securitization markets. The banking system was only about 33% of all credit creation, and securitization was the other two-thirds. We complain the banks are not lending, but they are lending... But they only had a small market share to begin with."
-- Jim Bianco on Bloomberg Television, 1/5/08

I have written extensively since October about how the collapse of the bond market in general would have a paralytic effect on the U.S. economy. In postings such as this one, I have argued that we now have a new kind of financial system that behaves differently than the textbooks say. Combining my own knowledge of how markets work and theories from people such as George Soros, I have suggested that we face something very similar to the Great Depression. While I have yet to find anyone agree with my bigger thesis, I find lots of quotes that validate parts of it. Bianco's above it one of them.

Last week, I had another one from a respected economist who is frequently quoted in the financial press. Because he didn't know I would cite him on this blog, I will not identify him by name, but he works for a major bank and is well known:

"Policy makers globally have lost control of the money supply. Money is no longer just the bills. It's the credit and the leverage. We're seeing a structural shift, and this implosion of the money supply isn’t something that's going to be reversed anytime soon."

Before going any further, let's look at what happened:

This chart shows how the financial system has stopped packaging up different kinds of loans into bonds which are sold to investors -- the process known as securization. My basic argument is that the banking system has grown dependent on securization as the underlying source of credit, and the ultimate arbiter of value. Levels in the bond market are used to set rates on ordinary loans. Extra money in the bond market caused reckless lending. Now that the bubble has broken, the market has swung in the opposite direction and lending is shutting down throughout the entire economy. (I discuss in this posting and this one how all the extra money wound up in the bond market in the first place.)

As a result of this collapse, mortgage lending has ground to a halt:

(Two quick notes: Issuance can be negative because bonds are paid off when they come due, and because they're counted as a negative number when borrowers default. Secondly, I use estimates for 2008 because I do not yet have the numbers for 2008 from the investment banks. Instead I used the average for the first three quarters according to the Fed. All numbers are net, in billions of dollars.)

"You have a market that has been so shut down by the shutdown in the securitization market... What you haven't seen yet digested yet by the market is banks pulling lines from consumers... You're going to see the consumer start to get really strained on their credit card lines ..."

--Meredith Whitney, Oppenheimer & Co. on CNBC 12/1/08.

Whitney estimates consumers will lose $1.5-$2 trillion of borrowing capacity by mid-2010, which dwarfs Obama's planned $300bln tax cut/stimulus plan.
So far, most economists predict things will gradually improve as the banks return to more of their established role as ordinary lenders. I am more skeptical of this because our financial system has spent the last 5-10 years building itself around the securitization model. While I do not fully understand the reasons why this happened, I am sure they make sense. This process is not going to just reverse itself. (For some hard facts on how much things have changed, see this posting.)

When you're dealing with large numbers of people and big institutions, it's best to change as little as possible. This is why the political process is often "conservative", and why some companies keep using technology that is decades old. It's also true in the military, where some procedures and rules persist for decades longer than you might expect. In general, the bigger the group of people, the more robotic and conservative behavior is.

To understand why, think about the English language.. no one thinks it makes sense that we have hundreds of irregular verbs like think/thought, go/went, run/ran. But it's never possible to get millions of speakers in one place at one time to tell them the words have changed.

Markets and industries work the same way. Now that securitization has become established, it's the language people speak. Expecting them to just go back to the old bank-lending model could be unrealistic, especially when the industry is facing huge layoffs, writedowns and scrambling to figure out who owns what now that everything has been packaged up and sold to investors from Bangalore to Bakersfield.

This is why I say the government needs to focus on getting bond issuance moving again. They have nibbled around the edges of this issue by doing things like trying to force mortgage rates lower and guaranteeing bank bonds. This has improved the market for some high-quality corporate bond issuers, and is expected to cause a surge of mortgage refinancing. But like all socialist measures, it tends to help those who are already privileged and does nothing for those "most in need." Just like public schools, if you're rich enough to live in a good town, you get access to a good education... If you don't really need the money, you can get it.

Of course, this will do little to prevent lots of small and weaker companies from going bankrupt and laying off their workers. Even if the government forces mortgage rates lower, I have yet to hear anyone claim it will prevent foreclosures or support home prices.

This is why I think that when Bernanke of Obama/Geithner try to do liquidity injections, it will be like an intern giving someone a shot for the first time and missing the vein.

I want to end with three final charts I made from data in the Fed's H.8 report, a mega-breakdown off all the banks' assets and liabilities. I notice some worrying patterns.

1) Bank asset quality looks poor. Riskless investments like Treasury bonds and Agency bonds are plotted in the top chart (I accidentally labeled it only as Treasuries). They are now below 13% of total bank credit, close to the lowest level since the data started in 1973. If you look back to the early 1990s, you see that banks accumulated huge piles of Treasuries in the wake of the S+L crisis. (This was Greenspan's "brilliant" way to let them rebuild their balance sheets.)
Given all their problems with bad assets now and climbing corporate defaults, it seems probable that banks will continue to stock pile Treasuries rather than making loans.

2) Keeping with the theme point #1, loans appear to have actually peaked at around 74% of bank credit and now are declining.

3) The bottom chart shows that banks have a huge amount of "Other Securities" on their balance sheets. These probably include lots of "toxic assets," which gives banks even more incentive to buy only Treasuries going forward.

Ordinary people have recently been piling money into bank accounts as they swing from being compulsive spenders to savers. The only problem with this phenomenon is that the same banks are not lending the money back into the economy, but to the government!! Treasuries climbed from 15% of bank credit in 1989 to 23% in 1993, and averaged 16% in the post 1973 era. Given that it's now less than 13%, banks are destined to buy tons of government debt going forward -- especially when you consider the trillions of dollars in Treasury bonds we're going to sell in coming years to "stimulate" the economy. Meredith Whitney's words about less access to credit cards resonate in my thoughts... The government is going to crowd American businesses and consumers out of their own economy!

You might counter: "So what?" Once banks rebuilt their balance sheets in 1995, the financial system was stronger than ever and produced the greatest bull market for stocks in history. That is true, but at that time, there were many other positive secular forces at work on their own that are gone today. For instance, productivity was rising thanks to new technology. Consumer debt and home prices were still rising. Demographics were still favorable as the baby boomers entered their highest earning years.

These things have all reversed now, or at least slowed (I am less sure about productivity gains, but that doesn't even matter during a recession.)

The thing we need to start thinking about is that our established paradigms for making money are coming under seige... Since the 1920s, we have relied on the integrated industrial company to generate wealth and innovation -- the IBM, GE, GM, etc. I believe this model as an overall concept is now coming under increasing secular pressure. (When I say secular, I mean a long-term mega-trend, as opposed to a business cycle trend that improves when the economy bounces back. For instance, typewriters suffered a secular trend in the 1990s -- even as the economy grew, they declined in relevance.)

According to Pullitzer prize winning business historian Alfed Chandler, the modern industrial corporation is more a center of knowledge than of production. This started with the railroads, which amassed armies of clerks to manage time tables, and progressed for decades as the "white collar" or "pink collar" revolution took off. This is why during the 1920s, even as the agricultural economy was already in depression and parts of the industrial economy were already in recession, a new consuming middle class of office workers was emerging.

The corporation centralized knowledge and coordinated production. By owning brands and knowing customers, they were able to ensure a steady revenue stream. Once the cash was reliable flowing in the door, they were able to invest in cost-saving mass-production. This is how companies like Kraft, Anhueser-Busch, Proctor & Gamble and so many others enjoyed an upper hand in the economy for years.

I see this shifting now due to revolutions in information technology. Companies are going to see their comparative advantages shrink going forward. Already consumer-product companies are facing growing threats from generic-brand competition. My sister, for one, has used the Internet to buy shares in a live cow rather than buy meat at the store. All of this is anecdotal, but there is a new secular trend emerging, which I actually discussed in this blog entry over the summer.

So, in the early 1990s, we also had a banking crisis. But, we had a whole bunch of great companies and industries, all blasting off on their own massive growth cycles: computers, biotech, Wal-Mart, Fannie Mae, etc. The stock market was already in an uptrend from the 1980s, and slowly ground higher for a few years before taking off again. Plus, the consumer at that point was still on solid footing.

This is very different. Not only is our financial crisis much bigger, this time we have few industries that are enjoying real positive growth. (That's why companies spent the last 5 years buying back their own shares rather than investing in their own businesses.) Alternate energy looked promising for a while, but even that is now going to be in question with oil so much cheaper. One final shoe to drop is will be the education industry, which is going to get slammed by losses in their endowments and tighter credit. (I think STRA is getting ready to be a huge short-selling opportunity.)

In one final chart, I plot the debt of non-financial corporations relative to GDP from 1952 to the present. One important thing is that corporate profits have risen faster than GDP in recent years, so companies' ability to service this debt has done better than this chart suggests. But now corporate profits are contracting and returning to more historically normal levels. (From 10-11% of GDP probably back to 7-8% of GDP.)

That means that leverage ratios will be going up and overall creditworthiness will fall. This is worrisome because it is a general sign of decline: Companies almost always move down in credit quality as they mature. They start as growth dynamos and then gradually accumulate debt on their balance sheets like old people building up plaque in their arteries. (For instance, during my time covering credit, I saw most of the entire hospital industry borrow itself into the poorhouse and witnessed willful balance-sheet hari-kari of once strong AA and A credits like Home Depot and Target.)
Debt is a sign of decadence and decline. You saw it in GM, and you see it in our own national government. This time is different. Hard times lay ahead. The post-WWII party when everything always went right for the USA is over. There's no "going back to normal" this time.

Going forward, we're going to learn just how unusual normal was.

Tearing the Cartilage of Trust

2009-01-04T00:14:00.012-05:00

When I first saw blood flowing in the streets of the credit markets during late September, I knew the financial system had taken a turn for the worse. My immediate fear was the sharp collapse of corporate bond prices would prevent companies from borrowing and force a broad contraction in business activity. For more, see the charts in this posting.

And right I was. To me, the broad shutdown of the market for corporate bonds and asset-backed securities remains the biggest problem facing the economy now. The reason is that this is where companies and consumers get their money. Companies always have different kinds of debt to refinance, whether it consists of debt coming due, or bank debt (working capital) that needs to be "termed out." (When companies build a factory or buy inventory they plan to convert into products, they usually borrow the money in the short term using bank lines. They then often sell longer-term bonds to pay off these bank loans.)

If companies cannot sell new bonds, they are forced to rely more on short-term debt, which is dangerous. Most of the time they respond by reducing costs, which means they order less inventory and shed jobs. (Sound familiar??) As this collapse of confidence spreads through the business community, companies grow less willing to extend credit to each other. Under normal circumstances, they might wait say 90 days for payment. They record this IOU as an "Account Recievable," and consider it an asset more or less akin to cash.

When things are contracting, like now, companies demand payment sooner and are less willing to trust each other in general. This results in a decline of Accounts Recievables, which is shown in the chart above.

I called it "Trust Broken" because it illustrates what's really going on in the economy. The word credit, after all, derives from the Latin word for "believe" ... You believe you're going to get paid back. I have described this as the cartilage that holds the body of the economy together. Companies and customers are like bones and muscle.. they do the work. But without credit, they can't work together.

While it might sound like an abstract concept, like everything else, it has a price. When a single market exists to provide that price, it will inevitably set the levels for everyone else.

Accounts Recievables contract during all recessions, but what is interesting about this one is the sheer speed. It had been growing at 1-2.4% of GDP over the previous six quarters, but suddenly dropped to -1.8% of GDP. That represents a swing of 4.26 percentage points of GDP, the sharpest contraction since at least 1952, when the Fed data begins.

The other noteworthy thing is that corporate bond issuance plunged and bank lending increased. This shows how companies, unable to sell bonds or issue short-term commercial paper, increasingly rely on backstop bank loans.

We're likely to see an outright contraction in corporate bond sales in the fourth quarter, which would be another first in the data. The really key issue is whether it will rebound going forward. If it doesn't, the economy and stock prices will be in serious trouble.

In the last few months, yields have fallen as the authorities muscle borrowing costs lower. This is clearly good news for some savvy investors who bought the bonds at the most panicked moments in October. But it won't help the broader economy until we see a follow-through of real bond issuance. Until we see big numbers on the volume front, it won't help to restore credit to the economy.

I am skeptical of Bernanke & Co. because they have managed to force borrowing costs lower, but there is less and less lending going on. Everyone is hopeful the new Administration will stimulate the economy... My biggest fear is that the high expectations will undermine business confidence because it gives decision makers a reason to wait before doing anything. I personally think that creating high expectations and then being unable to deliver is much more damaging that not creating any expectations at all. Let's hope it doesn't wind up what former Supreme Court Justice John Marshall would call a "splendid bauble..."

This January's pipeline of new corporate bond offerings will be extremely important to watch. Will people bid for new deals, or will they demand huge concessions, pushing yields back to record high levels? Those are the key things to watch in coming weeks, and will be a good barometer on the health of the credit market.

Trade and the Mortgage Stupidity Index

2009-01-03T10:40:00.028-05:00

After many hours making dozens of charts, I have hit upon a measure that truly reflects what happened in the U.S. credit market. I call it the Mortgage Stupidity Index, depicted in the blue line below.

(All of the data in this entry comes from the Federal Reserve's Flow of Funds report.)

Definition of the Mortgage Stupidity Index: Purchases of Mortgages by Asset-Backed Securities Issuers / GDP.

Why? In my opinion two key underlying trends combined to make the housing bubble so special:
1-Housing as an asset class experienced a final surge in the 2003-2007 period after decades of positive growth. Most bubbles occur after years of healthy and sustainable returns. This gradually convinces sane people that "houses never lose value" or that "shares prices only go up" (a la late 1990s). This attitude is a part of most financial bubbles.
2-Securitization reached an apogee after more than 20 years of quiet growth. I am not an expert on securitization, but there is no doubt our financial system became increasingly dependent on packaging assets into bonds as a way of funding itself as the housing bubble inflated.

Another key aspect of securitization is that it separated loan officer from lender. This gave an incentive for reckless fly-by-night mortgage originators to generate as many loans as possible, regardless of the borrowers' ability to pay. Wall Street and the rating agencies also loved securitization because they made at least twice as much in fees selling the bonds to investors relative to corporate or municipal securities.

The Mortgage Stupidity Index combines these two trends. It can only rise when mortgage lending and securitization are both going up. Mortgage origination averaged 7.7% of GDP in the 2003-2007 period, compared with just 3% over the previous 50 years. At the same time, ABS issuers funded 35-53% of all home mortgages, a level essentially unprecedented in American history. (One data blip higher higher occurred in the early 1990s, but it's not material.)

To capture how securitization bred reckless lending, I took the amount of mortgages funded via securitization and divided it by GDP. The result is somewhat jaw-dropping: "Stupid" mortgages rose from less than 1% of GDP in 2001 to over 5% of GDP at the peak of the housing bubble in the third quarter of 2005.

This Mortgage Stupidity Index is reflected in the blue line of the chart at the top of that page. (The two bar charts above show the two components of the stupidity index. The green line in the same top chart shows Non-Financial Corporate Bond Issuance as a % of GDP. Why? Because nothing occurs in a vacuum. This wave of mortgage securitization occurred at the same time that "ordinary" borrowers like utilities, telecoms and railroads signficantly reduced their bond sales. They had been selling large amounts of debt through 2001 as they locked in long-term financing for capital investments made in the late 1990s. As that cycle waned and the tech IPO boom ended, Wall Street turned to home mortgages to compensate for declining fees.

The top chart establishes that in the 2003-2007 period, stupid mortgages surged. Everyone knows this anecdotally (after all, that's why we're now in the middle of a massive financial crisis), but I wanted to establish it using real data.
The lower chart highlights a trend that is much less commonly known: The role foreign capital played inflating the credit bubble. The purple line shows the trade deficit rising as a percentage of GDP from a mere 1-1.5% in the 1990s to more 6% in late 2005. As those dollars piled up overseas, they were recycled into dollar-based assets like U.S. debt securities, reflected by the red line. (It's called ROW for "Rest of the World", which is how the Fed labels this data series. Also, the data lumps all corporate bonds and mortgage-backed securities under the label "corporate bonds," so we don't know what was buying what. It doesn't really matter however, because the yields on all these securities moved in tandem.)

It is no coincidence the trade deficit and foreign purchases of U.S. bonds peaked at the same time as stupid mortgage lending!

If Americans had been buying products made domestically, those dollars would have filtered through the U.S. economy in the form of higher wages. That's how it worked in the 1950s-1970s, when imports were a tiny portion of GDP and inflationary pressures mounted. Only a small amount of that money would have entered the credit market via savings and the purchase of things like life insurance. But between 2003 and 2007, a whopping 54% of the trade deficit flowed directly back into the U.S. credit market -- into corporate bonds and mortgage-backed securities. (They bought such securities at a much quicker pace they they purchased GSE debt, Treasuries or U.S. stocks.)

What happened? After the emerging-market crisis of the late 1990s, Asian exporters turned to the U.S. to prop up their own economies. Even more importantly, China ascended to the World Trade Organization December 2001, and quickly flooded the U.S. with cheap merchandise. As China grew, it started buying lots of commodities like petroleum. This drove up the price of oil and everything else, which in turn forced Americans to send even more of their dollars overseas. That's why the trade deficit got so big in the 2003-2007 period.

To me, the Age of Globalization truly exploded in 1997, but it took a few years for all those dollars to find their way into the U.S. credit market. And, in the early stages of that period, companies like WorldCom and AT&T were soaking up a lot of the money by selling bonds. The chart below shows how the trade deficit surged to levels previously unseen in the post-WWII era:

One final note: Trade was one of a few key factors that inflated the credit bubble. But, like any huge historical development, such as a war or social change, there is never a single cause. Many forces converge at one moment in space, time and finance. An important subtext was an ongoing multi-decade bull market for U.S. bonds after the Fed defeated inflation in the early 1980s. This trend is now arguably in its own bubble phase with long-term Treasury yields below 3%.

Two other factors worth mentioning that contributed to the boom from 2003 to 2007:

1-Low interest rates in Japan channeled large amounts of capital into foreign economies like the USA and Australia in search of higher returns.

2-The rise of leveraged bond investors like hedge funds and structured investment vehicles (SIVs), which channeled hundreds of billions of dollars into the mortgage market at the same time it grew increasingly "stupid," according to my index.

My personal suspicion is that the Fed inadvertently faciliated this process in the 2003-2007 period by raising interest rates. That ensured a steady appreciation of the dollar versus the yen between 2004 and 2007, making the "yen-carry trade" a sure money maker. (This was strategy that involved borrowing in yen at say 1% and buying mortgage bonds yielding say 5%. The difference is called "positive carry.") Also, by rising short-term rates, hedge funds' borrowing costs rose. Over time, this forced them to buy increasingly risky assets to break even.

I have hypothosized that by cutting rates so aggressively, the Fed contributed to the current crisis. Most Wall Street professionals have reacted in shock and anger at this suggestion, which means it may contain a kernel of truth. I shall elaborate in a subsequent posting.

Breaking Down the Credit Bubble

2009-01-03T02:43:00.007-05:00

I have written a lot about how the credit bubble formed, but wanted to quickly list the factors I view as the real driving forces. These factors all came to a head in the 2003-2007 period:

A 25-year bull market in U.S. bonds: Starting in the 1980s after the Fed defeated inflation, this bull market saw the yield on 10-year Treasuries collapse from over 15% to less than 4%. As the entire yield complex declined, overall borrowing costs fell and the financial industry went into a major boom period.

Less need to borrow by normal corporations: For centuries, corporate bonds were mainly issued by non-financial companies like utilities, telecoms and railroads. But after a surge of capital spending in the late 1990s, these companies had less need for debt capital. Ever inventive, Wall Street created new kinds of credit securities to fill the vacuum.

Trade dollars were recycled into the credit market: Thanks to globalization and free-trade policies, imports flooded the U.S. economy. Americans bought much more from the rest of the world than we sold to it, causing a huge transfer of dollars from the U.S. economy overseas. Between 2003 and 2007, we imported $9.9 trillion of goods and services, while exporting $6.6 trillion, resulting in a running trade deficit of $3.3 trillion.

As dollars piled up overseas, the same exporting countries needed to do something with it. They weren't wise investors like Warren Buffett, who carefully examine all investments with an eye on both expected profits and recovery in case things go badly. They had a big pile of money with nowhere to go until it found its way into our credit market. Of that $3.3 trillion trade deficit from 2003 to 2007, 54% of it went into corporate bonds, asset-backed securities and private-label mortgage securities (that means stuff cooked up by Wall Street, not issued by Fannie Mae and Freddie Mac).

Proponents of globalization had claimed it would drive economic growth in the U.S. While it clearly destroyed many manufacturing jobs and lower skilled white-collar positions, it clearly helped drive construction and investment banking.

Securitization: This is the practice of taking lots of individual loans and bundling them into bonds. Lenders liked it because it allowed them to lend more aggressively and remove assets from their balance sheets, transferring the risks to bond investors. Wall Street liked it because they did the securitization, charging big fees to sell the bonds. The rating agencies liked securitization for the same reason: They charged much higher fees rating the bonds. And, finally, investors liked securitization because the bonds typically paid a little bit more yield for "comparable" credit risk. (The rating agencies made that call.)
The big thing about securitization is that it allowed certain people to originate loans, which they then sold to someone else. Essentially, fly-by-night mortgage companies lent other people's money without any risk if they messed up. This produced one of the biggest instances of moral hazard in financial history because
Securitization took off in the mid-1980s and, along with the bull market in fixed income mentioned above, reached its peak in the 2003-2007 period.

Declining Inflation: Consumer prices steadily edged lower throughout the post-1982 period. This mainly resulted from the Fed's high interest rates early on, aided by a collapse of oil prices, increasingly cheap imports from around the world, higher productivity thanks to technology and a stagnation of per-capita incomes.

Government endorsement of housing: For decades, the Federal government pushed homeownership as a cure to the economy's ills. It poured money into everything from subsidies for roads and mortgages and flood insurance.

Deregulation: Everyone likes to blame deregulation for the credit crisis. I think it played a much smaller role than many people might initially think. First, it seems to me that the places where the growth occurred were not contemplated by existing rules. Our regulation didn't contemplate things like massive securitization or trillions in foreign capital flowing into the economy. But the general attitude that the market is "self-policing" certainly didn't help matters.

Much more important than deregulation was complacency. This is key to any bubble, because when people are making money, no one wants it to stop. Wall Street was making money, investors were making money, homeowners were making money... Most importantly, the watch dogs in government were making money. They would jump from the SEC to Wall Street, work as lobbyists or as outright thralls of the financial industry -- such as Charles Schumer, who repeatedly intervened on behalf of the investment banks.

Rationing Credit

2008-12-30T01:08:00.004-05:00

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

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

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

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

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

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

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

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

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

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

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