Getting Ready for the Roof to Fall [¹]
By Jonathan R. Laing, Barron's | 29 September 2007
For celebrated bond fund manager Jeffrey Gundlach, the intensifying meltdown in the U.S. housing market has all the inevitability of a Sophoclean tragedy.
The Chief Investment Officer of Santa Monica, Calif.-based TCW Group has been sounding warnings for more than a year that mortgage lenders had taken leave of their senses by spooning out mortgages without owner-equity cushions and with little or no verification of the borrowers' ability to pay back the debt.
By now, with mortgage defaults climbing and home sales falling, the plot line of this drama is becoming clear. But Gundlach says there are still several acts to come— and that the curtain may not come down until the close of this decade. He sees U.S. home prices dropping an average of 12% to 15% annually from the highs achieved last year and not reaching their eventual trough until late 2008, at the earliest. And they may not start recovering until 2010 or 2011, inflicting, in the meantime, real damage on the economy.
About the only bright spot: the mortgage market may offer some excellent investment opportunities in the year ahead, he says.
Gundlach was among the first to rail against the profusion of new types of home loans— interest-only mortgages, adjustable-rate mortgages with artificially low teaser interest rates in the early years of repayment, and so-called option ARMs, which allowed borrowers to make monthly payments that didn't even cover interest costs— all of them designed, in Gundlach's phrase, to "shoehorn" borrowers into homes often far beyond their financial means.
Sure enough, all these dicey loans helped bring about what Gundlach now calls "the great margin call of 2007." As home-price appreciation flamed out, subprime borrowers began to default in droves, especially on new mortgages, and mail back the keys to lenders. As a consequence, major subprime mortgage lenders like New Century began hitting the wall. Ultimately more than 100 subprime lenders were forced to close their doors as Spring turned into Summer.
That was followed in June by disclosure that two hedge funds managed by Bear Stearns were in deep trouble because of highly-leveraged subprime-debt bets that had gone bad. Soon a number of hedge funds, banks and other financial institutions from Asia and North America to Europe were reporting heavy losses on subprime debt investments. A number of hedge funds ended up being liquidated, and banking authorities in Germany and England were forced to arrange hasty bail-outs to save various banks.
The financial markets were further shocked in July and August when Moody's and Standard & Poor's and Fitch belatedly took over 5,000 negative ratings actions, decimating prices on all manner of residential mortgage-backed and home equity loan securities. "This was the biggest credit ratings catastrophe that our markets have ever seen," Gundlach observed to Barron's during a lengthy telephone interview.
Soon, the subprime contagion spread to other markets— from leveraged-buyout debt to asset-backed commercial paper, triggering a full-scale seizing up of global credit markets. Yields on risky debt paper soared. Buyers went on strike. The ascendancy of fear over greed forced central bankers to flood their financial systems with liquidity, and in the case of the Fed two weeks ago, to drop short-term interest rates.
As the rest of the tragedy unfolds, the pain may be especially bad in what Gundlach calls "the bubble markets" of California, Florida, Nevada and Arizona and hard-hit Rust Belt areas in Michigan, Ohio and Indiana. Housing prices in those locales will likely fall 30% to 40%, he maintains.
His pessimism is grounded in some two decades of trading mortgage-backed securities and analyzing homeowner behavior with the underlying loans. He lived through, for example, the housing bear-market of 1989 to 1993 that saw home prices fall 30% to 40% in some overextended markets like Boston and Orange County. In his opinion what happened in some of those pockets of price weakness may be but a dress rehearsal of what impends for broader swaths of the country.
Moreover, the worrisome trends in mortgage delinquencies, defaults and foreclosures figure to accelerate in the months ahead. That's because next year and early-2009 will see a crescendo in the troubled 2006 and early-2007 subprime mortgage vintages reaching their two-year rate reset points, when the low teaser rates expire. Facing jumps in monthly payments of 30% or more, many homeowners are likely to just throw in the towel and default on their mortgages.
Worse, Gundlach doesn't see much chance of a recovery in home prices until still later. Housing cycles in his experience typically trace elongated U-shapes rather than the V-type patterns so often seen in stock markets. For one thing, home-price information is often episodic and poorly-reported. Too, housing market fundamentals take a long time to play out, making shifts in market psychology far less mercurial than in the stock market.
It's easy to dismiss such dark ruminations. After all, Gundlach is a fixed-income guy. And at least up to a point, bad news is good news in the bond market. A slowing economy, for example, eventually causes the prices of high-quality bonds to rally as a result of reduced inflation expectations and less demand for credit. At the same time, the differences among yields on bonds of varying credit quality often widen to better reflect levels of risk, allowing investment managers like Gundlach to be more properly compensated for any risks they may take.
He is still agog at the galvanic moves in yield spreads that occurred last month at the height of the global crunch. Yields on top-rated asset-backed commercial paper that on Aug. 8 traded at just 41 basis points (or hundredths of a percentage point) over the three-month T-Bill rate soared to 289 basis points over on August 20 before settling back to around 185 basis points over. "This is what happens when the ocean of liquidity that everybody was talking about just a couple of months ago has turned into a swamp of troubled debt," Gundlach observes.
But Gundlach is more than a mere bondo spoilsport. Indeed, he has earned much street cred over the years. He was named Morningstar Fixed Income Manager of the Year for 2006 after being a finalist for the three previous years. The $900 million TCW Total Return Bond Fund, which he has co-run for some two decades, has been a top-performer in credit cycle after cycle, finishing in the second percentile of the Morningstar universe of intermediate-term bond funds for the 10 years ended Aug. 31 and in the seventh percentile for the year ended Sept. 27. In all, Gundlach has direct control over some $90 billion in fixed-income portfolios at TCW, mostly for institutional investors.
"His performance has been all the more remarkable since he has done it by mostly focusing on the mortgage-backed securities, while many of his peers have much more flexibility in what they own," says Morningstar analyst Lawrence Miller. "And this year he has done well, despite all the convulsions in the mortgage-debt sectors, by concentrating on high-quality paper, much of it guaranteed by government and quasi-government agencies like Fannie Mae."
Gundlach was early in seeing the virulence of the housing slump that the subprime debt excesses would spawn. In a Barron's Current Yield column last December he opined that the U.S. housing bust was merely in its "early innings" and would likely continue well into 2008 because of subprime-debt problems. At the time, no less a personage than former Fed chairman Alan Greenspan claimed that stabilizing new mortgage applications indicated the housing market had already bottomed.
To Gundlach, the problem is not so much the losses that investors in the U.S. and around the globe will take on the $2 trillion or so of subprime and "Alt-A" mortgage-backed securities and collateralized debt obligations that are currently outstanding. Those losses will probably top out at around $300 billion, which, in his estimation, constitutes a rounding error in a $14 trillion economy.
The problems lie in the knock-on effects that subprime is having and will continue to have on the economy. Gundlach asserts that the mortgage-triggered housing downturn has already cost GDP about one and half percentage points of growth. That negative impact figures to intensify some in the quarters ahead.
Increasing defaults and foreclosures will add to an already swollen inventory of unsold homes that now stands by some reckonings at 10 months. As last week's August numbers showed, new home sales are continuing their descent, falling over 20% year-over-year.
Likewise, says Gundlach, demand for housing is likely to continue to suffer as now-timorous lenders and mortgage bond investors pull back from the market. And dicey subprime mortgages exist at all price points of the housing food chain, from the most modest starter homes up to fancy $700,000 homes.
Housing woes, of course, radiate far into the general economy. Housing accounts for a big chunk of U.S. employment when one takes into account all the construction, finance and retail jobs that depend on a strong housing market. Consumer confidence and spending suffer mightily when cash-out refinancings dry up and the value of most families' primary asset falls in value.
Gundlach and TCW haven't emerged completely unscathed by the current credit crunch. Two weeks ago, TCW was forced to liquidate a $3.2 billion mortgage-backed CDO it managed called Westway's Funding X, when the market price of certain tranches fell below certain levels. There was nothing wrong with any of the assets backing the CDO. "They were of pristine quality and performed fine," says Gundlach. It was just a case of market jitters that led to the price markdowns.
But overall Gundlach is salivating at all the mortgage-market investment opportunities that are likely to emerge in the quarters ahead. TCW has already raised $1.6 billion from various institutional investors for a new vulture fund. After all, one investor's grief can be another's opportunity.
The Bottom Line
As the housing slump deepens, the toll on the American economy could be severe. Already, it has cost GDP one-and-a-half percentage points of growth; and median U.S. home prices are unlikely to recover until the decade's end..
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Saturday, September 29, 2007
Is It To Be Inflation OR Deflation, Fire Or Ice?
Inflation versus deflation debate for Red Pill consumers [¹]
Click here for link to complete article,
By Eric Janszen, iTulip.com | 29 September 2007
Reading Hudson and Phillips is like taking the Red Pill. If you're not familiar with the movie The Matrix, the Red Pill is the one you take if you want to see past the surface illusion of the made-up world. Once you read Hudson and Phillips, no matter whether you agree with their solutions, it's hard to go back to seeing the economy as anything but two distinct economies: the great, big FIRE Economy and the itty bitty Production/Consumption Economy.
Inflation versus deflation: Red Pill view
For readers who've taken the Red Pill, the inflation vs deflation discussion needs to be put into the context of the FIRE and P/C Economies.
FIRE Economy Failure?
When we interviewed Dr. Hudson, he didn't buy our Next Bubble idea. He believes that the FIRE Economy will gradually fail. He calls it the "slow crash." In that case demand declines within the P/C Economy as Japan experienced. Does that mean the US experiences deflation as Japan did? Japan was a net creditor when its FIRE Economy began a slow crash starting in 1992. The US was also a net creditor when its FIRE Economy crashed hard in the 1930s. For net creditors, as asset price deflation within the FIRE Economy spills over into the P/C Economy, the impact on interest rates and currency values is deflationary for wage and goods prices. For net debtors, on the other hand, the impact is the opposite: interest rates rise and currency values fall as capital flows reverse, ala Ka-Poom Theory. We believe failure of the FIRE Economy therefor means inflation.
Mike (Mish) Shedlock believes the banks can't be resuscitated once the credit defaults get rolling (see Death Spiral Financing). Rick Ackerman and Gary North are in the same camp. In Red Pill terms, they believe excessive debt levels and credit derivatives will swamp and wreck the FIRE Economy, taking the P/C Economy down with it.
I got into the topic with GaveKal CEO Louis-Vincent Gave on Sunday (interview here). His case for deflation in Europe is well articulated and specific: run-away asset price deflation happens because there is no euro bond market like the US and Japan have dollar and yen bond markets, each connected to a national central bank. The euro is a multinational political animal, with no centralized means to inflate.
The euro's lack of a euro bond market was first pointed out to us in our interview with Jamie Galbraith (JK's son) earlier this year when we were asking victims of various interviews: "What sort of international monetary regime after this one turns turtle?" It was one of those slap-your-forehead moments we hope to experience at least once in each interview we conduct. Jamie said a multilateral dollar-yen-euro regime depends on the development a euro bond market— so don't hold your breath.
The Road to Inflation
The inflation versus deflation debate was re-ignited by the Fed's 50 basis point rate shock therapy last week. Readers of pundits in the deflation camp demanded to know, "The long awaited credit meltdown is here. Where's the deflation? Gold and oil are going through the roof!"
Hudson’s prediction of the decline of the FIRE Economy is more or less a traditional Marxist one, that total interest payments eventually exceed the economy’s debt carrying capacity. At some point there’s a "break in the chain of payments," and the system collapses. Preventing such a break is what the Fed has been up to for the past few weeks, and the Bank of England is still doing for Barclays and other banks today.
No one knows whether the FIRE Economy is doomed or not. But its imminent demise has been prematurely announced many times over the past 20 years. I heard similar arguments from Marxist economics professors in college in the early 1980s. Now you can hear them from Libertarians, too.
Our Red Pill conclusion is that to keep the FIRE Economy running until the Next Bubbles get going, the Fed is willing to risk inflation in the P/C Economy, thus the 50 basis point cut while inflation is at multi-year highs and the dollar at multi-year lows. A bit of extra heat from the 1/10th HP heater is a necessary cost of preserving the 400 HP engine; once the FIRE Economy is firing on all cylinders again, P/C Economy inflation can be brought back under control. And, in the unlikely case that the FIRE Economy fails, expect massive capital outflows, a collapsing dollar and inflation as Mexico experienced in the late 1980s.
Either way, we don't see wage and goods price deflation in our future.
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Click here for link to complete article,
By Eric Janszen, iTulip.com | 29 September 2007 - The inflation versus deflation debate keeps contrarian economics and finance pundits pontificating for ten fabulous years. Fed flushes banks with funds and a fresh flurry of articles fills the blogosphere. Finally, the "financial economy" enters.
- "I would argue the most critical reformation in the past twenty years since Volcker’s prime has been the transition of the U.S. from a manufacturing/to a service/to a finance-based economy within the span of two decades. Purists will perhaps rightly quarrel with the chronology or maybe even the logic, but it seems to me in any case that the critical difference between then and now is that profits and employment— 2/3 of the critical constituents that a Fed Vigilante must protect (inflation being the third)— are now primarily a function of the amount of debt/leverage and its cost."
- Phillips uses the term "financialization" to describe how the U.S. economy has been radically restructured from a focus on production, manufacturing and wages, to a focus on speculation, debt, and profits. Since the 1980s, Phillips argues in American Theocracy,
- "...the underlying Washington strategy… was less to give ordinary Americans direct sums than to create a low-interest-rate boom in real estate, thereby raising the percentage of American home ownership, ballooning the prices of homes, and allowing householders to take out some of that increase through low-cost refinancing. This triple play created new wealth to take the place of that destroyed in the 2000-2002 stock-market crash and simultaneously raised consumer confidence.
"Nothing similar had ever been engineered before. Instead of a recovery orchestrated by Congress and the White House and aimed at the middle— and bottom-income segments, this one was directed by an appointed central banker, a man whose principal responsibility was to the banking system. His relief, targeted on financial assets and real estate, was principally achieved by monetary stimulus. This in itself confirmed the massive realignment of preferences and priorities within the American system….
"Likewise huge and indisputable but almost never discussed were the powerful political economics lurking behind the stimulus: the massive rate-cut-driven post-2000 bailout of the FIRE sector, with its ever-climbing share of GDP and proximity to power. No longer would Washington concentrate stimulus on wages or public-works employment. The Fed's policies, however shrewd, were not rooted in an abstraction of the national interest but in pursuit of its statutory mandate to protect the U.S. banking and payments system, now inseparable from the broadly defined financial-services sector."
- "The exponential growth of savings and debt takes the form mainly of loans to finance the purchase of real estate, stocks and bonds. These loans extract interest and amortization charges that divert revenue away from being spent on goods and services. The payment of debt service by the economy’s non-financial sectors interrupts the circular flow that Say’s Law postulates to exist between producers and consumers."
Reading Hudson and Phillips is like taking the Red Pill. If you're not familiar with the movie The Matrix, the Red Pill is the one you take if you want to see past the surface illusion of the made-up world. Once you read Hudson and Phillips, no matter whether you agree with their solutions, it's hard to go back to seeing the economy as anything but two distinct economies: the great, big FIRE Economy and the itty bitty Production/Consumption Economy.
Inflation versus deflation: Red Pill view
For readers who've taken the Red Pill, the inflation vs deflation discussion needs to be put into the context of the FIRE and P/C Economies.
- Fed monetary policy for the FIRE Economy is distinct from monetary policy for the P/C Economy.
- Continuous asset price inflation is the objective of FIRE Economy monetary policy. Within the residential real estate market these policies have been effective until recently. They continue to work in the commercial real estate market, but perhaps for not much longer, starting with retail.
- Low wage inflation is the primary objective of P/C Economy monetary and government policy because wages are the mechanism for transmission of inflation into the inflation cycle. Wage inflation can be managed via immigration policy, outsourcing policy to affect global wage arbitrage, and so on.
- Payments within the FIRE Economy may be 100 or more times the total payments within the P/C Economy.
- This does not mean that small changes in FIRE Economy growth have an out-sized impact on the P/C Economy. The opposite is true. The FIRE Economy is a 400 HP car engine in your car and the P/C economy as the 1/10th HP heater that warms your car with the waste heat from the engine.
- Asset price inflation and deflation occurs within the FIRE Economy without a direct impact on wages and goods prices within the P/C Economy. For example, housing price asset inflation ran more than 10% per year between 2002 and 2005 while consumer price inflation remained in the low single digits. Conversely, asset price deflation can occur in the FIRE Economy without necessarily leading to wage and goods price deflation in the P/C Economy.
- However, as the Japanese learned in the 1990s, sustained banking system dysfunction (inability to multiply the money supply) and asset price deflation in the FIRE Economy, with asset price deflation continuing for years on end, eventually spills over into the P/C economy.
FIRE Economy Failure?
When we interviewed Dr. Hudson, he didn't buy our Next Bubble idea. He believes that the FIRE Economy will gradually fail. He calls it the "slow crash." In that case demand declines within the P/C Economy as Japan experienced. Does that mean the US experiences deflation as Japan did? Japan was a net creditor when its FIRE Economy began a slow crash starting in 1992. The US was also a net creditor when its FIRE Economy crashed hard in the 1930s. For net creditors, as asset price deflation within the FIRE Economy spills over into the P/C Economy, the impact on interest rates and currency values is deflationary for wage and goods prices. For net debtors, on the other hand, the impact is the opposite: interest rates rise and currency values fall as capital flows reverse, ala Ka-Poom Theory. We believe failure of the FIRE Economy therefor means inflation.
Mike (Mish) Shedlock believes the banks can't be resuscitated once the credit defaults get rolling (see Death Spiral Financing). Rick Ackerman and Gary North are in the same camp. In Red Pill terms, they believe excessive debt levels and credit derivatives will swamp and wreck the FIRE Economy, taking the P/C Economy down with it.
I got into the topic with GaveKal CEO Louis-Vincent Gave on Sunday (interview here). His case for deflation in Europe is well articulated and specific: run-away asset price deflation happens because there is no euro bond market like the US and Japan have dollar and yen bond markets, each connected to a national central bank. The euro is a multinational political animal, with no centralized means to inflate.
The euro's lack of a euro bond market was first pointed out to us in our interview with Jamie Galbraith (JK's son) earlier this year when we were asking victims of various interviews: "What sort of international monetary regime after this one turns turtle?" It was one of those slap-your-forehead moments we hope to experience at least once in each interview we conduct. Jamie said a multilateral dollar-yen-euro regime depends on the development a euro bond market— so don't hold your breath.
The Road to Inflation
The inflation versus deflation debate was re-ignited by the Fed's 50 basis point rate shock therapy last week. Readers of pundits in the deflation camp demanded to know, "The long awaited credit meltdown is here. Where's the deflation? Gold and oil are going through the roof!"
Hudson’s prediction of the decline of the FIRE Economy is more or less a traditional Marxist one, that total interest payments eventually exceed the economy’s debt carrying capacity. At some point there’s a "break in the chain of payments," and the system collapses. Preventing such a break is what the Fed has been up to for the past few weeks, and the Bank of England is still doing for Barclays and other banks today.
No one knows whether the FIRE Economy is doomed or not. But its imminent demise has been prematurely announced many times over the past 20 years. I heard similar arguments from Marxist economics professors in college in the early 1980s. Now you can hear them from Libertarians, too.
Our Red Pill conclusion is that to keep the FIRE Economy running until the Next Bubbles get going, the Fed is willing to risk inflation in the P/C Economy, thus the 50 basis point cut while inflation is at multi-year highs and the dollar at multi-year lows. A bit of extra heat from the 1/10th HP heater is a necessary cost of preserving the 400 HP engine; once the FIRE Economy is firing on all cylinders again, P/C Economy inflation can be brought back under control. And, in the unlikely case that the FIRE Economy fails, expect massive capital outflows, a collapsing dollar and inflation as Mexico experienced in the late 1980s.
Either way, we don't see wage and goods price deflation in our future.
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Friday, September 28, 2007
Has the Fed Lost Control Over Money?
Has the Fed Lost Control Over Money? [¹]
Or, a short primer on money and banking
By Gary North | 27 September 2007
In my previous article, "How Bernanke Snookered Us All," I made the case that during a one-month period, mid-August to mid-September, 2007, the Federal Reserve System deflated the adjusted monetary base. As with Austrian economists generally, I define "inflation" as "an increase of the money supply." [[But see also click.: normxxx]] I define "deflation" as "a decrease in the money supply." [[But see also click.: normxxx]] The adjusted monetary base (AMB) [[See also click.: normxxx]] is the only monetary aggregate that the FED controls directly. I referred readers to the chart and table provided by the Federal Reserve Bank of St. Louis which tracks this statistic. I do so again.
I said that this decrease in the monetary base was significant because this was during a period in which the Federal Open Market Committee (FOMC) of the Federal Reserve System was actively intervening in the market known as the Federal Funds Rate, i.e., overnight loans between banks, from banks to other banks. This rate had been exceeding the target rate of 5.25% for over two months. The FED normally intervened once a day to bring this rate back to about 5.25%. I offered a link to a page where anyone may see the daily rate in the FedFunds market: high, actual, and the FOMC's target rate. Here it is.
So far, we know two facts: (1) during the month leading up to the September 18 announcement by the FED of a reduction in the target rate for overnight bank loans to 4.75%, the FOMC was reducing the one monetary aggregate that it controls directly; (2) the FOMC was actively intervening daily to reduce the FedFunds rate to 5.25%[!?!]
My conclusion: the FED was buying repos from the banking system (inflationary— more money in circulation) while selling other assets (deflationary— less money in circulation). The FOMC sold more assets than it bought during this one-month period, which is the only way the adjusted monetary base could fall.
Are you with me so far?
I could be wrong about the FED's buy-and-sell techniques of this process. I am always open to suggestions. If someone can show me from the statistics how the adjusted monetary base could fall during a period in which the FOMC was actively intervening to push the interday FedFunds rate back to 5.25%, I want to hear it. I will certainly consider it. But I do not see how I can be wrong about the overall effect of this process: more FOMC sales of assets than purchases.
The adjusted monetary base fell. If the FOMC [[had: normxxx]] increased its [net] purchases of assets in this period, this [[would: normxxx]] indicates that the FOMC has lost control over the monetary base. [[[Because] : normxxx]]The base went down, contrary to the action that traditional central bank theory says must raise it: net purchases of assets. If the base fell while net monetary base assets (Federal Reserve credit) increased, this surely calls for an explanation. I am open to suggestions.
There is a second question: "Can the FOMC continue to do this, i.e., lower the adjusted monetary base while also keeping the Fedfunds rate to 4.75?" My guess is that it cannot— not for long, anyway. But that is a guess. The FOMC did it for a month.
I made this comment with respect to long-term FOMC policy:
I do not see how I could have been more clear. I did NOT say that the FOMC is deflating long-term. It is disinflating, compared to what the FOMC had done under Greenspan.
Fractional Reserves
One criticism I received from more than one source was this: the banking system can create credit, which is money, independent of the Federal Reserve System's monetary base.
At this point, the critics are breaking with what money and banking textbook authors have written about central banking for a century. Let me briefly review the argument of all economists— Austrian, Keynesian, Chicago School, and supply-side.
The central bank creates money when it purchases assets— any assets— for its account. It spends this new money into circulation when it buys an asset. This new money is deposited automatically in the asset-seller's account in a commercial bank. The fractional reserve process then takes over. This new money is used by the bank to make loans. The banks of the borrowers do the same, setting aside the required non-interest-bearing reserves with the FED. [[That is, the borrowers deposit the 'new' loan money into their own banks, and then their banks can lend out this money, less a small amount set asided as a required reserve, and so on, almost ad infinitum— this is known as "fractional reserve banking": normxxx]] When the process [eventually] ceases, the [[sum of all of the: normxxx]] reserves deposited with the FED [must] equal the initial purchase of assets by the FED. This is the standard textbook account.
Let us get this clear: the basis of all new credit created by the commercial banking system is the new money issued by the central bank.
In textbooks on money and banking, this process is described by the use of a conceptual tool called a T-account. Step by step, the author shows how the initial deposit of a check in a bank leads to the creation of new credit. The FED makes this initial deposit.
The best textbook I have seen on this process was written by Murray Rothbard: The Mystery of Banking (1983). You can download it for free here.
There are newsletter writers who argue that the banking system as a whole can create credit independently of an addition of Federal Reserve fiat money, which is often called high-powered money. I am surely willing to consider such an argument. What I need is evidence. I need to be shown how the commercial banking system as a whole can issue credit in a form that is not regulated by the central bank's legal reserve ratio.
As evidence, I would like a reference to some position paper issued by the FED which explains this. Also acceptable: a reference to a textbook or an academic journal that shows how the traditional textbook discussion of reserve requirements is incorrect.
Anyone who argues that fractional reserve banks can create credit that is not under the law regarding reserve requirements is making a very remarkable argument. For one thing, he is making it difficult to understand why the federal funds loan market even exists. The FedFunds market is universally recognized as a market for a bank that has temporarily exceeded its reserve requirement for the creation of new loans (credit) to meet this requirement by borrowing from another bank. Here is the description provided by the Federal Reserve Bank of New York.
Are bankers irrational? No. Are they in the habit of giving away money to other bankers? No. Then why does any bank borrow overnight money in the FedFunds market? The universal answer is: "To meet its reserve requirements for the day." If this answer is incorrect, then he who argues that the banking system can issue more credit than is allowed by the FED needs to show why this traditional argument is incorrect.
If the monetary base does not set the limit for bank credit, then he who argues this way needs to show why the entire academic field of money and banking has been wrong for over a century. He has to show that Murray Rothbard ignored something fundamental when he wrote The Mystery of Banking and his earlier book, Because, if the private commercial banks can create credit— money— independent of the government-licensed monopoly of the national central bank, then government is not the culprit that has destroyed our money; commercial banks are doing this all on their own.
You can download Rothbard's other book, which I regard as the best introduction to monetary theory despite being short, free of charge.
There are lots of things about money and banking that I do not understand. But I always thought I understood this: a central bank controls a nation's money supply by controlling (1) the reserve ratio and (2) the monetary base. Anyone who argues that commercial banks can and do issue credit independently of these two restraints is arguing that traditional monetary theory is incorrect. Such an argument requires considerable evidence.
Again, I am not saying that such evidence does not exist. I am saying that, so far, I have not seen anyone present it, especially those analysts who say that the commercial banking system, as a system, can do this any time it wants.
The bankers always want to maximize their revenues. They do this by creating credit, which is based on their banks' deposits. They do this at all times. They do not leave a penny on the books in a deposit that is not lent out at all times. Bank credit is always maximized.
Remember this: bank credit is money. Whatever a bank lends is money. This money buys things, which is why borrowers borrow it. They repay in money. Bankers want to be repaid in money. Credit is issued in the form of entries into borrowers' accounts. There is no bank credit that is not in the form of a deposit in a bank account. So, if anyone is increasing the supply of credit, this credit is in the form of an entry into a bank account. Bank accounts are regulated by the FED reserve requirements.
What we need to understand from those analysts who argue that the monetary base does not set monetary policy for the nation is exactly how the commercial banking system in the aggregate can issue credit independently of the FED's monetary base and its reserve requirements (which rarely change).
Is this too much to ask? So, you had better ask it. If someone tells you that the FED has lost control over the monetary system, and that banks can issue credit independently of the FED, ask him to explain why the standard textbook account is wrong, why T-account analysis is wrong, and how on earth Murray Rothbard got it wrong. The person who shows this may even win the Nobel Prize in economics, which is now over a million dollars. It seems like easy money to me for someone who argues that bank credit is independent of deposits in bank accounts.
Why M-3 Was Always Worthless
In my previous report, I wrote this about M-3.
The main purpose of following monetary statistics is to estimate what effect this will have on two things: (1) the price level; and, (2) the business cycle. Point #1 raises the question: Which statistics of prices?
The theoretical question of constructing a price index is amazingly complex. The best book on the question of price indexes was written in 1950 by economist Oskar Morgenstern, On the Accuracy of Economic Observations. Morgenstern was one of the few men smart enough to be invited by Ludwig von Mises to attend his private seminars in Austria. There is a good presentation of the implications of this book is posted on the Mises Institute's site.
I use the Median CPI figures— and other figures— to see the trend of past prices. I want to have some sense of how rapidly prices are trending upward. The statistics of the Median CPI go back 40 years. They are posted here (this week, anyway; they constantly change its address, which is very annoying).
I update the link whenever the Cleveland FED updates it. It is always on-line at my free department, "Price Indexes" (U.S.A.), here.
I have subscribers who tell me in no uncertain terms that all consumer price index statistics are fake. My response: as long as they are consistently fake, I can still use them to see the trend of prices. Only when the statisticians change their assumptions do the statistics become useless for assessing past periods that were not updated in terms of the revised assumptions. Even jiggered figures are useful if the statisticians retroactively revise previous figures. I can still see the trend.
Conclusion
I maintain that a nation's central bank controls the nation's money supply. It does so with two tools: (1) the legal reserve requirement, and (2) the purchase (inflationary) or sale (deflationary) of assets in its possession— the monetary base.
If someone says that a central bank does not control the nation's money supply in this way, then he owes it to his readers to explain either: (1) other ways that the central bank controls money; or (2) the ways that the commercial banks escape the controls set by the central bank. Either of these assertions requires textbook or similar evidence: simply saying that the central bank has lost control does not prove that it in fact has lost control.
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[ Normxxx Here: What most people miss or forget is that there are four parts to the Quantity Theory of Money Equation.
[The mathematically challenged can skip to the text below at "This equation"]
In its modern form, the Quantity Theory builds upon the following definitional relationship.
where
is the total amount of money in circulation on average in an economy during the period, say a year.
is the transactions' velocity of money, that is the average frequency across all transactions with which a unit of money is spent. It is derived from the other values in the equation.
and 
are the price and quantity of the i-th transaction.
is a vector of the .
is a vector of the .
Or, more simply:
where
V is the velocity of money in final expenditures.
Q is an index of the real value of final expenditures.
This equation, like the previous one, holds because V is constructed to make the two sides equal, although it is intended to represent the number of times a fixed amount of money changes hands in a given period (say, a year).
As an example, M might represent currency plus checking and savings-account money held by the public, Q real output with P the corresponding price level, and PQ the nominal (money) value of output. In one empirical formulation, velocity was defined as "the ratio of net national product in current prices to the money stock."
But, we ignore V at our peril, since this factor is as important as the quantity of money for inflation, and is crucial to understanding hyperinflation. Just because it is constructed by economists from the other elements of the equation doesn't mean it is not a real variable in the economy— it is calculated because there are (conveniently?) no direct means of measuring it. And no known way to control it independently of money supply.
To better understand V and why it changes as it does, there is no better article than Paul Tustain's "Hyperinflation: Creating Repulsive Money."
Next, there is the factor of "virtual" money. "Virtual" money (aka "paper" money, but not to be confused with Federal Reserve Notes) is what a thing (say, a stock or a derivative or a house) is measured in. It is not "real" because it does not represent any intrinsic value of the thing— it is usually set by so-called "market" transactions (i.e., recent purchases and sales of like things). In this sense, we can see that, e.g., gold has no 'intrinsic' value either— only a "market" value. We can at best argue that gold has been more stable than the dollar in price (what other things one can obtain/"buy" with it) over a large number of years. But if all (or even most) of the owners of gold decided to sell it at the same time, one fine day, its price would rapidly diminish towards zero, lacking an infinitely "liquid" market.
Thus, the amount of virtual money represented by all of the things of value (not necessarily only goods) in an economy, may be many, many times the (adjusted) monetary base (ABM). Virtual money is constantly being created and destroyed. When a stock goes up by one dollar, the total virtual money created is the stock's number of shares times the one dollar; and conversely, if it goes down, a like amount of virtual money can be said to be destroyed. This is true of housing; if the value of the most recent sales of like houses in my neighborhood goes down by $50,000, then I assume I have lost $50,000. That is because the instant I purchased my home, its value became virtual (it was real only at the point of transaction). What happened to the vanishing $50,000? It is held by the last seller of my house (assuming my house is now worth $50,000 less than when I purchased it)— or, if it is only $50,000 less than the last time I estimated its value, it never existed as real money in the system anyway, and so vanishes without a trace, like most dreams— all I can look forward to is realizing the virtual value of my house at any given time.
The Fed has precious little control of V, and absolutely no control of the virtual money supply.
But does the virtual money supply influence prices and inflation/deflation? Yes, of course, but being an imaginary quantity it can do so only indirectly through its influence on the psychology of economic person (aka, 'economic man').
First, it is obvious that having a virtual price for a thing allows one to transact in terms of an increase or decrease from that relative virtual price, which is far easier than trying to establish a value where none is known. So, it greatly diminishes price fluctuations and minimizes the possibility of 'wild bargains' and equally wild 'paper' losses (what one could have gotten for the thing less what one actually got). In the 'olden days', the value of a thing was generally somewhere around the minimum price a seller was prepared to part with it for, and the maximum price that a purchaser felt the thing was worth to him (or her). Such transactions often consumed the greater part of a day (or even several days for 'big ticket' items).
Second, virtual money value is the crucial factor in the "wealth effect"— how "rich" one tends to feel. And the "wealth effect" is a crucial factor in our propensity to spend (or save)— V, again. Moreover, since the wealth effect is psychological, it partly depends on the type of things one has and our personal or learned experience in converting such things into money. For most people, up until recently, a $500,000 house seemed a good bit more 'real' than an equal amount of stock, and probably contributed more to their feelings of wealth. Too, one can easily see how the current generation is far readier to equate their virtual worth with real money— as opposed to the post Great Depression generation, for example.
Lastly, There Is The Magic Of Derivatives, Or, How To Make Money Out Of Thin Air
We all live in the small town of X, Tomm, Dikk, Harrry, and I. Everybody knows that our word is as good as any bond. So, on Tuesday, thinking I might go to Big City, I borrow $10 from Tomm, giving him an IOU in exchange. On Wednesday, Dikk borrows the $10 from me (obviously, before I can spend it) and gives me an IOU for it. Then Harrry borrows the $10 from Dikk in exchange for an IOU. Now there are $30 of IOUs and one $10 bill in circulation— $40 where before there had only been the one $10 bill. Tomm, Dikk, Harrry, and I are not banks and pay no heed to the CB, much less pay any "fractional reserves," but we have just upped our local money supply by 300%!
Now this is just penney ante and is not likely to shake up the financial structure much. But when banks (and others) 'issue' derivatives, promising to pay money based on the outcome of some future event (like a mortgage being paid back)— but not strictly money nor a loan, and so completely outside of the Federal Reserve or any CB System, it explains how the world 'money supply' can be increased by over 40 times (not three times as in our penney ante example). In most cases, these derivatives can be used just like money (or, at least until the s--- hits the fan).
Tomm, Dikk, Harrry, and I can use those IOUs freely in lieu of cash, as long as we stay in X (where everyone knows us and is willing to take the IOUs). But, if I get run over by a horse some day, and die intestate, Tomm may be a long time in getting his $10 back, since neither Dikk nor Harrry owe him anything; although Dikk owes $10 to my estate, and Tomm can file a claim against my estate, assuming there is anything left after burial expenses.
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Now all I have left to do is tie this all together, but I'll leave that for another day. normxxx
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A postscript from Hussman's comments (see Reference): On Thursday, September 27th, the Federal Reserve entered into $6 billion in 14 day repos and $20 billion in 7 day repos. It also rolled over two small, shorter-term repos from earlier in the week that will roll over again on Monday— probably at least $10 billion, with a weekly total of about $30 billion by Thursday October 4th, to extend other repos that come due at that time. As of last week, the total amount of Fed repurchases outstanding is $44.75 billion. This is close to the total quantity of reserves in the U.S. banking system (which includes these repo proceeds). Meanwhile, total borrowings of depository institutions from the Fed— the much vaunted "liquidity" lent by the Fed at the Discount Rate— dropped from $2.4 billion to just $306 million last week, which is about the norm of recent years.
In short, next to nothing is actually lent through the discount window. Meanwhile, the Fed's open market operations are not injections of new liquidity, but a continuous rollover that finances a stable level of reserves, at a level that is negligible in relation to $6.3 trillion in total bank loans. If investors want to believe the superstition that Fed actions have anything but psychological effect, they should at least be prepared to demonstrate a specific mechanism by which observable FOMC operations exert that effect. It certainly is not through meaningful "injections of liquidity" into the banking system.
REFERENCE:
To See How Little The Fed Does Actually Control, See Hussman: Show Me The Money!
Remarkably, while arguing different aspects of the same facts and coming to somewhat different conclusions, Gary North and John Hussman are NOT in any dispute on the fundamental facts or issues, nor could they be.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Or, a short primer on money and banking
By Gary North | 27 September 2007
In my previous article, "How Bernanke Snookered Us All," I made the case that during a one-month period, mid-August to mid-September, 2007, the Federal Reserve System deflated the adjusted monetary base. As with Austrian economists generally, I define "inflation" as "an increase of the money supply." [[But see also click.: normxxx]] I define "deflation" as "a decrease in the money supply." [[But see also click.: normxxx]] The adjusted monetary base (AMB) [[See also click.: normxxx]] is the only monetary aggregate that the FED controls directly. I referred readers to the chart and table provided by the Federal Reserve Bank of St. Louis which tracks this statistic. I do so again.
I said that this decrease in the monetary base was significant because this was during a period in which the Federal Open Market Committee (FOMC) of the Federal Reserve System was actively intervening in the market known as the Federal Funds Rate, i.e., overnight loans between banks, from banks to other banks. This rate had been exceeding the target rate of 5.25% for over two months. The FED normally intervened once a day to bring this rate back to about 5.25%. I offered a link to a page where anyone may see the daily rate in the FedFunds market: high, actual, and the FOMC's target rate. Here it is.
So far, we know two facts: (1) during the month leading up to the September 18 announcement by the FED of a reduction in the target rate for overnight bank loans to 4.75%, the FOMC was reducing the one monetary aggregate that it controls directly; (2) the FOMC was actively intervening daily to reduce the FedFunds rate to 5.25%[!?!]
- [ Normxxx Here: But see reference below. ]
My conclusion: the FED was buying repos from the banking system (inflationary— more money in circulation) while selling other assets (deflationary— less money in circulation). The FOMC sold more assets than it bought during this one-month period, which is the only way the adjusted monetary base could fall.
Are you with me so far?
I could be wrong about the FED's buy-and-sell techniques of this process. I am always open to suggestions. If someone can show me from the statistics how the adjusted monetary base could fall during a period in which the FOMC was actively intervening to push the interday FedFunds rate back to 5.25%, I want to hear it. I will certainly consider it. But I do not see how I can be wrong about the overall effect of this process: more FOMC sales of assets than purchases.
The adjusted monetary base fell. If the FOMC [[had: normxxx]] increased its [net] purchases of assets in this period, this [[would: normxxx]] indicates that the FOMC has lost control over the monetary base. [[[Because] : normxxx]]The base went down, contrary to the action that traditional central bank theory says must raise it: net purchases of assets. If the base fell while net monetary base assets (Federal Reserve credit) increased, this surely calls for an explanation. I am open to suggestions.
There is a second question: "Can the FOMC continue to do this, i.e., lower the adjusted monetary base while also keeping the Fedfunds rate to 4.75?" My guess is that it cannot— not for long, anyway. But that is a guess. The FOMC did it for a month.
I made this comment with respect to long-term FOMC policy:
- The table at the bottom of the chart provides the important numbers: the rate of increase from various dates until now. From mid-September, 2006, to mid-September, 2007, the increase was 1.8% per annum. This is what it has been ever since Bernanke took over on February 1, 2006.
An increase of 1.8% is tight money policy by previous FED standards [[any time the rate of increase of AMB is below the rate of inflation, money policy is tight: normxxx]]. I have been hammering on this point for a year. The FED has dramatically reduced the rate of monetary inflation.
I do not see how I could have been more clear. I did NOT say that the FOMC is deflating long-term. It is disinflating, compared to what the FOMC had done under Greenspan.
Fractional Reserves
One criticism I received from more than one source was this: the banking system can create credit, which is money, independent of the Federal Reserve System's monetary base.
At this point, the critics are breaking with what money and banking textbook authors have written about central banking for a century. Let me briefly review the argument of all economists— Austrian, Keynesian, Chicago School, and supply-side.
The central bank creates money when it purchases assets— any assets— for its account. It spends this new money into circulation when it buys an asset. This new money is deposited automatically in the asset-seller's account in a commercial bank. The fractional reserve process then takes over. This new money is used by the bank to make loans. The banks of the borrowers do the same, setting aside the required non-interest-bearing reserves with the FED. [[That is, the borrowers deposit the 'new' loan money into their own banks, and then their banks can lend out this money, less a small amount set asided as a required reserve, and so on, almost ad infinitum— this is known as "fractional reserve banking": normxxx]] When the process [eventually] ceases, the [[sum of all of the: normxxx]] reserves deposited with the FED [must] equal the initial purchase of assets by the FED. This is the standard textbook account.
Let us get this clear: the basis of all new credit created by the commercial banking system is the new money issued by the central bank.
In textbooks on money and banking, this process is described by the use of a conceptual tool called a T-account. Step by step, the author shows how the initial deposit of a check in a bank leads to the creation of new credit. The FED makes this initial deposit.
The best textbook I have seen on this process was written by Murray Rothbard: The Mystery of Banking (1983). You can download it for free here.
There are newsletter writers who argue that the banking system as a whole can create credit independently of an addition of Federal Reserve fiat money, which is often called high-powered money. I am surely willing to consider such an argument. What I need is evidence. I need to be shown how the commercial banking system as a whole can issue credit in a form that is not regulated by the central bank's legal reserve ratio.
As evidence, I would like a reference to some position paper issued by the FED which explains this. Also acceptable: a reference to a textbook or an academic journal that shows how the traditional textbook discussion of reserve requirements is incorrect.
Anyone who argues that fractional reserve banks can create credit that is not under the law regarding reserve requirements is making a very remarkable argument. For one thing, he is making it difficult to understand why the federal funds loan market even exists. The FedFunds market is universally recognized as a market for a bank that has temporarily exceeded its reserve requirement for the creation of new loans (credit) to meet this requirement by borrowing from another bank. Here is the description provided by the Federal Reserve Bank of New York.
- Fed funds are unsecured loans of reserve balances at Federal Reserve Banks between depository institutions. Banks keep reserve balances at the Federal Reserve Banks to meet their reserve requirements and to clear financial transactions. Transactions in the fed funds market enable depository institutions with reserve balances in excess of reserve requirements to lend them, or "sell" as it is called by market participants, to institutions with reserve deficiencies. Fed funds transactions neither increase nor decrease total bank reserves. Instead, they redistribute bank reserves and enable otherwise idle funds to yield a return. Technical details on fed funds are described in Regulation D.
Are bankers irrational? No. Are they in the habit of giving away money to other bankers? No. Then why does any bank borrow overnight money in the FedFunds market? The universal answer is: "To meet its reserve requirements for the day." If this answer is incorrect, then he who argues that the banking system can issue more credit than is allowed by the FED needs to show why this traditional argument is incorrect.
If the monetary base does not set the limit for bank credit, then he who argues this way needs to show why the entire academic field of money and banking has been wrong for over a century. He has to show that Murray Rothbard ignored something fundamental when he wrote The Mystery of Banking and his earlier book, Because, if the private commercial banks can create credit— money— independent of the government-licensed monopoly of the national central bank, then government is not the culprit that has destroyed our money; commercial banks are doing this all on their own.
You can download Rothbard's other book, which I regard as the best introduction to monetary theory despite being short, free of charge.
There are lots of things about money and banking that I do not understand. But I always thought I understood this: a central bank controls a nation's money supply by controlling (1) the reserve ratio and (2) the monetary base. Anyone who argues that commercial banks can and do issue credit independently of these two restraints is arguing that traditional monetary theory is incorrect. Such an argument requires considerable evidence.
Again, I am not saying that such evidence does not exist. I am saying that, so far, I have not seen anyone present it, especially those analysts who say that the commercial banking system, as a system, can do this any time it wants.
The bankers always want to maximize their revenues. They do this by creating credit, which is based on their banks' deposits. They do this at all times. They do not leave a penny on the books in a deposit that is not lent out at all times. Bank credit is always maximized.
Remember this: bank credit is money. Whatever a bank lends is money. This money buys things, which is why borrowers borrow it. They repay in money. Bankers want to be repaid in money. Credit is issued in the form of entries into borrowers' accounts. There is no bank credit that is not in the form of a deposit in a bank account. So, if anyone is increasing the supply of credit, this credit is in the form of an entry into a bank account. Bank accounts are regulated by the FED reserve requirements.
What we need to understand from those analysts who argue that the monetary base does not set monetary policy for the nation is exactly how the commercial banking system in the aggregate can issue credit independently of the FED's monetary base and its reserve requirements (which rarely change).
Is this too much to ask? So, you had better ask it. If someone tells you that the FED has lost control over the monetary system, and that banks can issue credit independently of the FED, ask him to explain why the standard textbook account is wrong, why T-account analysis is wrong, and how on earth Murray Rothbard got it wrong. The person who shows this may even win the Nobel Prize in economics, which is now over a million dollars. It seems like easy money to me for someone who argues that bank credit is independent of deposits in bank accounts.
Why M-3 Was Always Worthless
In my previous report, I wrote this about M-3.
- I don't think my message has penetrated the thinking of most hard-money contrarians. They keep citing M-3, which was canceled by the FED a year ago, and which was always the most misleading of all monetary statistics. Year after year, the M-3 statistic was four times higher than the CPI. The M-3 statistic was worthless from day one. Anyone who used it to make investments lost most (or all) of his money. I have written a report on this, which provides the evidence: "Monetary Statistics."
The main purpose of following monetary statistics is to estimate what effect this will have on two things: (1) the price level; and, (2) the business cycle. Point #1 raises the question: Which statistics of prices?
The theoretical question of constructing a price index is amazingly complex. The best book on the question of price indexes was written in 1950 by economist Oskar Morgenstern, On the Accuracy of Economic Observations. Morgenstern was one of the few men smart enough to be invited by Ludwig von Mises to attend his private seminars in Austria. There is a good presentation of the implications of this book is posted on the Mises Institute's site.
I use the Median CPI figures— and other figures— to see the trend of past prices. I want to have some sense of how rapidly prices are trending upward. The statistics of the Median CPI go back 40 years. They are posted here (this week, anyway; they constantly change its address, which is very annoying).
I update the link whenever the Cleveland FED updates it. It is always on-line at my free department, "Price Indexes" (U.S.A.), here.
I have subscribers who tell me in no uncertain terms that all consumer price index statistics are fake. My response: as long as they are consistently fake, I can still use them to see the trend of prices. Only when the statisticians change their assumptions do the statistics become useless for assessing past periods that were not updated in terms of the revised assumptions. Even jiggered figures are useful if the statisticians retroactively revise previous figures. I can still see the trend.
Conclusion
I maintain that a nation's central bank controls the nation's money supply. It does so with two tools: (1) the legal reserve requirement, and (2) the purchase (inflationary) or sale (deflationary) of assets in its possession— the monetary base.
If someone says that a central bank does not control the nation's money supply in this way, then he owes it to his readers to explain either: (1) other ways that the central bank controls money; or (2) the ways that the commercial banks escape the controls set by the central bank. Either of these assertions requires textbook or similar evidence: simply saying that the central bank has lost control does not prove that it in fact has lost control.
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[ Normxxx Here: What most people miss or forget is that there are four parts to the Quantity Theory of Money Equation.
[The mathematically challenged can skip to the text below at "This equation"]
In its modern form, the Quantity Theory builds upon the following definitional relationship.
where
is the total amount of money in circulation on average in an economy during the period, say a year. is the transactions' velocity of money, that is the average frequency across all transactions with which a unit of money is spent. It is derived from the other values in the equation. and are the price and quantity of the i-th transaction. is a vector of the . is a vector of the .Or, more simply:
where
V is the velocity of money in final expenditures.
Q is an index of the real value of final expenditures.
This equation, like the previous one, holds because V is constructed to make the two sides equal, although it is intended to represent the number of times a fixed amount of money changes hands in a given period (say, a year).
As an example, M might represent currency plus checking and savings-account money held by the public, Q real output with P the corresponding price level, and PQ the nominal (money) value of output. In one empirical formulation, velocity was defined as "the ratio of net national product in current prices to the money stock."
But, we ignore V at our peril, since this factor is as important as the quantity of money for inflation, and is crucial to understanding hyperinflation. Just because it is constructed by economists from the other elements of the equation doesn't mean it is not a real variable in the economy— it is calculated because there are (conveniently?) no direct means of measuring it. And no known way to control it independently of money supply.
To better understand V and why it changes as it does, there is no better article than Paul Tustain's "Hyperinflation: Creating Repulsive Money."
Next, there is the factor of "virtual" money. "Virtual" money (aka "paper" money, but not to be confused with Federal Reserve Notes) is what a thing (say, a stock or a derivative or a house) is measured in. It is not "real" because it does not represent any intrinsic value of the thing— it is usually set by so-called "market" transactions (i.e., recent purchases and sales of like things). In this sense, we can see that, e.g., gold has no 'intrinsic' value either— only a "market" value. We can at best argue that gold has been more stable than the dollar in price (what other things one can obtain/"buy" with it) over a large number of years. But if all (or even most) of the owners of gold decided to sell it at the same time, one fine day, its price would rapidly diminish towards zero, lacking an infinitely "liquid" market.
Thus, the amount of virtual money represented by all of the things of value (not necessarily only goods) in an economy, may be many, many times the (adjusted) monetary base (ABM). Virtual money is constantly being created and destroyed. When a stock goes up by one dollar, the total virtual money created is the stock's number of shares times the one dollar; and conversely, if it goes down, a like amount of virtual money can be said to be destroyed. This is true of housing; if the value of the most recent sales of like houses in my neighborhood goes down by $50,000, then I assume I have lost $50,000. That is because the instant I purchased my home, its value became virtual (it was real only at the point of transaction). What happened to the vanishing $50,000? It is held by the last seller of my house (assuming my house is now worth $50,000 less than when I purchased it)— or, if it is only $50,000 less than the last time I estimated its value, it never existed as real money in the system anyway, and so vanishes without a trace, like most dreams— all I can look forward to is realizing the virtual value of my house at any given time.
The Fed has precious little control of V, and absolutely no control of the virtual money supply.
But does the virtual money supply influence prices and inflation/deflation? Yes, of course, but being an imaginary quantity it can do so only indirectly through its influence on the psychology of economic person (aka, 'economic man').
First, it is obvious that having a virtual price for a thing allows one to transact in terms of an increase or decrease from that relative virtual price, which is far easier than trying to establish a value where none is known. So, it greatly diminishes price fluctuations and minimizes the possibility of 'wild bargains' and equally wild 'paper' losses (what one could have gotten for the thing less what one actually got). In the 'olden days', the value of a thing was generally somewhere around the minimum price a seller was prepared to part with it for, and the maximum price that a purchaser felt the thing was worth to him (or her). Such transactions often consumed the greater part of a day (or even several days for 'big ticket' items).
Second, virtual money value is the crucial factor in the "wealth effect"— how "rich" one tends to feel. And the "wealth effect" is a crucial factor in our propensity to spend (or save)— V, again. Moreover, since the wealth effect is psychological, it partly depends on the type of things one has and our personal or learned experience in converting such things into money. For most people, up until recently, a $500,000 house seemed a good bit more 'real' than an equal amount of stock, and probably contributed more to their feelings of wealth. Too, one can easily see how the current generation is far readier to equate their virtual worth with real money— as opposed to the post Great Depression generation, for example.
Lastly, There Is The Magic Of Derivatives, Or, How To Make Money Out Of Thin Air
We all live in the small town of X, Tomm, Dikk, Harrry, and I. Everybody knows that our word is as good as any bond. So, on Tuesday, thinking I might go to Big City, I borrow $10 from Tomm, giving him an IOU in exchange. On Wednesday, Dikk borrows the $10 from me (obviously, before I can spend it) and gives me an IOU for it. Then Harrry borrows the $10 from Dikk in exchange for an IOU. Now there are $30 of IOUs and one $10 bill in circulation— $40 where before there had only been the one $10 bill. Tomm, Dikk, Harrry, and I are not banks and pay no heed to the CB, much less pay any "fractional reserves," but we have just upped our local money supply by 300%!
Now this is just penney ante and is not likely to shake up the financial structure much. But when banks (and others) 'issue' derivatives, promising to pay money based on the outcome of some future event (like a mortgage being paid back)— but not strictly money nor a loan, and so completely outside of the Federal Reserve or any CB System, it explains how the world 'money supply' can be increased by over 40 times (not three times as in our penney ante example). In most cases, these derivatives can be used just like money (or, at least until the s--- hits the fan).
Tomm, Dikk, Harrry, and I can use those IOUs freely in lieu of cash, as long as we stay in X (where everyone knows us and is willing to take the IOUs). But, if I get run over by a horse some day, and die intestate, Tomm may be a long time in getting his $10 back, since neither Dikk nor Harrry owe him anything; although Dikk owes $10 to my estate, and Tomm can file a claim against my estate, assuming there is anything left after burial expenses.
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Now all I have left to do is tie this all together, but I'll leave that for another day. normxxx
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A postscript from Hussman's comments (see Reference): On Thursday, September 27th, the Federal Reserve entered into $6 billion in 14 day repos and $20 billion in 7 day repos. It also rolled over two small, shorter-term repos from earlier in the week that will roll over again on Monday— probably at least $10 billion, with a weekly total of about $30 billion by Thursday October 4th, to extend other repos that come due at that time. As of last week, the total amount of Fed repurchases outstanding is $44.75 billion. This is close to the total quantity of reserves in the U.S. banking system (which includes these repo proceeds). Meanwhile, total borrowings of depository institutions from the Fed— the much vaunted "liquidity" lent by the Fed at the Discount Rate— dropped from $2.4 billion to just $306 million last week, which is about the norm of recent years.
In short, next to nothing is actually lent through the discount window. Meanwhile, the Fed's open market operations are not injections of new liquidity, but a continuous rollover that finances a stable level of reserves, at a level that is negligible in relation to $6.3 trillion in total bank loans. If investors want to believe the superstition that Fed actions have anything but psychological effect, they should at least be prepared to demonstrate a specific mechanism by which observable FOMC operations exert that effect. It certainly is not through meaningful "injections of liquidity" into the banking system.
REFERENCE:
To See How Little The Fed Does Actually Control, See Hussman: Show Me The Money!
Remarkably, while arguing different aspects of the same facts and coming to somewhat different conclusions, Gary North and John Hussman are NOT in any dispute on the fundamental facts or issues, nor could they be.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Thursday, September 27, 2007
The Greater Depression
The Greater Depression— UPDATE [¹]
By Doug Casey | 27 September 2007
Let me cover the big picture. I do think we're approaching the end of the world as we know it...[[aka, TEOTWAWKI: normxxx]] I think there is such thing as the business cycle. It exists. And we've had the longest expansion— and the strongest expansion— in the world history. But we're at the end of a 25-year boom. It's gone on more than a full generation now. And I'll tell you how it's going to end: It's going to end with a depression, and not just a depression; not just another Great Depression; it's going to be the Greater Depression.
What's a depression, incidentally? It's a period of time when distortions and misallocations of capital are liquidated [[wiped out!: normxxx]]; that's called a depression. Over the last 25 years, [increasing] distortions and misallocations of capital have produced an artificial boom. But when these distortions and misallocations of capital are liquidated, we'll get a depression.
Another general definition of a depression is this: a period of time when most people's standard of living goes down significantly. Now, for the long run, there's no question in my mind the standard of living of everybody on earth is going to go up immensely over the next hundred years. Immensely. But that doesn't mean that we're not going to have setbacks, and I think we're looking at one: A severe standard of living drop. So the economic picture [just ahead] is not going to be good...
So what should you be doing about all this? I suggest you really internationalize yourself. I think what you ought to have is your citizenship in one country, your bank account in another country, your investments in a third, and live in a fourth. You've got to internationalize yourself. Most people out there are like medieval serfs, psychologically and physically: they're born some place, they don't go very far from it and that's where they die, and they're going to get exactly what they deserve. Well, you can't be that way. I think you ought to treat the world as your oyster.
What am I doing about this? I've been all over the world. I guess I've lived in 12 countries now. And out of 175, I've been to most of them, numerous times actually. What am I doing, where do I want to go, where am I living?
Well, in New Zealand. I went there a few years ago for the polo, actually, and the reason was that playing polo there was about 10% what it cost me in Palm Beach, and I liked it better. So we bought a lot of real estate. But since then, the currency has doubled and the real estate within that currency has doubled at least. So I'm getting out of New Zealand. Where am I going now? I'm going to Argentina.
And let me give you a tip, okay? Forget about Europe, it's going to become a petting zoo. It's like Disneyland with real stones instead of papier maché stones. I mean, Europe is on the slippery slope. I wouldn't touch Europe with a ten-foot pole. If this war with Islam gets out of control, Europe is going to be an epicenter. It's going to be a disaster. I'll tell you where you ought to look. Argentina is the place to be. It's the cheapest country in the world. It has low population, incredibly beautiful, the climate is great. One hundred years ago, it was in competition with the US for being the best place in the world and the richest place. But it went downhill radically, radically.
But let me tell you something. It's turning around I think. And what's going to happen is driven by the fact that everything in Argentina costs between 10% to 30% of what it costs in North America. That's correct. It's that cheap. It's free. It's free. It's free for us as North Americans. But the Europeans really think it's free with that strong Euro. So you're getting a massive immigration from rich Europeans that can see the handwriting on the wall and like it down there. And I really like it down there. It's just a great society, great society, great place to hang out, prices are right. I mean this can solve most of your investment problems right there, just by transplanting yourself, if you've got some capital. Furthermore, Argentina is going to be insolated from WWIII to a good extent.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Doug Casey | 27 September 2007
Let me cover the big picture. I do think we're approaching the end of the world as we know it...[[aka, TEOTWAWKI: normxxx]] I think there is such thing as the business cycle. It exists. And we've had the longest expansion— and the strongest expansion— in the world history. But we're at the end of a 25-year boom. It's gone on more than a full generation now. And I'll tell you how it's going to end: It's going to end with a depression, and not just a depression; not just another Great Depression; it's going to be the Greater Depression.
What's a depression, incidentally? It's a period of time when distortions and misallocations of capital are liquidated [[wiped out!: normxxx]]; that's called a depression. Over the last 25 years, [increasing] distortions and misallocations of capital have produced an artificial boom. But when these distortions and misallocations of capital are liquidated, we'll get a depression.
Another general definition of a depression is this: a period of time when most people's standard of living goes down significantly. Now, for the long run, there's no question in my mind the standard of living of everybody on earth is going to go up immensely over the next hundred years. Immensely. But that doesn't mean that we're not going to have setbacks, and I think we're looking at one: A severe standard of living drop. So the economic picture [just ahead] is not going to be good...
So what should you be doing about all this? I suggest you really internationalize yourself. I think what you ought to have is your citizenship in one country, your bank account in another country, your investments in a third, and live in a fourth. You've got to internationalize yourself. Most people out there are like medieval serfs, psychologically and physically: they're born some place, they don't go very far from it and that's where they die, and they're going to get exactly what they deserve. Well, you can't be that way. I think you ought to treat the world as your oyster.
What am I doing about this? I've been all over the world. I guess I've lived in 12 countries now. And out of 175, I've been to most of them, numerous times actually. What am I doing, where do I want to go, where am I living?
Well, in New Zealand. I went there a few years ago for the polo, actually, and the reason was that playing polo there was about 10% what it cost me in Palm Beach, and I liked it better. So we bought a lot of real estate. But since then, the currency has doubled and the real estate within that currency has doubled at least. So I'm getting out of New Zealand. Where am I going now? I'm going to Argentina.
And let me give you a tip, okay? Forget about Europe, it's going to become a petting zoo. It's like Disneyland with real stones instead of papier maché stones. I mean, Europe is on the slippery slope. I wouldn't touch Europe with a ten-foot pole. If this war with Islam gets out of control, Europe is going to be an epicenter. It's going to be a disaster. I'll tell you where you ought to look. Argentina is the place to be. It's the cheapest country in the world. It has low population, incredibly beautiful, the climate is great. One hundred years ago, it was in competition with the US for being the best place in the world and the richest place. But it went downhill radically, radically.
But let me tell you something. It's turning around I think. And what's going to happen is driven by the fact that everything in Argentina costs between 10% to 30% of what it costs in North America. That's correct. It's that cheap. It's free. It's free. It's free for us as North Americans. But the Europeans really think it's free with that strong Euro. So you're getting a massive immigration from rich Europeans that can see the handwriting on the wall and like it down there. And I really like it down there. It's just a great society, great society, great place to hang out, prices are right. I mean this can solve most of your investment problems right there, just by transplanting yourself, if you've got some capital. Furthermore, Argentina is going to be insolated from WWIII to a good extent.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
The Downward Spiral Continues
Homebuilders: The Downward Spiral Continues [¹]
By Bank Credit Analyst | 27 September 2007
Homebuilding stocks have been stuck in a freefall and a turnaround in coming quarters is unlikely. Heightened concern about sub-prime loan defaults remains a key ingredient to the bear market in both sub-prime and housing stocks. Notably, sub-prime relative performance, has led homebuilding stocks in the past decade, and the current message is still negative. Meanwhile, Lennar posted a massive third-quarter loss Tuesday, highlighting that the industry still has the ability to surprise on the downside. It will take a substantial drop in interest rates, house prices, or a combination of the two, to bolster affordability sufficiently to clear excess housing stock. The latter is unlikely with lenders still in the early stages of tightening standards on mortgage loans and a still high level of home sales relative to the housing stock. Thus, while the industry has already been through a dreadful year, it is too soon to attempt any bottom fishing.Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Bloomberg: CPI Inflation Data is a "Lie"
Bloomberg: CPI Inflation Data is a "Lie" [¹]
By TheBigPicture | 27 September 2007
Click Here, or on the image, to see a larger, undistorted image.
~~~
Those of you who are fellow tri-state residents (NY, NJ, CT) will be as thrilled as I was that BLS shows transportation costs are declining; especially since the MTA (NY) said it will be increasing NYC subway fares .25 (12.5%) to to $2.25 per ride. Commuter railroad fares on both the Long Island Rail Road and Metro-North rail lines are rising 8% to close its budget gap.
This is now far, far beyond spin— its simply outright lying to present a version of reality that radically differs from the "Real" one (pun intended).
So why haven't we gotten a more realistic version of inflation— one that has a high correlation with the construct known as reality? Well, it would wreak havoc with GDP, and potentially, the stock market. An accurate cost of living increase— in theory, what CPI is supposed to measure— would’ve eradicated a whole lot of GDP gains over the past 5 years.
That "Real 'Real'" GDP figure— adjusted for 'true' CPI inflation, which was adjusted for ACTUAL inflation— would be far more in in line with the lack of growth in real income and ‘real’ jobs . . .
As reflected in the plummeting dollar, many of the gains of the past few years were purely inflation driven, nominal asset price increases— not real (after inflation) gains.
Source:
Rise and Be Counted
Willow Duttge
Portfolio, October 2007
http://www.portfolio.com/news-markets/national-news/portfolio/2007/09/17/Consumer-Price-Index
Download indicator.gif
CPI's Lie on Household Inflation Doesn't Wash
John F. Wasik
Bloomberg, September 24 2007
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a2SUCQ3Bslk0
John Williams'— The Real Stats— Using Pre-Clinton Formulations
SHADOW GOVERNMENT STATISTICS
Analysis Behind and Beyond Government Economic Reporting
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By TheBigPicture | 27 September 2007
Click Here, or on the image, to see a larger, undistorted image.
- We have long railed against the absurdity of the CPI data. The ridiculous adjustments, the lack of correlation between CPI prices and reality, as well as the Fed focus on the core (inflation ex-inflation).
For the most part, the media has dutifully reported the nonsensical CPI data as if it were scripture. This drumbeat of criticism— both here and elsewhere— has begun to penetrate the MSM. We've seen a few critical columns over the past year or so. But I never expected to see this kind of critical reporting in a mainstream outlet: CPI's Lie on Household Inflation Doesn't Wash.
Perhaps the era of uncritical reporting is waning.
- "The U.S. consumer price index continues to be a testament to the art of economic spin.
Since wages, Social Security cost-of-living increases and some agency budgets are tied to it, the government has a vested interest in keeping it as low as possible.
Yet your real cost of living— what you keep after taxes, medical bills, college expenses and other household costs— is probably much higher than the 2 percent annual rate the government reported in July, showing a slight decline.
Millions are falling behind inflation because wage increases aren't keeping pace with the cost of medical care, lost employment benefits, homeownership expenses, energy and transportation.
And there's also a goliath looming in the U.S. economy that makes the government's consumer gauge more deceptive. Even with the stinging reality that housing values are dropping in many markets, homeownership costs such as taxes, maintenance and financing are still rising much faster than the index."
- • Since 2001, health premiums have risen 78%; Wages have gained 19% over the same period. CPI inflation measure? 17%.
• Housing is the single-largest expense for most Americans— as much as a third of total cash outlays. The Labor Department's Bureau of Labor Statistics only tracks "owner's equivalent rent" (OER). Housing costs/Owners’ Equivalent Rent is 23.158% of CPI.
• During the housing boom, OFHEO had housing prices increasing 13% per year; Non-government foundations had real estate taxes increasing about 6%; Over the same period, BLS measured ‘housing cost increases’ at 4%— about half of its actual price increases.
• Median real-estate taxes on owner-occupied housing went from $1,614 in 2005 to $1,742 in 2006, an increase of 7.93%. (That's more than double CPI inflation rate).Oh, and ‘Owners’ Equivalent Rent’ doesn’t account for real estate taxes.
~~~
Those of you who are fellow tri-state residents (NY, NJ, CT) will be as thrilled as I was that BLS shows transportation costs are declining; especially since the MTA (NY) said it will be increasing NYC subway fares .25 (12.5%) to to $2.25 per ride. Commuter railroad fares on both the Long Island Rail Road and Metro-North rail lines are rising 8% to close its budget gap.
This is now far, far beyond spin— its simply outright lying to present a version of reality that radically differs from the "Real" one (pun intended).
So why haven't we gotten a more realistic version of inflation— one that has a high correlation with the construct known as reality? Well, it would wreak havoc with GDP, and potentially, the stock market. An accurate cost of living increase— in theory, what CPI is supposed to measure— would’ve eradicated a whole lot of GDP gains over the past 5 years.
That "Real 'Real'" GDP figure— adjusted for 'true' CPI inflation, which was adjusted for ACTUAL inflation— would be far more in in line with the lack of growth in real income and ‘real’ jobs . . .
As reflected in the plummeting dollar, many of the gains of the past few years were purely inflation driven, nominal asset price increases— not real (after inflation) gains.
Source:
Rise and Be Counted
Willow Duttge
Portfolio, October 2007
http://www.portfolio.com/news-markets/national-news/portfolio/2007/09/17/Consumer-Price-Index
Download indicator.gif
CPI's Lie on Household Inflation Doesn't Wash
John F. Wasik
Bloomberg, September 24 2007
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a2SUCQ3Bslk0
John Williams'— The Real Stats— Using Pre-Clinton Formulations
SHADOW GOVERNMENT STATISTICS
Analysis Behind and Beyond Government Economic Reporting
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Why The Fed "Panicked" ...
Subprime Panic Freezes $40 Billion of Canadian Commercial Paper [¹]
By Rob Delaney | 25 September 2007
Sept. 25 (Bloomberg)—
"We have 200 people to keep alive," Chief Executive Officer Gordon McCreary said in an interview in Toronto. "Our lifeline to getting critical materials to the north" was the C$43.8 million ($43.8 million) invested in commercial paper, he said.
The Canadian cash crunch that started with defaults on subprime mortgages in Southern California and Florida has hurt more than 25 companies that invested in commercial paper, including Sun-Times Media Group Inc. and Canada Post, the nation's mail service. Baffinland has 95 percent of its cash in Canadian commercial paper, debt that is due in 364 days or less.
Investors fled Canada's asset-backed commercial paper, paralyzing the C$40 billion market for debt that carried the highest credit ratings, after losses from home loans to people with poor credit histories roiled global credit markets.
Coventree Can't Pay
That left Baffinland and other investors in the lurch because 17 funds run by finance companies including Toronto— based Coventree Inc., Newshore Financial Corp. and Quanto Financial Corp., couldn't raise money to pay back lenders, according to ratings company DBRS Ltd.
Coventree managed C$16 billion in commercial paper funds with the highest ratings.
The funds run by companies such as Coventree paid interest of about 4.6 percent for 30 days, compared with three-month Canadian government bills that yielded 4.35 percent. The debt is backed by mortgages, corporate bonds, and car loans that typically yield as much as 1 percentage point more than commercial paper, according to Colin Kilgour, president of Connor Clark & Lunn Wholesale Finance, the structured credit and securitization unit of Connor Clark & Lunn Financial Group.
About 4 percent of Coventree's commercial paper was backed by subprime mortgages.
No commercial paper borrower had failed to pay on time in two decades and Toronto-based DBRS gave the securities its top rating of R-1. The funds also had backup lines of credit from banks should a market disruption shut down the market.
Canada's asset-backed commercial paper market doubled to C$120 billion since 2000, according to Moody's Investors Service in New York. Buyers snapped up the IOUs as government debt sales fell 60 percent to C$23.5 billion in the past decade after nine straight surpluses, according to the March budget.
`Concept of Risk'
"You can get what the bank pays you, which is not very much, or you can put it in asset-backed commercial paper, which have always been rated as high as you can get so there's never been any concept of risk," said Geoff Chater, a spokesman for Vancouver-based First Quantum Resources Minerals Ltd., a copper mining company operating in Africa.
First Quantum hasn't been repaid on C$7.5 million of debt issued by Coventree that matured on Aug. 14 and Aug. 15, he said. It had about 28 percent of its cash in commercial paper.
Six-Year Highs
Starting in July, growing defaults in U.S. home loans caused the cost of borrowing to increase for all but the most creditworthy companies. Rates on asset-backed commercial paper soared, rising to six-year highs in the U.S. as the three-month London interbank offered rate, or Libor, climbed to 5.82 percent from 5.35 percent. Libor is a benchmark for commercial paper rates.
Making matters worse banks, including Frankfurt-based Deutsche Bank AG and Barclays Bank Plc of London, refused to provide emergency financing. They said there was no market disruption because some of Canada's biggest commercial banks were able to refinance debt.
Investors began demanding yields of about 6.03 percent to own Coventree's commercial paper. On Aug. 13 the company said it couldn't find enough buyers to refinance C$950 million of short=term debt and its banks refused to provide emergency funds. Company spokesman Craig Armitage declined to comment.
"Anytime there's a reliance on short-term funding without specific alternative plans for liquidity, that's going to be suspect," said John Hollyer, principal at Valley Forge, Pennsylvania-based Vanguard Group Inc., which has $170 billion in money market funds under management. "That's the overriding lesson of what happened here."
Debt Extension
A group of 10 banks and pension funds agreed on Aug. 16 to convert C$35 billion of debt into notes maturing in as much as 10 years. Terms of the debt won't be released until mid-October, said Purdy Crawford, a lawyer at the Toronto firm Osler, Hoskin & Harcourt LLP who heads the group. Until then, investors won't know when they will get their money back, or whether they will be repaid in full.
Deutsche Bank spokesman Ted Meyer in New York declined to comment, as did Barclays spokesman Peter Truell, also in New York.
Companies invested in the debt in part because of the ratings from DBRS, formerly Dominion Bond Rating Service, said Robin Roopchan, director of investor relations at Ontario Power Generation in Toronto, which bought C$103 million of the securities, none of which has been repaid.
`Global Liquidity'
DBRS figured on banks providing funds, said Managing Director Huston Loke.
"We expected a combination of the market and liquidity providers would have carried investors through," Loke said in an interview. The disruption clause "took good care of the market for 18 years," he said.
DBRS said Sept. 12 it will change its rating rules and adopt a "global liquidity" standard to prevent debt getting the highest credit rating if banks can refuse to provide funding.
"The banks are saying there's no market disruption, and obviously there is a market disruption," said Troy Winsor, a spokesman for Redcorp Ventures Ltd., based in Vancouver.
Redcorp put 43 percent of its money in Coventree commercial paper on the advice of HSBC Canada, Winsor said. Redcorp is building a copper, zinc and lead mine in British Columbia.
Sharon Wilks, a spokeswoman in Toronto for HSBC Canada, a unit of HSBC Holdings Plc, Europe's biggest bank, declined to comment. HSBC is among the banks working on the debt plan.
`Driving On'
Canada Post had about 3.5 percent, or C$37.9 million, of its treasury investments in asset-backed commercial paper, according to John Caines, manager for media relations. The company is representing investors negotiating with the banks.
Sun-Times, the publisher of the Chicago Sun-Times newspaper formerly controlled by convicted felon Conrad Black, said it doesn't anticipate a "major capital loss" after two trusts failed to pay back C$48 million in commercial paper.
The company signed "standstill" agreements in August with both National Bank of Canada's Ironstone Trust and Coventree's Planet Trust to avoid taking legal action until Oct. 15, Sun— Times spokesman Tammy Chase said.
Baffinland bought commercial paper on the advice of Toronto-based Bank of Nova Scotia. McCreary wouldn't say how much interest he is now paying on the C$21 million credit line.
"We're driving on," McCreary said.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Rob Delaney | 25 September 2007
Sept. 25 (Bloomberg)—
- On Baffin Island in the Arctic Circle, Baffinland Iron Mines Corp. almost missed its window to ship provisions to workers before winter arrives. The delay came not from the weather, but from a sudden freeze in the market for short-term debt 2,000 miles south in Toronto.
"We have 200 people to keep alive," Chief Executive Officer Gordon McCreary said in an interview in Toronto. "Our lifeline to getting critical materials to the north" was the C$43.8 million ($43.8 million) invested in commercial paper, he said.
The Canadian cash crunch that started with defaults on subprime mortgages in Southern California and Florida has hurt more than 25 companies that invested in commercial paper, including Sun-Times Media Group Inc. and Canada Post, the nation's mail service. Baffinland has 95 percent of its cash in Canadian commercial paper, debt that is due in 364 days or less.
Investors fled Canada's asset-backed commercial paper, paralyzing the C$40 billion market for debt that carried the highest credit ratings, after losses from home loans to people with poor credit histories roiled global credit markets.
Coventree Can't Pay
That left Baffinland and other investors in the lurch because 17 funds run by finance companies including Toronto— based Coventree Inc., Newshore Financial Corp. and Quanto Financial Corp., couldn't raise money to pay back lenders, according to ratings company DBRS Ltd.
Coventree managed C$16 billion in commercial paper funds with the highest ratings.
The funds run by companies such as Coventree paid interest of about 4.6 percent for 30 days, compared with three-month Canadian government bills that yielded 4.35 percent. The debt is backed by mortgages, corporate bonds, and car loans that typically yield as much as 1 percentage point more than commercial paper, according to Colin Kilgour, president of Connor Clark & Lunn Wholesale Finance, the structured credit and securitization unit of Connor Clark & Lunn Financial Group.
About 4 percent of Coventree's commercial paper was backed by subprime mortgages.
No commercial paper borrower had failed to pay on time in two decades and Toronto-based DBRS gave the securities its top rating of R-1. The funds also had backup lines of credit from banks should a market disruption shut down the market.
Canada's asset-backed commercial paper market doubled to C$120 billion since 2000, according to Moody's Investors Service in New York. Buyers snapped up the IOUs as government debt sales fell 60 percent to C$23.5 billion in the past decade after nine straight surpluses, according to the March budget.
`Concept of Risk'
"You can get what the bank pays you, which is not very much, or you can put it in asset-backed commercial paper, which have always been rated as high as you can get so there's never been any concept of risk," said Geoff Chater, a spokesman for Vancouver-based First Quantum Resources Minerals Ltd., a copper mining company operating in Africa.
First Quantum hasn't been repaid on C$7.5 million of debt issued by Coventree that matured on Aug. 14 and Aug. 15, he said. It had about 28 percent of its cash in commercial paper.
Six-Year Highs
Starting in July, growing defaults in U.S. home loans caused the cost of borrowing to increase for all but the most creditworthy companies. Rates on asset-backed commercial paper soared, rising to six-year highs in the U.S. as the three-month London interbank offered rate, or Libor, climbed to 5.82 percent from 5.35 percent. Libor is a benchmark for commercial paper rates.
Making matters worse banks, including Frankfurt-based Deutsche Bank AG and Barclays Bank Plc of London, refused to provide emergency financing. They said there was no market disruption because some of Canada's biggest commercial banks were able to refinance debt.
Investors began demanding yields of about 6.03 percent to own Coventree's commercial paper. On Aug. 13 the company said it couldn't find enough buyers to refinance C$950 million of short=term debt and its banks refused to provide emergency funds. Company spokesman Craig Armitage declined to comment.
"Anytime there's a reliance on short-term funding without specific alternative plans for liquidity, that's going to be suspect," said John Hollyer, principal at Valley Forge, Pennsylvania-based Vanguard Group Inc., which has $170 billion in money market funds under management. "That's the overriding lesson of what happened here."
Debt Extension
A group of 10 banks and pension funds agreed on Aug. 16 to convert C$35 billion of debt into notes maturing in as much as 10 years. Terms of the debt won't be released until mid-October, said Purdy Crawford, a lawyer at the Toronto firm Osler, Hoskin & Harcourt LLP who heads the group. Until then, investors won't know when they will get their money back, or whether they will be repaid in full.
Deutsche Bank spokesman Ted Meyer in New York declined to comment, as did Barclays spokesman Peter Truell, also in New York.
Companies invested in the debt in part because of the ratings from DBRS, formerly Dominion Bond Rating Service, said Robin Roopchan, director of investor relations at Ontario Power Generation in Toronto, which bought C$103 million of the securities, none of which has been repaid.
`Global Liquidity'
DBRS figured on banks providing funds, said Managing Director Huston Loke.
"We expected a combination of the market and liquidity providers would have carried investors through," Loke said in an interview. The disruption clause "took good care of the market for 18 years," he said.
DBRS said Sept. 12 it will change its rating rules and adopt a "global liquidity" standard to prevent debt getting the highest credit rating if banks can refuse to provide funding.
"The banks are saying there's no market disruption, and obviously there is a market disruption," said Troy Winsor, a spokesman for Redcorp Ventures Ltd., based in Vancouver.
Redcorp put 43 percent of its money in Coventree commercial paper on the advice of HSBC Canada, Winsor said. Redcorp is building a copper, zinc and lead mine in British Columbia.
Sharon Wilks, a spokeswoman in Toronto for HSBC Canada, a unit of HSBC Holdings Plc, Europe's biggest bank, declined to comment. HSBC is among the banks working on the debt plan.
`Driving On'
Canada Post had about 3.5 percent, or C$37.9 million, of its treasury investments in asset-backed commercial paper, according to John Caines, manager for media relations. The company is representing investors negotiating with the banks.
Sun-Times, the publisher of the Chicago Sun-Times newspaper formerly controlled by convicted felon Conrad Black, said it doesn't anticipate a "major capital loss" after two trusts failed to pay back C$48 million in commercial paper.
The company signed "standstill" agreements in August with both National Bank of Canada's Ironstone Trust and Coventree's Planet Trust to avoid taking legal action until Oct. 15, Sun— Times spokesman Tammy Chase said.
Baffinland bought commercial paper on the advice of Toronto-based Bank of Nova Scotia. McCreary wouldn't say how much interest he is now paying on the C$21 million credit line.
"We're driving on," McCreary said.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Wednesday, September 26, 2007
We Must Live Through All Time, Or Die By Suicide
As A Nation Of Freemen, We Must Live Through All Time, Or Die By Suicide. [¹]
Click here for link to complete article: http://jessel.100megsfree3.com/DXVLT.png
By Abraham Lincoln | 27 January 1838
At what point shall we expect the approach of danger? By what means shall we fortify against it?— Shall we expect some transatlantic military giant, to step the Ocean, and crush us at a blow? Never!— All the armies of Europe, Asia and Africa combined, with all the treasure of the earth (our own excepted) in their military chest; with a Buonaparte for a commander, could not by force, take a drink from the Ohio, or make a track on the Blue Ridge, in a trial of a thousand years.
At what point then is the approach of danger to be expected? I answer, if it ever reach us, it must spring up amongst us. It cannot come from abroad. If destruction be our lot, we must ourselves be its author and finisher. As a nation of freemen, we must live through all time, or die by suicide.
Click Here, or on the image, to see a larger, undistorted image.
Click here for link to complete article: http://jessel.100megsfree3.com/DXVLT.png
By Abraham Lincoln | 27 January 1838
At what point shall we expect the approach of danger? By what means shall we fortify against it?— Shall we expect some transatlantic military giant, to step the Ocean, and crush us at a blow? Never!— All the armies of Europe, Asia and Africa combined, with all the treasure of the earth (our own excepted) in their military chest; with a Buonaparte for a commander, could not by force, take a drink from the Ohio, or make a track on the Blue Ridge, in a trial of a thousand years.
At what point then is the approach of danger to be expected? I answer, if it ever reach us, it must spring up amongst us. It cannot come from abroad. If destruction be our lot, we must ourselves be its author and finisher. As a nation of freemen, we must live through all time, or die by suicide.
Click Here, or on the image, to see a larger, undistorted image.
Tuesday, September 25, 2007
New Buy Signal
Chart Spotlight: New Buy Signal [¹]
http://www.financialsense.com/editorials/swenlin/2007/0924.html
By Carl Swenlin, DecisionPoint.com | 24 September 2007
Ever since the market hit its correction lows in August I have written three articles, each emphasizing that the odds favored a retest of those lows (see Chart Spotlight on our website). As it turns out, we haven't had any decline that I would classify as a retest, and the market has broken out of a triangle formation on high volume. When the breakout happened, it eliminated any reasonable possibility of a retest, in my opinion. Sometimes the low odds take it.
One thing I have been cautioning about is to not get too bearish, because many of our key indicators had remained bullish. Another thing I should mention is that we should never get too invested in a forecast. I have watched as many of my bearish colleagues, after being proven wrong by the market, are still tying to justify their being bearish rather than trying to get aligned with the market. The market will eventually prove them right because, because, because . . . Maybe they will be right sooner than we think, but for now the market looks as if it will be moving higher for a while.
My bullish stance is due to our S&P 500 timing model having switched from neutral to a buy on September 13, three trading days prior to the Fed-induced market breakout. Also, prior to the breakout, about half of the market and sector indexes that we track with our primary timing model were also on buy signals. On the day of the breakout, the other half switched to buy signals.
The chart below shows the two components needed to generate a buy signal— the Percent Buy Index (PBI) crossed above its 32-EMA, AND the PMO (Price Momentum Oscillator) was above its 10-EMA. Note that the PBI is only at 59%, but it is trending up, which is most important.
Click Here, or on the image, to see a larger, undistorted image.
Bottom Line: The long-awaited retest did not materialize, and. in my opinion, the market has begun another leg upward that should challenge and exceed all-time highs for the S&P 500 Index.
Regardless of my personal opinion, we rely on the mechanical trend models to determine our market posture. Below is a recent snapshot of our primary trend-following timing model status for the major indexes and sectors we track. Note that we have added the nine Rydex Equal Weight ETF versions of the S&P Spider Sectors. This may seem redundant, but the equal weighted indexes most often do not perform the same as their cap-weighted counterparts, and they provide a way to diversify exposure.
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
http://www.financialsense.com/editorials/swenlin/2007/0924.html
By Carl Swenlin, DecisionPoint.com | 24 September 2007
Ever since the market hit its correction lows in August I have written three articles, each emphasizing that the odds favored a retest of those lows (see Chart Spotlight on our website). As it turns out, we haven't had any decline that I would classify as a retest, and the market has broken out of a triangle formation on high volume. When the breakout happened, it eliminated any reasonable possibility of a retest, in my opinion. Sometimes the low odds take it.
One thing I have been cautioning about is to not get too bearish, because many of our key indicators had remained bullish. Another thing I should mention is that we should never get too invested in a forecast. I have watched as many of my bearish colleagues, after being proven wrong by the market, are still tying to justify their being bearish rather than trying to get aligned with the market. The market will eventually prove them right because, because, because . . . Maybe they will be right sooner than we think, but for now the market looks as if it will be moving higher for a while.
My bullish stance is due to our S&P 500 timing model having switched from neutral to a buy on September 13, three trading days prior to the Fed-induced market breakout. Also, prior to the breakout, about half of the market and sector indexes that we track with our primary timing model were also on buy signals. On the day of the breakout, the other half switched to buy signals.
The chart below shows the two components needed to generate a buy signal— the Percent Buy Index (PBI) crossed above its 32-EMA, AND the PMO (Price Momentum Oscillator) was above its 10-EMA. Note that the PBI is only at 59%, but it is trending up, which is most important.
Click Here, or on the image, to see a larger, undistorted image.
Bottom Line: The long-awaited retest did not materialize, and. in my opinion, the market has begun another leg upward that should challenge and exceed all-time highs for the S&P 500 Index.
Regardless of my personal opinion, we rely on the mechanical trend models to determine our market posture. Below is a recent snapshot of our primary trend-following timing model status for the major indexes and sectors we track. Note that we have added the nine Rydex Equal Weight ETF versions of the S&P Spider Sectors. This may seem redundant, but the equal weighted indexes most often do not perform the same as their cap-weighted counterparts, and they provide a way to diversify exposure.
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Housing: Negative Annual Returns
Continuation of Negative Annual Returns in Housing [¹]
By TheBigPicture | 25 September 2007
Case Shiller Housing Index July 2007
Click Here, or on the image, to see a larger, undistorted image.
Here's the excerpt that goes with it:
Note that all 10 regions covered are now in the red, and for the most part, rather deeply; Only Chicago and Denver are off by less than 1%.
Click Here, or on the image, to see a larger, undistorted image.
via TFS Derivatives
Great Housing chart, from an article in the Sunday NYT:
Click Here, or on the image, to see a larger, undistorted image.
courtesy of the NYT
Incidentally, not everyone was crying wolf. Some of us were adducing significant data proving the point.
Such is the life of a skeptic . . .
Mortgage Withdrawals Driving UK Consumer Spending, Also
We have, for several years now, highlighted the significance of Mortgage Equity Withdrawal (MEW) in the U.S. as a major source of consumer spending.
As MEW slows, so too will consumer spending.
It turns out that this phenomena is not limited to the U.S.: In Great Britain, where nearly all mortgages are adjustable APRs, MEW has been a major source of fuel for their consumer spending.
From Monday's WSJ:
Sources:
Summer Swoon Evident in the S&P/Case-Shiller® Home Price Indices
Sep 25, 2007 09:00 AM EST PDF
http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_Release_092512.pdf
S&P/Case-Shiller Home Price Index Falls 3.9% in July
Courtney Schlisserman
Bloomberg, Sept. 25 2007
http://www.bloomberg.com/apps/news?pid=20601087&sid=aqOuSeaFXx3Y&
They Cried Wolf. They Were Right.
VIKAS BAJAJ
NYT, September 23, 2007
http://www.nytimes.com/2007/09/23/weekinreview/23bajaj.html
Northern Rock May Point to U.K. Crunch
CARRICK MOLLENKAMP and MARK WHITEHOUSE
WSJ, September 24, 2007; Page A2
http://online.wsj.com/article/SB119058413986236614.html
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By TheBigPicture | 25 September 2007
Case Shiller Housing Index July 2007
Click Here, or on the image, to see a larger, undistorted image.
Here's the excerpt that goes with it:
- "Data through July released today by Standard & Poor’s for its S&P/Case-Shiller® Home Price Indices, the leading measure of U.S. home prices, shows a continuation of negative annual returns in the 10-City Composite and the 20-City Composite, as well as 15 of the 20 metro area indices. Both composite indices have registered negative annual growth rates since the beginning of the year. In addition, both indices rate of decline has become larger in each of the seven months from January through July.
The chart above, depicting the annual returns of the 10-City Composite and the 20-City Composite, shows the 10-City Composite was down 4.5% versus July of 2006, while the 20-City Composite was down 3.9% over the same time period.
“The decline in home prices clearly continued into the summer months,” says Robert J. Shiller, Chief Economist at MacroMarkets LLC. “The year-over-year decline reported for the 10-City Composite is the lowest since July 1991. The lowest annual decline in this Index, which dates back to January 1987, was— 6.3%, which was reported in April 1991. The further deceleration in prices is still apparent across the majority of regions, with 16 of the 20 metro areas showing a drop in their annual growth rate from what was reported in June.”
- "Home prices in 20 U.S. metropolitan areas fell the most on record in July, indicating the threat to consumer spending was rising even before credit markets seized up in August, a private survey showed today.
Values dropped 3.9 percent in the 12 months through July, steeper than the 3.4 percent decrease in June, according to the S&P/Case-Shiller home-price index. The index declined in January for the first time since the group started the measure in 2001, and has receded every month since then.
Stricter lending standards and reduced demand are prolonging the housing slump, now entering its third year. Prices may continue to fall as homes stay on the market longer, economists said. Diminished housing wealth may spur households to pare spending, hurting economic growth."
Note that all 10 regions covered are now in the red, and for the most part, rather deeply; Only Chicago and Denver are off by less than 1%.
Click Here, or on the image, to see a larger, undistorted image.
via TFS Derivatives
Great Housing chart, from an article in the Sunday NYT:
Click Here, or on the image, to see a larger, undistorted image.
courtesy of the NYT
Incidentally, not everyone was crying wolf. Some of us were adducing significant data proving the point.
Such is the life of a skeptic . . .
Mortgage Withdrawals Driving UK Consumer Spending, Also
We have, for several years now, highlighted the significance of Mortgage Equity Withdrawal (MEW) in the U.S. as a major source of consumer spending.
As MEW slows, so too will consumer spending.
It turns out that this phenomena is not limited to the U.S.: In Great Britain, where nearly all mortgages are adjustable APRs, MEW has been a major source of fuel for their consumer spending.
From Monday's WSJ:
- "In the past decade, U.K. consumers have become more dependent on borrowed money, both to buy homes and to finance spending. As of July, total mortgage debt in the U.K. had reached £1.1 trillion ($2.2 trillion), more than double the level of 10 years earlier and equivalent to more than 80% of annual gross domestic product. In the first quarter of this year, U.K. homeowners tapped their home equity for about £13.2 billion, or 6.1% of disposable income, an indication of how much rising home prices have been raising consumer spending, which makes up about two-thirds of the U.K. economy."
- "Perhaps no company symbolizes the borrowing boom better than Northern Rock. In the late 1990s, the company became a pioneer in the securitization of U.K. mortgage loans, packaging thousands of loans into pools and selling the cash flows as securities to investors in the U.S. and Asia.
By tapping capital markets rather than relying solely on typical deposits, Northern Rock was able to expand at great speed. By June, it had about £87 billion in mortgage loans outstanding and had accounted for almost a fifth of new mortgage loans made in the first half. According to brokers, Northern Rock gained market share in part by taking risks— allowing home buyers, for example, to get loans covering as much as 90% of the purchase price.
Their mortgages "were prime, but they were operating at the outer limit of it," said Howard Cook, a partner at Talbot Insurance Services, an independent financial adviser in Cumbria, in northwestern England. A Northern Rock spokesman said the credit quality of the company's loans was solid, and that the percentage of loans in arrears was well below the industry average."
Sources:
Summer Swoon Evident in the S&P/Case-Shiller® Home Price Indices
Sep 25, 2007 09:00 AM EST PDF
http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_Release_092512.pdf
S&P/Case-Shiller Home Price Index Falls 3.9% in July
Courtney Schlisserman
Bloomberg, Sept. 25 2007
http://www.bloomberg.com/apps/news?pid=20601087&sid=aqOuSeaFXx3Y&
They Cried Wolf. They Were Right.
VIKAS BAJAJ
NYT, September 23, 2007
http://www.nytimes.com/2007/09/23/weekinreview/23bajaj.html
Northern Rock May Point to U.K. Crunch
CARRICK MOLLENKAMP and MARK WHITEHOUSE
WSJ, September 24, 2007; Page A2
http://online.wsj.com/article/SB119058413986236614.html
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Monday, September 24, 2007
One Last Fling..........
One Last Fling [¹]
By Rick Ackerman | 23 September 2007
We’re convinced that no amount of monetary stimulus can revive the real estate boom at this point, even if the Fed seems determined to try. But suppose we’re wrong and home prices take off again? Does anyone actually believe that that would lead the economy back to health? Of course not (Larry Kudlow aside). It would simply postpone a debt deflation that by now has become as likely as…the next recession. Keep in mind that when the Fed eased aggressively following the 9/11 attack, it required "only" about $2.70 of new borrowing to create a dollar’s worth of GDP growth. These days, though, the figure is even worse— far worse— and has been running well above $8.00.
What this suggests is that the task of getting consumers to aggressively ramp up the spending of borrowed money on big-ticket items is going to prove well nigh impossible. While the indefatigable and globally indispensable American shopper can never be completely counted out, it strains the imagination to think that he will be able to outrun the economic avalanche that has been gathering destructive momentum in the housing sector these last few months.
Even so, as counterpoint we offer another possible scenario from a friend of ours, John D., whose observations have been featured here before. John is in the commercial construction business in Southern California, and it never fails to astound us whenever we hear from him about how strong the industry has been, and continues to be, notwithstanding the collapse in residential building that has already occurred. John is not exactly an optimist, not by any stretch, but his forecast does leave a bit more room for an escape than ours:
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Rick Ackerman | 23 September 2007
We’re convinced that no amount of monetary stimulus can revive the real estate boom at this point, even if the Fed seems determined to try. But suppose we’re wrong and home prices take off again? Does anyone actually believe that that would lead the economy back to health? Of course not (Larry Kudlow aside). It would simply postpone a debt deflation that by now has become as likely as…the next recession. Keep in mind that when the Fed eased aggressively following the 9/11 attack, it required "only" about $2.70 of new borrowing to create a dollar’s worth of GDP growth. These days, though, the figure is even worse— far worse— and has been running well above $8.00.
What this suggests is that the task of getting consumers to aggressively ramp up the spending of borrowed money on big-ticket items is going to prove well nigh impossible. While the indefatigable and globally indispensable American shopper can never be completely counted out, it strains the imagination to think that he will be able to outrun the economic avalanche that has been gathering destructive momentum in the housing sector these last few months.
Even so, as counterpoint we offer another possible scenario from a friend of ours, John D., whose observations have been featured here before. John is in the commercial construction business in Southern California, and it never fails to astound us whenever we hear from him about how strong the industry has been, and continues to be, notwithstanding the collapse in residential building that has already occurred. John is not exactly an optimist, not by any stretch, but his forecast does leave a bit more room for an escape than ours:
- A False Spring
"I don't believe a ‘housing boom’ is about to start," he writes, "but just enough good news to make people think the worst is over and that the price deflation is, or almost is, done. In California in the late 80's early 90's the housing recession was very nasty. I watched a house I bought for $265k go ‘up’ in value in a year and a half to $350k, only to be worth about 220k or less after the Northridge quake and everyone left town. I agree with you that we may one day see the Aspen [ski] house with no value, and the ultimate decline in price will make the 90's look like nothing.
"[But] there has yet to be a decline in commercial and industrial real-estate. The signs are out there, but vacancy rates are still very low in our area and the ‘For Lease’ signs are not on every corner. Lease rates for office and light industrial are still are at a premium. In the early to mid 90's it was cheaper to buy an existing building then it was to build a new one. We still have a ways to go before we get there, though I realize the climate can change overnight in the leveraged world we live in.
Getting Out Now
"My family, through a trust my dad set up, owns some mid-sized buildings in East Los Angeles, all three in the 30k square-foot range. We are in the process of trying to sell the buildings now, while prices are still high and there are still buyers, we just need things to hold together for a little while longer. One advantage is that we owe nothing on the buildings; they were all bought with cash in the 1990's. At the same time, there is no problem leasing the buildings to quality tenants.
"[The information you sent me] confirms a lot of what I already am seeing and do believe is ahead of us. I was reading another ‘deflationist’ (Tim Wood) who puts out a newsletter, and in his September issuer he sees a ‘perfect storm’ (my words, not his) coming. He has housing topping first and then commodities. He says commodities are the key, as reckoned by the CRB index. He is looking for the index to drop below its January 2007 low. If it does, then deflation is here; if it does not, and commodities continue to inflate, then the markets may continue to rise for a time.
Not Enough Euphoria
"It seems to me that if the Fed successfully inflates assets, then we are moving into an incredible blow-off top that has never been seen. [[1928 - 1929 redux?: normxxx]] With all the euphoria over the 50-basis-point cut, it finally does seem like we are going to be seeing fewer doom-and-gloomers on CNBC. Everyone is going to be talking about their 401k profits in a few months— especially when the Dow hits your 15k target. Up until now there has not been enough euphoria, only caution everywhere you turn. It is going to take one more run-up to get us to the top.
"I'll bet we start to hear about a housing turnaround within the next month or two, with sales and closings up, etc. All the jobs we have bid and which the owners have been holding back will probably go forward, and we will enjoy one last money making year. Everyone from business to the consumer is going to be leveraged to the hilt. Gold, silver, and the Dow will be at record highs, and then boom!! Nobody will know what hit them. I think it is time to sit on the sidelines, or to enjoy the final ride up and then watch out!
"It will be perfect. Hilary will be entering the White House and the people will be crying for socialistic government solutions! GWB and the do-nothing Republicans will be blamed, and the Clintons will be able to be the next Hugo Chavez's of the world. (How depressing!). It's the American people’s fault. We just can't help ourselves. We must consume and spend— that's the way we were raised. We live in interesting times, for sure."
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Hussman: Show Me The Money!
Show Me The Money! [¹]
Click here for link to complete article: http://www.hussmanfunds.com/wmc/wmc070924.htm
By John P. Hussman, Ph.D. | 24 September 2007
All rights reserved and actively enforced.
Investors were cheered last week when the Federal Reserve lowered its target for the Federal Funds Rate by 50 basis points, and lowered the Discount Rate (the interest rate it charges on loans directly to the banking system) by 50 basis points as well. It's important to emphasize that the impact of these changes is mainly psychological, and outside of a pool of a few billion dollars, won't have any effective bearing on the "liquidity" of the banking system, nor on the solvency of $3.4 trillion in real estate loans, [[nor on the: normxxx]] $6.3 trillion in total bank lending [[nor on the almost $300 trillion in derivatives: normxxx]].
The Fed certainly does play an important role in accommodating temporary spikes in the demand for currency (as it did around the "year 2000" turn), and in providing economic information, data and analysis. Unfortunately, Fed governors generally believe in their own power not because they actually understand that "power" as insiders, but because as outsiders, they worked on theoretical models of "economies" where the links between Fed actions and market interest rates, bank lending, and overall GDP could simply be assumed by writing down one or more algebraic equations.
In one of his most referenced papers, for example, Ben Bernanke assumes
Here's how monetary policy operates in a world like this (taken straight from Bernanke and Gertler, Monetary Policy and Asset Price Volatility, 1999). If you hate equations, ignore the graphic below. The first equation is the Fed Funds rate, which the Fed sets using an inflation targeting rule. The second equation is the actual real interest rate in the economy, tied directly to the Fed Funds rate, which is convenient. The third equation is the household consumption function, tied directly to the real interest rate that is tied directly to the Fed Funds rate. So by assumption, the Fed Funds rate, and thereby the relevant interest rate to consumers, and thereby consumption, and thereby economic activity, are all simply controlled by the central bank. Don't ask how.
Much ado about nothing
To see how monetary policy actually works, look at the data, which you can get from:
The New York Federal Reserve Bank, or
The St. Louis Federal Reserve Economic Database
If you examine the data you'll find that the total level of "liquidity" that the FOMC deals with is minuscule in relation to a $13.8 trillion economy, and the variation is even smaller. The total reserves of the U.S. banking system are about $40-$45 billion, and are very stable. The Fed simply does not "inject" meaningful amounts of "liquidity" [into] the banking system.
Indeed, the latest cuts in Fed controlled interest rates were effected without any injection of "liquidity" into the banking system at all. Total borrowings by depository institutions from the Federal Reserve (i.e. borrowings at the Discount Rate) actually fell last week to $2.421 billion, from $3.158 billion the preceding week. That couple of billion dollars is the sum total of all outstanding borrowings at the Discount Rate. Though these figures are still higher than the typical level of discount window borrowing (a few hundred million), they are minuscule. Yet these are the figures that investors are revved up about as if this "liquidity" will save the mortgage market.
Meanwhile, there has been no material change in the "liquidity" provided by the Federal Reserve in the federal funds market either. It's kind of funny (and just a little pathetic) how the press and investors get all excited every time the FOMC does an open market operation, as if they represent fresh "injections" of liquidity into the banking system. They are generally nothing but rollovers of existing repurchase agreements.
Open market operations come in two flavors: permanent and temporary. As I've frequently noted, about 99% of the monetary base created by the Federal Reserve represents gradual and predictable increases in the amount of currency in circulation. Year-to-date, the Federal Reserve engaged in what it classifies as "permanent" open market purchases amounting to $1.9 billion in February, $6.1 billion in April, and $2.7 billion in May, for a year-to-date "permanent" increase of $10.7 billion in the monetary base. Not surprisingly, most of this has been drawn off as currency in circulation, which has increased by $9.1 billion since January. Simply put, "permanent" open market operations are simply the way the Fed increases currency in circulation. It is simply incorrect to believe that these open market operations add meaningfully to the "liquidity" from which banks are able to make loans.
Temporary open market operations generally take the form of "repurchase agreements" [[aka, "repos": normxxx]] whereby the Fed takes collateral in the form of Treasury securities or U.S. government backed agency securities, and provides funds to banks for periods typically ranging from 1 day to 2 weeks. At the end of that period, the banks are obligated to repurchase the securities from the Fed at the sale price, plus interest.
Since reserves are only required on checking deposits, the total amount of reserves in the U.S. banking system is only about $40 to $45 billion. Banks don't stack a pile of idle cash in a corner of the vault to maintain these reserves. Instead, they hold securities like Treasury bills and U.S. government-backed agency notes, and if they find themselves in need of reserves, they just pledge these securities to the Federal Reserve as collateral.
Look at the last month of data. We know that total bank reserves during this period have ranged between about $40 to $45 billion. Using data on the last 25 FOMC operations reported by the New York Fed, we can tie out the amount of outstanding repurchase agreements on any given day. Recall that total reserves include those obtained through Discount rate borrowing and Fed repos (though "nonborrowed reserves" exclude Discount borrowings). Evidently, the majority of the reserves in the U.S. banking system are represented by a continuous rollover of outstanding "temporary" repurchase agreements. If one set of repurchase agreements for $10 billion matures 3 days from now, you can pretty well predict that the Fed will enter new repurchase agreements of nearly this amount when the existing agreements expire. As a result, the total amount of repos outstanding is fairly stable. On balance, the Fed injected nothing— repeat nothing— this week.
Click Here, or on the image, to see a larger, undistorted image.
Importantly, investors are misled when they interpret each new repurchase agreement as if it is a "new injection of liquidity" into the banking system. The bulk of these repos do nothing more than to replace the ones that are due.
Show me the money!
This week provides an instructive opportunity to observe this in real time. On Thursday, September 27th, an unusually large $24 billion amount of repurchase agreements will come due, leaving only about $7 billion of repos outstanding. It should come as no surprise, then, that the Federal Reserve will most likely enter into a seemingly enormous $24 billion or so in new repurchase agreements by Thursday afternoon. This will undoubtedly be reported with great fanfare, and will be interpreted as a "massive injection of reserves into the banking system" by the Federal Reserve, as if these funds are new liquidity. This interpretation will be utterly incorrect. It will be nothing but a rollover of existing repurchase agreements that the Fed routinely enters into in order to maintain a stable amount of reserves in the banking system.
That said, if investors are naïve enough (and last week's exuberance gives every indication that they are), they may very well rally the market on this meaningless and entirely predictable "injection of liquidity" by the Fed. Though we wouldn't speculate on that outcome, it will be interesting to see how Wall Street interprets this rollover.
Simon Says
The simple fact is that while the Federal Reserve lowered the Fed Funds Rate and the Discount Rate last week, it did not do so by "injecting" any new funds at all into the banking system. Rather, the Fed lowered these rates strictly by announcing they were now lower.
It's easy to understand this in the context of the Discount Rate, because the Fed is the only entity that charges that rate. With Fed Funds, you can understand how the announcement alone can change the rate by understanding a) that the entire variation in bank reserves that determines the Fed Funds rate amounts to only a few billion dollars, and b) banks are generally willing to follow the rate "called out" by the Fed so long as it doesn't affect the spread they earn.
Think for a second about how borrowers and depositors differ when they choose a bank. If you're a borrower, you frankly couldn't care less about whether an institution is credit worthy. In fact, you'd just as soon have the entire bank vanish into thin air the second after you take your loan. For that reason, "offered" lending rates like the Prime Rate, Fed Funds, and LIBOR tend to move in lock step between banks— they tend to coordinate these rates because there is no point in competing on that front. Borrowers can simply look at the rates, compare apples-to-apples, and choose the lowest cost lender. Indeed, the whole reason that mortgage loans are complicated by points, closing costs, and other fees is because the only way lenders can charge different rates is to make it hard for borrowers to make a clear apples-to-apples comparison.
It's strictly on the bid side (savings deposit rates, CD rates, interest checking rates, etc) that you see a wide variation in the interest rates paid to depositors.
As a result, you'll generally observe that when the Fed lowers the Fed Funds Rate, banks often lower other "offered" rates like the Prime Rate and LIBOR, but they also simultaneously lower deposit rates. As long as they can maintain the spread between deposit rates and lending rates, they're often willing to change the levels (though you'll notice that there's currently still a wide spread between LIBOR and Fed Funds). No new liquidity needs to be introduced, and there is typically no material change in either the volume of deposits or the volume of loans. The data simply don't demonstrate any significant elasticity in either the demand for funds or the supply of deposits in response to marginal changes in Fed-controlled rates.
Outside of the banking system, you'll notice that while Fed-controlled interest rates dropped last week, market-controlled interest rates rose. Treasury yields increased at nearly all maturities, as did mortgage rates, including those on 30-year conventional mortgages. Indeed, the only "relief" to borrowers was on rates tied to LIBOR, which fell. But even this is not "new purchasing power" for the economy, because the drop was matched by a reduction in deposit rates, so any relief to borrowers with rates tied to LIBOR came entirely at the expense of savers.
Again, the argument is not that interest rates are irrelevant, or that there is no relationship between total government liabilities and inflation (though the tightest relationship is between government spending growth, regardless of how it is financed, and inflation— particularly over horizons of 4-5 years). The argument [here] is that there is no credible mechanism by which Fed actions control the economy [[except for investor/consumer psychology: normxxx]].
The bottom line— the much celebrated move by the Fed last week created no new liquidity, no new reserves, and no new purchasing power. Given all that, it's unlikely that all of this will result in any material improvement in the solvency of the mortgage market.
Market Climate
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and still unfavorable market action. Market internals have significantly lagged the strength in the major averages here, while investment advisory bullishness surged above 53%. While we can't rule out further strength, last week saw a return to the overvalued, overbought, overbullish combination of conditions that has historically been followed by returns averaging less than Treasury bills. On that basis, we widened the "staggered strike" configuration of our hedges on last week's strength, in order to provide a better defense against potential market losses that often abruptly follow such conditions.
Investors will likely be reminded of how the market has historically performed following two consecutive cuts in the Discount Rate. We've observed 11 instances of this since 1950, with average total returns in the S&P 500 of 6.18% over the following 3 months, 12.48% over the following 6 months, and 21.05% over the following year. The difficulty with these averages is that the cuts almost invariably occurred well into bear markets, where valuations were already depressed. Specifically, the average P/E on the S&P 500 (based on trailing net earnings) was only 14 (with a median closer to 12), while the average dividend yield was 3.75% and the average price/revenue multiple was just 0.90. Presently, the trailing net P/E on the S&P 500 is 17.9, with a dividend yield of just 1.84 and a price/revenue multiple of 1.55.
Indeed, only two of those "second Discount Rate cuts" occurred with the S&P 500 P/E above 15 and advisory bullishness running over 50%. Those instances were December 1971 and January 2001. The average subsequent performance of the S&P 500 following those cuts was— 1.22 over 3 months, 0.92% over 6 months, and 3.17% over the following year.
In short, the strong historical performance of the market following consecutive Discount Rate cuts can be traced to the fact that these cuts typically occurred when stocks had already declined considerably, market valuations were below average (and usually very cheap), investment sentiment was widely negative, and the economy was already entrenched in well-recognized recessions. It was not the Discount Rate cuts themselves that produced the advances. Rather, consecutive Discount Rate cuts were a "sufficient statistic" that the market was depressed, heavily bearish, cheaply valued, and had largely discounted an ongong recession. It is superstitious and wishful thinking to assume that the market will perform strongly simply because of two Discount Rate cuts, despite elevated valuations, high levels of bullishness, absence of a recession, and an S&P 500 index that is only about 2% from its all-time high.
That said, over the very short-term, the headline CPI number may startle investors in the months ahead owing to upward pressures on oil prices and the rental component of that index [[which by the arcana of how these stats are calculated, will continue to reflect recently soaring housing prices: normxxx]]. A year-over-year CPI figure of about 4% or more, as I've mentioned before, is statistically baked-in-the-cake by November.
In precious metals, the Strategic Total Return Fund continues to have about 10% of assets in these shares. While this market appears overbought in the near term, we've already clipped our exposure enough to allow for some retrenchment, and given the continued favorable Market Climate overall, there is no reason to lighten our position so much that we would have to hope for weakness in order to reestablish a base position. As our position stands, we'll be inclined to increase our exposure on any substantial weakness, but we also don't have any need to "chase" the market in order to obtain exposure, should precious metals move higher from here.
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Click here for link to complete article: http://www.hussmanfunds.com/wmc/wmc070924.htm
By John P. Hussman, Ph.D. | 24 September 2007
All rights reserved and actively enforced.
Investors were cheered last week when the Federal Reserve lowered its target for the Federal Funds Rate by 50 basis points, and lowered the Discount Rate (the interest rate it charges on loans directly to the banking system) by 50 basis points as well. It's important to emphasize that the impact of these changes is mainly psychological, and outside of a pool of a few billion dollars, won't have any effective bearing on the "liquidity" of the banking system, nor on the solvency of $3.4 trillion in real estate loans, [[nor on the: normxxx]] $6.3 trillion in total bank lending [[nor on the almost $300 trillion in derivatives: normxxx]].
The Fed certainly does play an important role in accommodating temporary spikes in the demand for currency (as it did around the "year 2000" turn), and in providing economic information, data and analysis. Unfortunately, Fed governors generally believe in their own power not because they actually understand that "power" as insiders, but because as outsiders, they worked on theoretical models of "economies" where the links between Fed actions and market interest rates, bank lending, and overall GDP could simply be assumed by writing down one or more algebraic equations.
In one of his most referenced papers, for example, Ben Bernanke assumes
- "standard dynamic new Keynesian framework. The most important sectors are a household sector and a business sector. Households are infinitely lived. They work, consume and save. Business firms are owned by entrepreneurs who have a finite expected life. There is also a government that manages fiscal and monetary policy."
Here's how monetary policy operates in a world like this (taken straight from Bernanke and Gertler, Monetary Policy and Asset Price Volatility, 1999). If you hate equations, ignore the graphic below. The first equation is the Fed Funds rate, which the Fed sets using an inflation targeting rule. The second equation is the actual real interest rate in the economy, tied directly to the Fed Funds rate, which is convenient. The third equation is the household consumption function, tied directly to the real interest rate that is tied directly to the Fed Funds rate. So by assumption, the Fed Funds rate, and thereby the relevant interest rate to consumers, and thereby consumption, and thereby economic activity, are all simply controlled by the central bank. Don't ask how.
- [ Normxxx Here: So, I guess this means that all booms and recessions are planned by the Fed? ]
To see how monetary policy actually works, look at the data, which you can get from:
The New York Federal Reserve Bank, or
The St. Louis Federal Reserve Economic Database
If you examine the data you'll find that the total level of "liquidity" that the FOMC deals with is minuscule in relation to a $13.8 trillion economy, and the variation is even smaller. The total reserves of the U.S. banking system are about $40-$45 billion, and are very stable. The Fed simply does not "inject" meaningful amounts of "liquidity" [into] the banking system.
Indeed, the latest cuts in Fed controlled interest rates were effected without any injection of "liquidity" into the banking system at all. Total borrowings by depository institutions from the Federal Reserve (i.e. borrowings at the Discount Rate) actually fell last week to $2.421 billion, from $3.158 billion the preceding week. That couple of billion dollars is the sum total of all outstanding borrowings at the Discount Rate. Though these figures are still higher than the typical level of discount window borrowing (a few hundred million), they are minuscule. Yet these are the figures that investors are revved up about as if this "liquidity" will save the mortgage market.
Meanwhile, there has been no material change in the "liquidity" provided by the Federal Reserve in the federal funds market either. It's kind of funny (and just a little pathetic) how the press and investors get all excited every time the FOMC does an open market operation, as if they represent fresh "injections" of liquidity into the banking system. They are generally nothing but rollovers of existing repurchase agreements.
Open market operations come in two flavors: permanent and temporary. As I've frequently noted, about 99% of the monetary base created by the Federal Reserve represents gradual and predictable increases in the amount of currency in circulation. Year-to-date, the Federal Reserve engaged in what it classifies as "permanent" open market purchases amounting to $1.9 billion in February, $6.1 billion in April, and $2.7 billion in May, for a year-to-date "permanent" increase of $10.7 billion in the monetary base. Not surprisingly, most of this has been drawn off as currency in circulation, which has increased by $9.1 billion since January. Simply put, "permanent" open market operations are simply the way the Fed increases currency in circulation. It is simply incorrect to believe that these open market operations add meaningfully to the "liquidity" from which banks are able to make loans.
Temporary open market operations generally take the form of "repurchase agreements" [[aka, "repos": normxxx]] whereby the Fed takes collateral in the form of Treasury securities or U.S. government backed agency securities, and provides funds to banks for periods typically ranging from 1 day to 2 weeks. At the end of that period, the banks are obligated to repurchase the securities from the Fed at the sale price, plus interest.
Since reserves are only required on checking deposits, the total amount of reserves in the U.S. banking system is only about $40 to $45 billion. Banks don't stack a pile of idle cash in a corner of the vault to maintain these reserves. Instead, they hold securities like Treasury bills and U.S. government-backed agency notes, and if they find themselves in need of reserves, they just pledge these securities to the Federal Reserve as collateral.
Look at the last month of data. We know that total bank reserves during this period have ranged between about $40 to $45 billion. Using data on the last 25 FOMC operations reported by the New York Fed, we can tie out the amount of outstanding repurchase agreements on any given day. Recall that total reserves include those obtained through Discount rate borrowing and Fed repos (though "nonborrowed reserves" exclude Discount borrowings). Evidently, the majority of the reserves in the U.S. banking system are represented by a continuous rollover of outstanding "temporary" repurchase agreements. If one set of repurchase agreements for $10 billion matures 3 days from now, you can pretty well predict that the Fed will enter new repurchase agreements of nearly this amount when the existing agreements expire. As a result, the total amount of repos outstanding is fairly stable. On balance, the Fed injected nothing— repeat nothing— this week.
Click Here, or on the image, to see a larger, undistorted image.
Importantly, investors are misled when they interpret each new repurchase agreement as if it is a "new injection of liquidity" into the banking system. The bulk of these repos do nothing more than to replace the ones that are due.
Show me the money!
This week provides an instructive opportunity to observe this in real time. On Thursday, September 27th, an unusually large $24 billion amount of repurchase agreements will come due, leaving only about $7 billion of repos outstanding. It should come as no surprise, then, that the Federal Reserve will most likely enter into a seemingly enormous $24 billion or so in new repurchase agreements by Thursday afternoon. This will undoubtedly be reported with great fanfare, and will be interpreted as a "massive injection of reserves into the banking system" by the Federal Reserve, as if these funds are new liquidity. This interpretation will be utterly incorrect. It will be nothing but a rollover of existing repurchase agreements that the Fed routinely enters into in order to maintain a stable amount of reserves in the banking system.
That said, if investors are naïve enough (and last week's exuberance gives every indication that they are), they may very well rally the market on this meaningless and entirely predictable "injection of liquidity" by the Fed. Though we wouldn't speculate on that outcome, it will be interesting to see how Wall Street interprets this rollover.
Simon Says
The simple fact is that while the Federal Reserve lowered the Fed Funds Rate and the Discount Rate last week, it did not do so by "injecting" any new funds at all into the banking system. Rather, the Fed lowered these rates strictly by announcing they were now lower.
It's easy to understand this in the context of the Discount Rate, because the Fed is the only entity that charges that rate. With Fed Funds, you can understand how the announcement alone can change the rate by understanding a) that the entire variation in bank reserves that determines the Fed Funds rate amounts to only a few billion dollars, and b) banks are generally willing to follow the rate "called out" by the Fed so long as it doesn't affect the spread they earn.
Think for a second about how borrowers and depositors differ when they choose a bank. If you're a borrower, you frankly couldn't care less about whether an institution is credit worthy. In fact, you'd just as soon have the entire bank vanish into thin air the second after you take your loan. For that reason, "offered" lending rates like the Prime Rate, Fed Funds, and LIBOR tend to move in lock step between banks— they tend to coordinate these rates because there is no point in competing on that front. Borrowers can simply look at the rates, compare apples-to-apples, and choose the lowest cost lender. Indeed, the whole reason that mortgage loans are complicated by points, closing costs, and other fees is because the only way lenders can charge different rates is to make it hard for borrowers to make a clear apples-to-apples comparison.
It's strictly on the bid side (savings deposit rates, CD rates, interest checking rates, etc) that you see a wide variation in the interest rates paid to depositors.
As a result, you'll generally observe that when the Fed lowers the Fed Funds Rate, banks often lower other "offered" rates like the Prime Rate and LIBOR, but they also simultaneously lower deposit rates. As long as they can maintain the spread between deposit rates and lending rates, they're often willing to change the levels (though you'll notice that there's currently still a wide spread between LIBOR and Fed Funds). No new liquidity needs to be introduced, and there is typically no material change in either the volume of deposits or the volume of loans. The data simply don't demonstrate any significant elasticity in either the demand for funds or the supply of deposits in response to marginal changes in Fed-controlled rates.
Outside of the banking system, you'll notice that while Fed-controlled interest rates dropped last week, market-controlled interest rates rose. Treasury yields increased at nearly all maturities, as did mortgage rates, including those on 30-year conventional mortgages. Indeed, the only "relief" to borrowers was on rates tied to LIBOR, which fell. But even this is not "new purchasing power" for the economy, because the drop was matched by a reduction in deposit rates, so any relief to borrowers with rates tied to LIBOR came entirely at the expense of savers.
Again, the argument is not that interest rates are irrelevant, or that there is no relationship between total government liabilities and inflation (though the tightest relationship is between government spending growth, regardless of how it is financed, and inflation— particularly over horizons of 4-5 years). The argument [here] is that there is no credible mechanism by which Fed actions control the economy [[except for investor/consumer psychology: normxxx]].
The bottom line— the much celebrated move by the Fed last week created no new liquidity, no new reserves, and no new purchasing power. Given all that, it's unlikely that all of this will result in any material improvement in the solvency of the mortgage market.
Market Climate
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and still unfavorable market action. Market internals have significantly lagged the strength in the major averages here, while investment advisory bullishness surged above 53%. While we can't rule out further strength, last week saw a return to the overvalued, overbought, overbullish combination of conditions that has historically been followed by returns averaging less than Treasury bills. On that basis, we widened the "staggered strike" configuration of our hedges on last week's strength, in order to provide a better defense against potential market losses that often abruptly follow such conditions.
Investors will likely be reminded of how the market has historically performed following two consecutive cuts in the Discount Rate. We've observed 11 instances of this since 1950, with average total returns in the S&P 500 of 6.18% over the following 3 months, 12.48% over the following 6 months, and 21.05% over the following year. The difficulty with these averages is that the cuts almost invariably occurred well into bear markets, where valuations were already depressed. Specifically, the average P/E on the S&P 500 (based on trailing net earnings) was only 14 (with a median closer to 12), while the average dividend yield was 3.75% and the average price/revenue multiple was just 0.90. Presently, the trailing net P/E on the S&P 500 is 17.9, with a dividend yield of just 1.84 and a price/revenue multiple of 1.55.
Indeed, only two of those "second Discount Rate cuts" occurred with the S&P 500 P/E above 15 and advisory bullishness running over 50%. Those instances were December 1971 and January 2001. The average subsequent performance of the S&P 500 following those cuts was— 1.22 over 3 months, 0.92% over 6 months, and 3.17% over the following year.
In short, the strong historical performance of the market following consecutive Discount Rate cuts can be traced to the fact that these cuts typically occurred when stocks had already declined considerably, market valuations were below average (and usually very cheap), investment sentiment was widely negative, and the economy was already entrenched in well-recognized recessions. It was not the Discount Rate cuts themselves that produced the advances. Rather, consecutive Discount Rate cuts were a "sufficient statistic" that the market was depressed, heavily bearish, cheaply valued, and had largely discounted an ongong recession. It is superstitious and wishful thinking to assume that the market will perform strongly simply because of two Discount Rate cuts, despite elevated valuations, high levels of bullishness, absence of a recession, and an S&P 500 index that is only about 2% from its all-time high.
- [ Normxxx Here: But this does add to the evidence that BB and the Feds decided to act "preemptively". ]
That said, over the very short-term, the headline CPI number may startle investors in the months ahead owing to upward pressures on oil prices and the rental component of that index [[which by the arcana of how these stats are calculated, will continue to reflect recently soaring housing prices: normxxx]]. A year-over-year CPI figure of about 4% or more, as I've mentioned before, is statistically baked-in-the-cake by November.
- [ Normxxx Here: And has been for at least 6 months or more, but will probably be blamed on the recent Fed actions, e.g., lowering the Fed Funds rate by 0.5%. ]
In precious metals, the Strategic Total Return Fund continues to have about 10% of assets in these shares. While this market appears overbought in the near term, we've already clipped our exposure enough to allow for some retrenchment, and given the continued favorable Market Climate overall, there is no reason to lighten our position so much that we would have to hope for weakness in order to reestablish a base position. As our position stands, we'll be inclined to increase our exposure on any substantial weakness, but we also don't have any need to "chase" the market in order to obtain exposure, should precious metals move higher from here.
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Sunday, September 23, 2007
Sea Change at the Fed
Sea Change at the Fed [¹]
Click here for link to complete article: http://www.safehaven.com/article-8470.htm
By John Mauldin | 23 September 2007
A Sea Change At The Fed
As everyone knows, the Federal Reserve cut both the fed funds rate and the discount rate by 50 basis points this week. The rate cut was clearly telegraphed and only the amount of the cut was a mystery. And for reasons I lay out later on, I think there will be more cuts. But that is not the interesting thing, at least to me. I think the Fed under Bernanke has clearly taken a new direction in determining monetary policy, one that differs with past deliberations.
At Jackson Hole on August 31, Bernanke addressing the problem of moral hazard faced by Central Banks, Bernanke noted: "It is not the responsibility of the Federal Reserve— nor would it be appropriate— to protect lenders and investors from the consequences of their financial decisions." He did acknowledge that if the system as a whole was at risk, then a central bank would have to act even in spite of the moral hazard issue.
That was then and this is now. We got rate cuts September 18. Bernanke in his testimony to Congress this week said the Fed cut rates "to try to get out ahead of the situation and try to forestall potential effects of tighter credit conditions on the broader economy." While he gave no hints as to future policy, he did note that the Fed would "keep reassessing our outlook and adjusting policy" as the situation demanded.
Read those words again. "...to try to get out ahead of the situation..." Hello. That is something new. Normally watching the Fed and predicting the next move is about as exciting as watching paint dry. The Fed has always waited until the data suggested (and/or the market demanded) a rate hike or especially a cut. The Fed has been what good friend Paul McCulley calls "opportunistically disinflationary" for the past two-plus decades. They tighten until inflation comes down and only when it is apparent that a recession is in the works, or if there is a crisis like 1987 or 1998 (more on that important distinction later) do they cut rates. They have reacted to the data rather than made forward looking assumptions.
Over time, this has been a good policy, as it dropped inflation down from the mid-teens in 1980 to below 2% a few years ago. There are those who argue (and with some justification) that Greenspan left rates too low for too long and allowed inflation to rise back to an uncomfortable 3%, although it has been tending down of late.
But the point is that inflation is merely tending down. It is not below 2%, and year over year comparisons in the fourth quarter suggest that headline inflation of closer to 3% is quite possible. That being said, the similar comparison numbers for core inflation are not as difficult, but certainly do not suggest— at this time— that we will drop below 2% this year.
Indeed, there may be some concerns that the CPI (Consumer Price Index) number could come under pressure from the housing component. Given that home prices are falling, that may be considered odd by many. But CPI does not measure home prices. It measures something called owner's equivalent rent. And even as house prices rose by 93% in real terms (per Bob Shiller) in the last decade run-up, rent in real terms did not go up all that much, so the cost of a new home was not reflected in the CPI.
Now, we may have the opposite problem. As more and more people cannot get a mortgage coupled with a very precipitous rise in foreclosures, we are seeing more people who need to rent. Rental property availability in many markets is quite tight, which means that rent prices are increasing. If you go to the Bureau of Labor Statistics and look at the housing rent data, it is not too hard to think that the housing component of CPI could easily rise by more than 4% in the fourth quarter given the current trend.
Since the housing component is about 30% of the total CPI, a 4% inflation in housing could be significant. And oil is over $80 and rising. The dollar is falling, meaning that import prices are going to rise. And should we mention that food costs a lot more than this time last year?
Given that the Fed has two mandates, stable prices and full employment, is the Fed abandoning its inflation mandate? Is Bernanke, who argued in academia for explicit inflation targeting, no longer worried about inflation? Is he willing to accept the possibility of 3% inflation? Is inflation getting ready to come back, a la the 1970s? Isn't that what the rise of gold is telling us? And aren't TIPS suggesting the same since the rate cut (a long term 2.64% inflation)?
In general I think the answer is no. I think that the Fed is concerned about other problems, and specifically heading off a recession. And to that topic, we need to turn to a recent speech at Jackson Hole by Fed Governor Fred Mishkin.
Long time readers of this letter should recognize that name. Mishkin was the co-author of a 1996 New York Federal Reserve paper on the predictive power of an inverted yield curve and recessions, which I have written about on several occasions. He was most recently a professor at the Graduate School of Business at Columbia before President Bush nominated him to the Fed Board of Governors which he joined last September, 2006. His resume is long and strong. He is a consummate and well-regarded insider. (http://www.federalreserve.gov/aboutthefed/bios/board/mishkin.htm)
At Jackson Hole in late August, he essentially argued that central bankers should ease monetary policy quickly and aggressively in response to a big fall in housing prices.
In a car, the transmission is responsible for taking the power of the engine and transmitting it to wheels. Economists also talk about transmission. How does an opportunity (or problem) in one area affect another seemingly unrelated area? How does a rise in housing prices affect overall consumer spending? What is the mechanism (the transmission) of the Wealth Effect? One obvious answer (among many) would be Mortgage Equity Withdrawals that are possible as home prices double in ten years.
And Mishkin talks about just that transmission in his paper. And he makes it clear that a precipitous drop in home prices would be a negative force. Of course, that is somewhat intuitively obvious. But the interesting thing is that he argues for a pro-active response from the Fed when it becomes clear that housing prices are getting ready to fall. Let's read carefully the following from the closing arguments of his paper. (You can read the speech at http://www.federalreserve.gov/pubs/feds/2007/200740/200740pap.pdf)
Dr. Robert Shiller of Yale (of Irrational Exuberance fame) also presented at Jackson Hole. He said housing prices could fall as much as 50% in some areas given how home prices have diverged relative to rents.
Let's put the timing in perspective before we get back to housing. At the time of the Jackson Hole conference (my invitation once again seemed to get lost in the mail), the credit markets were in the process of freezing up. The European Central Bank was injecting hundreds of billions of euros into the economy. The Fed was also opening the monetary door. But as noted here often, the problem is not one of available liquidity, but of confidence.
The subprime problem, which everyone assured us last spring would not spread to other markets, clearly had infected the entire world. What should be a US problem was more of a problem for European banks. We were told that the housing markets were bottoming last winter and then last spring and now it is clear that we are no where close to a bottom. (I wrote about this time last year we would see a crash in the housing market in late 2007 and 2008 and this winter that the subprime problems would spread.)
By the end of August, all this had to be clear to the Fed gathering at Jackson Hole. And when Shiller stands up and starts talking about precipitous housing price drops, everyone evidently paid attention. Mishkin argues for a pro-active response, and the FOMC (the Federal Open Market Committee which sets rates) responded.
Let's run through the scenario that the US economy, and thus the world, faces. It is going to be many months before there is a functioning subprime mortgage market in the sense that mortgages can be packaged and sold to investors. We are first going to have to create transparency in the various banks to allow the commercial paper market to function. No one is going to buy commercial paper from a bank unless they are 100% sure they can get their money back. And you can't be sure unless there is transparency into the books of the lending institutions. And that includes all the SIVs or Special Investment Vehicles that allow banks to move liabilities off their books. Kind of. Sort of. Maybe. As long as there is not a problem. And then they come back.
Jumbo mortgages (over $417,000) are difficult to obtain without paying exorbitantly high rates. The only functioning mortgage markets are for conforming loans that can be sold to Fannie Mae or Freddie Mac or with FHA backing. (As an aside, I expect that $417,000 to be raised, and for government intervention in subprime markets.)
In effect, with what will be tighter standards for loans going forward, we are going to remove 10-15% of the home buyers that were in the market in 2005-6. That is a serious drop in potential demand. That in itself argues for a large drop in housing prices. Couple that with the rest of the housing market problems, and it could get ugly. Gary Shilling suggests a 25% drop. Dr. Roubini thinks 15-20%.
The total housing market value in the US is $20 trillion. Knock off $4 trillion, and you have a serious drop in the wealth of homeowners. For many, that completely wipes out equity built up over the years.
Wildness Lies in Wait
And thus the difference between risk and uncertainty. Risk has a price. You can establish the probability of a loss, and price it. Life insurance, as an example, or the likelihood of defaults in subprime mortgages (at least, before they dropped rational lending practices).
But you cannot price uncertainty. And now the markets are uncertain about subprime debt, and uncertain as to where that debt is. And so how do you price the debt? If you are no longer certain about German banks when two of them go belly up, then do you take any German bank paper? French paper? Commercial paper from Countrywide Mortgage?
You are a central banker. You can see the problem, and you can see that a housing led recession or at the very least a serious slowdown is in the near future. The mortgage credit markets are not functioning and may not for some time. Do you wait? Mishkin argues no.
Even though housing is only 5% of the economy, it is a huge part of the Wealth Effect. $4 trillion is not a small sum in the psychology of the consumer. Slower consumer spending, and consumer spending is clearly slowing, is the transmission which takes us from a housing recession to a general recession.
Slower consumer spending should result in lower inflation and lower prices. If you read Mishkin's paper, the Fed is clearly modeling the economy, and just as clearly their models suggests a problem.
And so we get a sea change. We get a Fed that is pro-active instead of reactive. That makes Fed-watching a whole new ball game.
A couple of side points. In 1998, the Fed cut rates 75 basis points in response to the Russian bond crisis and LTCM. When the crisis subsided, they took those cuts away fairly quickly. While I do not think this crisis subsides in a few months, if it does, and inflation even remotely ticks up, they will take the recent cut, and the ones they are going to make in the near future, off the table just as quickly [[BB has already said as much: normxxx]].
And I am running out of room, but the Bank of England's response to NorthRock was also a sea change. They in effect guaranteed all bank deposits in Great Britain. This will take some fleshing out on the part of authorities, but it is a big change.
I Still Think Recession
Even with a proactive Fed, I think we do not avoid a recession.
I think the Fed did the right thing by cutting rates. I think they will cut them more as the economy continues to slow. We will see a Fed funds rate with a "3 handle" before this process is over (meaning that the Fed funds rate starts with a 3 from the current 4.75%). The Fed did not start down this road with the thought 50 basis points would be enough.
The point is to try and drop rates enough to make mortgages (when that market finally rights itself) low enough that home buyers can afford to buy homes. While that will help some individuals, the more important concern from a central bankers perspective is the total economy. You do not allow the housing market to implode on your watch and do nothing.
And yes, it will help business with lower funding costs and encourage deals and risk taking. Which is what you want when an economy is on the verge of recession.
But home construction, even with lower rates, is not going to turn around fast. At the peak of the market, we were building 2,000,000 new homes a year in the US. As the following chart from the Conference Board shows (thanks to Dennis Gartman), it is not unusual for housing starts to drop below 1,000,000, and this typically precedes a recession.
Click Here, or on the image, to see a larger, undistorted image.
This of course is not helped by all the homes that are coming back onto the market via foreclosures. Mortgage delinquencies are rising, especially in the variable rate subprime market, as the chart below indicates.
Click Here, or on the image, to see a larger, undistorted image.
And all this puts pressure on consumer spending. Hugh Moore of Guerite Advisors writes:
Click Here, or on the image, to see a larger, undistorted image.
And quickly, a preview from next week's Outside the Box, courtesy of my friends at GaveKal (this actually written by Louis Gave). They track the velocity of money. As they note, central banks are pushing money into the system. But is it going anywhere?
Click Here, or on the image, to see a larger, undistorted image.
We do live in interesting times. Next week I will try and look at the currency markets. The dollar is going to continue to be under pressure.
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Click here for link to complete article: http://www.safehaven.com/article-8470.htm
By John Mauldin | 23 September 2007
- "Of his bones are coral made:
Those are pearls that were his eyes:
Nothing of him that doth fade,
But doth suffer a sea change
Into something rich and strange"
(The Tempest— Shakespeare)
A Sea Change At The Fed
As everyone knows, the Federal Reserve cut both the fed funds rate and the discount rate by 50 basis points this week. The rate cut was clearly telegraphed and only the amount of the cut was a mystery. And for reasons I lay out later on, I think there will be more cuts. But that is not the interesting thing, at least to me. I think the Fed under Bernanke has clearly taken a new direction in determining monetary policy, one that differs with past deliberations.
At Jackson Hole on August 31, Bernanke addressing the problem of moral hazard faced by Central Banks, Bernanke noted: "It is not the responsibility of the Federal Reserve— nor would it be appropriate— to protect lenders and investors from the consequences of their financial decisions." He did acknowledge that if the system as a whole was at risk, then a central bank would have to act even in spite of the moral hazard issue.
That was then and this is now. We got rate cuts September 18. Bernanke in his testimony to Congress this week said the Fed cut rates "to try to get out ahead of the situation and try to forestall potential effects of tighter credit conditions on the broader economy." While he gave no hints as to future policy, he did note that the Fed would "keep reassessing our outlook and adjusting policy" as the situation demanded.
Read those words again. "...to try to get out ahead of the situation..." Hello. That is something new. Normally watching the Fed and predicting the next move is about as exciting as watching paint dry. The Fed has always waited until the data suggested (and/or the market demanded) a rate hike or especially a cut. The Fed has been what good friend Paul McCulley calls "opportunistically disinflationary" for the past two-plus decades. They tighten until inflation comes down and only when it is apparent that a recession is in the works, or if there is a crisis like 1987 or 1998 (more on that important distinction later) do they cut rates. They have reacted to the data rather than made forward looking assumptions.
Over time, this has been a good policy, as it dropped inflation down from the mid-teens in 1980 to below 2% a few years ago. There are those who argue (and with some justification) that Greenspan left rates too low for too long and allowed inflation to rise back to an uncomfortable 3%, although it has been tending down of late.
But the point is that inflation is merely tending down. It is not below 2%, and year over year comparisons in the fourth quarter suggest that headline inflation of closer to 3% is quite possible. That being said, the similar comparison numbers for core inflation are not as difficult, but certainly do not suggest— at this time— that we will drop below 2% this year.
Indeed, there may be some concerns that the CPI (Consumer Price Index) number could come under pressure from the housing component. Given that home prices are falling, that may be considered odd by many. But CPI does not measure home prices. It measures something called owner's equivalent rent. And even as house prices rose by 93% in real terms (per Bob Shiller) in the last decade run-up, rent in real terms did not go up all that much, so the cost of a new home was not reflected in the CPI.
Now, we may have the opposite problem. As more and more people cannot get a mortgage coupled with a very precipitous rise in foreclosures, we are seeing more people who need to rent. Rental property availability in many markets is quite tight, which means that rent prices are increasing. If you go to the Bureau of Labor Statistics and look at the housing rent data, it is not too hard to think that the housing component of CPI could easily rise by more than 4% in the fourth quarter given the current trend.
Since the housing component is about 30% of the total CPI, a 4% inflation in housing could be significant. And oil is over $80 and rising. The dollar is falling, meaning that import prices are going to rise. And should we mention that food costs a lot more than this time last year?
Given that the Fed has two mandates, stable prices and full employment, is the Fed abandoning its inflation mandate? Is Bernanke, who argued in academia for explicit inflation targeting, no longer worried about inflation? Is he willing to accept the possibility of 3% inflation? Is inflation getting ready to come back, a la the 1970s? Isn't that what the rise of gold is telling us? And aren't TIPS suggesting the same since the rate cut (a long term 2.64% inflation)?
In general I think the answer is no. I think that the Fed is concerned about other problems, and specifically heading off a recession. And to that topic, we need to turn to a recent speech at Jackson Hole by Fed Governor Fred Mishkin.
Long time readers of this letter should recognize that name. Mishkin was the co-author of a 1996 New York Federal Reserve paper on the predictive power of an inverted yield curve and recessions, which I have written about on several occasions. He was most recently a professor at the Graduate School of Business at Columbia before President Bush nominated him to the Fed Board of Governors which he joined last September, 2006. His resume is long and strong. He is a consummate and well-regarded insider. (http://www.federalreserve.gov/aboutthefed/bios/board/mishkin.htm)
At Jackson Hole in late August, he essentially argued that central bankers should ease monetary policy quickly and aggressively in response to a big fall in housing prices.
- "Presenting a paper on the final day of the Fed's Jackson Hole symposium, Mr. Mishkin said policymakers should not wait until output falls, but should 'react immediately to the house price decline when they see it.'
"He said the optimal policy response was both quicker and more aggressive than that suggested by a standard policy rule, in which policymakers respond only to deviations in output and inflation.
"He said simulations show that this approach 'can be very successful at counteracting the real effects' of even a large house price slump, because of the long lags from changes in housing wealth to changes in consumer spending." (Financial Times)
In a car, the transmission is responsible for taking the power of the engine and transmitting it to wheels. Economists also talk about transmission. How does an opportunity (or problem) in one area affect another seemingly unrelated area? How does a rise in housing prices affect overall consumer spending? What is the mechanism (the transmission) of the Wealth Effect? One obvious answer (among many) would be Mortgage Equity Withdrawals that are possible as home prices double in ten years.
And Mishkin talks about just that transmission in his paper. And he makes it clear that a precipitous drop in home prices would be a negative force. Of course, that is somewhat intuitively obvious. But the interesting thing is that he argues for a pro-active response from the Fed when it becomes clear that housing prices are getting ready to fall. Let's read carefully the following from the closing arguments of his paper. (You can read the speech at http://www.federalreserve.gov/pubs/feds/2007/200740/200740pap.pdf)
- "My discussion so far argues against a special emphasis on house prices in the conduct of monetary policy. This argument does not extend to a recommendation that central banks stand by idly when house prices climb steeply. To the contrary, central banks can take steps to reduce the negative consequences for aggregate economic activity of sharp movements in house prices. But rather than try to preemptively deal with the bubble— which I have argued is almost impossible to do— a prudent central bank would be better advised to deal with adverse macroeconomic consequences as they emerge in the wake of any substantial decline in asset prices. One way a central bank can prepare itself to react quickly is to explore various scenarios as a normal part of its business to assess how it might respond to a variety of shocks, including a drop in house prices, to achieve maximum sustainable employment and price stability.
"Indeed, the exploration of different scenarios by the central bank can be thought of as stress testing similar to that regularly conducted by commercial financial institutions and banking supervisors. They see how financial institutions will be affected by particular scenarios and then propose plans to ensure that the banks can withstand the negative effects. By conducting similar exercises, in this case for monetary policy, a central bank can mitigate the effects of a drop in house prices without having to judge that a bubble may be in progress or predict when a bubble might burst.
"One objection to an easing of monetary policy following the collapse of an asset bubble is that it might lead market participants to believe that the central bank will always act to prop up asset prices, a belief that can make a bubble more likely. The central bank can mitigate such an interpretation, however, if it publicly emphasizes that its monetary policy is not directed at stabilizing any particular asset price but is rather focused on achieving price stability and maximum sustainable employment. Making sure that a house-price collapse does not do serious harm to the aggregate economy in no way eliminates sharp declines in house prices and so does not provide insurance against such declines. The same reasoning holds true for stock prices. Indeed, we have seen substantial declines in housing and other asset prices in many countries even when monetary policy has been eased substantially."
Dr. Robert Shiller of Yale (of Irrational Exuberance fame) also presented at Jackson Hole. He said housing prices could fall as much as 50% in some areas given how home prices have diverged relative to rents.
Let's put the timing in perspective before we get back to housing. At the time of the Jackson Hole conference (my invitation once again seemed to get lost in the mail), the credit markets were in the process of freezing up. The European Central Bank was injecting hundreds of billions of euros into the economy. The Fed was also opening the monetary door. But as noted here often, the problem is not one of available liquidity, but of confidence.
The subprime problem, which everyone assured us last spring would not spread to other markets, clearly had infected the entire world. What should be a US problem was more of a problem for European banks. We were told that the housing markets were bottoming last winter and then last spring and now it is clear that we are no where close to a bottom. (I wrote about this time last year we would see a crash in the housing market in late 2007 and 2008 and this winter that the subprime problems would spread.)
By the end of August, all this had to be clear to the Fed gathering at Jackson Hole. And when Shiller stands up and starts talking about precipitous housing price drops, everyone evidently paid attention. Mishkin argues for a pro-active response, and the FOMC (the Federal Open Market Committee which sets rates) responded.
Let's run through the scenario that the US economy, and thus the world, faces. It is going to be many months before there is a functioning subprime mortgage market in the sense that mortgages can be packaged and sold to investors. We are first going to have to create transparency in the various banks to allow the commercial paper market to function. No one is going to buy commercial paper from a bank unless they are 100% sure they can get their money back. And you can't be sure unless there is transparency into the books of the lending institutions. And that includes all the SIVs or Special Investment Vehicles that allow banks to move liabilities off their books. Kind of. Sort of. Maybe. As long as there is not a problem. And then they come back.
Jumbo mortgages (over $417,000) are difficult to obtain without paying exorbitantly high rates. The only functioning mortgage markets are for conforming loans that can be sold to Fannie Mae or Freddie Mac or with FHA backing. (As an aside, I expect that $417,000 to be raised, and for government intervention in subprime markets.)
In effect, with what will be tighter standards for loans going forward, we are going to remove 10-15% of the home buyers that were in the market in 2005-6. That is a serious drop in potential demand. That in itself argues for a large drop in housing prices. Couple that with the rest of the housing market problems, and it could get ugly. Gary Shilling suggests a 25% drop. Dr. Roubini thinks 15-20%.
The total housing market value in the US is $20 trillion. Knock off $4 trillion, and you have a serious drop in the wealth of homeowners. For many, that completely wipes out equity built up over the years.
Wildness Lies in Wait
- "The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians.
"It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait."
— G. K. Chesterton
And thus the difference between risk and uncertainty. Risk has a price. You can establish the probability of a loss, and price it. Life insurance, as an example, or the likelihood of defaults in subprime mortgages (at least, before they dropped rational lending practices).
But you cannot price uncertainty. And now the markets are uncertain about subprime debt, and uncertain as to where that debt is. And so how do you price the debt? If you are no longer certain about German banks when two of them go belly up, then do you take any German bank paper? French paper? Commercial paper from Countrywide Mortgage?
You are a central banker. You can see the problem, and you can see that a housing led recession or at the very least a serious slowdown is in the near future. The mortgage credit markets are not functioning and may not for some time. Do you wait? Mishkin argues no.
Even though housing is only 5% of the economy, it is a huge part of the Wealth Effect. $4 trillion is not a small sum in the psychology of the consumer. Slower consumer spending, and consumer spending is clearly slowing, is the transmission which takes us from a housing recession to a general recession.
Slower consumer spending should result in lower inflation and lower prices. If you read Mishkin's paper, the Fed is clearly modeling the economy, and just as clearly their models suggests a problem.
And so we get a sea change. We get a Fed that is pro-active instead of reactive. That makes Fed-watching a whole new ball game.
A couple of side points. In 1998, the Fed cut rates 75 basis points in response to the Russian bond crisis and LTCM. When the crisis subsided, they took those cuts away fairly quickly. While I do not think this crisis subsides in a few months, if it does, and inflation even remotely ticks up, they will take the recent cut, and the ones they are going to make in the near future, off the table just as quickly [[BB has already said as much: normxxx]].
And I am running out of room, but the Bank of England's response to NorthRock was also a sea change. They in effect guaranteed all bank deposits in Great Britain. This will take some fleshing out on the part of authorities, but it is a big change.
I Still Think Recession
Even with a proactive Fed, I think we do not avoid a recession.
I think the Fed did the right thing by cutting rates. I think they will cut them more as the economy continues to slow. We will see a Fed funds rate with a "3 handle" before this process is over (meaning that the Fed funds rate starts with a 3 from the current 4.75%). The Fed did not start down this road with the thought 50 basis points would be enough.
The point is to try and drop rates enough to make mortgages (when that market finally rights itself) low enough that home buyers can afford to buy homes. While that will help some individuals, the more important concern from a central bankers perspective is the total economy. You do not allow the housing market to implode on your watch and do nothing.
And yes, it will help business with lower funding costs and encourage deals and risk taking. Which is what you want when an economy is on the verge of recession.
But home construction, even with lower rates, is not going to turn around fast. At the peak of the market, we were building 2,000,000 new homes a year in the US. As the following chart from the Conference Board shows (thanks to Dennis Gartman), it is not unusual for housing starts to drop below 1,000,000, and this typically precedes a recession.
Click Here, or on the image, to see a larger, undistorted image.
This of course is not helped by all the homes that are coming back onto the market via foreclosures. Mortgage delinquencies are rising, especially in the variable rate subprime market, as the chart below indicates.
Click Here, or on the image, to see a larger, undistorted image.
And all this puts pressure on consumer spending. Hugh Moore of Guerite Advisors writes:
- "Consumer spending accounts for two-thirds of the U.S. economy. Total Household Debt is particularly important in supporting the growth of consumer spending. This indicator includes mortgage debt due to the important role that Home Equity Withdrawal (HEW) has played in sustaining the growth in consumption since the beginning of the decade.
"As shown in the graph below, each time the year-over-year increase in Total Household Debt has dropped more than 40% below its recent peak, a recession (or in the case of 1967, a mini-recession) has occurred. The mid-1980's slowdown touched this level, but did not exceed it. The current 38.9% level is approaching this boundary and, based on recent credit tightening by financial institutions, is likely to drop significantly below the— 40% level."
Click Here, or on the image, to see a larger, undistorted image.
And quickly, a preview from next week's Outside the Box, courtesy of my friends at GaveKal (this actually written by Louis Gave). They track the velocity of money. As they note, central banks are pushing money into the system. But is it going anywhere?
- "Which brings us to today. Following the recent central bank actions in the US, Europe and the UK, most commentators seem to expect a sharp acceleration of either inflation, economic activity, or asset prices (or all three). As a result, gold is making new highs, the US$ is plunging to new depths, etc.... But aren't the recent buyers of gold focusing solely on likely changes in the money supply (M), while forgetting why central banks are set to dump money into the system in the first place? Isn't the reason behind the loosening of monetary policies the fact that the velocity of money (V) has been plummeting?
"As in 2001, the question investors should thus ask themselves is whether velocity is set to rebound? If it is, then investors are right to position themselves for an ample liquidity environment (long gold, long commodities, long deep cyclicals).
"But if it isn't, then the investment environment could start getting a lot trickier."
Click Here, or on the image, to see a larger, undistorted image.
We do live in interesting times. Next week I will try and look at the currency markets. The dollar is going to continue to be under pressure.
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Saturday, September 22, 2007
An Epic Bear Market?
Are We Headed For An Epic Bear Market? [¹]
Click here for link to complete article: http://articles.moneycentral.msn.com/Investing/SuperModels/AreWeHeadedForAnEpicBearMarket.aspx
By Jon Markman, MSN Money | 22 September 2007
One of the world's leading experts on credit derivatives, Das is the author of a 4,200-page reference work on the subject, among a half-dozen other tomes. As a developer and marketeer of the exotic instruments himself over the past 30 years, he seemed like the ideal industry insider to help us get to the bottom of the recent debt crunch— and I expected him to defend and explain the practice.
I started by asking the Calcutta-born Australian whether the credit crisis was in what Americans would call the "third inning." This was pretty amusing, it seemed, judging from the laughter. So I tried again. "Second inning?" More laughter. "First?"
Still too optimistic. Das, who knows as much about global money flows as anyone in the world, stopped chuckling long enough to suggest that we're actually still in the middle of the national anthem, before a game destined to go into extra innings. And it won't end well for the global economy.
An Epic Bear Market
Das is pretty droll for a math whiz, but his message is dead serious. He thinks we're on the verge of a bear market of epic proportions.
The cause: Massive levels of debt underlying the world economy system are about to unwind in a profound and persistent way.
He's not sure if it will play out like the 13-year decline of 90% in Japan from 1990 to 2003 that followed the bursting of the credit bubble there, or like the 15-year flat spot in the U.S. market from 1960 to 1975. But either way, he foresees hard times ahead as an [[overly?: normxxx]] optimistic era of too much liquidity, too much leverage and too much financial engineering slowly and inevitably deflates.
Like an ex-mobster turning state's witness, Das has turned his back on his old pals in the derivatives biz to warn anyone who will listen— mostly banks and hedge funds that pay him consulting fees— that the jig is up.
Rather than joining the crowd that blames the mess on American slobs who took on more mortgage debt than they could afford and have endangered the world by stiffing lenders, he points a finger at three parties: regulators who stood by as U.S. banks developed ingenious but dangerous ways of shifting trillions of dollars of credit risk off their balance sheets and into the hands of unsophisticated foreign investors; hedge and pension fund managers who gorged on high-yield debt instruments they didn't understand; and financial engineers who built towers of "securitized" debt with math models that were fundamentally flawed.
"Defaulting middle-class U.S. homeowners are blamed, but they are merely a pawn in the game," he says. "Those loans were invented so that hedge funds would have high-yield debt to buy."
The Liquidity Factory
Das' view sounds cynical, but it makes sense if you stop thinking about mortgages as a way for people to finance houses and think about them instead as a way for lenders to generate cash flow and create collateral during an era of a flat interest-rate curve. Although subprime U.S. loans seem like small change in the context of the multitrillion-dollar debt market, it turns out these high-yield instruments were an important part of the machine that Das calls the global "liquidity factory." Just as a small amount of gasoline can power a huge semi-trailer given the right combination of spark plugs, pistons and transmission, so too did subprime loans become both the impetus for, and eventually the shaky foundation that now underlies, derivative securities many, many times their size.
Here's how it worked: In olden days, like 10 years ago, banks wrote and funded their own loans. In the new game, Das points out, banks "originate" loans, "warehouse" them on their balance sheet for a brief time, then "distribute" them to investors by packaging them into derivatives called collateralized debt obligations, or CDOs, and similar instruments. In this scheme, banks don't need to tie up as much capital, so they can put more money out on loan.
The more loans that were sold, the more they could use as collateral for more loans, so credit standards were lowered to get more paper out the door— a task that was accelerated in recent years via fly-by-night brokers now accused of predatory lending practices.
Buyers of these credit risks in CDO form were insurance companies, pension funds and hedge-fund managers from Bonn to Beijing. Because money was readily available at low interest rates in Japan and the United States, these managers leveraged up their bets by buying the CDOs with borrowed funds.
So, if you follow the bouncing ball, borrowed money bought borrowed money. And then because they had the blessing of credit-ratings agencies relying on suitably arcane mathematical models suggesting that they would rarely default, these CDOs were in turn used as collateral to do more borrowing.
In this way, Das points out, credit risk moved from banks, where it was regulated and observable, to places where it was less regulated and difficult to identify.
Turning $1 Into $20
The liquidity factory was self-perpetuating and seemingly unstoppable [[a runaway positive feedback system that grew hyperbolically faster and faster, until eventually going vertical just before crashing: normxxx]]. As assets bought with borrowed money rose in value, players could borrow more money against them, and it thus seemed logical to borrow still more to 'maximize' returns. Bankers figured out [[all kinds of ways: normxxx]] to strip money out of existing assets to do so, much as a homeowner might strip equity from his house to buy a second house [[and then repeat the process with the second house, and then a third— ad infinitum: normxxx]].
These triple-borrowed assets were in turn increasingly used as collateral for commercial paper (CP)— the short-term borrowings of banks and corporations— which was purchased by supposedly low-risk [[supposedly all but zero risk: normxxx]] money market funds.
According to Das' figures, up to 53% of the $2.2 trillion commercial paper in the U.S. market is now asset-backed, with about 50% of that in mortgages.
When you add it all up, according to Das' research, a single dollar of "real" capital supports $20 to $30 of loans. This spiral of borrowing on an increasingly thin base of real assets, writ large and in nearly infinite variety, ultimately created a world in which the derivatives outstanding earlier this year stood at $485 trillion— or eight times total global gross domestic product of $60 trillion.
Without a central governmental authority [[actually, without anyone: normxxx]] keeping tabs on these cross-border flows and ensuring minimum standards of record-keeping and quality, investors increasingly didn't know what they were buying or what any given security was really worth.
A Painful Unwinding
Now here is where the U.S. mortgage holder shows up again. As subprime loan default rates doubled, in contravention to what the models forecast, the CDOs that those mortgages backed began to collapse [[i.e., lenders began to treat them like poison: normxxx]]. Because they were so hard to value [[or to determine their actual contents: normxxx]], banks and funds started looking at all CDOs and other paper backed by mortgages with [great] suspicion, and refused to accept them as collateral for the sort of short-term borrowing that underpins today's money markets.
Through late last month, according to Das, as much as $300 billion in leveraged finance loans had been "orphaned," which means that they can't be sold off or used as collateral.
One of the wonders of leverage is that it amplifies losses on the way down just as it amplifies gains on the way up. The more an asset that is bought with borrowed money falls in value, the more you have to sell other stuff to fulfill the loan-to-value covenants. It's a 'vicious' cycle [[as opposed to the previous 'virtuous' cycle— negative feedback, instead of positive feedback: normxxx]]. In this context, the banks' objective was to prevent customers from selling their derivates at a discount because they would then have to mark down the value of all the other assets in the debt chain, an event that would lead to the need to make margin calls on customers already thin on cash.
Now it may seem hard to believe, but much of the past few years' advance in the stock market was underwritten by CDO-type instruments which go under the heading of "structured finance." I'm talking about private-equity takeovers, leveraged buyouts and corporate stock buybacks— the works.
So to the extent that the structured finance market is coming undone, not only will those pillars of strength for equities be knocked away, but many recent deals that were predicated on the easy availability of money will likely also go bust, Das says.
That is why he considers the current market volatility much more profound than a simple "correction" in prices. He sees it as a gigantic liquidity bubble unwinding— a process that can take a long, long time.
While you might think that the U.S. Federal Reserve can help prevent disaster by lowering interest rates dramatically, as they did [Tuesday], the evidence is not at all clear.
The problem, after all, is not the amount of money in the system but the fact that buyers are in the process of rejecting the entire new risk-transfer model and its associated leverage and counterparty risks.
The Fine Print
Das notes that Japan in the 1990s lowered interest rates to zero and the country still suffered through a prolonged recession. His timetable for the start of the next serious phase of the unwinding is later this year or early 2008. . . . Das' most readable book for laypeople is an amusing exposé of high finance, published last year.
Traders, Guns & Money: Knowns and unknowns in the dazzling world of derivatives"
by Satyajit Das
Das occasionally writes a blog at his publisher's Web site. Also available are a boxed set of his reference books on derivatives and his book specifically on CDOs. . . .
Perhaps the oddest line on the subject by a world leader was uttered by Luiz Inacio Lula da Silva, the president of Brazil. Asked if he was worried about the effects of the credit crunch in his country, he dismissively called it "an eminently American crisis" caused by people trying to make a lot of "third-class money." . . .
CDOs were first widely used back in the late 1980s by Drexel Burnham Lambert junk-bond king Michael Milken to sell off damaged and previously unsellable debt in a way that was more palatable to customers.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Click here for link to complete article: http://articles.moneycentral.msn.com/Investing/SuperModels/AreWeHeadedForAnEpicBearMarket.aspx
By Jon Markman, MSN Money | 22 September 2007
- The credit bubble is just starting to unwind, a credit-derivative insider says. And while U.S. borrowers are being blamed for the mess, they were really just pawns in a global game.
One of the world's leading experts on credit derivatives, Das is the author of a 4,200-page reference work on the subject, among a half-dozen other tomes. As a developer and marketeer of the exotic instruments himself over the past 30 years, he seemed like the ideal industry insider to help us get to the bottom of the recent debt crunch— and I expected him to defend and explain the practice.
I started by asking the Calcutta-born Australian whether the credit crisis was in what Americans would call the "third inning." This was pretty amusing, it seemed, judging from the laughter. So I tried again. "Second inning?" More laughter. "First?"
Still too optimistic. Das, who knows as much about global money flows as anyone in the world, stopped chuckling long enough to suggest that we're actually still in the middle of the national anthem, before a game destined to go into extra innings. And it won't end well for the global economy.
An Epic Bear Market
Das is pretty droll for a math whiz, but his message is dead serious. He thinks we're on the verge of a bear market of epic proportions.
The cause: Massive levels of debt underlying the world economy system are about to unwind in a profound and persistent way.
He's not sure if it will play out like the 13-year decline of 90% in Japan from 1990 to 2003 that followed the bursting of the credit bubble there, or like the 15-year flat spot in the U.S. market from 1960 to 1975. But either way, he foresees hard times ahead as an [[overly?: normxxx]] optimistic era of too much liquidity, too much leverage and too much financial engineering slowly and inevitably deflates.
Like an ex-mobster turning state's witness, Das has turned his back on his old pals in the derivatives biz to warn anyone who will listen— mostly banks and hedge funds that pay him consulting fees— that the jig is up.
Rather than joining the crowd that blames the mess on American slobs who took on more mortgage debt than they could afford and have endangered the world by stiffing lenders, he points a finger at three parties: regulators who stood by as U.S. banks developed ingenious but dangerous ways of shifting trillions of dollars of credit risk off their balance sheets and into the hands of unsophisticated foreign investors; hedge and pension fund managers who gorged on high-yield debt instruments they didn't understand; and financial engineers who built towers of "securitized" debt with math models that were fundamentally flawed.
"Defaulting middle-class U.S. homeowners are blamed, but they are merely a pawn in the game," he says. "Those loans were invented so that hedge funds would have high-yield debt to buy."
The Liquidity Factory
Das' view sounds cynical, but it makes sense if you stop thinking about mortgages as a way for people to finance houses and think about them instead as a way for lenders to generate cash flow and create collateral during an era of a flat interest-rate curve. Although subprime U.S. loans seem like small change in the context of the multitrillion-dollar debt market, it turns out these high-yield instruments were an important part of the machine that Das calls the global "liquidity factory." Just as a small amount of gasoline can power a huge semi-trailer given the right combination of spark plugs, pistons and transmission, so too did subprime loans become both the impetus for, and eventually the shaky foundation that now underlies, derivative securities many, many times their size.
Here's how it worked: In olden days, like 10 years ago, banks wrote and funded their own loans. In the new game, Das points out, banks "originate" loans, "warehouse" them on their balance sheet for a brief time, then "distribute" them to investors by packaging them into derivatives called collateralized debt obligations, or CDOs, and similar instruments. In this scheme, banks don't need to tie up as much capital, so they can put more money out on loan.
The more loans that were sold, the more they could use as collateral for more loans, so credit standards were lowered to get more paper out the door— a task that was accelerated in recent years via fly-by-night brokers now accused of predatory lending practices.
Buyers of these credit risks in CDO form were insurance companies, pension funds and hedge-fund managers from Bonn to Beijing. Because money was readily available at low interest rates in Japan and the United States, these managers leveraged up their bets by buying the CDOs with borrowed funds.
So, if you follow the bouncing ball, borrowed money bought borrowed money. And then because they had the blessing of credit-ratings agencies relying on suitably arcane mathematical models suggesting that they would rarely default, these CDOs were in turn used as collateral to do more borrowing.
In this way, Das points out, credit risk moved from banks, where it was regulated and observable, to places where it was less regulated and difficult to identify.
Turning $1 Into $20
The liquidity factory was self-perpetuating and seemingly unstoppable [[a runaway positive feedback system that grew hyperbolically faster and faster, until eventually going vertical just before crashing: normxxx]]. As assets bought with borrowed money rose in value, players could borrow more money against them, and it thus seemed logical to borrow still more to 'maximize' returns. Bankers figured out [[all kinds of ways: normxxx]] to strip money out of existing assets to do so, much as a homeowner might strip equity from his house to buy a second house [[and then repeat the process with the second house, and then a third— ad infinitum: normxxx]].
These triple-borrowed assets were in turn increasingly used as collateral for commercial paper (CP)— the short-term borrowings of banks and corporations— which was purchased by supposedly low-risk [[supposedly all but zero risk: normxxx]] money market funds.
According to Das' figures, up to 53% of the $2.2 trillion commercial paper in the U.S. market is now asset-backed, with about 50% of that in mortgages.
When you add it all up, according to Das' research, a single dollar of "real" capital supports $20 to $30 of loans. This spiral of borrowing on an increasingly thin base of real assets, writ large and in nearly infinite variety, ultimately created a world in which the derivatives outstanding earlier this year stood at $485 trillion— or eight times total global gross domestic product of $60 trillion.
Without a central governmental authority [[actually, without anyone: normxxx]] keeping tabs on these cross-border flows and ensuring minimum standards of record-keeping and quality, investors increasingly didn't know what they were buying or what any given security was really worth.
A Painful Unwinding
Now here is where the U.S. mortgage holder shows up again. As subprime loan default rates doubled, in contravention to what the models forecast, the CDOs that those mortgages backed began to collapse [[i.e., lenders began to treat them like poison: normxxx]]. Because they were so hard to value [[or to determine their actual contents: normxxx]], banks and funds started looking at all CDOs and other paper backed by mortgages with [great] suspicion, and refused to accept them as collateral for the sort of short-term borrowing that underpins today's money markets.
Through late last month, according to Das, as much as $300 billion in leveraged finance loans had been "orphaned," which means that they can't be sold off or used as collateral.
One of the wonders of leverage is that it amplifies losses on the way down just as it amplifies gains on the way up. The more an asset that is bought with borrowed money falls in value, the more you have to sell other stuff to fulfill the loan-to-value covenants. It's a 'vicious' cycle [[as opposed to the previous 'virtuous' cycle— negative feedback, instead of positive feedback: normxxx]]. In this context, the banks' objective was to prevent customers from selling their derivates at a discount because they would then have to mark down the value of all the other assets in the debt chain, an event that would lead to the need to make margin calls on customers already thin on cash.
Now it may seem hard to believe, but much of the past few years' advance in the stock market was underwritten by CDO-type instruments which go under the heading of "structured finance." I'm talking about private-equity takeovers, leveraged buyouts and corporate stock buybacks— the works.
So to the extent that the structured finance market is coming undone, not only will those pillars of strength for equities be knocked away, but many recent deals that were predicated on the easy availability of money will likely also go bust, Das says.
That is why he considers the current market volatility much more profound than a simple "correction" in prices. He sees it as a gigantic liquidity bubble unwinding— a process that can take a long, long time.
While you might think that the U.S. Federal Reserve can help prevent disaster by lowering interest rates dramatically, as they did [Tuesday], the evidence is not at all clear.
The problem, after all, is not the amount of money in the system but the fact that buyers are in the process of rejecting the entire new risk-transfer model and its associated leverage and counterparty risks.
- [ Normxxx Here: In other words, the entire half QUADrillion dollar derivatives market! ]
The Fine Print
Das notes that Japan in the 1990s lowered interest rates to zero and the country still suffered through a prolonged recession. His timetable for the start of the next serious phase of the unwinding is later this year or early 2008. . . . Das' most readable book for laypeople is an amusing exposé of high finance, published last year.
Traders, Guns & Money: Knowns and unknowns in the dazzling world of derivatives"by Satyajit Das
Das occasionally writes a blog at his publisher's Web site. Also available are a boxed set of his reference books on derivatives and his book specifically on CDOs. . . .
Perhaps the oddest line on the subject by a world leader was uttered by Luiz Inacio Lula da Silva, the president of Brazil. Asked if he was worried about the effects of the credit crunch in his country, he dismissively called it "an eminently American crisis" caused by people trying to make a lot of "third-class money." . . .
CDOs were first widely used back in the late 1980s by Drexel Burnham Lambert junk-bond king Michael Milken to sell off damaged and previously unsellable debt in a way that was more palatable to customers.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Real Homes of Genius: Today we Salute you Bell, Cal.
Real Homes of Genius: Today we Salute you Bell. 551 Square feet for $349,999. No Bubble Here [¹]
Click here for link to complete article: http://drhousingbubble.blogspot.com/
By Dr. Housing Bubble | 22 September 2007
The market has gone completely bipolar. A few weeks ago, the market was tanking and practically every day, we were hearing about one after another lending institution collapsing. Now, we are riding the stock market to prosperity once again thanks to the Federal Reserve and easy money (you can use these interchangeably). Even though we still hear about lending institutions tanking this is already baked into the market since data doesn’t matter anymore. This past week was full of pyrotechnic housing fireworks. Let us recap the week:
And guess what happened to the 10 year Treasury note?:
Click Here, or on the image, to see a larger, undistorted image.
It actually went up! I’m not sure why so many in the housing industry think that the Fed has some kind of direct impact on the direction of long-term interest rates. Do you now get that they are simply bailing out Wall Street and hedge funds? Take a look at the stock market and you should get a clear idea who has gained the most benefit. The Feds have a massive impact and influence on direction, but this doesn’t always hold true. Fears of a falling dollar, inflation, and rocketing commodities had a larger impact on the direction of rates. And the LIBOR rates that most adjustable rate mortgages track is still holding strong. We aren’t having a 30 year conventional fixed mortgage crises; we are having an exotic banana republic mortgage credit debacle. Thanks Ben for that 0.5% cut which does so very little for 9+ percent subprime loans! Making lending standards more lax at this juncture may not get you into MENSA, so let us take a look at a case example.
Today we salute you Bell, California with our Real Home of Genius Award.
Today’s home is one of the smallest Real Homes of Genius ever featured coming in at an eye-popping 551 square feet. This 1 bedroom 1 bath home is the envy of the neighborhood. Who said you couldn’t have a white picket fence in Los Angeles County? This place can be your's for only $349,999. Make sure you mention to your broker that you are looking for the Bernanke Special since it’ll save you $100 a month. What was this home initially listed for?
Price Reduced: 09/13/07 — $370,000 to $349,999
A $20,001 discount is not a bad incentive. Indeed, I would not have looked any further if it had been $20,002, but I’m a fan of one dollar bills with that great green portrait of Mr. Washington. In fact, I’m hearing that in a few years they’ll be collectibles since they’ll stop printing them and only dish out bills in denominations of $10 or more. I’m not buying any $100,000 boat, but show me one at $99,999 and then we are talking. What does the sales history on this place tell us?
Sale History
10/26/2005: $299,500
12/30/1998: $78,100
06/29/1998: $95,970
Say what? 5 figures in Los Angeles County and within the past 10 years? This place had an 18 percent decline in 1998. This 18 percent decline amounted to $17,870. We already got that discount in a few weeks plus a few extra dollars; we’ll need those extra dollars for higher energy costs. Do you realize that this home went up by a multiple of 4 in 9 years according to the current sales price? Somehow I doubt incomes went up by this margin. Let us assume that they sell this home at the current price:
$349,999 less a six percent commission of $20,999 = $329,000. A profit of nearly $30,000 (with ROI = infinite, assuming no money down) in one year if they stay in the home until the end of October and pay no capital gains tax. Again, this is assuming they sell it at their current price. Let us take a look at the neighborhood information:
Average/Household: $41,464
Median Rent Price: $900
So let us say that a hypothetical family in this area was to buy this place. Let us run their monthly budget:
PITI: $2,465 (5 percent down and 30 year fixed mortgage)
Monthly Net Income: $2,868 (filing as married with 2 exemptions)
So this family is left with $403 of disposable income each month. They are spending an unbelievable 85 percent of their income on housing. 401k? Forget it. Roth IRAs? If there is money after food. Do you see why this makes no sense? No investor would purchase this place since they would be negative cash-flowing by $1,565 a month. I know that here in California finding postitive cash flowing properties is like finding a leprechaun. Even so, the number of "investment" properties bought in California has exploded over the past seven years. This was the flipping, mortgage-equity-withdrawal with other-people’s-money (OPM) kind of crowd.
Apparently, this mantra is straight from the Fed, because they too have little respect for your American dollar and are using this OPM strategy. Too bad those other people are you and your family. Now that we are seeing depreciation in California, who do you think will buy these homes? Income ratios do not make sense so families in the immediate area are very unlikely to buy these places. Investors will not buy unless they want to feed an alligator property with no appreciation [[or even any potential for appreciation: normxxx]]. Could it be that we have been living in a major Ponzi bubble here in Southern California and the game has now stopped? No amount of rate dropping will change the above facts.
Today we salute you Bell with our Real Homes of Genius Award.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Click here for link to complete article: http://drhousingbubble.blogspot.com/
By Dr. Housing Bubble | 22 September 2007
The market has gone completely bipolar. A few weeks ago, the market was tanking and practically every day, we were hearing about one after another lending institution collapsing. Now, we are riding the stock market to prosperity once again thanks to the Federal Reserve and easy money (you can use these interchangeably). Even though we still hear about lending institutions tanking this is already baked into the market since data doesn’t matter anymore. This past week was full of pyrotechnic housing fireworks. Let us recap the week:
- Fed drops Funds rate to 4.75; Discount rate to 5.25%
- Stock market soars like an eagle on methamphetamines
- Dollar index falls [well] below key support levels, to historic lows
- Gold shining at 27 year highs
- Oil prices keep chugging along
And guess what happened to the 10 year Treasury note?:
Click Here, or on the image, to see a larger, undistorted image.
It actually went up! I’m not sure why so many in the housing industry think that the Fed has some kind of direct impact on the direction of long-term interest rates. Do you now get that they are simply bailing out Wall Street and hedge funds? Take a look at the stock market and you should get a clear idea who has gained the most benefit. The Feds have a massive impact and influence on direction, but this doesn’t always hold true. Fears of a falling dollar, inflation, and rocketing commodities had a larger impact on the direction of rates. And the LIBOR rates that most adjustable rate mortgages track is still holding strong. We aren’t having a 30 year conventional fixed mortgage crises; we are having an exotic banana republic mortgage credit debacle. Thanks Ben for that 0.5% cut which does so very little for 9+ percent subprime loans! Making lending standards more lax at this juncture may not get you into MENSA, so let us take a look at a case example.
Today we salute you Bell, California with our Real Home of Genius Award.
Today’s home is one of the smallest Real Homes of Genius ever featured coming in at an eye-popping 551 square feet. This 1 bedroom 1 bath home is the envy of the neighborhood. Who said you couldn’t have a white picket fence in Los Angeles County? This place can be your's for only $349,999. Make sure you mention to your broker that you are looking for the Bernanke Special since it’ll save you $100 a month. What was this home initially listed for?
Price Reduced: 09/13/07 — $370,000 to $349,999
A $20,001 discount is not a bad incentive. Indeed, I would not have looked any further if it had been $20,002, but I’m a fan of one dollar bills with that great green portrait of Mr. Washington. In fact, I’m hearing that in a few years they’ll be collectibles since they’ll stop printing them and only dish out bills in denominations of $10 or more. I’m not buying any $100,000 boat, but show me one at $99,999 and then we are talking. What does the sales history on this place tell us?
Sale History
10/26/2005: $299,500
12/30/1998: $78,100
06/29/1998: $95,970
Say what? 5 figures in Los Angeles County and within the past 10 years? This place had an 18 percent decline in 1998. This 18 percent decline amounted to $17,870. We already got that discount in a few weeks plus a few extra dollars; we’ll need those extra dollars for higher energy costs. Do you realize that this home went up by a multiple of 4 in 9 years according to the current sales price? Somehow I doubt incomes went up by this margin. Let us assume that they sell this home at the current price:
$349,999 less a six percent commission of $20,999 = $329,000. A profit of nearly $30,000 (with ROI = infinite, assuming no money down) in one year if they stay in the home until the end of October and pay no capital gains tax. Again, this is assuming they sell it at their current price. Let us take a look at the neighborhood information:
Average/Household: $41,464
Median Rent Price: $900
So let us say that a hypothetical family in this area was to buy this place. Let us run their monthly budget:
PITI: $2,465 (5 percent down and 30 year fixed mortgage)
Monthly Net Income: $2,868 (filing as married with 2 exemptions)
So this family is left with $403 of disposable income each month. They are spending an unbelievable 85 percent of their income on housing. 401k? Forget it. Roth IRAs? If there is money after food. Do you see why this makes no sense? No investor would purchase this place since they would be negative cash-flowing by $1,565 a month. I know that here in California finding postitive cash flowing properties is like finding a leprechaun. Even so, the number of "investment" properties bought in California has exploded over the past seven years. This was the flipping, mortgage-equity-withdrawal with other-people’s-money (OPM) kind of crowd.
Apparently, this mantra is straight from the Fed, because they too have little respect for your American dollar and are using this OPM strategy. Too bad those other people are you and your family. Now that we are seeing depreciation in California, who do you think will buy these homes? Income ratios do not make sense so families in the immediate area are very unlikely to buy these places. Investors will not buy unless they want to feed an alligator property with no appreciation [[or even any potential for appreciation: normxxx]]. Could it be that we have been living in a major Ponzi bubble here in Southern California and the game has now stopped? No amount of rate dropping will change the above facts.
Today we salute you Bell with our Real Homes of Genius Award.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Credit Markets Revive
Credit Markets Show Revival After Rate Cut [¹]
Click here for link to complete article: http://online.wsj.com/article/SB119021077354432327.html?mod=hpp_us_whats_news
By Damian Paletta and Serena Ng, WSJ | 20 September 2007
The Donnelley sale marked the first significant junk-bond sale since the summer drought, which was marked by more than 50 postponements of junk-debt offerings.
The stock market also got a lift, with the Dow Jones Industrial Average rising 76.17 to 13815.56, continuing the robust rally started by the Fed's interest rate cut and putting it up 11% for the year.
The most significant moves continued to emanate from Washington, where rising default and foreclosure rates are putting pressure on the government to act. A critical issue is whether Fannie Mae and Freddie Mac, government-sponsored enterprises, should be allowed to purchase mortgages above the current $417,000 conforming loan limit. Currently, the two mortgage-finance companies can only acquire home loans below this limit, while Wall Street firms have traditionally played a more active role buying and securitizing large, or jumbo, mortgages.
This issue is crucial because the market for jumbo mortgages has seized up, and a lack of funding for these more expensive loans could have a major impact on housing values in large U.S cities. There is strong pressure in Congress to loosen the reins on Fannie and Freddie even more in the current housing downturn.
The Bush administration, which has tried to rein in Fannie and Freddie, eased its position in light of the credit crisis. "There is little question that allowing the GSEs [government-sponsored enterprises] to securitize jumbo mortgages would give a short-term lift," Treasury Secretary Henry Paulson is expected to tell the House Financial Services Committee at a hearing today, according to prepared remarks. He is expected to say, however, that it would be "unreasonable and irresponsible" to expand their businesses without addressing their regulatory problems.
Mortgage Limits
After The Boom: Delinquency Rates, Key U.S. Areas, Second Quarter, 2007
Federal Reserve Chairman Ben Bernanke appears to be opening the door to temporarily allowing Fannie and Freddie to purchase mortgages above the current limit. Mr. Bernanke sent a letter Monday to House Financial Services Committee Chairman Barney Frank (D., Mass.) saying that if Congress is inclined to raise the limit it should consider doing so in a way "that makes the change explicitly temporary as well as promptly implemented." Mr. Bernanke stopped short of endorsing the idea.
As the Bush administration's position on the issue continues to bend, the top officials at Fannie Mae and Freddie Mac are expected to go on the offensive today as they appear before the same committee. Freddie Mac Chief Executive Richard Syron is expected to say that a temporary lifting of the limit would "provide needed liquidity," according to prepared remarks.
In another sign of an administration shift, the regulator for Fannie Mae and Freddie Mac, the Office of Federal Housing Enterprise Oversight, agreed to relax restrictions on the mortgage-finance companies' investment holdings. OFHEO's new policy allows Fannie Mae to increase its portfolio by 2% a year, a level comparable with an existing limit on rival Freddie Mac.
The move could allow the companies to add a combined $40 billion in mortgages to their portfolios by the end of March. In making the changes, OFHEO cited recent progress by both companies in repairing internal controls, though it pointed out that neither company had returned to timely filing of financial statements from past accounting scandals.
Fannie Mae called on the regulator to allow bigger increases. "We still believe the more effective response, given the extent of the market disruption, would be to raise our portfolio cap by at least 10%," Fannie Mae spokesman Brian Faith said.
The cascade of positive news was well-received by the parched credit markets, pushing yields on corporate bonds and loans lower. The market for asset-backed commercial paper, which seized up a few weeks ago and had been threatening to create funding problems for many financial institutions, also improved.
The Fed rate cut triggered a 0.35-percentage-point drop in the one-month London interbank offered rate to 5.15%, a development that should help improve liquidity in the money markets. The three-month Libor, which many leveraged-buyout loans are pegged to, fell to 5.24%, down sharply from more than 5.7% earlier this month. Libor had hit a multiyear high after this summer's liquidity crisis reduced the willingness of banks to lend money to each other.
"There's been a 100% change in sentiment," said Marc Frank, a bond trader at Group G Capital Partners LLC, a New York hedge fund. "The feeling is that money may be getting cheaper, and some large buyout loan financings can now get done."
Still, investment banks that need to sell more than $300 billion of debt from leveraged buyouts they are financing in the coming months are treading carefully. They are opting not to sell too much debt at the same time. Many investors worry that a flood of issuance could push down prices of many other bonds and loans. Bond prices move in the opposite direction as yields.
Wall Street banks are currently seeking buyers for a $5 billion loan for First Data Corp., part of $24 billion in debt financing for the deal. The banks will likely keep most of that debt on their own books for the time being.
Takeover Financing
Debt Dilemmas
Yesterday, another group of banks began marketing a $3.15 billion loan that will help finance the $15.2 billion acquisition of apartment giant Archstone-Smith Trust by Tishman Speyer Properties and Lehman Brothers. Underwriters are also close to selling an additional $500 million in loans for Allison Transmission Inc. after having sold $1 billion in debt for the auto-parts maker last week, according to Standard & Poor's Leveraged Commentary & Data.
While the Fed's rate cut helped to unfreeze pockets of the credit markets, some investors worried the Fed's aggressive stance is an acknowledgment of signs of weakness in the economy. The housing market is still eroding, as home-loan delinquencies and defaults continue to rise.
"We're seeing a lot of encouraging signs that the gears are starting to turn again in the credit markets, but there's still a lot of skepticism around," said Derrick Wulf, a portfolio manager at Dwight Asset Management in Burlington, Vt.
Attracting Funds
Some investors also remain concerned that so-called SIVs, or structured investment vehicles, are still having difficulty attracting investment funds. That could leave some of these vehicles unable to pay off liabilities in coming months. "Conditions have improved broadly, but it's still a bifurcated market," said Ron Flynn, an executive director at J.P. Morgan Chase & Co. who trades in the short-term debt markets.
Still, the broader commercial-paper market improved. The average yield companies pay on 30-day asset-backed commercial paper dropped to about 5.3% by late afternoon, down from nearly 6% just before the Fed move, according to UBS interest-rate strategist Mary Beth Fisher. The average yield on overnight financial commercial paper fell to 4.75%, down from just over 5% before the Fed cut, she said.
"Everything is improving," Ms. Fisher said. "But the liquidity crisis hasn't passed yet."
In the U.S., an affiliate of British bank HBOS PLC was able to sell $2 billion in short-term debt on Tuesday and around $1 billion yesterday. In August, HBOS had to step in to cover the maturing debt of the affiliate after it couldn't roll over its commercial paper.
Click Here, or on the image, to see a larger, undistorted image.
• The Next Bubble?
• Has Fed Risked Creating Moral Hazard? Or Just Risked Its Own Credibility
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Click here for link to complete article: http://online.wsj.com/article/SB119021077354432327.html?mod=hpp_us_whats_news
By Damian Paletta and Serena Ng, WSJ | 20 September 2007
- The Federal Reserve's rate-cut medicine revived corporate debt markets yesterday, as the Bush administration sought to give the nation's weakened housing market a boost by backing modest expansions in the powers of mortgage giants Fannie Mae and Freddie Mac.
The Donnelley sale marked the first significant junk-bond sale since the summer drought, which was marked by more than 50 postponements of junk-debt offerings.
The stock market also got a lift, with the Dow Jones Industrial Average rising 76.17 to 13815.56, continuing the robust rally started by the Fed's interest rate cut and putting it up 11% for the year.
The most significant moves continued to emanate from Washington, where rising default and foreclosure rates are putting pressure on the government to act. A critical issue is whether Fannie Mae and Freddie Mac, government-sponsored enterprises, should be allowed to purchase mortgages above the current $417,000 conforming loan limit. Currently, the two mortgage-finance companies can only acquire home loans below this limit, while Wall Street firms have traditionally played a more active role buying and securitizing large, or jumbo, mortgages.
This issue is crucial because the market for jumbo mortgages has seized up, and a lack of funding for these more expensive loans could have a major impact on housing values in large U.S cities. There is strong pressure in Congress to loosen the reins on Fannie and Freddie even more in the current housing downturn.
The Bush administration, which has tried to rein in Fannie and Freddie, eased its position in light of the credit crisis. "There is little question that allowing the GSEs [government-sponsored enterprises] to securitize jumbo mortgages would give a short-term lift," Treasury Secretary Henry Paulson is expected to tell the House Financial Services Committee at a hearing today, according to prepared remarks. He is expected to say, however, that it would be "unreasonable and irresponsible" to expand their businesses without addressing their regulatory problems.
Mortgage Limits
After The Boom: Delinquency Rates, Key U.S. Areas, Second Quarter, 2007
Federal Reserve Chairman Ben Bernanke appears to be opening the door to temporarily allowing Fannie and Freddie to purchase mortgages above the current limit. Mr. Bernanke sent a letter Monday to House Financial Services Committee Chairman Barney Frank (D., Mass.) saying that if Congress is inclined to raise the limit it should consider doing so in a way "that makes the change explicitly temporary as well as promptly implemented." Mr. Bernanke stopped short of endorsing the idea.
As the Bush administration's position on the issue continues to bend, the top officials at Fannie Mae and Freddie Mac are expected to go on the offensive today as they appear before the same committee. Freddie Mac Chief Executive Richard Syron is expected to say that a temporary lifting of the limit would "provide needed liquidity," according to prepared remarks.
In another sign of an administration shift, the regulator for Fannie Mae and Freddie Mac, the Office of Federal Housing Enterprise Oversight, agreed to relax restrictions on the mortgage-finance companies' investment holdings. OFHEO's new policy allows Fannie Mae to increase its portfolio by 2% a year, a level comparable with an existing limit on rival Freddie Mac.
The move could allow the companies to add a combined $40 billion in mortgages to their portfolios by the end of March. In making the changes, OFHEO cited recent progress by both companies in repairing internal controls, though it pointed out that neither company had returned to timely filing of financial statements from past accounting scandals.
Fannie Mae called on the regulator to allow bigger increases. "We still believe the more effective response, given the extent of the market disruption, would be to raise our portfolio cap by at least 10%," Fannie Mae spokesman Brian Faith said.
The cascade of positive news was well-received by the parched credit markets, pushing yields on corporate bonds and loans lower. The market for asset-backed commercial paper, which seized up a few weeks ago and had been threatening to create funding problems for many financial institutions, also improved.
The Fed rate cut triggered a 0.35-percentage-point drop in the one-month London interbank offered rate to 5.15%, a development that should help improve liquidity in the money markets. The three-month Libor, which many leveraged-buyout loans are pegged to, fell to 5.24%, down sharply from more than 5.7% earlier this month. Libor had hit a multiyear high after this summer's liquidity crisis reduced the willingness of banks to lend money to each other.
"There's been a 100% change in sentiment," said Marc Frank, a bond trader at Group G Capital Partners LLC, a New York hedge fund. "The feeling is that money may be getting cheaper, and some large buyout loan financings can now get done."
Still, investment banks that need to sell more than $300 billion of debt from leveraged buyouts they are financing in the coming months are treading carefully. They are opting not to sell too much debt at the same time. Many investors worry that a flood of issuance could push down prices of many other bonds and loans. Bond prices move in the opposite direction as yields.
Wall Street banks are currently seeking buyers for a $5 billion loan for First Data Corp., part of $24 billion in debt financing for the deal. The banks will likely keep most of that debt on their own books for the time being.
Takeover Financing
Debt Dilemmas
Yesterday, another group of banks began marketing a $3.15 billion loan that will help finance the $15.2 billion acquisition of apartment giant Archstone-Smith Trust by Tishman Speyer Properties and Lehman Brothers. Underwriters are also close to selling an additional $500 million in loans for Allison Transmission Inc. after having sold $1 billion in debt for the auto-parts maker last week, according to Standard & Poor's Leveraged Commentary & Data.
While the Fed's rate cut helped to unfreeze pockets of the credit markets, some investors worried the Fed's aggressive stance is an acknowledgment of signs of weakness in the economy. The housing market is still eroding, as home-loan delinquencies and defaults continue to rise.
"We're seeing a lot of encouraging signs that the gears are starting to turn again in the credit markets, but there's still a lot of skepticism around," said Derrick Wulf, a portfolio manager at Dwight Asset Management in Burlington, Vt.
Attracting Funds
Some investors also remain concerned that so-called SIVs, or structured investment vehicles, are still having difficulty attracting investment funds. That could leave some of these vehicles unable to pay off liabilities in coming months. "Conditions have improved broadly, but it's still a bifurcated market," said Ron Flynn, an executive director at J.P. Morgan Chase & Co. who trades in the short-term debt markets.
Still, the broader commercial-paper market improved. The average yield companies pay on 30-day asset-backed commercial paper dropped to about 5.3% by late afternoon, down from nearly 6% just before the Fed move, according to UBS interest-rate strategist Mary Beth Fisher. The average yield on overnight financial commercial paper fell to 4.75%, down from just over 5% before the Fed cut, she said.
"Everything is improving," Ms. Fisher said. "But the liquidity crisis hasn't passed yet."
In the U.S., an affiliate of British bank HBOS PLC was able to sell $2 billion in short-term debt on Tuesday and around $1 billion yesterday. In August, HBOS had to step in to cover the maturing debt of the affiliate after it couldn't roll over its commercial paper.
Click Here, or on the image, to see a larger, undistorted image.
• The Next Bubble?
• Has Fed Risked Creating Moral Hazard? Or Just Risked Its Own Credibility
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Jim Grant Review: The Age of Turbulence
The Banker Looks Back [¹]
By JAMES GRANT | 18 September 2007
The Age of Turbulence"
by Alan Greenspan
At one point during his long interview on "60 Minutes" Sunday evening, Alan Greenspan could be seen autographing dollar bills for his smiling fans. Meanwhile, off camera, unautographed greenbacks continue to depreciate against a variety of metals and foreign currencies. A century ago the pound sterling anticipated the dollar's role today as the pre-eminent global monetary brand. But the pound was exchangeable into gold at the bearer's demand. Not since 1971 has the dollar been collateralized by gold or exchangeable at the U.S. Treasury into anything except nickels, dimes and quarters [[and even that's now getting too expensive for the U.S. Mint: normxxx]].
Sooner or later, the dollar will lose its luster and finally its value, as paper currencies always do. Striving to understand why people trusted it in the first place, historians will naturally reach for the memoirs of the foremost central banker of his day. But Mr. Greenspan's "The Age of Turbulence" will leave them just as confused as they ever were.
The first reports of the book's contents trumpeted Mr. Greenspan's criticism of the current administration's spending habits and his (approving) sense that the Iraq war had something to do with crude oil. But the real news in "The Age of Turbulence" is what it reveals about the greenbacks to which Mr. Greenspan affixed his celebrity signature and the ways in which the currency has been managed and, especially, mismanaged.
A more self-knowing memoirist might have titled this book "The Age of Credulity." The great public drama of Mr. Greenspan's life is, of course, the work he performed as chairman of the Federal Reserve from 1987 to 2006. That work, in all but name, was price fixing. It consisted (and, under his successor, Ben S. Bernanke, still consists) of setting an interest rate and shoving it down the throat of the world's largest economy. It is a mighty strange work for a "libertarian Republican," as the Maestro styles himself here, let alone a former worshipful member of the inner circle of the radical individualist Ayn Rand. "It did not go without notice," the author writes of his swearing-in as chairman of the President's Council of Economic Advisers in 1974, "that Ayn Rand stood beside me as I took the oath of office in the presence of President Ford in the Oval Office."
The fantastic irony of Mr. Greenspan's career path— from gold-standard libertarian to federal interest-rate fixer— seems hardly to have registered on Mr. Greenspan himself. The closest he comes to acknowledging it is his description of how the Fed looked to him from the outside. It was, he writes, a "black box." Having watched his mentor, Arthur Burns, struggle with the chairmanship, Mr. Greenspan notes, "it did not seem like a job I felt equipped to do; setting interest rates for an entire economy seemed to involve so much more than I knew." A deeper kind of libertarian might have added: "Maybe nobody can know enough to set interest rates for an entire economy."
So Mr. Greenspan, a consulting economist of no special attainments (on the eve of the 1974 stock-market collapse, he was quoted in the New York Times saying "it is rare that you can be as unqualifiedly bullish as you can now"), agreed to perform the impossible. Succeeding Paul A. Volcker, he became America's monetary central-planner-in-all-but-name. Mr. Greenspan ruled the roost in 74 fiscal quarters, of which recession darkened only five.
Under his direction, the Fed became a kind of first responder to the scene of financial and economic distress. It soothed taut nerves following the 1987 stock-market break, nourished a crisis-ridden banking system with cheap money in 1990-92, helped to lead the Clinton administration's rescue of the Mexican economy in 1994-95 and engineered the so-called soft landing of the U.S. economy, also in 1995. It famously trimmed its interest rate three times during the Long-Term Capital Management crisis of 1998, succeeding so well in one artfully timed intervention that the stock market, in the final hour of a single session, leapt by 7%. And the market kept right on leaping, all the way to the Nasdaq's own Mount Everest in March 2000. One of those rare recessions followed, after which came the campaign to scotch what Mr. Greenspan was pleased to call "deflation." To fend off the [hideous] peril of low and lower everyday prices, the Fed pressed its interest rate all the way down to 1% in 2003 and kept it there until mid-2004. Now it was house prices that went into orbit. They were just beginning to return to Earth when Mr. Greenspan retired from public life.
Readers who got one of the fancy new teaser-rate mortgages in 2003 or 2004, and who have lived to rue the day, are unlikely to find much nourishment in Mr. Greenspan's discussion of the theory of financial bubbles or in his self-exculpating account of the Fed's role in financing them with artificially low interest rates. Nobody can identify a bubble as it is inflating, Mr. Greenspan has long insisted— though, as you will not read in these pages, Mr. Greenspan was so certain that he detected a stock-market bubble in 1994 that he tried to prick it by pushing interest rates up. Strangely, the author's bubble-sensor failed him later in the decade. He did, in 1997, utter the innocuous phrase "irrational exuberance," [[which phrase apparently 'came to him' while in the tub where, like Archimedes, he 'got his best ideas': normxxx]] but that was as far as he went in attacking sky-high equity valuations.
Mr. Greenspan now writes that the enlightened central banker will let speculation take its course. Following the inevitable blow-up, he will clean up the mess with low interest rates and lots of freshly printed dollar bills— thereby gassing up a new bubble.
Only one of the troubles with this prescription is that it requires an enlightened central banker to carry it out. Nowhere in this book does Mr. Greenspan own up to his role of underestimating the severity of the credit troubles of 1990, or of cheering on the tech-stock frenzy in 1998-2000, or of dangling the most beguiling teaser rate of all during the mortgage frolics of 2004— i.e., that 1% federal-funds rate. In February 2004, only months before the Fed started to raise its rate, in a speech titled "Understanding Household Debt Obligations," Mr. Greenspan demonstrated next to no understanding. His advice to American homeowners was not that they lock in a fixed-rate mortgage while the locking was good, but rather that they consider an adjustable-rate model. He who set the rates got it backward [[unless you assume he was simply trying to draw in the last marginal householder: normxxx]].
An only child of divorced parents growing up in New York City in the 1930s, Mr. Greenspan had seemed destined for better things than a career in interest-rate manipulation. He was an exceptional clarinetist, a Morse code enthusiast and the developer of a personal system for scoring baseball games. The boy who would date Barbara Walters, marry NBC's Andrea Mitchell and be knighted by the queen of England was, above all things, LUCKY. In 1944, a dark spot on the X-ray of his lung made him undraftable. He spent the late war years in the reed section of the Henry Jerome orchestra. Luck still with him, he gravitated to economics, thence to Ayn Rand and thence— what could Rand have thought?— to the security of the federal payroll.
Admirers or detractors of Mr. Greenspan's central banking record will turn the pages of the first half of this book— the story of his life, his loves and his economics— without once having to stifle a yawn. But few will remain alert while toiling through the public-policy ruminations that pad out the final 200 pages. As Fed chairman, Mr. Greenspan had a habit of inflicting on captive audiences his not always original views on such topics as rural electrification, education in a global economy and the bright promise of technology. Such ponderations are no more scintillating now that he is out of office.
"As Fed chairman," Mr. Greenspan writes, "I was queried by fellow central bankers with large holdings of U.S. dollars about whether dollars were safe investments." The monetary bureaucrats will find no reassurance in these all-too-many pages.
Mr. Grant is the editor of Grant's Interest Rate Observer.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By JAMES GRANT | 18 September 2007
The Age of Turbulence"by Alan Greenspan
At one point during his long interview on "60 Minutes" Sunday evening, Alan Greenspan could be seen autographing dollar bills for his smiling fans. Meanwhile, off camera, unautographed greenbacks continue to depreciate against a variety of metals and foreign currencies. A century ago the pound sterling anticipated the dollar's role today as the pre-eminent global monetary brand. But the pound was exchangeable into gold at the bearer's demand. Not since 1971 has the dollar been collateralized by gold or exchangeable at the U.S. Treasury into anything except nickels, dimes and quarters [[and even that's now getting too expensive for the U.S. Mint: normxxx]].
Sooner or later, the dollar will lose its luster and finally its value, as paper currencies always do. Striving to understand why people trusted it in the first place, historians will naturally reach for the memoirs of the foremost central banker of his day. But Mr. Greenspan's "The Age of Turbulence" will leave them just as confused as they ever were.
The first reports of the book's contents trumpeted Mr. Greenspan's criticism of the current administration's spending habits and his (approving) sense that the Iraq war had something to do with crude oil. But the real news in "The Age of Turbulence" is what it reveals about the greenbacks to which Mr. Greenspan affixed his celebrity signature and the ways in which the currency has been managed and, especially, mismanaged.
A more self-knowing memoirist might have titled this book "The Age of Credulity." The great public drama of Mr. Greenspan's life is, of course, the work he performed as chairman of the Federal Reserve from 1987 to 2006. That work, in all but name, was price fixing. It consisted (and, under his successor, Ben S. Bernanke, still consists) of setting an interest rate and shoving it down the throat of the world's largest economy. It is a mighty strange work for a "libertarian Republican," as the Maestro styles himself here, let alone a former worshipful member of the inner circle of the radical individualist Ayn Rand. "It did not go without notice," the author writes of his swearing-in as chairman of the President's Council of Economic Advisers in 1974, "that Ayn Rand stood beside me as I took the oath of office in the presence of President Ford in the Oval Office."
The fantastic irony of Mr. Greenspan's career path— from gold-standard libertarian to federal interest-rate fixer— seems hardly to have registered on Mr. Greenspan himself. The closest he comes to acknowledging it is his description of how the Fed looked to him from the outside. It was, he writes, a "black box." Having watched his mentor, Arthur Burns, struggle with the chairmanship, Mr. Greenspan notes, "it did not seem like a job I felt equipped to do; setting interest rates for an entire economy seemed to involve so much more than I knew." A deeper kind of libertarian might have added: "Maybe nobody can know enough to set interest rates for an entire economy."
So Mr. Greenspan, a consulting economist of no special attainments (on the eve of the 1974 stock-market collapse, he was quoted in the New York Times saying "it is rare that you can be as unqualifiedly bullish as you can now"), agreed to perform the impossible. Succeeding Paul A. Volcker, he became America's monetary central-planner-in-all-but-name. Mr. Greenspan ruled the roost in 74 fiscal quarters, of which recession darkened only five.
Under his direction, the Fed became a kind of first responder to the scene of financial and economic distress. It soothed taut nerves following the 1987 stock-market break, nourished a crisis-ridden banking system with cheap money in 1990-92, helped to lead the Clinton administration's rescue of the Mexican economy in 1994-95 and engineered the so-called soft landing of the U.S. economy, also in 1995. It famously trimmed its interest rate three times during the Long-Term Capital Management crisis of 1998, succeeding so well in one artfully timed intervention that the stock market, in the final hour of a single session, leapt by 7%. And the market kept right on leaping, all the way to the Nasdaq's own Mount Everest in March 2000. One of those rare recessions followed, after which came the campaign to scotch what Mr. Greenspan was pleased to call "deflation." To fend off the [hideous] peril of low and lower everyday prices, the Fed pressed its interest rate all the way down to 1% in 2003 and kept it there until mid-2004. Now it was house prices that went into orbit. They were just beginning to return to Earth when Mr. Greenspan retired from public life.
Readers who got one of the fancy new teaser-rate mortgages in 2003 or 2004, and who have lived to rue the day, are unlikely to find much nourishment in Mr. Greenspan's discussion of the theory of financial bubbles or in his self-exculpating account of the Fed's role in financing them with artificially low interest rates. Nobody can identify a bubble as it is inflating, Mr. Greenspan has long insisted— though, as you will not read in these pages, Mr. Greenspan was so certain that he detected a stock-market bubble in 1994 that he tried to prick it by pushing interest rates up. Strangely, the author's bubble-sensor failed him later in the decade. He did, in 1997, utter the innocuous phrase "irrational exuberance," [[which phrase apparently 'came to him' while in the tub where, like Archimedes, he 'got his best ideas': normxxx]] but that was as far as he went in attacking sky-high equity valuations.
Mr. Greenspan now writes that the enlightened central banker will let speculation take its course. Following the inevitable blow-up, he will clean up the mess with low interest rates and lots of freshly printed dollar bills— thereby gassing up a new bubble.
Only one of the troubles with this prescription is that it requires an enlightened central banker to carry it out. Nowhere in this book does Mr. Greenspan own up to his role of underestimating the severity of the credit troubles of 1990, or of cheering on the tech-stock frenzy in 1998-2000, or of dangling the most beguiling teaser rate of all during the mortgage frolics of 2004— i.e., that 1% federal-funds rate. In February 2004, only months before the Fed started to raise its rate, in a speech titled "Understanding Household Debt Obligations," Mr. Greenspan demonstrated next to no understanding. His advice to American homeowners was not that they lock in a fixed-rate mortgage while the locking was good, but rather that they consider an adjustable-rate model. He who set the rates got it backward [[unless you assume he was simply trying to draw in the last marginal householder: normxxx]].
An only child of divorced parents growing up in New York City in the 1930s, Mr. Greenspan had seemed destined for better things than a career in interest-rate manipulation. He was an exceptional clarinetist, a Morse code enthusiast and the developer of a personal system for scoring baseball games. The boy who would date Barbara Walters, marry NBC's Andrea Mitchell and be knighted by the queen of England was, above all things, LUCKY. In 1944, a dark spot on the X-ray of his lung made him undraftable. He spent the late war years in the reed section of the Henry Jerome orchestra. Luck still with him, he gravitated to economics, thence to Ayn Rand and thence— what could Rand have thought?— to the security of the federal payroll.
Admirers or detractors of Mr. Greenspan's central banking record will turn the pages of the first half of this book— the story of his life, his loves and his economics— without once having to stifle a yawn. But few will remain alert while toiling through the public-policy ruminations that pad out the final 200 pages. As Fed chairman, Mr. Greenspan had a habit of inflicting on captive audiences his not always original views on such topics as rural electrification, education in a global economy and the bright promise of technology. Such ponderations are no more scintillating now that he is out of office.
"As Fed chairman," Mr. Greenspan writes, "I was queried by fellow central bankers with large holdings of U.S. dollars about whether dollars were safe investments." The monetary bureaucrats will find no reassurance in these all-too-many pages.
Mr. Grant is the editor of Grant's Interest Rate Observer.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
The End Of The Credit Crunch?
The End Of The Credit Crunch [¹]
Click here for link to complete article: http://www.sensiblestocks.com/
By David P. Van Knapp | 20 September 2007
1. The credit crunch, begun by sub-prime mortgage lending in the USA, had spread into all areas of the [international] credit markets. Ill-advised loans, over-reaching by unqualified borrowers, and over-leveraged purchases of "loan packages" had led to spreading defaults, the failure of some hedge funds [[and mortgage brokers and banks: normxxx]], and the tightening or withdrawal of credit availability not only in the USA but around the world.
2. Investor sentiment had been badly shaken and would continue to yo-yo. Investors would fret over the credit situation, possible effects on the economy, and the ability of the Fed and central banks around the world to contain damage. They would have hair-trigger reactions to any signs, positive or negative. Therefore, severe market volatility was inevitable. Up and down days would exceed 200-300 points repeatedly, with an overall downward trend until the situation clarified. At one point, stocks had dropped nearly 10% from their high on July 19.
3. The Fed and other national banks had responded by [repeatedly] injecting massive amounts of money into the financial systems to stave off panic, illiquidity, and total 'seizure' of the credit markets. It was not at all clear whether such moves would stave off a true economic crisis. However, the initial moves did suggest to all that the central banks recognized the gravity of the situation and would try to head off and/or mitigate grave damage.
4. Investors were likely, but not guaranteed, to recognize that in the overall scheme of things, the credit crisis was limited in size [[and scope?: normxxx]] and was unlikely to drag the economy into recession[!?!] Pullbacks from the market had driven many stocks down to attractive valuations, and investors were more likely than not to see these as entry points if they could regain confidence that the economy was not going down the tubes. While investor sentiment would swing wildly, on balance it would tilt positive, and the markets were likely to be higher than lower six months hence.
5. Therefore, I recommended that investors (a) look for excellent companies with strong balance sheets; (b) loosen or eliminate sell stops to allow for the likely market volatility over the next few weeks or months; but (c) limit their stock investments to 1/2 or 2/3 of available "stock money" as a hedge against the thesis being wrong.
That thesis has proved quite prophetic. The markets, while extremely volatile, did start to bottom out and trend upward again. It did become clearer that the credit crisis was unlikely to topple the economy into recession[!?!]
Now, with Tuesday's slashing of the federal funds rate by 0.5%, and an equal lowering of the discount rate (the amount the Fed charges banks for loans directly from the government), along with similar moves by central banks around the world, I believe we can declare that the credit panic of 2007 is over.
This does not mean that there won't be more bad news. Some over-leveraged hedge funds and investors may still go belly-up. More borrowers will default, especially as adjustable-rate mortgages reset. Credit will be harder to obtain generally (which is a good thing) [[but not for the economy: normxxx]].
But I now believe it is clear that the Fed and other central banks will contain the damage from the credit crisis. Stock investors can return to more "normal" strategies. Using appropriate caution, they can take advantage of good valuations to purchase shares in excellent companies. If they use sell-stops, they can return them to more normal levels. And they can become fully invested again. There is now a very high probability that the market will continue on an upward trend, and move toward more normal volatility ranges, over the next few months.
In his Kelly Letter, Jason Kelly Adds:
The Fed doesn't cut rates every day and the predictable pop after its doing so may not last, so I wouldn't get overly excited about missing that.
What I would understand as quickly as possible, however, is that the market is poised for a solid performance in the medium term. If you're still stuck on last month's headlines about sub-prime and shaky credit markets, you're looking in the wrong direction on your calendar. Flip forward, not back. It won't be long until this silly little correction isn't even talked about, and it won't rate anywhere near the top of the issues successfully faced down by the stock market.
Here at The Kelly Letter, we were never afraid of sub-prime. We never thought the "state of the market these days" was scary. We watched all of the action with amusement, and watched for bargain prices, but not for even a minute did we think systemic failure was imminent.
I do not think it's too late to get in this market. The beauty of my permanent portfolios is that they're never too late, hence their name. What most really want to know, though, is whether they've missed the opportunity to get money in for the end-of-year run-up I wrote about.
Obviously, some of the performance has been missed, but not all. The end of the year is quite a ways out there still, and the people who think the market is scary will take more convincing to realize that it's not— and will pile on just about the time the bargains are all gone. That will send prices higher, so there's still upside in this market.
As ever, be smart. Don't put your money in at the highs following the Fed's rate cut. Wait for another scary headline and a price drop. It'll happen along the path higher, which is still intact.
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Click here for link to complete article: http://www.sensiblestocks.com/
By David P. Van Knapp | 20 September 2007
- I believe that the credit crisis of 2007 is over, at least insofar as it is likely to impact the stock market. To be frank, it ended somewhat sooner than I expected.
1. The credit crunch, begun by sub-prime mortgage lending in the USA, had spread into all areas of the [international] credit markets. Ill-advised loans, over-reaching by unqualified borrowers, and over-leveraged purchases of "loan packages" had led to spreading defaults, the failure of some hedge funds [[and mortgage brokers and banks: normxxx]], and the tightening or withdrawal of credit availability not only in the USA but around the world.
2. Investor sentiment had been badly shaken and would continue to yo-yo. Investors would fret over the credit situation, possible effects on the economy, and the ability of the Fed and central banks around the world to contain damage. They would have hair-trigger reactions to any signs, positive or negative. Therefore, severe market volatility was inevitable. Up and down days would exceed 200-300 points repeatedly, with an overall downward trend until the situation clarified. At one point, stocks had dropped nearly 10% from their high on July 19.
3. The Fed and other national banks had responded by [repeatedly] injecting massive amounts of money into the financial systems to stave off panic, illiquidity, and total 'seizure' of the credit markets. It was not at all clear whether such moves would stave off a true economic crisis. However, the initial moves did suggest to all that the central banks recognized the gravity of the situation and would try to head off and/or mitigate grave damage.
4. Investors were likely, but not guaranteed, to recognize that in the overall scheme of things, the credit crisis was limited in size [[and scope?: normxxx]] and was unlikely to drag the economy into recession[!?!] Pullbacks from the market had driven many stocks down to attractive valuations, and investors were more likely than not to see these as entry points if they could regain confidence that the economy was not going down the tubes. While investor sentiment would swing wildly, on balance it would tilt positive, and the markets were likely to be higher than lower six months hence.
5. Therefore, I recommended that investors (a) look for excellent companies with strong balance sheets; (b) loosen or eliminate sell stops to allow for the likely market volatility over the next few weeks or months; but (c) limit their stock investments to 1/2 or 2/3 of available "stock money" as a hedge against the thesis being wrong.
That thesis has proved quite prophetic. The markets, while extremely volatile, did start to bottom out and trend upward again. It did become clearer that the credit crisis was unlikely to topple the economy into recession[!?!]
Now, with Tuesday's slashing of the federal funds rate by 0.5%, and an equal lowering of the discount rate (the amount the Fed charges banks for loans directly from the government), along with similar moves by central banks around the world, I believe we can declare that the credit panic of 2007 is over.
This does not mean that there won't be more bad news. Some over-leveraged hedge funds and investors may still go belly-up. More borrowers will default, especially as adjustable-rate mortgages reset. Credit will be harder to obtain generally (which is a good thing) [[but not for the economy: normxxx]].
But I now believe it is clear that the Fed and other central banks will contain the damage from the credit crisis. Stock investors can return to more "normal" strategies. Using appropriate caution, they can take advantage of good valuations to purchase shares in excellent companies. If they use sell-stops, they can return them to more normal levels. And they can become fully invested again. There is now a very high probability that the market will continue on an upward trend, and move toward more normal volatility ranges, over the next few months.
In his Kelly Letter, Jason Kelly Adds:
The Fed doesn't cut rates every day and the predictable pop after its doing so may not last, so I wouldn't get overly excited about missing that.
What I would understand as quickly as possible, however, is that the market is poised for a solid performance in the medium term. If you're still stuck on last month's headlines about sub-prime and shaky credit markets, you're looking in the wrong direction on your calendar. Flip forward, not back. It won't be long until this silly little correction isn't even talked about, and it won't rate anywhere near the top of the issues successfully faced down by the stock market.
Here at The Kelly Letter, we were never afraid of sub-prime. We never thought the "state of the market these days" was scary. We watched all of the action with amusement, and watched for bargain prices, but not for even a minute did we think systemic failure was imminent.
- [ Normxxx Here: That's strange; BB surely thought so, and a number of equally astute economic gurus too. Well, where angels fear to tread... ]
- [ Normxxx Here: Or, you could use investment strategies that don't require you to play along the edges of the cliff... ]
- [ Normxxx Here: Indeed, I am looking for a substantial pullback this coming week. ]
I do not think it's too late to get in this market. The beauty of my permanent portfolios is that they're never too late, hence their name. What most really want to know, though, is whether they've missed the opportunity to get money in for the end-of-year run-up I wrote about.
Obviously, some of the performance has been missed, but not all. The end of the year is quite a ways out there still, and the people who think the market is scary will take more convincing to realize that it's not— and will pile on just about the time the bargains are all gone. That will send prices higher, so there's still upside in this market.
As ever, be smart. Don't put your money in at the highs following the Fed's rate cut. Wait for another scary headline and a price drop. It'll happen along the path higher, which is still intact.
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Friday, September 21, 2007
iTulip: "Ka-Poom!"
"Ka-Poom Theory Playing Out" [¹]
By iTulip.com | 22 September 2007
Didn't take long for US creditors to figure out that whether the US economy sinks from the economic impact of the collapsing housing, private equity, and other bubbles, or is kept afloat by inflation, they lose either way.
Here at iTulip we call this process "Poom" and it ain't pretty. "Poom" is the back end of the Ka-Poom Theory disinflation/inflation cycle that is both monetary cause and effect of the bubble cycle. The bubble cycle replaced the business cycle as the focus of monetary policy since the finance-based economy, popularly mis-labeled the "service economy," aka the FIRE Economy, became the centerpiece of US national industrial/economic policy starting around 1980.
The first Ka-Poom was 2000 - 2006, with disinflation 2000 - 2001 following the crash of the stock market bubble and inflation in everything from oil to gold to houses during the re-inflation cycle 2002 - 2006.
The disinflation phase of the current bubble cycle started after the housing bubble peaked in mid 2005. As the disinflation was gradual due to the nature of the market for houses, which are not marked to market all at once like stock portfolios [[but only gradually over an extended period of time: normxxx]], wealth and employment and thus demand were not suddenly hit. There was little spill-over into the so-called "real economy" such as occurred after the crash of the stock market bubble, so only a muted disinflationary phase occurred. Until May, that is, when the some of the financial engineers at Merrill Lynch foolishly decided to actually sell some of those creative securities that had for years been the engine of all of the credit for the housing, private equity, and other bubbles. The markets priced them at zero and the credit markets seized up.
Anyone paying attention could see this coming a mile away. A leading indicator we've been tracking is housing permits, which by plunging 25% below last year's issuance early this year and staying there confirmed, with other data, our Oct. 2006 projection of a recession Q4 2007. Then in August we noted iTulip Prosper Lending Group default rates soaring along with duration of unemployment numbers, a leading indicator of future unemployment.
The cascading economic impact of simultaneously collapsing housing, private equity, and other bubbles [[not to mention the seizure in the ABS and the commercial paper market— which has frozen all or most ST lending and brought down many engaged in the mortgage markets: normxxx]] is The Iceberg. As recently as two weeks ago the Fed had apparently not spotted it as Bernanke continued to give speeches indicating a focus on inflation, which is in our view well justified. In fact, we actually thought he was serious, and the iTulip ShadowFed predicted a .25% cut. We thought the Fed's worry about US creditors would trump concerns about the economy. After spotting the iceberg, the Fed re-calculated: if the US economy is sinking like the Titanic, no one is going to want to lend the US money anyway. That is probably true. But lenders may not want to buy anything denominated in dollars if they believe that the only thing really supporting the dollar is their purchases of dollar assets, that the US isn't willing to accept the consequences of its asset bubbles and instead wants to dump them on its creditors. Just ask the Saudis.
That is what "Poom" is about. The no-win choice after a bubble pops to hurriedly re-inflate in order to hold off a run-away debt deflation and suffer even more inflation and dollar depreciation as a side effect of a premature re-inflation policy.
1999 Ka-Poom Theory also posits that a final "Poom" happens— the terminal bubble in the bubble cycle— when the Fed attempts to re-inflate the economy via rate cuts and dollar depreciation when the dollar is weak and inflation is already running high, as it is now. Instead of causing long rates to fall, the cuts have the opposite result: long rates rise as the bond market prices in inflation fueled by dollar depreciation. Mortgage rates rise and the housing market tanks some more. A self-reinforcing, 'vicious cycle starts.
The IMF warned of this last year:
We await the next Fed Flow of Funds report, due out Dec. 7, for our answer.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By iTulip.com | 22 September 2007
Didn't take long for US creditors to figure out that whether the US economy sinks from the economic impact of the collapsing housing, private equity, and other bubbles, or is kept afloat by inflation, they lose either way.
Here at iTulip we call this process "Poom" and it ain't pretty. "Poom" is the back end of the Ka-Poom Theory disinflation/inflation cycle that is both monetary cause and effect of the bubble cycle. The bubble cycle replaced the business cycle as the focus of monetary policy since the finance-based economy, popularly mis-labeled the "service economy," aka the FIRE Economy, became the centerpiece of US national industrial/economic policy starting around 1980.
The first Ka-Poom was 2000 - 2006, with disinflation 2000 - 2001 following the crash of the stock market bubble and inflation in everything from oil to gold to houses during the re-inflation cycle 2002 - 2006.
The disinflation phase of the current bubble cycle started after the housing bubble peaked in mid 2005. As the disinflation was gradual due to the nature of the market for houses, which are not marked to market all at once like stock portfolios [[but only gradually over an extended period of time: normxxx]], wealth and employment and thus demand were not suddenly hit. There was little spill-over into the so-called "real economy" such as occurred after the crash of the stock market bubble, so only a muted disinflationary phase occurred. Until May, that is, when the some of the financial engineers at Merrill Lynch foolishly decided to actually sell some of those creative securities that had for years been the engine of all of the credit for the housing, private equity, and other bubbles. The markets priced them at zero and the credit markets seized up.
- [ Normxxx Here: Even markets not immediately affected by the sub-prime disaster (there was a sudden collapse of CREDIBILITY in the markets, and ALL asset-backed securities became suspect). ]
Anyone paying attention could see this coming a mile away. A leading indicator we've been tracking is housing permits, which by plunging 25% below last year's issuance early this year and staying there confirmed, with other data, our Oct. 2006 projection of a recession Q4 2007. Then in August we noted iTulip Prosper Lending Group default rates soaring along with duration of unemployment numbers, a leading indicator of future unemployment.
The cascading economic impact of simultaneously collapsing housing, private equity, and other bubbles [[not to mention the seizure in the ABS and the commercial paper market— which has frozen all or most ST lending and brought down many engaged in the mortgage markets: normxxx]] is The Iceberg. As recently as two weeks ago the Fed had apparently not spotted it as Bernanke continued to give speeches indicating a focus on inflation, which is in our view well justified. In fact, we actually thought he was serious, and the iTulip ShadowFed predicted a .25% cut. We thought the Fed's worry about US creditors would trump concerns about the economy. After spotting the iceberg, the Fed re-calculated: if the US economy is sinking like the Titanic, no one is going to want to lend the US money anyway. That is probably true. But lenders may not want to buy anything denominated in dollars if they believe that the only thing really supporting the dollar is their purchases of dollar assets, that the US isn't willing to accept the consequences of its asset bubbles and instead wants to dump them on its creditors. Just ask the Saudis.
That is what "Poom" is about. The no-win choice after a bubble pops to hurriedly re-inflate in order to hold off a run-away debt deflation and suffer even more inflation and dollar depreciation as a side effect of a premature re-inflation policy.
1999 Ka-Poom Theory also posits that a final "Poom" happens— the terminal bubble in the bubble cycle— when the Fed attempts to re-inflate the economy via rate cuts and dollar depreciation when the dollar is weak and inflation is already running high, as it is now. Instead of causing long rates to fall, the cuts have the opposite result: long rates rise as the bond market prices in inflation fueled by dollar depreciation. Mortgage rates rise and the housing market tanks some more. A self-reinforcing, 'vicious cycle starts.
The IMF warned of this last year:
- IMF Identifies Risk of `Disorderly' U.S. Dollar Drop
September 13, 2006 (Bloomberg)
A "disorderly" drop in the dollar is the biggest risk to world financial markets, the International Monetary Fund said, urging policy makers to prepare and act quickly when asset prices slump.
Investors are buying U.S. bonds under the assumption that the dollar won't slide, and a drop in the currency might turn into a rout as foreign investors and central banks move to cut losses, the global financial watchdog said.
"A low-probability but potentially high-cost risk to the global financial system is that a dollar decline could become self-reinforcing and hence disorderly," the IMF said in its Global Financial Stability Report today.
Last week, IMF Managing Director Rodrigo De Rato singled out lopsided global trade and investment flows, protectionist sentiment and high energy prices as sources of concern to an otherwise benign outlook for the global economy. The IMF says the U.S. current account deficit, running at a record rate, needs to narrow.
We await the next Fed Flow of Funds report, due out Dec. 7, for our answer.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
The Cruelest Tax?
Fears Of Dollar Collapse? [¹]
By TheBigPicture | 21 September 2007
Saudi Arabia, who usually mimics every FOMC move, has refused to cut interest rates in lockstep with the US Federal Reserve for the first time, according to a UK Telegraph article (Fears of dollar collapse as Saudis take fright, SEPTEMBER 2007), is signalling that the oil-rich Gulf kingdom is preparing to break the dollar currency peg. This could potentially cause a cascading chain reaction across the Middle East— setting off a stampede out of the dollar and towards either a basket of currency, or more likely the Euro.
Last month, this same author was expressing concern that the "Chinese government has begun a concerted campaign of economic threats against the United States, hinting that it may liquidate its vast holding of US treasuries if Washington imposes trade sanctions to force a yuan revaluation."
Described as China's "nuclear option" in the state media, such action could trigger a dollar crash at a time when the US currency is already breaking down through historic support levels. It would also cause a spike in US bond yields, hammering the US housing market and [probably] tipping the economy into [severe] recession. It is estimated that China holds over $900bn in a mix of US bonds. (August 2007)
Before you dismiss the author of both of these pieces as a Dollar Bear, recognize what he has said in the past about the Greenback:
Above, we discussed the potential impact of the ongoing weakening of the US dollar.
Today, we look at a few printing press Money Supply issues. Our focus: The spread between the Fed liquidity action (a/k/a Repos) and the M2 money supply measures.
This is simply a measure of how much cash the Fed is injecting into the system.
The following Bloomberg chart shows the spread between the two of these monetary measures. It is quite instructive:
Click Here, or on the image, to see a larger, undistorted image.
Speaking of surges: As you can clearly see above (bottom left chart), the amount of MZM (repos) versus M2 during 2007 is enormous.
This means that the Fed is "inflating" at a rate faster today than it did right after 9/11, or during the deflationary scare of 2003.
As we asked Wednesday night, "What did the Fed Chair and the FOMC see that spooked them into a half point (over) reaction?" I am not sure what is was (and we've discussed many of the potential issues over the past 2 years), but the Fed is obviously scared witless.
Why? One way to think about it is supply and demand. Print A LOT more dollars and each one is worth a little less.
Or, consider it this way: Extracting Oil or Gold from the earth ain't easy. We have to explore for Oil, determine where it is, how deep, what quality, etc. Then we have to use lots of heavy machinery to extract it, ship it to where it gets processed, refined, used in chemical manufacturing. Some of it gets refined into gasoline, and it is then transported to a network of gasoline stations, and it gets pumped into your car— all for less per gallon than diet Coke or peach Snapple!
For gold, the process is not all that dissimilar.
But just crank up the printing press: Its cheap and easy. Why should us gold and oil producers exchange our hard won commodities (its hard work) for pieces of paper you people are simply cranking out for free? Either give us something of real value— or, instead, we will insist on more of your crappy little pieces of green paper.
Thus, the inflationary repercussions of a "free money" policy. In fact, every commodity that is priced in dollars can potentially see much higher prices: Gold, Oil, Wheat, Soybeans, Copper, Timber, Corn, etc.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By TheBigPicture | 21 September 2007
Saudi Arabia, who usually mimics every FOMC move, has refused to cut interest rates in lockstep with the US Federal Reserve for the first time, according to a UK Telegraph article (Fears of dollar collapse as Saudis take fright, SEPTEMBER 2007), is signalling that the oil-rich Gulf kingdom is preparing to break the dollar currency peg. This could potentially cause a cascading chain reaction across the Middle East— setting off a stampede out of the dollar and towards either a basket of currency, or more likely the Euro.
Last month, this same author was expressing concern that the "Chinese government has begun a concerted campaign of economic threats against the United States, hinting that it may liquidate its vast holding of US treasuries if Washington imposes trade sanctions to force a yuan revaluation."
Described as China's "nuclear option" in the state media, such action could trigger a dollar crash at a time when the US currency is already breaking down through historic support levels. It would also cause a spike in US bond yields, hammering the US housing market and [probably] tipping the economy into [severe] recession. It is estimated that China holds over $900bn in a mix of US bonds. (August 2007)
Before you dismiss the author of both of these pieces as a Dollar Bear, recognize what he has said in the past about the Greenback:
- "Disregard all hysteria. The ailing Greenback will not collapse this year, not in ten years, not in twenty years, not in half a century. There is no credible currency against which it can collapse. (Unless you count gold). None of the world's rival power blocs have the economic and demographic depth to challenge American dominance." (JULY 2007)
Above, we discussed the potential impact of the ongoing weakening of the US dollar.
Today, we look at a few printing press Money Supply issues. Our focus: The spread between the Fed liquidity action (a/k/a Repos) and the M2 money supply measures.
This is simply a measure of how much cash the Fed is injecting into the system.
The following Bloomberg chart shows the spread between the two of these monetary measures. It is quite instructive:
Click Here, or on the image, to see a larger, undistorted image.
Speaking of surges: As you can clearly see above (bottom left chart), the amount of MZM (repos) versus M2 during 2007 is enormous.
This means that the Fed is "inflating" at a rate faster today than it did right after 9/11, or during the deflationary scare of 2003.
As we asked Wednesday night, "What did the Fed Chair and the FOMC see that spooked them into a half point (over) reaction?" I am not sure what is was (and we've discussed many of the potential issues over the past 2 years), but the Fed is obviously scared witless.
- [ Normxxx Here: How about the lack of those repos having any visible effect on the intended markets? ]
Why? One way to think about it is supply and demand. Print A LOT more dollars and each one is worth a little less.
Or, consider it this way: Extracting Oil or Gold from the earth ain't easy. We have to explore for Oil, determine where it is, how deep, what quality, etc. Then we have to use lots of heavy machinery to extract it, ship it to where it gets processed, refined, used in chemical manufacturing. Some of it gets refined into gasoline, and it is then transported to a network of gasoline stations, and it gets pumped into your car— all for less per gallon than diet Coke or peach Snapple!
For gold, the process is not all that dissimilar.
But just crank up the printing press: Its cheap and easy. Why should us gold and oil producers exchange our hard won commodities (its hard work) for pieces of paper you people are simply cranking out for free? Either give us something of real value— or, instead, we will insist on more of your crappy little pieces of green paper.
Thus, the inflationary repercussions of a "free money" policy. In fact, every commodity that is priced in dollars can potentially see much higher prices: Gold, Oil, Wheat, Soybeans, Copper, Timber, Corn, etc.
- [ Normxxx Here: But especially those things already in international trade, e.g., just about all manufactured and processed things. ]
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Thursday, September 20, 2007
Gold Triumphant?
Monetary Doves at Point of Gun [¹]
By Jim Willie CB | 20 September 2007
editor of the "Hat Trick Letter"
WOW! What an interesting couple of weeks. A lousy August Jobs Report— even though it exaggerated job growth to the upside! The Birth-Death Model actually added 120 thousand mythical jobs, including construction jobs and financial sector jobs, both clearly in retreat, a blatant deception. The US Federal Reserve finally was given the gun they needed to cut interest rates. Martin Feldstein gave the USFed considerable political cover, urging cuts, claiming they were already 100 basis points too high. So gold is breaking out, crude oil is breaking out, the euro is breaking out, the Canadian looney dollar is breaking out, the HUI stock index of miners is breaking out, and the USDollar is breaking down. HATS OFF TO THE CANADIAN DOLLAR, WHICH HIT PARITY, A LONGSTANDING FORECAST OF MINE! MAY CANADIAN STOCKS BENEFIT FROM US INVESTORS SEEKING REFUGE! The USFed showed wisdom, if not veiled desperation in a rate cut of 50 basis points not only for the Fed Funds rate target, but also for the discount rate. The floodgates are now opened for monetary stimulus, monetary inflation, and higher commodity prices. Central bankers have given inflation full endorsement and approval, sufficient for a gold breakout to extend to wild levels, like $1000 before mid-2008. Nothing can stop it, because central bankers are held hostage to the crippled US financial system. They have become fast converts to monetary doves. By the way, the USFed denies they have begun an entirely new easing cycle. This is of course nonsense, as usual. With the disconnect between S&P stocks and mining stocks, any shock wave to mainstream stocks might be beneficial to the gold community.
The key commodities remain gold as a financial meter and crude oil as a commercial meter. My thesis here is a parallel concept, of vital importance to gold (silver too) and its investment arenas. The central banks have a gun at their heads, which dictates that they continue to flood money into the system without raising interest rates further. The extreme banking, bond, and growing economic distress in the United States [[actually, in the whole world!: normxxx]] prevents further rate hikes widely broadcasted by the Europeans (Germany, France, and Italy), British, and Japanese. They, together with the US and Canada, form the G7 nations of Western world banking.
Rising monetary inflation as the unintentional result of an intended policy, coupled with lowered interest rates in the United States, and stalled economic activity in Europe and Japan, constitute a near perfect scenerio for a gold spree [[especially when the "carry trade" bails out— which may already have begun: normxxx]]. The implications to the USDollar are dire. The fact that a USDX index falling below 79 has not generated much alarm tells us that it must descend closer to 70 than 75 before the alarms are sounded. What alarms are those? Clearly here, the threat is systemic cost inflation in the USEconomy NOT matched by rising wage income. The import of price inflation through the FOREX back door from a weaker USDollar exchange rate will soon become a big topic. Next on the table are bank runs, first in Countrywide, now in England's Northern Rock, and much more to come [[in all those 'non-bank banks' uninsured and unregulated by anybody: normxxx]]!!!
Gold On Notice To Launch
Gold, even as it breaks out above the 730 old highs, continues to be misunderstood. Sure, it catches the attention of network anchors, but their explanations and those from interviewed guests fall short of adequate assessment. At the same time, denials persist on the huge damage to be doled out by the USDollar decline. They have noticed the breakout above 700 and cited gold's favorable technical chart. They have identified gold as an commodity play in the same vein as crude oil and copper, which have all risen in the last couple years. They have mentioned that gold is approaching its beneficial season, as the annual holiday season invites jewelry shopping in the Western world.
But hardly anywhere in the mainstream press is the monetary reason cited in connection with gold breakout above 700. Stories do appear that the USEconomy should not tumble terribly, since the central banks have reacted so responsibly to the banking and bond problems plaguing the system. They report a 20% global money supply growth rate as the proper remedy, but fail to recognize that that is precisely why gold [[and other commodities are: normxxx]] rising. Gold reacts to monetary debasement.
My targets for gold are becoming more vague. They depend upon continued USFed rate cut action, any surprises in hedge fund blowups, massive writedown losses for major banks on mortgage bond holdings, debt ratings agency downgrades, any credit derivative backfire, sudden hit of the brick wall by the USEconomy, continued decline in housing prices, continued rise in home foreclosures, foreign central bank decisions, and breakout of military war on the Iran front. The onset of a USFed rate easing cycle presents a $1000 gold price target in the next 18 months, regardless of these numerous ongoing ingredients in a giant cauldron. Clearly, gold is heading toward $800 very soon, and probably to $1000 within one year.
Click Here, or on the image, to see a larger, undistorted image.
We finally have a breakout on the HUI stock index of unhedged precious metals mining stocks. Gold responds to the monetary medicine, and mining stocks respond to the filtering through the system of that medicine. On a weekly open & close basis, we have an HUI index breakout. My target is 440 in the near term and 470 in the intermediate term. The filter down to Canadian junior stocks will take a few weeks or couple months, as investment institutions take action, investors return with an all clear signal, and many deal with basic fear to wade back into waters which have not been friendly this summer.
Click Here, or on the image, to see a larger, undistorted image.
The globally furnished fuel for considerable follow-through to the gold advance in breakout will be USDollar doubts, reserves defections by foreign institutions, gradual economic decline in the US, and response to the housing asset destruction [[which, despite all the furor, has scarcely slowed!: normxxx]]. Alternatives to traditional reserves investment, led by the USTreasury Bond instrument, are actively being pursued. This is the foundation to the next Mania Phase for gold. When it gathers speed and force, it will become breathtaking, attracting the enlightened individuals, then the fund managers, and finally the public. On some day in the next 18 months to two years, gold will rise by nearly $100, yes, on a single day!!! The Plunge Protection Team is slowly losing control of the situation, as new chambers show strain, like commercial interbank paper and money markets. The foreign perspective will increasingly be a witness of a desperation to prevent a USEconomic recession. That will be highly destructive to the USDollar as well, motivating flight. My forecast made several times one year ago, was that the USEconomy will be the weakest, perhaps in recession mode, in stark contrast to the global economy powered by Asian expansion. We are here. The implications for a weaker USDollar are huge, profound, and ongoing.
The Asians, with their huge trade surpluses, will direct increasing amounts of funds into gold, crude oil stockpiles, metal ore stockpiles, properties which produce the same, and entire companies which own such properties. The new trend of government sovereign funds is an important vehicle with which to manifest those investments. They are looking away from the traditional knee-jerk USTBond investments. Look for China to increasingly purchase gold, not just for their own best economic benefit, but also to send a message to Americans deliberately intended to rattle their financial cages. At the same time, the Asians will soon begin funding their own credit market(s) for regional development. Continued reliance upon the USTreasury Bond as the entire superstructure for the financial system, even in just Asia, now seems highly impractical. GOLD STANDS READY TO ANSWER THE INVESTMENT CALL BY ASIANS AS MORE STABLE AND PROFITABLE ASSETS ARE SOUGHT.
Gold and Dollar Decoupoing
A grand decouple is coming, as the world financial system has begun to separate from the modified "Bretton Woods Agreement," also known (in part) as the "floating Bretton Woods" or (in part) as "Bretton Woods II", whereby the asiatic currencies (and many other weak currencies), at least, remain pegged to the dollar, but most of the 'stronger' currencies "floated". They realize that their own currencies can and must be managed to realize greater stability than remaining pegged to the dollar. This stands in contrast to unchecked credit growth, unbridled financial leverage, and the machinations of Wall Street and the G7 financial machinery. They have come to realize that pegging to the dollar is a two-edged sword that permits too much financial risk to be 'exported' from the US.
Money will soon flow into the gold sector at an accelerated pace, on a global basis. The Fed will continue cutting interest rates, will expand its balance sheet in monetized assets (that nobody else wants), and start to print money at a faster rate than the 14% of recent months [[actually, the Fed has been adding at less than 3%, or around the inflation rate— the rest has been 'credit' money, added by various banking and pseudo-banking enterprises.: normxxx]]. A two week growth, when annualized, pressed toward 50% in money supply growth was just registered in September!!! [[That's true!: normxxx]] Other governments, now reluctant to be accommodative, will eventually engage in a race to the bottom, to outdo each other in creating money. Political participation is not far off, with even greater deficit spending measures and consumer debt relief proposals, to climax in rescue packages to save BOTH housing prices and mortgage bonds. House values must be halted in their decline, while mortgages bonds must find a strong buyer of last resort[!?!]
Foreign Central Banks Frozen Solid
European and Japanese central bankers stand on similar conflicted positions. In the first week of September, the Euro Central Bank held steady at 4.0%, and did not hike interest rates as originally intended, but simply talked in stern tones about their vigilance against price inflation. The Bank of England also held pat on rates at 5.75%, as did the Bank of Canada and Australia. Citation of 'financial market turbulence' sounds simple, but banking distress and reluctance to see their native currencies appreciate are other, more germaine, motives, given the huge problems facing the United States [[and hardly just the US!: normxxx]]. We see a cooperative move to offer assistance to the USFed, cornered and facing an urgent need to cut rates.
Debate over monetary matters in Brussels and London ended suddenly when the USFed cut the Discount Window rate [[but this was done to forestall total seizure of the European banks!: normxxx]]. The banking world took notice, as a gigantic distress flag emerged. None of the major and secondary nations can alone reign in their vast money supply growth. The reversal in USFed monetary policy will have broad global implications not only on continued money supply growth, but also add to the speculative fervor in alternatives like gold and other commodities.
The problems of the [Too Big To Fail Bank] Northern Rock in the UK highlights the ongoing intractable situation, a story of insolvency free of US subprime roots [[not entirely; it is being brought down by failure of the international commercial paper market, which has caught the contagion from those sub-primes: normxxx]], a disaster on British soil. Bank of England head Mervyn King declared that bad practices in the banks should not be rewarded, but may have reversed his position. [[The spreading cancer of lack of CREDIBILITY has suddenly rendered central bankers into monetary doves.: normxxx]] The entire Western world banking system, especially the US and England, is a house of cards [[built on FAITH: normxxx]], built on the quicksand of a housing bubble!
The rally in gold and related mining stock investments will quickly enter the next phase, powered by global inflation, easier terms for money, and defensive desperation by central banks to ward off recession and massive asset deflation. Whether the USDollar will be harmed and sent lower will be of secondary importance, in the larger sphere. The key is keeping unbridled retail inflation in check in the US, Europe, and Japan, in coordinated fashion, while providing enough stimulus for the various economies. The stimulus to prevent profound economic reversals is always of the higher priority.
EUROPE: The USFed requires foreign central banks to halt their rate hikes, a process evidently begun, but not without risk. If the USFed cuts rates while Europe continues to hike rates, the USDollar will enter a profound decline. The Euro Central Bank is embroiled in a battle with French President Sarkozy. The ECB [[(read: Germany): normxxx]] wants more rate hikes to deal with price inflation. Sarkozy wants politicians to have a role in such decisions, and to be able to halt them. The European Union Monetary Affairs Commissioner Joaquin Almunia on Sept 3rd made an important public statement.
On the other side is pressure to cut rates, obviously from the French, but also from the European Trade Union Confederation. Stress reverberates throughout German banks, where US$-based subprime loans have roiled the banking system. Gold is seen as a vote in response to discontinued ECB rate hikes. Regardless, the euro currency will rise further, from the start of a USFed easing cycle, if it's not joined by Europe. Gold psychology is rising in Europe. It finds a strong bid as a vote that Trichet is bluffing. After their next and possibly final rate hike, the ECB will implicitly give the green light signal for buying gold [[I very much doubt the ECB would buy gold; they are far more likely to sell it. Europeans, on the other hand, are likely to buy. As a whole, they are more sophisticated in this matter than Americans.: normxxx]].
BRITISH: The British pound sterling money supply is growing at an annual rate of 12.8%, year over year in August. It fuels their housing bubble. Given the decline in North Sea oil production, the English economy is more reliant upon phony monetary inflation for growth, a reflection of the US situation where dependence upon home value appreciation is crucial. With an official rate of 5.75%, fully 50 basis points above the USFed official rate, England encourages bond speculation while it inhibits borrowing through higher cost. At that last hike in July, they cited limited spare capacity, elevated price pressures, and an upside balance of risk to price inflation. But England is now heading for a housing bust and economic fallout. New UK prime minister Gordon Brown explained the heretical position justifying political input in July, when he said "Rigid monetary rules that assume a fixed relationship between money and inflation do not produce reliable targets or policy." The pound sterling is basically tracking the euro currency lately. Like their ECB counter-parts, the BOE cannot hike rates when the USFed cuts, since doing so would revalue the pound sterling significantly and harmfully.
JAPAN: The Japanese, on the other hand, have been cooperative for over a year, have held rates steady since July 2006, and are grumbling about their urgent need to increase the official rate from a lunatic 0.5% now [[That's the BOJ complaining; the Ministry of Finance and the Government want no higher rates!: normxxx]]. Bank of Japan board member Atsushi Mizuno points to the loan crisis as justification for higher rates in Japan. He cites excesses that enabled unchecked borrowing helped to trigger the US subprime mortgage crisis. Mizuno sees continued Japanese economic growth, especially with billion$ in newly injected funds by central banks, with no reason to lower forecasted growth or inflation [[however, the Japanese, still recovering from well over a decade of DEflation, welcome INflation, in moderation: normxxx]]. Risky mortgage related bonds have been dumped in recent months, many funded by cheap yen loans. The Japanese yen has witnessed quite a runup. It had risen by 20% versus the New Zealand Dollar, and by 9% versus the USDollar since June and July, event before the recent activity.
What Mizuno did not mention is the dilemma facing the BOJ. The Japanese yen currency has begun to rise WITHOUT a BOJ rate hike. The USGovt and Wall Street constantly pressure Tokyo not to hike rates, and to continue funding the global carry trade. In just the last couple weeks, more chatter was heard that Tokyo financial warlords are prepared to intervene to support the USDollar. The USFed Discount Window decision also froze the Japanese central bankers. Fukui said, "If the Fed were to take some kind of policy step in September, we will closely examine whether our views match those of the Fed. There is a possibility that US growth will be restrained. That is the point we need to watch. We do not have any preset schedule on when to act." There is your green light for the yen carry trade to be revived after a stall this summer when the yen currency rose almost 10%. Easy Japanese money has been an important source for speculative investments, which might include gold more than we are aware. The yen will pull back from here [[which would be bad for gold: normxxx]].
Socialized Price Inflation
The USEconomy will next socialize price inflation as a sickening unpalatable trade-off to avert a recession, with an acceleration of job losses, home foreclosures, and careening asset declines [[stagflation!?!: normxxx]]. Rate cuts will do little to repair the housing slow motion free fall and mortgage bond quicksand. The single easiest to understood price to observe for as an inflation index, is the price of gasoline [[also food; but neither appear in the 'core' CPI index: normxxx]]. It is a surefire lock to jump past $3 per gallon by next spring and thus focus public attention. Food prices are on the rise, from energy feeder costs, from farmers' decisions, from the national movement toward ethanol fuels and away from feed corn.
Refinery constraints will worsen the problem. We may enjoy a repeat of the 2002 to 2005 runup in costs systemically, squeezing businesses' profit margins unmercifully. This time, a further corporate response by outsourcing jobs and cutting costs generally is not likely to be available. The benefit, if there ever was any to the United States as a whole, from Asian participation in globalization (mostly by providing cheap labor), is reaching a critical impasse. Thank the trade protection battles for that. A US economic response might be a sizeable push through the pipeline of some wage increases to meet the higher cost of living. Watch for this, since it might well mark the end of this round of globilization.
Oil Confirms Gold Breakout
Confirmation of resource inflation is the record crude oil price, now over $82 per barrel. Confirmation of currency debasement and monetary inflation is the approach of a record gold price, now over $742 per ounce. It is interesting. The justification of the record crude oil price is the frequent supply disruptions from numerous corners, desire by OPEC producers to exploit income revenue streams, and a powerful Asian economic expansion accompanied by strong persistent demand. These miss the mark. The crude oil price is rising from the threat of an even weaker USDollar. When the USFed announced the change in the Discount Window rate, both energy stocks and the crude oil price jumped up. Exxon Mobil (XOM) stock rise by 4.3% on the day. Crude oil on a volatile day had a 1.60 range but rose half a buck. The rise in crude oil price came before the USFed rate cut. More importantly, the OPEC nations are slowly moving toward an abandonment of the PetroDollar. The current downleg in the USDollar is likely to do irreversible damage to the PetroDollar defacto standard and invite difficult friction with key Arab nations!
The Saudis might be the last remaining pillar to that important support mechanism to the USDollar and related banking system. If the Saudis hold to their own monetary policy, they might easily deliver formidable blows to the USDollar in hidden ways. Saudi money supply growth is running at 22% with higher price inflation than seen in 30 years. A refusal to cut interest rates is seen by certain keen analysts as a precursor to a full break away from the US$ peg, an absolutely crucial move! Hans Redeker of BNP Paribas summarized well. "This is a very dangerous situation for the dollar. Saudi Arabia has $800 billion in their future generation fund, and the entire region has $3500 billion under management. They face an inflationary threat and do not want to import an interest rate policy set for recessionary conditions in the Untied States." The Saudi central bank said Thursday that they will take "appropriate measures" to halt huge capital inflows into their nation. The policy is not sustainable and will inevitably result in a resounding collapse of the US$ peg which is vital for the PetroDollar.
The United Arab Emirates still leads the movement for the entire Gulf Cooperative Council of nations to de-peg from the US$ and halt the import of price inflation into their smaller economies. UAE bankers want the entire group to depeg together. Persian Gulf economies almost all have much more commerce with Europe than the US, and a PetroEuro now makes more sense. The current UAE price inflation threatens to hit 10%.
Americans take the USDollar and its international support for granted, either out of ignorance, or out of arrogance by those "in the know". Yet, both will become victims in the next phase, from higher retail costs to [eventually] higher borrowing.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Jim Willie CB | 20 September 2007
editor of the "Hat Trick Letter"
WOW! What an interesting couple of weeks. A lousy August Jobs Report— even though it exaggerated job growth to the upside! The Birth-Death Model actually added 120 thousand mythical jobs, including construction jobs and financial sector jobs, both clearly in retreat, a blatant deception. The US Federal Reserve finally was given the gun they needed to cut interest rates. Martin Feldstein gave the USFed considerable political cover, urging cuts, claiming they were already 100 basis points too high. So gold is breaking out, crude oil is breaking out, the euro is breaking out, the Canadian looney dollar is breaking out, the HUI stock index of miners is breaking out, and the USDollar is breaking down. HATS OFF TO THE CANADIAN DOLLAR, WHICH HIT PARITY, A LONGSTANDING FORECAST OF MINE! MAY CANADIAN STOCKS BENEFIT FROM US INVESTORS SEEKING REFUGE! The USFed showed wisdom, if not veiled desperation in a rate cut of 50 basis points not only for the Fed Funds rate target, but also for the discount rate. The floodgates are now opened for monetary stimulus, monetary inflation, and higher commodity prices. Central bankers have given inflation full endorsement and approval, sufficient for a gold breakout to extend to wild levels, like $1000 before mid-2008. Nothing can stop it, because central bankers are held hostage to the crippled US financial system. They have become fast converts to monetary doves. By the way, the USFed denies they have begun an entirely new easing cycle. This is of course nonsense, as usual. With the disconnect between S&P stocks and mining stocks, any shock wave to mainstream stocks might be beneficial to the gold community.
The key commodities remain gold as a financial meter and crude oil as a commercial meter. My thesis here is a parallel concept, of vital importance to gold (silver too) and its investment arenas. The central banks have a gun at their heads, which dictates that they continue to flood money into the system without raising interest rates further. The extreme banking, bond, and growing economic distress in the United States [[actually, in the whole world!: normxxx]] prevents further rate hikes widely broadcasted by the Europeans (Germany, France, and Italy), British, and Japanese. They, together with the US and Canada, form the G7 nations of Western world banking.
Rising monetary inflation as the unintentional result of an intended policy, coupled with lowered interest rates in the United States, and stalled economic activity in Europe and Japan, constitute a near perfect scenerio for a gold spree [[especially when the "carry trade" bails out— which may already have begun: normxxx]]. The implications to the USDollar are dire. The fact that a USDX index falling below 79 has not generated much alarm tells us that it must descend closer to 70 than 75 before the alarms are sounded. What alarms are those? Clearly here, the threat is systemic cost inflation in the USEconomy NOT matched by rising wage income. The import of price inflation through the FOREX back door from a weaker USDollar exchange rate will soon become a big topic. Next on the table are bank runs, first in Countrywide, now in England's Northern Rock, and much more to come [[in all those 'non-bank banks' uninsured and unregulated by anybody: normxxx]]!!!
Gold On Notice To Launch
Gold, even as it breaks out above the 730 old highs, continues to be misunderstood. Sure, it catches the attention of network anchors, but their explanations and those from interviewed guests fall short of adequate assessment. At the same time, denials persist on the huge damage to be doled out by the USDollar decline. They have noticed the breakout above 700 and cited gold's favorable technical chart. They have identified gold as an commodity play in the same vein as crude oil and copper, which have all risen in the last couple years. They have mentioned that gold is approaching its beneficial season, as the annual holiday season invites jewelry shopping in the Western world.
But hardly anywhere in the mainstream press is the monetary reason cited in connection with gold breakout above 700. Stories do appear that the USEconomy should not tumble terribly, since the central banks have reacted so responsibly to the banking and bond problems plaguing the system. They report a 20% global money supply growth rate as the proper remedy, but fail to recognize that that is precisely why gold [[and other commodities are: normxxx]] rising. Gold reacts to monetary debasement.
My targets for gold are becoming more vague. They depend upon continued USFed rate cut action, any surprises in hedge fund blowups, massive writedown losses for major banks on mortgage bond holdings, debt ratings agency downgrades, any credit derivative backfire, sudden hit of the brick wall by the USEconomy, continued decline in housing prices, continued rise in home foreclosures, foreign central bank decisions, and breakout of military war on the Iran front. The onset of a USFed rate easing cycle presents a $1000 gold price target in the next 18 months, regardless of these numerous ongoing ingredients in a giant cauldron. Clearly, gold is heading toward $800 very soon, and probably to $1000 within one year.
- [ Normxxx Here: But recognize that at any time that the CBers want to bring its price down, they can unload tonnes of gold into a very thin market! ]
Click Here, or on the image, to see a larger, undistorted image.
We finally have a breakout on the HUI stock index of unhedged precious metals mining stocks. Gold responds to the monetary medicine, and mining stocks respond to the filtering through the system of that medicine. On a weekly open & close basis, we have an HUI index breakout. My target is 440 in the near term and 470 in the intermediate term. The filter down to Canadian junior stocks will take a few weeks or couple months, as investment institutions take action, investors return with an all clear signal, and many deal with basic fear to wade back into waters which have not been friendly this summer.
Click Here, or on the image, to see a larger, undistorted image.
The globally furnished fuel for considerable follow-through to the gold advance in breakout will be USDollar doubts, reserves defections by foreign institutions, gradual economic decline in the US, and response to the housing asset destruction [[which, despite all the furor, has scarcely slowed!: normxxx]]. Alternatives to traditional reserves investment, led by the USTreasury Bond instrument, are actively being pursued. This is the foundation to the next Mania Phase for gold. When it gathers speed and force, it will become breathtaking, attracting the enlightened individuals, then the fund managers, and finally the public. On some day in the next 18 months to two years, gold will rise by nearly $100, yes, on a single day!!! The Plunge Protection Team is slowly losing control of the situation, as new chambers show strain, like commercial interbank paper and money markets. The foreign perspective will increasingly be a witness of a desperation to prevent a USEconomic recession. That will be highly destructive to the USDollar as well, motivating flight. My forecast made several times one year ago, was that the USEconomy will be the weakest, perhaps in recession mode, in stark contrast to the global economy powered by Asian expansion. We are here. The implications for a weaker USDollar are huge, profound, and ongoing.
- [ Normxxx Here: Needless to say, I do not concur. I hardly think things have yet gotten out of control of the CBers— and as BB himself has said, the possibilities for Fed intervention in the markets are almost unlimited. I expect things to settle down into a more or less chronic monetary and economic deterioration (and, though gold may yet break $1000, it will not break $1500 any time soon). 2008 and early 2009 are still looking up to be middling to good for the stock market, gold, and the economy. Indeed, at this point, the stock market is as likely to rise as gold— for the same reasons, namely, devaluation of the dollar relative to other currencies. ]
The Asians, with their huge trade surpluses, will direct increasing amounts of funds into gold, crude oil stockpiles, metal ore stockpiles, properties which produce the same, and entire companies which own such properties. The new trend of government sovereign funds is an important vehicle with which to manifest those investments. They are looking away from the traditional knee-jerk USTBond investments. Look for China to increasingly purchase gold, not just for their own best economic benefit, but also to send a message to Americans deliberately intended to rattle their financial cages. At the same time, the Asians will soon begin funding their own credit market(s) for regional development. Continued reliance upon the USTreasury Bond as the entire superstructure for the financial system, even in just Asia, now seems highly impractical. GOLD STANDS READY TO ANSWER THE INVESTMENT CALL BY ASIANS AS MORE STABLE AND PROFITABLE ASSETS ARE SOUGHT.
- [ Normxxx Here: Stable is why gold is such a good investment in unstable financial times, but (since it pays no interest, and costs 'overhead' to insure, protect, and store) is a lousy investment in stable financial times. ]
Gold and Dollar Decoupoing
A grand decouple is coming, as the world financial system has begun to separate from the modified "Bretton Woods Agreement," also known (in part) as the "floating Bretton Woods" or (in part) as "Bretton Woods II", whereby the asiatic currencies (and many other weak currencies), at least, remain pegged to the dollar, but most of the 'stronger' currencies "floated". They realize that their own currencies can and must be managed to realize greater stability than remaining pegged to the dollar. This stands in contrast to unchecked credit growth, unbridled financial leverage, and the machinations of Wall Street and the G7 financial machinery. They have come to realize that pegging to the dollar is a two-edged sword that permits too much financial risk to be 'exported' from the US.
Money will soon flow into the gold sector at an accelerated pace, on a global basis. The Fed will continue cutting interest rates, will expand its balance sheet in monetized assets (that nobody else wants), and start to print money at a faster rate than the 14% of recent months [[actually, the Fed has been adding at less than 3%, or around the inflation rate— the rest has been 'credit' money, added by various banking and pseudo-banking enterprises.: normxxx]]. A two week growth, when annualized, pressed toward 50% in money supply growth was just registered in September!!! [[That's true!: normxxx]] Other governments, now reluctant to be accommodative, will eventually engage in a race to the bottom, to outdo each other in creating money. Political participation is not far off, with even greater deficit spending measures and consumer debt relief proposals, to climax in rescue packages to save BOTH housing prices and mortgage bonds. House values must be halted in their decline, while mortgages bonds must find a strong buyer of last resort[!?!]
Foreign Central Banks Frozen Solid
European and Japanese central bankers stand on similar conflicted positions. In the first week of September, the Euro Central Bank held steady at 4.0%, and did not hike interest rates as originally intended, but simply talked in stern tones about their vigilance against price inflation. The Bank of England also held pat on rates at 5.75%, as did the Bank of Canada and Australia. Citation of 'financial market turbulence' sounds simple, but banking distress and reluctance to see their native currencies appreciate are other, more germaine, motives, given the huge problems facing the United States [[and hardly just the US!: normxxx]]. We see a cooperative move to offer assistance to the USFed, cornered and facing an urgent need to cut rates.
Debate over monetary matters in Brussels and London ended suddenly when the USFed cut the Discount Window rate [[but this was done to forestall total seizure of the European banks!: normxxx]]. The banking world took notice, as a gigantic distress flag emerged. None of the major and secondary nations can alone reign in their vast money supply growth. The reversal in USFed monetary policy will have broad global implications not only on continued money supply growth, but also add to the speculative fervor in alternatives like gold and other commodities.
The problems of the [Too Big To Fail Bank] Northern Rock in the UK highlights the ongoing intractable situation, a story of insolvency free of US subprime roots [[not entirely; it is being brought down by failure of the international commercial paper market, which has caught the contagion from those sub-primes: normxxx]], a disaster on British soil. Bank of England head Mervyn King declared that bad practices in the banks should not be rewarded, but may have reversed his position. [[The spreading cancer of lack of CREDIBILITY has suddenly rendered central bankers into monetary doves.: normxxx]] The entire Western world banking system, especially the US and England, is a house of cards [[built on FAITH: normxxx]], built on the quicksand of a housing bubble!
The rally in gold and related mining stock investments will quickly enter the next phase, powered by global inflation, easier terms for money, and defensive desperation by central banks to ward off recession and massive asset deflation. Whether the USDollar will be harmed and sent lower will be of secondary importance, in the larger sphere. The key is keeping unbridled retail inflation in check in the US, Europe, and Japan, in coordinated fashion, while providing enough stimulus for the various economies. The stimulus to prevent profound economic reversals is always of the higher priority.
EUROPE: The USFed requires foreign central banks to halt their rate hikes, a process evidently begun, but not without risk. If the USFed cuts rates while Europe continues to hike rates, the USDollar will enter a profound decline. The Euro Central Bank is embroiled in a battle with French President Sarkozy. The ECB [[(read: Germany): normxxx]] wants more rate hikes to deal with price inflation. Sarkozy wants politicians to have a role in such decisions, and to be able to halt them. The European Union Monetary Affairs Commissioner Joaquin Almunia on Sept 3rd made an important public statement.
- "The current cycle of Eurozone interest rate tightening is nearing its end. The main part of the interest rate rise is already done. I do not think its is going to rise much more. In the very short term, rate cuts will not be announced, but for sure, in the medium term, interest rates are going to fall because the Spanish, European, and world economies are fundamentally solid."
On the other side is pressure to cut rates, obviously from the French, but also from the European Trade Union Confederation. Stress reverberates throughout German banks, where US$-based subprime loans have roiled the banking system. Gold is seen as a vote in response to discontinued ECB rate hikes. Regardless, the euro currency will rise further, from the start of a USFed easing cycle, if it's not joined by Europe. Gold psychology is rising in Europe. It finds a strong bid as a vote that Trichet is bluffing. After their next and possibly final rate hike, the ECB will implicitly give the green light signal for buying gold [[I very much doubt the ECB would buy gold; they are far more likely to sell it. Europeans, on the other hand, are likely to buy. As a whole, they are more sophisticated in this matter than Americans.: normxxx]].
BRITISH: The British pound sterling money supply is growing at an annual rate of 12.8%, year over year in August. It fuels their housing bubble. Given the decline in North Sea oil production, the English economy is more reliant upon phony monetary inflation for growth, a reflection of the US situation where dependence upon home value appreciation is crucial. With an official rate of 5.75%, fully 50 basis points above the USFed official rate, England encourages bond speculation while it inhibits borrowing through higher cost. At that last hike in July, they cited limited spare capacity, elevated price pressures, and an upside balance of risk to price inflation. But England is now heading for a housing bust and economic fallout. New UK prime minister Gordon Brown explained the heretical position justifying political input in July, when he said "Rigid monetary rules that assume a fixed relationship between money and inflation do not produce reliable targets or policy." The pound sterling is basically tracking the euro currency lately. Like their ECB counter-parts, the BOE cannot hike rates when the USFed cuts, since doing so would revalue the pound sterling significantly and harmfully.
JAPAN: The Japanese, on the other hand, have been cooperative for over a year, have held rates steady since July 2006, and are grumbling about their urgent need to increase the official rate from a lunatic 0.5% now [[That's the BOJ complaining; the Ministry of Finance and the Government want no higher rates!: normxxx]]. Bank of Japan board member Atsushi Mizuno points to the loan crisis as justification for higher rates in Japan. He cites excesses that enabled unchecked borrowing helped to trigger the US subprime mortgage crisis. Mizuno sees continued Japanese economic growth, especially with billion$ in newly injected funds by central banks, with no reason to lower forecasted growth or inflation [[however, the Japanese, still recovering from well over a decade of DEflation, welcome INflation, in moderation: normxxx]]. Risky mortgage related bonds have been dumped in recent months, many funded by cheap yen loans. The Japanese yen has witnessed quite a runup. It had risen by 20% versus the New Zealand Dollar, and by 9% versus the USDollar since June and July, event before the recent activity.
What Mizuno did not mention is the dilemma facing the BOJ. The Japanese yen currency has begun to rise WITHOUT a BOJ rate hike. The USGovt and Wall Street constantly pressure Tokyo not to hike rates, and to continue funding the global carry trade. In just the last couple weeks, more chatter was heard that Tokyo financial warlords are prepared to intervene to support the USDollar. The USFed Discount Window decision also froze the Japanese central bankers. Fukui said, "If the Fed were to take some kind of policy step in September, we will closely examine whether our views match those of the Fed. There is a possibility that US growth will be restrained. That is the point we need to watch. We do not have any preset schedule on when to act." There is your green light for the yen carry trade to be revived after a stall this summer when the yen currency rose almost 10%. Easy Japanese money has been an important source for speculative investments, which might include gold more than we are aware. The yen will pull back from here [[which would be bad for gold: normxxx]].
Socialized Price Inflation
The USEconomy will next socialize price inflation as a sickening unpalatable trade-off to avert a recession, with an acceleration of job losses, home foreclosures, and careening asset declines [[stagflation!?!: normxxx]]. Rate cuts will do little to repair the housing slow motion free fall and mortgage bond quicksand. The single easiest to understood price to observe for as an inflation index, is the price of gasoline [[also food; but neither appear in the 'core' CPI index: normxxx]]. It is a surefire lock to jump past $3 per gallon by next spring and thus focus public attention. Food prices are on the rise, from energy feeder costs, from farmers' decisions, from the national movement toward ethanol fuels and away from feed corn.
Refinery constraints will worsen the problem. We may enjoy a repeat of the 2002 to 2005 runup in costs systemically, squeezing businesses' profit margins unmercifully. This time, a further corporate response by outsourcing jobs and cutting costs generally is not likely to be available. The benefit, if there ever was any to the United States as a whole, from Asian participation in globalization (mostly by providing cheap labor), is reaching a critical impasse. Thank the trade protection battles for that. A US economic response might be a sizeable push through the pipeline of some wage increases to meet the higher cost of living. Watch for this, since it might well mark the end of this round of globilization.
Oil Confirms Gold Breakout
Confirmation of resource inflation is the record crude oil price, now over $82 per barrel. Confirmation of currency debasement and monetary inflation is the approach of a record gold price, now over $742 per ounce. It is interesting. The justification of the record crude oil price is the frequent supply disruptions from numerous corners, desire by OPEC producers to exploit income revenue streams, and a powerful Asian economic expansion accompanied by strong persistent demand. These miss the mark. The crude oil price is rising from the threat of an even weaker USDollar. When the USFed announced the change in the Discount Window rate, both energy stocks and the crude oil price jumped up. Exxon Mobil (XOM) stock rise by 4.3% on the day. Crude oil on a volatile day had a 1.60 range but rose half a buck. The rise in crude oil price came before the USFed rate cut. More importantly, the OPEC nations are slowly moving toward an abandonment of the PetroDollar. The current downleg in the USDollar is likely to do irreversible damage to the PetroDollar defacto standard and invite difficult friction with key Arab nations!
The Saudis might be the last remaining pillar to that important support mechanism to the USDollar and related banking system. If the Saudis hold to their own monetary policy, they might easily deliver formidable blows to the USDollar in hidden ways. Saudi money supply growth is running at 22% with higher price inflation than seen in 30 years. A refusal to cut interest rates is seen by certain keen analysts as a precursor to a full break away from the US$ peg, an absolutely crucial move! Hans Redeker of BNP Paribas summarized well. "This is a very dangerous situation for the dollar. Saudi Arabia has $800 billion in their future generation fund, and the entire region has $3500 billion under management. They face an inflationary threat and do not want to import an interest rate policy set for recessionary conditions in the Untied States." The Saudi central bank said Thursday that they will take "appropriate measures" to halt huge capital inflows into their nation. The policy is not sustainable and will inevitably result in a resounding collapse of the US$ peg which is vital for the PetroDollar.
The United Arab Emirates still leads the movement for the entire Gulf Cooperative Council of nations to de-peg from the US$ and halt the import of price inflation into their smaller economies. UAE bankers want the entire group to depeg together. Persian Gulf economies almost all have much more commerce with Europe than the US, and a PetroEuro now makes more sense. The current UAE price inflation threatens to hit 10%.
Americans take the USDollar and its international support for granted, either out of ignorance, or out of arrogance by those "in the know". Yet, both will become victims in the next phase, from higher retail costs to [eventually] higher borrowing.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Wednesday, September 19, 2007
Trade on the U.S. Dollar?
Tactical Trade on the U.S. Dollar? [¹]
By Henry To | 19 September 2007
Let us begin our commentary by first providing an update on our three most recent signals in our DJIA Timing System:
1st signal entered: 50% long position on September 7, 2006 at 11,385;
2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;
3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.
As of Sunday evening on September 16th, we are still neutral in our DJIA Timing System. At this point, we are still not looking to go long in our DJIA Timing System just yet, as we believe that there is a good chance of a retest of the mid-August lows— as we have already discussed in many of our past commentaries. As always, should we decide go long in our DJIA Timing System, we will email all our subscribers on a real-time basis informing of the change, but as of today, we do not expect this to happen anytime soon.
Before we jump into the subject of our commentary, I want to discuss a contrarian indicator that we use at turning points in the market: Mutual Fund Inflows And Outflows. As long-time subscribers know, the latest mutual fund inflows/outflows data is released by http://www.amgdata.com every Wednesday night. By looking at mutual fund inflows/outflows, one can often times spot a changing trend in the market from a contrarian standpoint. That is, during months when inflows are abnormally high (such as January to March 2000, or January 2004), there is a reasonable chance that the market is reaching a significant top, while during months when we see outflows, there is usually a good chance that the market is nearing a bottom, such as during August 1998 or during the fateful period of June 2002 to October 2002. In interpreting these numbers, this author usually likes to look at pure mutual fund flows, as opposed to fund flows including ETF flows.
There is a good reason for doing this. Keep in mind that holders of mutual funds usually represent investors that are not active in trading (i.e. 401(k) and 403(b) account holders, defined benefit plans, etc.) and thus are not as apt to keep up with the financial markets or the economy. In other words— to the extent that they try to time the markets by redeeming their mutual funds— they are usually dead wrong. On the contrary, while not all folks who trade ETFs may be professional investors or hedge fund managers, many of these folks are more knowledgeable about the markets and why it is moving, and therefore are better market timers in general than mutual fund holders. In other words, for contrarian-timing purposes, it is more reliable to look at mutual fund excluding ETF inflows/outflows rather than total inflows/outflows.
Moreover, it is important to keep the size of the mutual fund and the ETF market in perspective. According to ICI, total equity mutual fund assets were US$6.4 trillion at the end of July 2007, while total balanced mutual fund assets were US$688 billion. Assuming that 60% of all balanced mutual funds are invested in equities (which is a conservative assumption), that means that is approximately US$413 billion of equity assets held in balanced funds. In total, that is US$6.8 trillion of equities held in U.S. mutual funds. Compare this with ETF assets— where we have $315 billion in domestic equity ETFS and $147 billion in global equity ETFs. In other words, equity ETF assets still make up less than 7% of all equity mutual fund assets in the US. At this point, "throwing away" ETF inflow/outflow is still a relatively safe bet.
So Henry, what are your mutual fund inflow/outflow indicators telling you now? And how did mutual fund outflows during August of this year compare to past historical outflows? Is this indicator telling us that we may have a significant bottom in place?
First, a disclaimer. The official mutual fund inflows/outflows data for August will not be released until two weeks from now, so all the August numbers that we are currently citing are just estimates. However, using the weekly data from http://www.amgdata.com, we can make a good guess. According to http://www.amgdata.com, equity (domestic and global) mutual fund outflows (again, excluding ETF flows) were approximately US$9 billion in August. Following is a monthly chart (courtesy of Reuters EcoWin) showing mutual fund inflows/outflows from January 1995 to August 2007 (note that the August 2007 number is just an estimate at this time):
Click Here, or on the image, to see a larger, undistorted image.
As mentioned on the above chart, the estimated net outflows from U.S. equity mutual funds during August is approximately $9 billion— representing the highest outflow since June 2006— the last time that the S&P made a significant bottom. More importantly, aside from the June 2006 outflow, U.S. equity mutual funds have not previously witnessed another outflow since February 2003, when U.S. mutual fund holders redeemed $11 billion from equity mutual funds. In an ongoing cyclical bull market (such as during the end of summer last year when this author went long in our DJIA Timing System), this would have been a strong signal to go long— but as I have mentioned many times before, we are now witnessing the end of a variety of bull markets in the financial markets today. No, not the equity kind, but we are now witnessing the end of a cyclical bull market in structured finance, in REITs, in private equity funds, and potentially in hedge funds as well.
As I have mentioned before, we have had a genuine credit crisis for the last six weeks and we still do— and a genuine credit crisis usually ends with some sort of capitulation by investors as they dump every liquid asset they could get their hands on, including, of course, equities (note that "Black Swans" usually occur more frequently during times of credit contraction). For now, I do not believe the mid August decline represented capitulation, and given the mediocre breadth and volume we have witnessed in the rally of the U.S. and global equity markets (with the exception of the Chinese and Hong Kong stock markets) since mid August, my guess is that we are due for a retest of the mid August lows sometime over the next few weeks.
As I am typing this [[Monday morning?: normxxx]], the FTSE 100 is down more than 1% on the catastrophic developments over the weekend in the UK— as doubts grew that the 8th largest bank and 5th largest mortgage lender in the UK, Northern Rock, will survive as an independent going concern. In a demonstration of early 20th century "laissez faire" central banking, the Bank of England has refused to step in and mediate or expedite any takeover attempts by potential private sector bidders, as it believes that "the market will take care of itself." Case in point: Lloyds TSB was mulling a bid for Northern Rock as early as the beginning of last week, but the deal fell apart when the Bank of England refused to lend monetary support to the deal— as the BoE did not want to "subsidize" the bailout of a private bank. Given the money markets are still closed, chances are that no bidders would show up now unless there is a fire sale of Northern Rock's assets.
Since Friday morning, more than 2 billion pounds (or 7% of the deposit base) at Northern Rock has been withdrawn or transferred to other financial institutions. Chances are that this will rise going forward, given the disastrous news over the weekend and the fact that 10 billion pounds are held in postal accounts at Northern Rock (it usually takes a week or so for the paperwork to go through to withdraw funds from these postal accounts). This is perfectly understandable— as the UK's Financial Service Authority will only guarantee 100% of deposits up to £2,000, and 90% up to £32,000. For those with deposits over £32,000, you are out of luck if Northern Rock goes under (the Northern Rock customers who were laughing at the queues on Friday are not feeling so amused now).
Whether this current crisis will blossom into something bigger remains to be seen— but if the Bank of England continues to sit on its hands, then it very well may. For what it's worth, GaveKal is now calling this the biggest disaster for the UK financial system since Black Wednesday of 15 years ago.
Let us now shift to our major topic of this commentary: the U.S. Dollar Index. Over the last two and a half years, we have— off and on— gotten bullish in the U.S. Dollar Index (see our May 1, 2005 and November 12, 2006 commentaries). While the official calls that we made in our commentaries were, for the most part, correct and tradable on the long side in the short-run— in retrospect, the "bullish dollar" call was far too early and (so far) has not yet substantially panned out as we expect over the longer-run. We do still stand by our original thesis— that over the longer-run, while most Asian currencies should out perform the U.S. Dollar (not only because of higher economic growth in Asia ex. Japan, but also because of the differences from a purchasing power parity standpoint), things are not so clear in either the UK or Euroland.
I have discussed our many reasons before, but among them are: 1) deteriorating demographics, combined with the lack of a coherent immigration policy of young and enthusiastic talent with good education, 2) lack of structural reforms, 3) housing bust in Spain,
But, over the short-term, this author is still not willing to go long the U.S. Dollar just yet. The reasons is that the growth in foreign reserves held in the custody of the Federal Reserve has continued to increase exponentially over the last six months, signaling that there is still far "too much U.S. Dollars" in the system. For readers who have not been with us for long, we first discussed the high (negative) correlation between the change in the rate of growth in the amount of foreign assets (i.e. the second derivative) held in the custody of the Federal Reserve and the year-over-year return in the U.S. Dollar Index in our May 1, 2005 commentary. In that commentary, I stated:
Click Here, or on the image, to see a larger, undistorted image.
Please note that the second y-axis has been inverted. This is done in order to illustrate to our readers the significant negative correlation between the annual change in the dollar index and the annual change in the growth (second derivative) of foreign assets held at the Federal Reserve banks. Please note that while the recent change in the growth of foreign reserves has slightly decreased (while the U.S. dollar has decreased significantly on a year-over-year basis), the divergence between the rate of growth in foreign reserves and the decline of the U.S. dollar index is still not wide enough for us to bet on the dollar one way or another. Historically, the action in the U.S. Dollar Index and our foreign reserves indicator does not diverge for long— suggesting that the U.S. dollar should rise at some point, unless foreign reserve growth accelerates from here. We will update our readers once the above chart flashes a "buy" on the U.S. dollar index.
Another way to spot a good entry point on the U.S. Dollar Index is to keep track of its percentage deviation from its 200-day simple moving average. This is one of the advantages of using an overbought/oversold indicator on a major currency— and especially the world's reserve currency— as major currencies usually do not gap up or gap down in a major way. That is, as long as there are no abnormally sinister forces in the market place (such as Japanese housewives speculating on foreign currencies)— buying the dollar index when it is oversold (e.g. when it is trading at 5% below its 200-day moving average) has usually been a profitable endeavor, as long as one is not heavily leveraged.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Henry To | 19 September 2007
Let us begin our commentary by first providing an update on our three most recent signals in our DJIA Timing System:
1st signal entered: 50% long position on September 7, 2006 at 11,385;
2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;
3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.
As of Sunday evening on September 16th, we are still neutral in our DJIA Timing System. At this point, we are still not looking to go long in our DJIA Timing System just yet, as we believe that there is a good chance of a retest of the mid-August lows— as we have already discussed in many of our past commentaries. As always, should we decide go long in our DJIA Timing System, we will email all our subscribers on a real-time basis informing of the change, but as of today, we do not expect this to happen anytime soon.
Before we jump into the subject of our commentary, I want to discuss a contrarian indicator that we use at turning points in the market: Mutual Fund Inflows And Outflows. As long-time subscribers know, the latest mutual fund inflows/outflows data is released by http://www.amgdata.com every Wednesday night. By looking at mutual fund inflows/outflows, one can often times spot a changing trend in the market from a contrarian standpoint. That is, during months when inflows are abnormally high (such as January to March 2000, or January 2004), there is a reasonable chance that the market is reaching a significant top, while during months when we see outflows, there is usually a good chance that the market is nearing a bottom, such as during August 1998 or during the fateful period of June 2002 to October 2002. In interpreting these numbers, this author usually likes to look at pure mutual fund flows, as opposed to fund flows including ETF flows.
There is a good reason for doing this. Keep in mind that holders of mutual funds usually represent investors that are not active in trading (i.e. 401(k) and 403(b) account holders, defined benefit plans, etc.) and thus are not as apt to keep up with the financial markets or the economy. In other words— to the extent that they try to time the markets by redeeming their mutual funds— they are usually dead wrong. On the contrary, while not all folks who trade ETFs may be professional investors or hedge fund managers, many of these folks are more knowledgeable about the markets and why it is moving, and therefore are better market timers in general than mutual fund holders. In other words, for contrarian-timing purposes, it is more reliable to look at mutual fund excluding ETF inflows/outflows rather than total inflows/outflows.
Moreover, it is important to keep the size of the mutual fund and the ETF market in perspective. According to ICI, total equity mutual fund assets were US$6.4 trillion at the end of July 2007, while total balanced mutual fund assets were US$688 billion. Assuming that 60% of all balanced mutual funds are invested in equities (which is a conservative assumption), that means that is approximately US$413 billion of equity assets held in balanced funds. In total, that is US$6.8 trillion of equities held in U.S. mutual funds. Compare this with ETF assets— where we have $315 billion in domestic equity ETFS and $147 billion in global equity ETFs. In other words, equity ETF assets still make up less than 7% of all equity mutual fund assets in the US. At this point, "throwing away" ETF inflow/outflow is still a relatively safe bet.
So Henry, what are your mutual fund inflow/outflow indicators telling you now? And how did mutual fund outflows during August of this year compare to past historical outflows? Is this indicator telling us that we may have a significant bottom in place?
First, a disclaimer. The official mutual fund inflows/outflows data for August will not be released until two weeks from now, so all the August numbers that we are currently citing are just estimates. However, using the weekly data from http://www.amgdata.com, we can make a good guess. According to http://www.amgdata.com, equity (domestic and global) mutual fund outflows (again, excluding ETF flows) were approximately US$9 billion in August. Following is a monthly chart (courtesy of Reuters EcoWin) showing mutual fund inflows/outflows from January 1995 to August 2007 (note that the August 2007 number is just an estimate at this time):
Click Here, or on the image, to see a larger, undistorted image.
As mentioned on the above chart, the estimated net outflows from U.S. equity mutual funds during August is approximately $9 billion— representing the highest outflow since June 2006— the last time that the S&P made a significant bottom. More importantly, aside from the June 2006 outflow, U.S. equity mutual funds have not previously witnessed another outflow since February 2003, when U.S. mutual fund holders redeemed $11 billion from equity mutual funds. In an ongoing cyclical bull market (such as during the end of summer last year when this author went long in our DJIA Timing System), this would have been a strong signal to go long— but as I have mentioned many times before, we are now witnessing the end of a variety of bull markets in the financial markets today. No, not the equity kind, but we are now witnessing the end of a cyclical bull market in structured finance, in REITs, in private equity funds, and potentially in hedge funds as well.
As I have mentioned before, we have had a genuine credit crisis for the last six weeks and we still do— and a genuine credit crisis usually ends with some sort of capitulation by investors as they dump every liquid asset they could get their hands on, including, of course, equities (note that "Black Swans" usually occur more frequently during times of credit contraction). For now, I do not believe the mid August decline represented capitulation, and given the mediocre breadth and volume we have witnessed in the rally of the U.S. and global equity markets (with the exception of the Chinese and Hong Kong stock markets) since mid August, my guess is that we are due for a retest of the mid August lows sometime over the next few weeks.
As I am typing this [[Monday morning?: normxxx]], the FTSE 100 is down more than 1% on the catastrophic developments over the weekend in the UK— as doubts grew that the 8th largest bank and 5th largest mortgage lender in the UK, Northern Rock, will survive as an independent going concern. In a demonstration of early 20th century "laissez faire" central banking, the Bank of England has refused to step in and mediate or expedite any takeover attempts by potential private sector bidders, as it believes that "the market will take care of itself." Case in point: Lloyds TSB was mulling a bid for Northern Rock as early as the beginning of last week, but the deal fell apart when the Bank of England refused to lend monetary support to the deal— as the BoE did not want to "subsidize" the bailout of a private bank. Given the money markets are still closed, chances are that no bidders would show up now unless there is a fire sale of Northern Rock's assets.
Since Friday morning, more than 2 billion pounds (or 7% of the deposit base) at Northern Rock has been withdrawn or transferred to other financial institutions. Chances are that this will rise going forward, given the disastrous news over the weekend and the fact that 10 billion pounds are held in postal accounts at Northern Rock (it usually takes a week or so for the paperwork to go through to withdraw funds from these postal accounts). This is perfectly understandable— as the UK's Financial Service Authority will only guarantee 100% of deposits up to £2,000, and 90% up to £32,000. For those with deposits over £32,000, you are out of luck if Northern Rock goes under (the Northern Rock customers who were laughing at the queues on Friday are not feeling so amused now).
Whether this current crisis will blossom into something bigger remains to be seen— but if the Bank of England continues to sit on its hands, then it very well may. For what it's worth, GaveKal is now calling this the biggest disaster for the UK financial system since Black Wednesday of 15 years ago.
Let us now shift to our major topic of this commentary: the U.S. Dollar Index. Over the last two and a half years, we have— off and on— gotten bullish in the U.S. Dollar Index (see our May 1, 2005 and November 12, 2006 commentaries). While the official calls that we made in our commentaries were, for the most part, correct and tradable on the long side in the short-run— in retrospect, the "bullish dollar" call was far too early and (so far) has not yet substantially panned out as we expect over the longer-run. We do still stand by our original thesis— that over the longer-run, while most Asian currencies should out perform the U.S. Dollar (not only because of higher economic growth in Asia ex. Japan, but also because of the differences from a purchasing power parity standpoint), things are not so clear in either the UK or Euroland.
I have discussed our many reasons before, but among them are: 1) deteriorating demographics, combined with the lack of a coherent immigration policy of young and enthusiastic talent with good education, 2) lack of structural reforms, 3) housing bust in Spain,
- [ Normxxx Here: which is likely to get extremely dramatic over the next few years ]
But, over the short-term, this author is still not willing to go long the U.S. Dollar just yet. The reasons is that the growth in foreign reserves held in the custody of the Federal Reserve has continued to increase exponentially over the last six months, signaling that there is still far "too much U.S. Dollars" in the system. For readers who have not been with us for long, we first discussed the high (negative) correlation between the change in the rate of growth in the amount of foreign assets (i.e. the second derivative) held in the custody of the Federal Reserve and the year-over-year return in the U.S. Dollar Index in our May 1, 2005 commentary. In that commentary, I stated:
- Studies by GaveKal (which is one of the best investment advisory outfits out there) have shown that, historically, the return of the U.S. Dollar Index has been very much correlated with the growth in the amount of foreign assets (which is pretty much all U.S. dollar-denominated) held in the custody of the Federal Reserve. By my calculations, the correlation between the annual return of the U.S. Dollar Index and the annual growth of the amount of foreign assets held at the Federal Reserve banks (calculated monthly) is an astounding negative 61% during the period January 1981 to February 2005! That is, whenever, the rate of growth of foreign assets (primarily in the form of Treasury Securities) held at the Federal Reserve banks have decreased, the U.S. Dollar has almost always rallied. This is very logical, as an increasing growth of U.S. dollar-denominated assets mean an increasing growth of the supply of U.S. dollars— thus depressing its value.
Click Here, or on the image, to see a larger, undistorted image.
Please note that the second y-axis has been inverted. This is done in order to illustrate to our readers the significant negative correlation between the annual change in the dollar index and the annual change in the growth (second derivative) of foreign assets held at the Federal Reserve banks. Please note that while the recent change in the growth of foreign reserves has slightly decreased (while the U.S. dollar has decreased significantly on a year-over-year basis), the divergence between the rate of growth in foreign reserves and the decline of the U.S. dollar index is still not wide enough for us to bet on the dollar one way or another. Historically, the action in the U.S. Dollar Index and our foreign reserves indicator does not diverge for long— suggesting that the U.S. dollar should rise at some point, unless foreign reserve growth accelerates from here. We will update our readers once the above chart flashes a "buy" on the U.S. dollar index.
Another way to spot a good entry point on the U.S. Dollar Index is to keep track of its percentage deviation from its 200-day simple moving average. This is one of the advantages of using an overbought/oversold indicator on a major currency— and especially the world's reserve currency— as major currencies usually do not gap up or gap down in a major way. That is, as long as there are no abnormally sinister forces in the market place (such as Japanese housewives speculating on foreign currencies)— buying the dollar index when it is oversold (e.g. when it is trading at 5% below its 200-day moving average) has usually been a profitable endeavor, as long as one is not heavily leveraged.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Tuesday, September 18, 2007
Greenspan Warns...
Greenspan warns dollar to fall victim to current account deficit [¹]
By Edmund Conway,Telegraph.co.uk, Economics Editor | 18 September 2007
Alan Greenspan is warning that inflation is set to double. The former Federal Reserve chairman predicts that within only a few years the world will undergo a huge spike in prices. He says central banks will have to raise interest rates to double-digit levels to hold down inflation.
In an exclusive interview with The Daily Telegraph, he predicts Mervyn King will miss the Bank of England inflation target countless times in the coming years as the Governor tries to keep UK prices under control. He also:
Alan Greenspan
The Telegraph has serialised the eagerly awaited memoirs of Alan Greenspan, who spent almost two decades at the helm of the world's biggest economy as chairman of the Federal Reserve.
In an exclusive interview with Edmund Conway, the Daily Telegraph's Economics Editor, Greenspan predicts a painful correction for the UK housing market and says the full impact of the credit crunch has yet to be felt.
LEGACY
Greenspan says critics are wrong
Greenspan has been blamed for the US sub-prime crisis. Unrepentant, he tells Edmund Conway his critics are wrong.
Audio: Greenspan defends his record
Video: Decades of turbulence at the Fed
Your view: Is Alan Greenspan to blame for the credit crunch?
UK Warning
UK housing set for a painful correction
Warning of 'difficulties' for UK home owners.
UK more vulnerable than US to crunch
Higher number of adjustable-rate mortgages raises exposure for UK economy.
Iraq
'Iraq war was about oil'
Alan Greenspan has launched a stinging attack on George W Bush and Tony Blair.
Dollar
Greenspan gives warning over dollar
Former Fed chairman expects America's deficit to catch-up with greenback.
Comment
Greenspan 'was too much the rock star'
We forget, but Greenspan first rose in Washington as a Nixon political aide.
Full transcript of interview
Exclusive extract on the 1987 crash
How I dealt with the aftermath of 9/11
In exclusive extracts from his new book, The Age of Turbulence: Adventures in a New World, Alan Greenspan, former chairman of the US Federal Reserve, tells the story of his life and times at the centre of Wall Street and Washington.
Alan Greenspan in depth
GREENSPAN ON...
The 1987 crash
I felt like a seven-armed paperhanger, going from one phone to another. I was not inclined to panic because I understood the nature of the problems we would face.
The response
Our public statement had been painstakingly worded. It was as short and concise as the Gettysburg Address, though possibly not as stirring.
President H.W. Bush
I was saddened when I discovered that he blamed me for his [election] loss. His bitterness surprises me. I did not feel the same way about him.
President Clinton
By mid-1995 we had settled into an easy impromptu relationship. I never thought he would reappoint me.
The dotcom era
The dual forces of information technology and globalisation were taking hold.
Inspiration
The concept of irrational exuberance came to me in the bathtub. It's where I get many of my best ideas.
Overheating
It wasn't that I wanted to stand up and shout 'the stock market is over-valued' but I thought it important to put the issue on the table.
The LTCM saga
Hollywood could not have scripted a more dramatic financial train wreck.
Market mayhem
Panic in a market is like liquid nitrogen— it can quickly cause a devastating freeze.
Bursting bubbles
How do you draw the line between a healthy, exciting boom and a wanton, speculative bubble driven by the less savoury aspects of human nature?
Post-9/11
For a full year and a half we were in limbo. Growth was uncertain and weak; business and investors felt besieged.
Shopping
Consumer spending carried the economy through the post-9/11 malaise and what carried consumer spending was housing.
Sub-prime times
I was aware loosening mortgage credit terms for sub-prime borrowers increased financial risk but I believe the benefits of broadened home ownership are worth it.
The UK Government
To its credit New Labour embraced the new freedoms begun by Margaret Thatcher, tempering the historical socialist ethos with a fresh emphasis on opportunity.
On top of the world
Today London is arguably the leader in cross-border finance but New York remains the financial capital of the world.
1987...
I felt a real need to hit the ground running because I knew the Fed would soon face big decisions. The Reagan-era expansion was well into its fourth year and while the economy was thriving, it was also showing clear signs of instability.
Since the beginning of the year, when the Dow Jones Industrial Average had risen through 2,000 for the first time, the stock market had run up more than 40%. Now it stood at more than 2,700 and Wall Street was in a speculative froth. The dollar was falling, and people were worried about America losing its competitive edge— the media were full of alarmist talk about the growing "Japanese threat".
I thought a rate increase would be prudent, but the Fed hadn't raised interest rates for three years. Signs of trouble in the economy continued to mount. Slowing growth and a further weakening of the dollar put Wall Street on edge, as investors and institutions began confronting the likelihood that billions of dollars in speculative bets would never pay off.
In early October, that fear turned to near panic. The worst loss was on Friday, October 16, when the Dow Jones average dropped by 108 points. Since the end of September nearly half a trillion dollars of paper wealth had evaporated in the stock market alone, not to mention the losses in currency and other markets.
I was supposed to fly on Monday afternoon to Dallas. That morning I conferred with the Board of Governors, and we agreed that I should make the trip, lest it seem that the Fed was in a panic. There was no telephone on the plane. So the first thing I did when I arrived was to ask one of the people who greeted me from the Federal Reserve Bank of Dallas: "How did the stock market finally go?" He said: "It was down five oh eight."
Usually when someone says "five oh eight," he means 5.08. So the market had dropped only 5 points. "Great," I replied. "What a terrific rally." But as I said it, I saw that the expression on his face was not shared relief. In fact, the market had crashed by 508 points, a 22.5% drop, the biggest one-day loss in history and bigger even than on the day that started the Great Depression, Black Friday 1929.
I went straight to the hotel, where I stayed on the phone into the night.
I was not inclined to panic, because I understood the nature of the problems we would face. Still, when I hung up the phone around midnight, I wondered if I'd be able to sleep. That would be the real test. "Now we're going to see what you're made of," I told myself as I went to bed, and, I'm proud to say, I slept for a good five hours.
The next thirty-six hours were intense. I joked that I felt like a seven-armed paperhanger, going from one phone to another, talking to the stock exchange, the Chicago futures exchanges, and the various Federal Reserve presidents. My most harrowing conversations were with financiers and bankers I'd known for years, major players from very large companies around the country, whose voices were tightened by fear.
The Fed attacked the crisis on two fronts. Our first challenge was Wall Street: we had to persuade giant trading firms and investment banks, many of which were reeling from losses, not to pull back from doing business. Our public statement early that morning had been painstakingly worded to hint that the Fed would provide a safety net for banks, in the expectation that they, in turn, would help support other financial companies.
It was as short and concise as the Gettysburg Address, I thought, although possibly not as stirring: "The Federal Reserve, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system."
But as long as the markets continued to function, we had no wish to prop up companies with cash. As all this was going on, we were careful to keep supplying liquidity to the system. The FOMC ordered the traders at the New York Fed to buy billions of dollars of treasury securities on the open market. This had the effect of putting more money into circulation and lowering short-term rates.
On Wednesday morning Goldman Sachs was scheduled to make a $700m payment to Continental Illinois Bank in Chicago, but initially withheld payment pending receipt of expected funds from other sources. Then Goldman thought better of it, and made the payment. Had Goldman withheld such a large sum, it would have set off a cascade of defaults. Subsequently, a senior Goldman official confided to me that had the firm anticipated the difficulties of the ensuing weeks, it would not have paid. And in future such crises, he suspected, Goldman would have second thoughts about making such unrequited payments.
It took well over a week for all the crises to play out, though most of them were hidden from public view. Days after the crash, for example, the Chicago options market nearly collapsed when its biggest trading firm ran short of cash. The Chicago Fed helped engineer a solution to that one.
Contrary to everyone's fears, the economy held firm, actually growing at a 2% annual rate in the first quarter of 1988 and at an accelerated 5% rate in the second quarter. Economic growth entered its fifth consecutive year.
However, this strong economic growth was not to last. As the 1980s came to an end, the US economy slowed dramatically, and by the early 1990s tipped into recession. To make matters worse, the banking system was in turmoil, with hundreds of small and medium-sized banks failing and giants like Citibank and Chase Manhatten in distress. Meanwhile, the real estate boom had collapsed, causing even more pain.
Nothing we did at the Fed seemed to work. We'd begun easing interest rates well before the recession hit, but the economy had stopped responding. Even though we lowered the fed funds rate no fewer than 23 times in the three-year period between July 1989 and July 1992, the recovery was one of the most sluggish on record. I would see President George Bush every six or seven weeks, usually in the context of a meeting with others but sometimes one-on-one. Before long, the administration began blaming its troubles on the Fed. Supposedly we were choking the economy by keeping the money supply too tight.
When the recession hit that fall, the friction only got worse. "There has been too much pessimism," President Bush declared in his 1991 State of the Union address. "Sound banks should be making sound loans now, and interest rates should be lower, now."
The Fed, of course, had been lowering rates for over a year, but the White House wanted more, faster cuts. Nonetheless, President Bush reappointed me. I think he concluded I was his least worst choice: the Fed itself by all accounts was functioning well, there was no other candidate whom Wall Street seemed to prefer, and a change would have roiled the markets.
The fact was, the economy was recovering, just not in time to save the election.
I was saddened years later when I discovered that President Bush blamed me for his loss. His bitterness surprised me; I did not feel the same way about him. His loss in the election reminded me of how voters in Britain had ousted Winston Churchill immediately after the Second World War. Quite rapidly, however, the dual forces of information technology and globalisation were beginning to take hold, and as President Bill Clinton later put it: "The rulebooks were out of date." By mid-1995, Clinton and I had settled into an easy, impromptu relationship. He believed dotcom millionaires were an inevitable by-product of progress. "Whenever you shift to a new economic paradigm, there's more inequality," he'd say. Now we were shifting into the digital age, so we had dotcom millionaires.
Politics being what they are, I never thought Clinton would reappoint me as chairman when my term ended in March 1996. He was a Democrat and no doubt he would want one of his own. But by the end of 1995, my prospects had changed. American business was doing exceptionally well. GDP growth was starting to revive without a recession. The relationship between the Fed and the Treasury had never been better.
President Clinton set a little challenge for me and for the two Fed officials he appointed at the same time. "There is now a debate, a serious debate in this country, about whether there is a maximum growth rate we can have over any period of years without inflation," the President told reporters. It wasn't hard to read between the lines. With the economy entering its sixth year of expansion, and with the soft landing looking real, he was asking for faster growth, higher wages, and new jobs. He wanted to see what this rocket could do.
Even rising productivity could not explain the looniness of stock prices. On October 14, 1996, the Dow Jones Industrial Average vaulted past 6,000. If you compared the total value of stock holdings with the size of the economy, the market's significance was increasing at a rapid rate: at $9.5?trillion, it now was 120% as large as GDP.
We'd now seen the Dow break through three "millennium marks"– 4,000, 5,000, and 6,000— in just over a year and a half. Though economic growth was strong, we worried that investors were getting carried away. It wasn't that I wanted to stand up and shout, "The stock market is overvalued and it will lead to no good." I didn't believe that. But I thought it important to put the issue on the table.
The concept of irrational exuberance came to me in the bathtub one morning as I was writing a speech. To this day, the bathtub is where I get many of my best ideas. After the Dow had broken 6,000, in mid-October 1996, I'd begun looking for an opportunity to speak up about asset values. I wrote the speech so that the issue of asset values accounted for only a dozen sentences toward the end, and I carefully hedged what I had to say in my usual Fedspeak. Yet when I showed the text to Alice Rivlin [director of Office of Management and Budget] on the day of the speech, "irrational exuberance" jumped right out at her. "Are you sure you want to say this?" she asked.
On the podium that night, I delivered the key passage, watching carefully to see how people would react. But the stock market did not slow down, which only reinforced my concern.
The Dow Jones was already nearing 7,000 when the FOMC convened for the first time in 1997, on February 4. Apart from the run-up in the stock market, the economy was as robust as it had been six months before, when I'd resisted the idea of tightening rates. But my concern about a bubble had changed my mind. I told the committee we might need an interest rate increase to try to rein in the bull.
The Fed does not operate in a vacuum. If we raised rates and gave as a reason that we wanted to rein in the stock market, it would have provoked a political firestorm. Then we met again on March 25 and raised short-term rates by 0.25%, to 5.5%. In late March and early April of 1997, right after our meeting, the Dow dipped by some 7%. This represented a loss of almost 500 points, to some minds a delayed reaction to our rate hike. But within a few weeks, the momentum shifted and the market came roaring back. In effect, investors were teaching the Fed a lesson. Bob Rubin [Secretary of the Treasury] was right: you can't tell when a market is overvalued, and you can't fight market forces. We looked for other ways to deal with the risk of a bubble. But we did not raise rates any further, and we never tried to rein in stock prices again.
Margaret Thatcher jolted Britain toward a capitalist paradigm. I first encountered Thatcher at a British Embassy function in Washington in September 1975, shortly after she became the Conservative Party's leader. And an encounter it was. Seated next to her at dinner, I was prepared for a dull evening with a politician. "Tell me, Chairman Greenspan," she asked. "Why is it that we in Britain cannot calculate M3?" I awoke. M3 is an arcane measure of money supply embraced by followers of Milton Friedman.
We spent the evening discussing market economics and the problems confronting the British economy. My favourable initial impressions of Thatcher were reinforced after she became Prime Minister. Elected to that office in 1979, she confronted Britain's sclerotic economy head-on. Her seminal battle was with the miners who went on strike in March 1984 following her announcement of the closing of some unprofitable government-owned coal mines.
Thatcher's embrace of market capitalism gained the grudging acceptance of the British electorate. Her spectacular run was finally undermined not by the general British electorate but by a revolt within the Conservative Party.
She remained bitter toward those who removed her from power.
In the fall of 1994, Gordon Brown and Tony Blair trekked into my office at the Federal Reserve. As we exchanged greetings, it appeared to me that Brown was the senior person. Blair stayed in the background while Brown did most of the talking about a "new" Labour. Gone were the socialist tenets of post-war Labour leaders.
Brown espoused globalisation and free markets and did not seem interested in reversing much of what Thatcher had changed.
In office from 1997 forward, Tony Blair and Gordon Brown, heads of a rejuvenated and far more centrist Labour Party, accepted Thatcher's profoundly important structural changes to British product and labour markets.
In fact Brown, the Chancellor of the Exchequer for a record number of years, appeared to revel in Britain's remarkable surge of economic flexibility.
By mid-August 1998 the Russian central bank had burned through more than half of its foreign exchange reserves. Frenzied last-minute diplomacy failed, and on August 26 the central bank withdrew support for the ruble. The exchange rate fell 38% overnight. The default, when it came, stunned investors and banks that had poured money into Russia in spite of the risks. Many operated on the assumption that the West would always bail out the fallen superpower— if for no other reason, the saying went, than that Russia was "too nuclear to fail". Those investors bet wrong.
After careful deliberation, President Bill Clinton and other leaders judged that the International Monetary Fund's withdrawal would not increase the nuclear risk, and approved its decision to pull the plug. We all held our breath.
Sure enough, the shock wave from Russia's default hit Wall Street much harder than the Asian crises had. In the last four trading days of August alone, the Dow lost more than 1,000 points, or 12% of its value. The threat of a worldwide recession seemed increasingly real to me. And I was convinced that the Fed did not have the power to cope alone.
Bob Rubin [Secretary of the Treasury] shared this view. Behind the scenes, he and I began contacting the finance ministers and central bankers of the G7 nations to try to coordinate a policy response. We argued for the need to increase liquidity and ease interest rates throughout the developed world. Some of our counterparts proved very difficult to convince. But at last, as the markets in Europe closed on September 14, the G7 issued a carefully written statement. "The balance of risks in the world economy has shifted," it declared.
Meanwhile Bill McDonough, the head of the New York Fed, took on the challenge of coping with the implosion of one of Wall Street's largest and most successful hedge funds, Long-Term Capital Management.
Hollywood could not have scripted a more dramatic financial train wreck. Despite its boring name, LTCM was a proud, high-visibility, high-prestige operation in Greenwich, Connecticut, that earned spectacular returns investing $5bn for wealthy clients. Among its principals were two Nobel laureate economists, Myron Scholes and Robert Merton, whose state-of-the-art mathematical models were at the heart of the firm's money machine.
LTCM specialised in risky, lucrative arbitrage deals in US, Japanese and European bonds, leveraging its bets with more than $120bn borrowed from banks. It also carried some $1.25 trillion in financial derivatives, exotic contracts that were only partly reflected on its balance sheet. Some of these were speculative investments, and some were engineered to hedge, or insure, LTCM's portfolio against every imaginable risk. (Even after the smoke cleared, no one ever knew for sure how highly leveraged LTCM was when things started to go wrong. The best estimates were that it had invested well over $35 for every $1 it actually owned.)
The Russian default turned out to be the iceberg for this financial Titanic. That development contorted the markets in a way even the Nobel winners had never imagined. The story of how McDonough godfathered LTCM's bailout by its creditors has been told so many times that it is part of Wall Street lore. He literally gathered top officials of 16 of the world's most powerful banks and investment houses in a room, suggested strongly that if they fully comprehended the losses they would face in a forced fire sale of LTCM's assets, they would work it out, and left. After days of increasingly tense negotiations, the bankers came up with an infusion of an additional $3.5bn for LTCM as they carefully unwound its 'bets'.
No taxpayer money was spent (except perhaps for some sandwiches and coffee), but the Fed's intervention touched a populist raw nerve. "Seeing a Fund as Too Big to Fail, New York Fed Assists Its Bailout," trumpeted the New York Times on its front page. A few days later, on October 1, McDonough and I were called before the House Banking Committee to explain why, as USA Today put it, "a private firm designed for millionaires [should] be saved by a plan that was brokered and supported by a federal government organisation".
But telling the banks involved with LTCM that they might save themselves money if they facilitated an orderly liquidation of the fund was by no stretch of the imagination a bailout. By facing the harsh reality and acting in their self-interest, they saved themselves and, I suspect, millions of their fellow citizens on both Main Street and Wall Street a lot of money.
I was tracking the signs of trouble in the financial world with mounting concern for how all this might damage the economy. Panic in a market is like liquid nitrogen— it can quickly cause a devastating freeze. And indeed, the Fed's research was already showing that banks were increasingly hesitant to lend.
It took no argument at all to get the FOMC to lower interest rates. We did so three times in rapid succession, between September 29 and November 17. Other European and Asian central banks, honouring their new G7 commitment, also eased their rates. Gradually, as we'd hoped, the medicine took hold. The world's markets calmed down, and a year and a half after the Asian crises began, Bob Rubin was finally able to take an uninterrupted family vacation.
The [follow on] boom rose to a crescendo late in 1999, with the NASDAQ stock market index at the end of December having nearly doubled in 12 months (the Dow rose 20%). This presented the Fed with a fascinating puzzle: how do you draw the line between a healthy, exciting economic boom and a wanton, speculative stock market bubble driven by the less savoury aspects of human nature?
I'd given a lot of thought to whether we were experiencing a stock-market bubble and, if we were, what to do about it. If the market were to fall 30% or 40% in a short time, I reasoned, I'd be willing to stipulate that, yes, there had been a bubble. But this implied that if I wanted to identify a bubble, I had to confidently predict that the market was going to drop by 30% or 40% in a short time. That was a tough position to take.
Even if the Fed were to decide there was a stock bubble and we wanted to let the air out of it, would we be able to? If Fed tightening could not knock stock prices down by weakening the economy and profits, owning stocks became a seemingly ever less-risky activity. A giant rate hike would be a different story. I had no doubt that by abruptly raising interest rates by, say, 10 percentage points, we could explode any bubble overnight. But we would do so by devastating the economy, wiping out the very growth we sought to protect. Unless the tightening broke the back of the economic boom and with it profits, an incremental tightening would, in my experience, reinforce the perceived power of the boom. Modest tightening was more likely to raise stock prices than to lower them.
After thinking a great deal about this, I decided that the best the Fed could do would be to stay with our central goal of stabilising product and services prices. By doing that job well, we would gain the power and flexibility needed to limit economic damage if there was a crash. In the event of a major market decline, we agreed, our policy would be to move aggressively, lowering rates and flooding the system with liquidity to mitigate the economic fallout. But the idea of addressing the stock-market boom directly and pre-emptively seemed out of our reach.
I'd come to realise we'd never be able to identify irrational exuberance with certainty, much less act on it, until after the fact. Ironically, very soon afterward, we ended up tightening interest rates all the same. But stock prices were largely undeterred— they didn't peak until March 2000, and even then the bulk of the market moved sideways for several months more.
Then came September 11, 2001.
For a full year and a half after September 11, 2001, we were in limbo. The economy managed to expand, but its growth was uncertain and weak. Businesses and investors felt besieged. Behind everything loomed the expectation of continued terrorist attacks on US soil. There was no bigger question in Washington than, Why no second attack? If al Qaeda's intent was to disrupt the US economy, as bin Laden had declared, the attacks had to continue. The Fed's response to all this uncertainty was to maintain our programme of aggressively lowering short-term interest rates. This extended a series of seven cuts we'd already made in early 2001 to mitigate the impact of the dotcom bust and the general stock market decline. After the September 11 attacks, we cut the Fed funds rate four times more, and then once again at the height of the corporate scandals in 2002.
By October of that year, the Fed funds rate stood at 1.25%, a figure most of us would have considered unfathomably low a decade before. Yet, the economy was clearly in the grip of disinflation, in which market forces combine to hold down wages and prices and cause inflation expectations, and hence long-term interest rates, to recede. Globalisation was exerting a disinflationary impact.
This was the possibility that the US economy might be entering a crippling spiral like the one we'd seen paralyze Japan for 13 years. I found it to be a very unsettling issue. At the FOMC meeting in late June, where we voted to reduce interest rates still further to 1%, deflation was Topic A. We agreed on the reduction despite our consensus that the economy probably did not need still another rate cut. Yet we went ahead on the basis of a balancing of risk. We wanted to shut down the possibility of corrosive deflation; we were willing to chance that by cutting rates we might foster a bubble, an inflationary boom of some sort, which we would subsequently have to address.
Consumer spending carried the economy through the post-9/11 malaise, and what carried consumer spending was housing. In many parts of the United States, residential real estate, energised by the fall in mortgage interest rates, began to see values surge. The market prices of existing homes rose 7.5% a year in 2000, 2001, and 2002, more than double the rate of just a few years before. Not only did construction of new houses rise to record levels, but also historic numbers of existing houses changed hands. This boom provided a big lift in morale— even if your house was not for sale, you could look down the block and see other people's homes going for what seemed like astonishing prices, which meant your house was worth more too.
By early 2003, thirty-year mortgages were below 6%, the lowest they'd been since the Sixties. Adjustable-rate mortgages cost even less. This spurred the turnover of houses that drove prices higher. This expansion of ownership gave more people a stake in the future of our country and boded well for the cohesion of the nation, I thought.
Capital gains, especially gains realised in cash, began burning holes in people's pockets. Soon statisticians could see a bulge in consumer spending that matched the surge in capital gains. This pickup in outlays was virtually all funded through increases in home mortgage debt, which financial institutions made particularly easy to tap.
Booms, of course, beget bubbles, as the owners of dotcom stocks had painfully learned. Were we setting ourselves up for a harrowing real estate crash?
The market for single-family homes in the United States had always been predominately for home ownership, with the proportion of purchases for investment or speculation rarely more than 10%. But by 2005, investors accounted for 28% of homes bought, according to the National Association of Realtors.
Whether a bubble or a froth, the party was winding down by late 2005, when first-time buyers began to find prices increasingly out of reach. Higher prices required larger mortgages, which began to claim a burdensome share of monthly income. Because of the housing boom and the accompanying explosion in new mortgage products, the typical American household ended up with a more valuable home and better access to the wealth it represented. More recently, the unwinding of the housing boom has hurt some groups. It did not create great difficulties for the great mass of homeowners who had built up substantial equity in their houses as prices rose.
But many low-income families who took advantage of sub-prime mortgage offerings to become first-time homeowners joined the boom too late to enjoy its benefits. Without an equity buffer to fall back on, they are having difficulty making their monthly payments, and increasing numbers are facing foreclosure. Of the nearly $3 trillion of home mortgage originations in 2006, a fifth were sub-prime and another fifth were so-called Alt-A mortgages. Poor performance of this two fifths of originations has induced a significant tightening of credit availability, with a noticeable impact on home sales.
I was aware that the loosening of mortgage credit terms for sub-prime borrowers increased financial risk, and that subsidised home ownership initiatives distort market outcomes. But I believed then, as now, that the benefits of broadened home ownership are worth the risk. Protection of property rights, so critical to a market economy, requires a critical mass of owners to sustain political support.
Today London is arguably the world's leader in cross-border finance, though New York, by financing much of the vast economy of the United States, remains the financial capital of the world. Inventive technologies have dramatically improved the effectiveness with which global savings have been employed to finance global investment in plant and equipment. That improved productivity of capital has engendered increased incomes for financial expertise, and UK finance has prospered.
The large tax revenues that have emerged have been used by the Labour Government to counter the income inequality that is an inevitable by-product of increasing technologically-oriented financial competition. The per capita GDP of the United Kingdom has recently outdistanced those of Germany and France. Britain's demographics are not so dire as those of the Continent, though its education of its children has many of the shortcomings of the American system. If Britain continues its new openness (a highly reasonable expectation), it should do well in the world of 2030.
Copyright © Alan Greenspan 2007. Taken from The Age of Turbulence by Alan Greenspan, published by The Penguin Press HC (September 17, 2007)
Normxxx
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By Edmund Conway,Telegraph.co.uk, Economics Editor | 18 September 2007
Alan Greenspan is warning that inflation is set to double. The former Federal Reserve chairman predicts that within only a few years the world will undergo a huge spike in prices. He says central banks will have to raise interest rates to double-digit levels to hold down inflation.
In an exclusive interview with The Daily Telegraph, he predicts Mervyn King will miss the Bank of England inflation target countless times in the coming years as the Governor tries to keep UK prices under control. He also:
- • Predicts the current credit crunch will persist much longer, for at least as long as US house prices are falling.
Greenspan admits he may have cut rates too much
• Fingers complex credit instruments and the ratings agencies that recommended them as among the main culprits for the mayhem.
• Admits he may have cut interest rates too low.
• Forecasts the dollar will continue to decline because of the size of America's current account deficit.
• Defends himself for commenting on the economy on numerous occasions since stepping down at the Fed.
- "Markets are going to start turning round and inflationary pressures are going to start to build.
"There's going to be more correspondence between the Chancellor and Mervyn King," he says, referring to the letter Mr King must write to the Chancellor when he misses the 2% inflation target.
Central banks will be able to create low inflation, "only at significantly higher real interest rates", he adds.
While the "great switch" could look something like the current credit crunch, Mr Greenspan adds that it is probably likely to hit in two or more years' time.
Alan Greenspan
The Telegraph has serialised the eagerly awaited memoirs of Alan Greenspan, who spent almost two decades at the helm of the world's biggest economy as chairman of the Federal Reserve.
In an exclusive interview with Edmund Conway, the Daily Telegraph's Economics Editor, Greenspan predicts a painful correction for the UK housing market and says the full impact of the credit crunch has yet to be felt.
LEGACY
Greenspan says critics are wrong
Greenspan has been blamed for the US sub-prime crisis. Unrepentant, he tells Edmund Conway his critics are wrong.
Audio: Greenspan defends his record
Video: Decades of turbulence at the Fed
Your view: Is Alan Greenspan to blame for the credit crunch?
UK Warning
UK housing set for a painful correction
Warning of 'difficulties' for UK home owners.
UK more vulnerable than US to crunch
Higher number of adjustable-rate mortgages raises exposure for UK economy.
Iraq
'Iraq war was about oil'
Alan Greenspan has launched a stinging attack on George W Bush and Tony Blair.
Dollar
Greenspan gives warning over dollar
Former Fed chairman expects America's deficit to catch-up with greenback.
Comment
Greenspan 'was too much the rock star'
We forget, but Greenspan first rose in Washington as a Nixon political aide.
Full transcript of interview
Exclusive extract on the 1987 crash
How I dealt with the aftermath of 9/11
In exclusive extracts from his new book, The Age of Turbulence: Adventures in a New World, Alan Greenspan, former chairman of the US Federal Reserve, tells the story of his life and times at the centre of Wall Street and Washington.
Alan Greenspan in depth
- Born before the Great Depression, he lived through the American Century and witnessed first hand many of its defining moments. For nearly 20 years he was charged with plotting a course for the US economy and was a central character in the drama of some of the greatest stockmarket booms and busts ever seen.
In exclusive extracts from his new book, The Age of Turbulence, Greenspan tells the story of his years as chairman of the US Federal Reserve, starting with the crash of 1987. Greenspan reveals how he dealt with the aftermath of 9/11, gives the inside track on the collapse of LTCM and explains his view on how to manage booms and busts.
GREENSPAN ON...
The 1987 crash
I felt like a seven-armed paperhanger, going from one phone to another. I was not inclined to panic because I understood the nature of the problems we would face.
The response
Our public statement had been painstakingly worded. It was as short and concise as the Gettysburg Address, though possibly not as stirring.
President H.W. Bush
I was saddened when I discovered that he blamed me for his [election] loss. His bitterness surprises me. I did not feel the same way about him.
President Clinton
By mid-1995 we had settled into an easy impromptu relationship. I never thought he would reappoint me.
The dotcom era
The dual forces of information technology and globalisation were taking hold.
Inspiration
The concept of irrational exuberance came to me in the bathtub. It's where I get many of my best ideas.
Overheating
It wasn't that I wanted to stand up and shout 'the stock market is over-valued' but I thought it important to put the issue on the table.
The LTCM saga
Hollywood could not have scripted a more dramatic financial train wreck.
Market mayhem
Panic in a market is like liquid nitrogen— it can quickly cause a devastating freeze.
Bursting bubbles
How do you draw the line between a healthy, exciting boom and a wanton, speculative bubble driven by the less savoury aspects of human nature?
Post-9/11
For a full year and a half we were in limbo. Growth was uncertain and weak; business and investors felt besieged.
Shopping
Consumer spending carried the economy through the post-9/11 malaise and what carried consumer spending was housing.
Sub-prime times
I was aware loosening mortgage credit terms for sub-prime borrowers increased financial risk but I believe the benefits of broadened home ownership are worth it.
The UK Government
To its credit New Labour embraced the new freedoms begun by Margaret Thatcher, tempering the historical socialist ethos with a fresh emphasis on opportunity.
On top of the world
Today London is arguably the leader in cross-border finance but New York remains the financial capital of the world.
1987...
I felt a real need to hit the ground running because I knew the Fed would soon face big decisions. The Reagan-era expansion was well into its fourth year and while the economy was thriving, it was also showing clear signs of instability.
Since the beginning of the year, when the Dow Jones Industrial Average had risen through 2,000 for the first time, the stock market had run up more than 40%. Now it stood at more than 2,700 and Wall Street was in a speculative froth. The dollar was falling, and people were worried about America losing its competitive edge— the media were full of alarmist talk about the growing "Japanese threat".
I thought a rate increase would be prudent, but the Fed hadn't raised interest rates for three years. Signs of trouble in the economy continued to mount. Slowing growth and a further weakening of the dollar put Wall Street on edge, as investors and institutions began confronting the likelihood that billions of dollars in speculative bets would never pay off.
In early October, that fear turned to near panic. The worst loss was on Friday, October 16, when the Dow Jones average dropped by 108 points. Since the end of September nearly half a trillion dollars of paper wealth had evaporated in the stock market alone, not to mention the losses in currency and other markets.
I was supposed to fly on Monday afternoon to Dallas. That morning I conferred with the Board of Governors, and we agreed that I should make the trip, lest it seem that the Fed was in a panic. There was no telephone on the plane. So the first thing I did when I arrived was to ask one of the people who greeted me from the Federal Reserve Bank of Dallas: "How did the stock market finally go?" He said: "It was down five oh eight."
Usually when someone says "five oh eight," he means 5.08. So the market had dropped only 5 points. "Great," I replied. "What a terrific rally." But as I said it, I saw that the expression on his face was not shared relief. In fact, the market had crashed by 508 points, a 22.5% drop, the biggest one-day loss in history and bigger even than on the day that started the Great Depression, Black Friday 1929.
I went straight to the hotel, where I stayed on the phone into the night.
I was not inclined to panic, because I understood the nature of the problems we would face. Still, when I hung up the phone around midnight, I wondered if I'd be able to sleep. That would be the real test. "Now we're going to see what you're made of," I told myself as I went to bed, and, I'm proud to say, I slept for a good five hours.
The next thirty-six hours were intense. I joked that I felt like a seven-armed paperhanger, going from one phone to another, talking to the stock exchange, the Chicago futures exchanges, and the various Federal Reserve presidents. My most harrowing conversations were with financiers and bankers I'd known for years, major players from very large companies around the country, whose voices were tightened by fear.
The Fed attacked the crisis on two fronts. Our first challenge was Wall Street: we had to persuade giant trading firms and investment banks, many of which were reeling from losses, not to pull back from doing business. Our public statement early that morning had been painstakingly worded to hint that the Fed would provide a safety net for banks, in the expectation that they, in turn, would help support other financial companies.
It was as short and concise as the Gettysburg Address, I thought, although possibly not as stirring: "The Federal Reserve, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system."
But as long as the markets continued to function, we had no wish to prop up companies with cash. As all this was going on, we were careful to keep supplying liquidity to the system. The FOMC ordered the traders at the New York Fed to buy billions of dollars of treasury securities on the open market. This had the effect of putting more money into circulation and lowering short-term rates.
On Wednesday morning Goldman Sachs was scheduled to make a $700m payment to Continental Illinois Bank in Chicago, but initially withheld payment pending receipt of expected funds from other sources. Then Goldman thought better of it, and made the payment. Had Goldman withheld such a large sum, it would have set off a cascade of defaults. Subsequently, a senior Goldman official confided to me that had the firm anticipated the difficulties of the ensuing weeks, it would not have paid. And in future such crises, he suspected, Goldman would have second thoughts about making such unrequited payments.
It took well over a week for all the crises to play out, though most of them were hidden from public view. Days after the crash, for example, the Chicago options market nearly collapsed when its biggest trading firm ran short of cash. The Chicago Fed helped engineer a solution to that one.
Contrary to everyone's fears, the economy held firm, actually growing at a 2% annual rate in the first quarter of 1988 and at an accelerated 5% rate in the second quarter. Economic growth entered its fifth consecutive year.
However, this strong economic growth was not to last. As the 1980s came to an end, the US economy slowed dramatically, and by the early 1990s tipped into recession. To make matters worse, the banking system was in turmoil, with hundreds of small and medium-sized banks failing and giants like Citibank and Chase Manhatten in distress. Meanwhile, the real estate boom had collapsed, causing even more pain.
Nothing we did at the Fed seemed to work. We'd begun easing interest rates well before the recession hit, but the economy had stopped responding. Even though we lowered the fed funds rate no fewer than 23 times in the three-year period between July 1989 and July 1992, the recovery was one of the most sluggish on record. I would see President George Bush every six or seven weeks, usually in the context of a meeting with others but sometimes one-on-one. Before long, the administration began blaming its troubles on the Fed. Supposedly we were choking the economy by keeping the money supply too tight.
When the recession hit that fall, the friction only got worse. "There has been too much pessimism," President Bush declared in his 1991 State of the Union address. "Sound banks should be making sound loans now, and interest rates should be lower, now."
The Fed, of course, had been lowering rates for over a year, but the White House wanted more, faster cuts. Nonetheless, President Bush reappointed me. I think he concluded I was his least worst choice: the Fed itself by all accounts was functioning well, there was no other candidate whom Wall Street seemed to prefer, and a change would have roiled the markets.
The fact was, the economy was recovering, just not in time to save the election.
I was saddened years later when I discovered that President Bush blamed me for his loss. His bitterness surprised me; I did not feel the same way about him. His loss in the election reminded me of how voters in Britain had ousted Winston Churchill immediately after the Second World War. Quite rapidly, however, the dual forces of information technology and globalisation were beginning to take hold, and as President Bill Clinton later put it: "The rulebooks were out of date." By mid-1995, Clinton and I had settled into an easy, impromptu relationship. He believed dotcom millionaires were an inevitable by-product of progress. "Whenever you shift to a new economic paradigm, there's more inequality," he'd say. Now we were shifting into the digital age, so we had dotcom millionaires.
Politics being what they are, I never thought Clinton would reappoint me as chairman when my term ended in March 1996. He was a Democrat and no doubt he would want one of his own. But by the end of 1995, my prospects had changed. American business was doing exceptionally well. GDP growth was starting to revive without a recession. The relationship between the Fed and the Treasury had never been better.
President Clinton set a little challenge for me and for the two Fed officials he appointed at the same time. "There is now a debate, a serious debate in this country, about whether there is a maximum growth rate we can have over any period of years without inflation," the President told reporters. It wasn't hard to read between the lines. With the economy entering its sixth year of expansion, and with the soft landing looking real, he was asking for faster growth, higher wages, and new jobs. He wanted to see what this rocket could do.
Even rising productivity could not explain the looniness of stock prices. On October 14, 1996, the Dow Jones Industrial Average vaulted past 6,000. If you compared the total value of stock holdings with the size of the economy, the market's significance was increasing at a rapid rate: at $9.5?trillion, it now was 120% as large as GDP.
We'd now seen the Dow break through three "millennium marks"– 4,000, 5,000, and 6,000— in just over a year and a half. Though economic growth was strong, we worried that investors were getting carried away. It wasn't that I wanted to stand up and shout, "The stock market is overvalued and it will lead to no good." I didn't believe that. But I thought it important to put the issue on the table.
The concept of irrational exuberance came to me in the bathtub one morning as I was writing a speech. To this day, the bathtub is where I get many of my best ideas. After the Dow had broken 6,000, in mid-October 1996, I'd begun looking for an opportunity to speak up about asset values. I wrote the speech so that the issue of asset values accounted for only a dozen sentences toward the end, and I carefully hedged what I had to say in my usual Fedspeak. Yet when I showed the text to Alice Rivlin [director of Office of Management and Budget] on the day of the speech, "irrational exuberance" jumped right out at her. "Are you sure you want to say this?" she asked.
On the podium that night, I delivered the key passage, watching carefully to see how people would react. But the stock market did not slow down, which only reinforced my concern.
The Dow Jones was already nearing 7,000 when the FOMC convened for the first time in 1997, on February 4. Apart from the run-up in the stock market, the economy was as robust as it had been six months before, when I'd resisted the idea of tightening rates. But my concern about a bubble had changed my mind. I told the committee we might need an interest rate increase to try to rein in the bull.
The Fed does not operate in a vacuum. If we raised rates and gave as a reason that we wanted to rein in the stock market, it would have provoked a political firestorm. Then we met again on March 25 and raised short-term rates by 0.25%, to 5.5%. In late March and early April of 1997, right after our meeting, the Dow dipped by some 7%. This represented a loss of almost 500 points, to some minds a delayed reaction to our rate hike. But within a few weeks, the momentum shifted and the market came roaring back. In effect, investors were teaching the Fed a lesson. Bob Rubin [Secretary of the Treasury] was right: you can't tell when a market is overvalued, and you can't fight market forces. We looked for other ways to deal with the risk of a bubble. But we did not raise rates any further, and we never tried to rein in stock prices again.
Margaret Thatcher jolted Britain toward a capitalist paradigm. I first encountered Thatcher at a British Embassy function in Washington in September 1975, shortly after she became the Conservative Party's leader. And an encounter it was. Seated next to her at dinner, I was prepared for a dull evening with a politician. "Tell me, Chairman Greenspan," she asked. "Why is it that we in Britain cannot calculate M3?" I awoke. M3 is an arcane measure of money supply embraced by followers of Milton Friedman.
We spent the evening discussing market economics and the problems confronting the British economy. My favourable initial impressions of Thatcher were reinforced after she became Prime Minister. Elected to that office in 1979, she confronted Britain's sclerotic economy head-on. Her seminal battle was with the miners who went on strike in March 1984 following her announcement of the closing of some unprofitable government-owned coal mines.
Thatcher's embrace of market capitalism gained the grudging acceptance of the British electorate. Her spectacular run was finally undermined not by the general British electorate but by a revolt within the Conservative Party.
She remained bitter toward those who removed her from power.
In the fall of 1994, Gordon Brown and Tony Blair trekked into my office at the Federal Reserve. As we exchanged greetings, it appeared to me that Brown was the senior person. Blair stayed in the background while Brown did most of the talking about a "new" Labour. Gone were the socialist tenets of post-war Labour leaders.
Brown espoused globalisation and free markets and did not seem interested in reversing much of what Thatcher had changed.
In office from 1997 forward, Tony Blair and Gordon Brown, heads of a rejuvenated and far more centrist Labour Party, accepted Thatcher's profoundly important structural changes to British product and labour markets.
In fact Brown, the Chancellor of the Exchequer for a record number of years, appeared to revel in Britain's remarkable surge of economic flexibility.
By mid-August 1998 the Russian central bank had burned through more than half of its foreign exchange reserves. Frenzied last-minute diplomacy failed, and on August 26 the central bank withdrew support for the ruble. The exchange rate fell 38% overnight. The default, when it came, stunned investors and banks that had poured money into Russia in spite of the risks. Many operated on the assumption that the West would always bail out the fallen superpower— if for no other reason, the saying went, than that Russia was "too nuclear to fail". Those investors bet wrong.
After careful deliberation, President Bill Clinton and other leaders judged that the International Monetary Fund's withdrawal would not increase the nuclear risk, and approved its decision to pull the plug. We all held our breath.
Sure enough, the shock wave from Russia's default hit Wall Street much harder than the Asian crises had. In the last four trading days of August alone, the Dow lost more than 1,000 points, or 12% of its value. The threat of a worldwide recession seemed increasingly real to me. And I was convinced that the Fed did not have the power to cope alone.
Bob Rubin [Secretary of the Treasury] shared this view. Behind the scenes, he and I began contacting the finance ministers and central bankers of the G7 nations to try to coordinate a policy response. We argued for the need to increase liquidity and ease interest rates throughout the developed world. Some of our counterparts proved very difficult to convince. But at last, as the markets in Europe closed on September 14, the G7 issued a carefully written statement. "The balance of risks in the world economy has shifted," it declared.
Meanwhile Bill McDonough, the head of the New York Fed, took on the challenge of coping with the implosion of one of Wall Street's largest and most successful hedge funds, Long-Term Capital Management.
Hollywood could not have scripted a more dramatic financial train wreck. Despite its boring name, LTCM was a proud, high-visibility, high-prestige operation in Greenwich, Connecticut, that earned spectacular returns investing $5bn for wealthy clients. Among its principals were two Nobel laureate economists, Myron Scholes and Robert Merton, whose state-of-the-art mathematical models were at the heart of the firm's money machine.
LTCM specialised in risky, lucrative arbitrage deals in US, Japanese and European bonds, leveraging its bets with more than $120bn borrowed from banks. It also carried some $1.25 trillion in financial derivatives, exotic contracts that were only partly reflected on its balance sheet. Some of these were speculative investments, and some were engineered to hedge, or insure, LTCM's portfolio against every imaginable risk. (Even after the smoke cleared, no one ever knew for sure how highly leveraged LTCM was when things started to go wrong. The best estimates were that it had invested well over $35 for every $1 it actually owned.)
The Russian default turned out to be the iceberg for this financial Titanic. That development contorted the markets in a way even the Nobel winners had never imagined. The story of how McDonough godfathered LTCM's bailout by its creditors has been told so many times that it is part of Wall Street lore. He literally gathered top officials of 16 of the world's most powerful banks and investment houses in a room, suggested strongly that if they fully comprehended the losses they would face in a forced fire sale of LTCM's assets, they would work it out, and left. After days of increasingly tense negotiations, the bankers came up with an infusion of an additional $3.5bn for LTCM as they carefully unwound its 'bets'.
No taxpayer money was spent (except perhaps for some sandwiches and coffee), but the Fed's intervention touched a populist raw nerve. "Seeing a Fund as Too Big to Fail, New York Fed Assists Its Bailout," trumpeted the New York Times on its front page. A few days later, on October 1, McDonough and I were called before the House Banking Committee to explain why, as USA Today put it, "a private firm designed for millionaires [should] be saved by a plan that was brokered and supported by a federal government organisation".
But telling the banks involved with LTCM that they might save themselves money if they facilitated an orderly liquidation of the fund was by no stretch of the imagination a bailout. By facing the harsh reality and acting in their self-interest, they saved themselves and, I suspect, millions of their fellow citizens on both Main Street and Wall Street a lot of money.
I was tracking the signs of trouble in the financial world with mounting concern for how all this might damage the economy. Panic in a market is like liquid nitrogen— it can quickly cause a devastating freeze. And indeed, the Fed's research was already showing that banks were increasingly hesitant to lend.
It took no argument at all to get the FOMC to lower interest rates. We did so three times in rapid succession, between September 29 and November 17. Other European and Asian central banks, honouring their new G7 commitment, also eased their rates. Gradually, as we'd hoped, the medicine took hold. The world's markets calmed down, and a year and a half after the Asian crises began, Bob Rubin was finally able to take an uninterrupted family vacation.
The [follow on] boom rose to a crescendo late in 1999, with the NASDAQ stock market index at the end of December having nearly doubled in 12 months (the Dow rose 20%). This presented the Fed with a fascinating puzzle: how do you draw the line between a healthy, exciting economic boom and a wanton, speculative stock market bubble driven by the less savoury aspects of human nature?
I'd given a lot of thought to whether we were experiencing a stock-market bubble and, if we were, what to do about it. If the market were to fall 30% or 40% in a short time, I reasoned, I'd be willing to stipulate that, yes, there had been a bubble. But this implied that if I wanted to identify a bubble, I had to confidently predict that the market was going to drop by 30% or 40% in a short time. That was a tough position to take.
Even if the Fed were to decide there was a stock bubble and we wanted to let the air out of it, would we be able to? If Fed tightening could not knock stock prices down by weakening the economy and profits, owning stocks became a seemingly ever less-risky activity. A giant rate hike would be a different story. I had no doubt that by abruptly raising interest rates by, say, 10 percentage points, we could explode any bubble overnight. But we would do so by devastating the economy, wiping out the very growth we sought to protect. Unless the tightening broke the back of the economic boom and with it profits, an incremental tightening would, in my experience, reinforce the perceived power of the boom. Modest tightening was more likely to raise stock prices than to lower them.
After thinking a great deal about this, I decided that the best the Fed could do would be to stay with our central goal of stabilising product and services prices. By doing that job well, we would gain the power and flexibility needed to limit economic damage if there was a crash. In the event of a major market decline, we agreed, our policy would be to move aggressively, lowering rates and flooding the system with liquidity to mitigate the economic fallout. But the idea of addressing the stock-market boom directly and pre-emptively seemed out of our reach.
I'd come to realise we'd never be able to identify irrational exuberance with certainty, much less act on it, until after the fact. Ironically, very soon afterward, we ended up tightening interest rates all the same. But stock prices were largely undeterred— they didn't peak until March 2000, and even then the bulk of the market moved sideways for several months more.
Then came September 11, 2001.
For a full year and a half after September 11, 2001, we were in limbo. The economy managed to expand, but its growth was uncertain and weak. Businesses and investors felt besieged. Behind everything loomed the expectation of continued terrorist attacks on US soil. There was no bigger question in Washington than, Why no second attack? If al Qaeda's intent was to disrupt the US economy, as bin Laden had declared, the attacks had to continue. The Fed's response to all this uncertainty was to maintain our programme of aggressively lowering short-term interest rates. This extended a series of seven cuts we'd already made in early 2001 to mitigate the impact of the dotcom bust and the general stock market decline. After the September 11 attacks, we cut the Fed funds rate four times more, and then once again at the height of the corporate scandals in 2002.
By October of that year, the Fed funds rate stood at 1.25%, a figure most of us would have considered unfathomably low a decade before. Yet, the economy was clearly in the grip of disinflation, in which market forces combine to hold down wages and prices and cause inflation expectations, and hence long-term interest rates, to recede. Globalisation was exerting a disinflationary impact.
This was the possibility that the US economy might be entering a crippling spiral like the one we'd seen paralyze Japan for 13 years. I found it to be a very unsettling issue. At the FOMC meeting in late June, where we voted to reduce interest rates still further to 1%, deflation was Topic A. We agreed on the reduction despite our consensus that the economy probably did not need still another rate cut. Yet we went ahead on the basis of a balancing of risk. We wanted to shut down the possibility of corrosive deflation; we were willing to chance that by cutting rates we might foster a bubble, an inflationary boom of some sort, which we would subsequently have to address.
Consumer spending carried the economy through the post-9/11 malaise, and what carried consumer spending was housing. In many parts of the United States, residential real estate, energised by the fall in mortgage interest rates, began to see values surge. The market prices of existing homes rose 7.5% a year in 2000, 2001, and 2002, more than double the rate of just a few years before. Not only did construction of new houses rise to record levels, but also historic numbers of existing houses changed hands. This boom provided a big lift in morale— even if your house was not for sale, you could look down the block and see other people's homes going for what seemed like astonishing prices, which meant your house was worth more too.
By early 2003, thirty-year mortgages were below 6%, the lowest they'd been since the Sixties. Adjustable-rate mortgages cost even less. This spurred the turnover of houses that drove prices higher. This expansion of ownership gave more people a stake in the future of our country and boded well for the cohesion of the nation, I thought.
Capital gains, especially gains realised in cash, began burning holes in people's pockets. Soon statisticians could see a bulge in consumer spending that matched the surge in capital gains. This pickup in outlays was virtually all funded through increases in home mortgage debt, which financial institutions made particularly easy to tap.
Booms, of course, beget bubbles, as the owners of dotcom stocks had painfully learned. Were we setting ourselves up for a harrowing real estate crash?
The market for single-family homes in the United States had always been predominately for home ownership, with the proportion of purchases for investment or speculation rarely more than 10%. But by 2005, investors accounted for 28% of homes bought, according to the National Association of Realtors.
Whether a bubble or a froth, the party was winding down by late 2005, when first-time buyers began to find prices increasingly out of reach. Higher prices required larger mortgages, which began to claim a burdensome share of monthly income. Because of the housing boom and the accompanying explosion in new mortgage products, the typical American household ended up with a more valuable home and better access to the wealth it represented. More recently, the unwinding of the housing boom has hurt some groups. It did not create great difficulties for the great mass of homeowners who had built up substantial equity in their houses as prices rose.
But many low-income families who took advantage of sub-prime mortgage offerings to become first-time homeowners joined the boom too late to enjoy its benefits. Without an equity buffer to fall back on, they are having difficulty making their monthly payments, and increasing numbers are facing foreclosure. Of the nearly $3 trillion of home mortgage originations in 2006, a fifth were sub-prime and another fifth were so-called Alt-A mortgages. Poor performance of this two fifths of originations has induced a significant tightening of credit availability, with a noticeable impact on home sales.
I was aware that the loosening of mortgage credit terms for sub-prime borrowers increased financial risk, and that subsidised home ownership initiatives distort market outcomes. But I believed then, as now, that the benefits of broadened home ownership are worth the risk. Protection of property rights, so critical to a market economy, requires a critical mass of owners to sustain political support.
- [ Normxxx Here: But, I scarcely think that includes those who have lost their meager life savings in trying for "the brass ring." ]
Today London is arguably the world's leader in cross-border finance, though New York, by financing much of the vast economy of the United States, remains the financial capital of the world. Inventive technologies have dramatically improved the effectiveness with which global savings have been employed to finance global investment in plant and equipment. That improved productivity of capital has engendered increased incomes for financial expertise, and UK finance has prospered.
The large tax revenues that have emerged have been used by the Labour Government to counter the income inequality that is an inevitable by-product of increasing technologically-oriented financial competition. The per capita GDP of the United Kingdom has recently outdistanced those of Germany and France. Britain's demographics are not so dire as those of the Continent, though its education of its children has many of the shortcomings of the American system. If Britain continues its new openness (a highly reasonable expectation), it should do well in the world of 2030.
Copyright © Alan Greenspan 2007. Taken from The Age of Turbulence by Alan Greenspan, published by The Penguin Press HC (September 17, 2007)
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Monday, September 17, 2007
Fantasy Island
Fantasy Island [¹]
Click here for link to complete article: http://www.agorafinancial.com/afrude/
Ouzilly, France | 17 September 2007
Joel Bowman, reporting from the Middle East…
When politicians urge you to remain calm, the rational man will realize there is but one reasonable option left— PANIC!
Last Friday politicians, regulators and representatives of Northern Rock (England’s fifth largest mortgage lender) sought to assure customers their savings in the beleaguered bank were safe. Shares of Northern Rock plummetted in Friday’s trading, down almost a third on news it had sought emergency funding from the Bank of England.
Spurred on by the subprime mess in the US, cheap credit has become increasingly scarce around the globe. The rate banks lend to each other in the UK, for example, currently rests a full percent above the base rate of 5.75% set by the Bank of England. The tightening has been particularly painful for Northern Rock as it relies heavily on the capital markets, rather than customer deposits, for its financing. During the first half of this year, 85% of the bank’s net funding came from the capital markets.
In short, the tide [[flood?: normxxx]] of EZ credit has receded, and Northern Rock is the first British bank to be caught swimming naked.
Chief Officer, Adam Applegarth, desperately tried to subdue panic in a written statement on the bank’s website. "Let me now reassure you," Mr. Applegarth began. "Your money is safe with us and if you want some, or all of it back, then you are perfectly entitled to it. Whilst you may have to wait a little longer than usual to receive it[!?!], you will get it..."
Customers duly took this as their cue to panic and raced to their nearest branch to withdraw funds. The Sunday Times estimates Northern Rock may see up to 12 billion pounds (USD$24 billion) march out the door. That’s about half of the bank’s existing deposits. Already over a billion pounds have been withdrawn.
The flailing lender has dropped squarely into acquisition range for larger banks, notably Barclays, HSBC, Lloyds TSB, Royal Bank of Scotland and French bank Credit Agricole. It has even been suggested that the Rock’s mortgage book be cut up and distributed among outside lenders.
While these other banks circle the lamed Northern Rock awaiting a cheap meal, customers are growing increasingly frantic. News pictures of lengthy queues will do little to calm them in the meantime.
For those Brits prone to serious bouts of anxiety, we recommend taking a seat before reading Bill Bonner’s column below…
Wall Street Credit Crisis Spreads to UK
Fantasy Island
By Bill Bonner
You thought the housing crisis was bad in the United States? Wait ’til you see what happens in Britain.
We thought some new top in conceit had been reached when we saw last week’s cover of Country Life magazine in London.
"Why everyone loves England," was the headline.
While the gentry’s rag exalts Britain’s geographic particularities,
Today’s worldwide boom has been the greatest ever. Its leading industry is finance. And the financial capital of the world is right here in London.
Ben Bernanke explained the broad outlines of it in his speech in Berlin earlier this week. Over the last few years, he said, oil producers made more money than ever. So too, Asian exporters booked huge surpluses. They were all making so much money they didn’t know what to do with it, ending up with a "glut of savings."
Ben Bernanke modestly declined to mention it, but this wash of foreign savings was heartily pumped up by an extremely liquid and extremely abundant reserve currency— the dollar. Since Paul Volcker left the Fed, dollars have gushed into the world financial system like sewage into a Chinese lake. And, whenever the flow threatened to weaken, central bankers rushed to open the valves yet wider.
What to do with all this money? The stars lined up…the heavens smiled. And nowhere was the smile wider and more sincere than over Wall Street’s counterpart in Britain, the City. Many rich people moved to London to spend their fortunes. Others turned to London to help hold onto them. What better way to invest it than through London’s sleek financial intermediaries? What cooler way to separate a man from his money than with a good accent and an aloof, slightly contemptuous air?
The money flowed; Britain flourished, London flourished, the City flourished. But in Britain as in America, it was a strange, fantastical boom— fueled almost entirely by credit, the financial industry…and by foreign money. While the City slicker made his millions, the average Englishman got his own portion of ruinously good luck. His house went up 200% in the last 10 years…twice as fast as houses in America. And now the poor man is delusional; he thinks it will never end.
"'The City' generates so much wealth," he says.
But what the financial industry really generates is wealth for a few and debt for the many. And now, according to Grant Thornton, British debt has surpassed total GDP— a milestone. Most of the debt is in the housing sector, which has pushed up prices in Britain far higher than those in America, and made the U.K. even more vulnerable to a downturn. The ratio of housing prices to disposable income— a fairly stable figure in the United States— is a rollercoaster in Britain. Today, it is at its highest level ever…with the last major peak in ‘89. And Fitch estimates that U.K. house prices are 20% overvalued, and that Britain is one of the three most vulnerable to a house price crash/correction (after NZ and Denmark).
In America, the National Association of Home Builders says market conditions are the worst in 27 years. Its index of prospective buyers— a leading indicator— is at its lowest level ever. Housing has held up consumer spending and consumer spending has held up the economy. Owners "took out" equity (Mortgage Equity Withdrawal or MEW) in order to continue spending. (Real wages have actually gone down slightly since 2000). Figures are only available through the first quarter, but they show MEW dropping almost in half from a year previously. That represents an amount of money nearly equal to America’s entire GDP growth.
In America, the subprime borrower loses his house…and the whole economy sags along with housing prices.
In Britain, it is the Buy-to-Let speculator who threatens to bring down the price structure. He buys his houses— on credit of course— and counts on rental income to pay off the loans. But lenders are now wary…investors are timid…and rates are rising. The spread of three-month LIBOR (London Inter-Bank Offer Rate) over the UK base rate has leapt to a record high. Without fees for sticking bad credits on dim investors, the financiers’ bonuses are bound to fall and so will the availability of cheap finance. At the margin, the BTL investor is no better off than an American subprime borrower or leveraged hedge-fund hustler. He will have to sell into a declining market in order to stay solvent. Result: falling prices, less MEW, softening sales, rising defaults, failing economy.
A long string of good luck is hard to recover from. But when the Brits finally get over it, they’ll find that everyone won’t love England quite so much— not even the English themselves.
Joel’s Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century, and Empire of Debt: The Rise of an Epic Financial Crisis.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Click here for link to complete article: http://www.agorafinancial.com/afrude/
Ouzilly, France | 17 September 2007
Joel Bowman, reporting from the Middle East…
When politicians urge you to remain calm, the rational man will realize there is but one reasonable option left— PANIC!
Last Friday politicians, regulators and representatives of Northern Rock (England’s fifth largest mortgage lender) sought to assure customers their savings in the beleaguered bank were safe. Shares of Northern Rock plummetted in Friday’s trading, down almost a third on news it had sought emergency funding from the Bank of England.
Spurred on by the subprime mess in the US, cheap credit has become increasingly scarce around the globe. The rate banks lend to each other in the UK, for example, currently rests a full percent above the base rate of 5.75% set by the Bank of England. The tightening has been particularly painful for Northern Rock as it relies heavily on the capital markets, rather than customer deposits, for its financing. During the first half of this year, 85% of the bank’s net funding came from the capital markets.
In short, the tide [[flood?: normxxx]] of EZ credit has receded, and Northern Rock is the first British bank to be caught swimming naked.
Chief Officer, Adam Applegarth, desperately tried to subdue panic in a written statement on the bank’s website. "Let me now reassure you," Mr. Applegarth began. "Your money is safe with us and if you want some, or all of it back, then you are perfectly entitled to it. Whilst you may have to wait a little longer than usual to receive it[!?!], you will get it..."
Customers duly took this as their cue to panic and raced to their nearest branch to withdraw funds. The Sunday Times estimates Northern Rock may see up to 12 billion pounds (USD$24 billion) march out the door. That’s about half of the bank’s existing deposits. Already over a billion pounds have been withdrawn.
The flailing lender has dropped squarely into acquisition range for larger banks, notably Barclays, HSBC, Lloyds TSB, Royal Bank of Scotland and French bank Credit Agricole. It has even been suggested that the Rock’s mortgage book be cut up and distributed among outside lenders.
While these other banks circle the lamed Northern Rock awaiting a cheap meal, customers are growing increasingly frantic. News pictures of lengthy queues will do little to calm them in the meantime.
For those Brits prone to serious bouts of anxiety, we recommend taking a seat before reading Bill Bonner’s column below…
Wall Street Credit Crisis Spreads to UK
Fantasy Island
By Bill Bonner
You thought the housing crisis was bad in the United States? Wait ’til you see what happens in Britain.
We thought some new top in conceit had been reached when we saw last week’s cover of Country Life magazine in London.
"Why everyone loves England," was the headline.
While the gentry’s rag exalts Britain’s geographic particularities,
- [ Normxxx Here: WRT tourism, of course ]
- [ Normxxx Here: "What, never? No, never!" "What, never? We-e-ell, hardly ever!" G&S, "H.M.S. Pinafore" ]
Today’s worldwide boom has been the greatest ever. Its leading industry is finance. And the financial capital of the world is right here in London.
Ben Bernanke explained the broad outlines of it in his speech in Berlin earlier this week. Over the last few years, he said, oil producers made more money than ever. So too, Asian exporters booked huge surpluses. They were all making so much money they didn’t know what to do with it, ending up with a "glut of savings."
Ben Bernanke modestly declined to mention it, but this wash of foreign savings was heartily pumped up by an extremely liquid and extremely abundant reserve currency— the dollar. Since Paul Volcker left the Fed, dollars have gushed into the world financial system like sewage into a Chinese lake. And, whenever the flow threatened to weaken, central bankers rushed to open the valves yet wider.
What to do with all this money? The stars lined up…the heavens smiled. And nowhere was the smile wider and more sincere than over Wall Street’s counterpart in Britain, the City. Many rich people moved to London to spend their fortunes. Others turned to London to help hold onto them. What better way to invest it than through London’s sleek financial intermediaries? What cooler way to separate a man from his money than with a good accent and an aloof, slightly contemptuous air?
The money flowed; Britain flourished, London flourished, the City flourished. But in Britain as in America, it was a strange, fantastical boom— fueled almost entirely by credit, the financial industry…and by foreign money. While the City slicker made his millions, the average Englishman got his own portion of ruinously good luck. His house went up 200% in the last 10 years…twice as fast as houses in America. And now the poor man is delusional; he thinks it will never end.
"'The City' generates so much wealth," he says.
But what the financial industry really generates is wealth for a few and debt for the many. And now, according to Grant Thornton, British debt has surpassed total GDP— a milestone. Most of the debt is in the housing sector, which has pushed up prices in Britain far higher than those in America, and made the U.K. even more vulnerable to a downturn. The ratio of housing prices to disposable income— a fairly stable figure in the United States— is a rollercoaster in Britain. Today, it is at its highest level ever…with the last major peak in ‘89. And Fitch estimates that U.K. house prices are 20% overvalued, and that Britain is one of the three most vulnerable to a house price crash/correction (after NZ and Denmark).
In America, the National Association of Home Builders says market conditions are the worst in 27 years. Its index of prospective buyers— a leading indicator— is at its lowest level ever. Housing has held up consumer spending and consumer spending has held up the economy. Owners "took out" equity (Mortgage Equity Withdrawal or MEW) in order to continue spending. (Real wages have actually gone down slightly since 2000). Figures are only available through the first quarter, but they show MEW dropping almost in half from a year previously. That represents an amount of money nearly equal to America’s entire GDP growth.
In America, the subprime borrower loses his house…and the whole economy sags along with housing prices.
In Britain, it is the Buy-to-Let speculator who threatens to bring down the price structure. He buys his houses— on credit of course— and counts on rental income to pay off the loans. But lenders are now wary…investors are timid…and rates are rising. The spread of three-month LIBOR (London Inter-Bank Offer Rate) over the UK base rate has leapt to a record high. Without fees for sticking bad credits on dim investors, the financiers’ bonuses are bound to fall and so will the availability of cheap finance. At the margin, the BTL investor is no better off than an American subprime borrower or leveraged hedge-fund hustler. He will have to sell into a declining market in order to stay solvent. Result: falling prices, less MEW, softening sales, rising defaults, failing economy.
A long string of good luck is hard to recover from. But when the Brits finally get over it, they’ll find that everyone won’t love England quite so much— not even the English themselves.
Joel’s Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century, and Empire of Debt: The Rise of an Epic Financial Crisis.
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Hussman: Magical Fairies and Pixie Dust
The Fed: Magical Fairies and Pixie Dust [¹]
Click here for link to complete article: http://www.hussmanfunds.com/wmc/wmc070917.htm
By John P. Hussman, Ph.D. | 17 September 2007
All rights reserved and actively enforced.
“All you need is faith and trust and just a little bit of pixie dust”
— Peter Pan
Wall Street continues to hold its breath about the upcoming decision by the Federal Reserve. There's no question that the Fed's decision will have a market impact. This is not because Federal Reserve operations matter, but because investors believe they matter. The total amount of U.S. bank reserves affected by FOMC operations is less than $45 billion, and only the “excess” portion of that— typically about $2 billion dollars— is what determines the overnight Federal Funds Rate. Meanwhile, the total amount of borrowings through the “discount window”— though higher than in recent years— still amounts to only about $3 billion.
There is no well defined "monetary transmission mechanism" by which these minuscule amounts affect bank lending. Yes, during periods of crisis, the Fed has an important role to play in providing day-to-day liquidity so banks can meet depositor withdrawals. But aside from this short-term variation in the monetary base (which we saw, for example, around the "year 2000" turn), there is not even a slight relationship between bank reserves and total bank lending. Indeed, any remnant of that relationship was wiped out in the early 1990's, when reserve requirements were removed on all bank deposits other than checking accounts.
The notion of a powerful Fed is not knowledge born of analysis, but belief born of repetition [[and propaganda— 'assurances' by the most respected 'talking heads': normxxx]]. Stop to think about how you learned that the Fed controls the economy. Not that interest rates are important (which is certainly true), but specifically, that the Fed is important. I learned it in college, from the "money multiplier" theory that links bank reserves and bank lending (obsolete since the early 1990's when reserve requirements were largely eliminated). Some investors learn it by hearing that the Fed "controls interest rates" and by quietly equating "interest rates" with "Federal Reserve." Some investors learn it by seeing economic outcomes that follow Fed moves "with a long and variable lag" (as one would learn that the sun rises because the rooster crows).
Once we believe that the Fed is important, we look for confirmation in the same way people read their horoscopes and remember only the accurate ones. If recessions follow expansions and expansions follow recessions, then any magical spell that is routinely invoked during recessions will also be routinely followed by expansions (though perhaps with [[some indefinite: normxxx]] lag). Similarly, any wave of the wand that routinely accompanies late-stage expansions near full capacity (as Fed tightenings do) will typically be followed by economic softness.
Correlation doesn't imply causation. We need to ask: what is the mechanism by which Fed actions have these effects? If we're convinced that the Fed matters, we can't stop at belief or argument— we need consider reasonable mechanisms, and then actually test them against data. If investors don't do this, they have nothing but superstition. They quietly equate the black cat, or the ladder, or the broken mirror, or Ben Bernanke with an outcome, without looking for any testable relationships that link cause and effect.
So let's look at the data. All figures are in billions of U.S. dollars.
Source: http://research.stlouisfed.org/fred2
A few notes. The Federal Funds Rate is the overnight rate at which banks lend their excess reserves to other banks. Excess reserves are typically only about $2 billion of the roughly $45 billion in total reserves. Meanwhile the Discount Rate is the interest rate on funds lent [[directly: normxxx]] by the Fed to U.S. banks. That amount is presently about $3 billion. These are the quantities and interest rates over which Wall Street is obsessing.
The Federal Reserve controls one monetary aggregate— the U.S. monetary base, the vast majority of which represents currency in circulation. In a nutshell, the Fed buys U.S. government debt and creates "base money" in the form of either bank reserves or currency. Of the $552.4 billion in securities purchased by the Fed since 1990 to create new base money, $546.3 billion— about 99%— represents currency in circulation; the pieces of paper in your pocket that have "Federal Reserve Note" printed on top.
In general, "injections" of base money by the Federal Reserve into the banking system don't stay in the banking system at all. The vast majority of base money created by the Fed is not used for new bank lending, but to provide a reasonably steady $30-50 billion a year in new currency that predictably gets drawn out of the banking system and stays there.
Total U.S. 'bank reserves' have grown by only $3.1 billion since 1990, to a total of $44.9 billion. Again, it is the day-to-day trading between banks of this amount (and actually, only of "excess reserves"— typically about $2 billion dollars) that determines the Federal Funds rate.
The Federal Reserve lowered the "discount rate" and opened the "discount window" a few weeks ago. Total borrowings from the Fed have increased from about $360 million in July, to $3.2 billion currently. While some analysts have breathlessly noted that "borrowings from the Fed have soared to the highest level in years," the total amount of this "fresh liquidity" is about the same as the total assets of the [Hussman] Strategic Growth Fund.
In contrast to about $2 billion in excess reserves that is the basis for the Federal Funds Rate, and about $3 billion that is currently being lent at the Discount Rate, the U.S. banking system presently carries about $3.4 trillion in real estate loans, and $6.3 trillion in total loans. Gross domestic product is currently about $13.8 trillion.
While the Fed has purchased a total of $240.7 billion in U.S. government securities since 2000, mostly to create currency, foreign investors have purchased $1,185.8 billion in Treasuries alone. Indeed, foreign purchases have absorbed all of the increase in U.S. Treasury debt over the past year (and then some). It makes a great deal of sense to pay attention to foreign capital flows and the U.S. current account. In contrast, except for the psychological effect on investors, it is a mistake to believe that Federal Reserve operations control the economy.
The Fed is, at best, a square-dance caller— the guy who by mutual consent gets to holler out when to swing your partner and when to do-si-do. The Fed provides coordination, but it is a mistake to think it has power. When the barn is on fire and people no longer find it in their best interests to follow along, you can bet they'll dance to their own tune (as we're starting to see in the Eurocurrency market, where LIBOR has significantly diverged from the Fed Funds rate being "called out"). The Fed can provide a modest amount of liquidity to the banking system, but it can't provide solvency to the mortgage market. It's dangerous to believe that a reduction in the Fed Funds rate or the Discount Rate will materially change credit conditions here.
Still, we'll all be gathered there under Ben's helicopter on Tuesday, hoping for a sprinkling of magical pixie dust.
Off to Neverland!
Market Climate
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. The Strategic Growth Fund continues to hold a fully hedged investment stance— fully invested in a diversified portfolio of individual stocks, with an offsetting short position in the S&P 500 and Russell 2000 indices to mute the impact of market fluctuations. As usual, when the Fund is fully hedged, the primary source of expected returns is the difference in performance between the stocks held by the Fund and the indices we use to hedge.
The Fund is emphatically not hedged based on a forecast or expectation of a major market decline here. It is hedged because— on average— the S&P 500 and other indices have lagged Treasury bills under similar [market] conditions. If market internals were to improve materially (without establishing a steeply overbought condition), we would remove a portion of our hedges and accept some amount of "speculative" exposure, despite valuations that I view as rich.
Though observed P/E ratios may not appear extreme, these multiples implicitly assume that record profit margins will be sustained indefinitely, and that earnings will permanently remain at the top of the long-term growth channel that has connected earnings peaks across past economic cycles. Historically, when earnings have been similarly elevated, the price/peak-earnings ratio on the S&P 500 averaged less than 11, and the price/forward-operating-earnings ratio would have been closer to 9. A "modestly elevated" P/E on record earnings at record profit margins is an exorbitant multiple on normalized earnings. Investors will learn this [[once again: normxxx]] over the complete cycle.
Credit spreads remain wide, and risk-sensitive spreads like 6-month commercial paper to 6-month Treasury bill yields and LIBOR to Treasury bills (the "TED" spread) are particularly concerning. While recession risks are elevated, we still don't have sufficient evidence to expect a recession as a probable outcome. A further weakening of the stock market coupled with a drop in the ISM Purchasing Managers Index would dramatically increase the risk of imminent recession.
Bonds have behaved well, but with a relatively flat yield curve, low yields at longer maturities, and a wide spread between Treasury bill yields and the Fed Funds rate, it's not at all clear that reductions in Fed controlled interest rates must or will translate into lower market interest rates. Indeed, yields on longer-term Treasuries are low enough that even modest yield increases (within a normal band of trading fluctuation) could wipe out the entire annual total return— even if yields remain in a general downtrend from a longer-term perspective. Suffice it to say that we would be much more inclined to extend our durations on bond price weakness (i.e. higher yields), even given the increasing recession risks. The Strategic Total Return Fund continues to carry a duration of about 2 years, mostly in TIPS, with about 10% of assets in precious metals shares, where the Market Climate continues to appear favorable on our measures.
New From Bill Hester: Recessions and Bear Markets
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Click here for link to complete article: http://www.hussmanfunds.com/wmc/wmc070917.htm
By John P. Hussman, Ph.D. | 17 September 2007
All rights reserved and actively enforced.
“All you need is faith and trust and just a little bit of pixie dust”
— Peter Pan
Wall Street continues to hold its breath about the upcoming decision by the Federal Reserve. There's no question that the Fed's decision will have a market impact. This is not because Federal Reserve operations matter, but because investors believe they matter. The total amount of U.S. bank reserves affected by FOMC operations is less than $45 billion, and only the “excess” portion of that— typically about $2 billion dollars— is what determines the overnight Federal Funds Rate. Meanwhile, the total amount of borrowings through the “discount window”— though higher than in recent years— still amounts to only about $3 billion.
There is no well defined "monetary transmission mechanism" by which these minuscule amounts affect bank lending. Yes, during periods of crisis, the Fed has an important role to play in providing day-to-day liquidity so banks can meet depositor withdrawals. But aside from this short-term variation in the monetary base (which we saw, for example, around the "year 2000" turn), there is not even a slight relationship between bank reserves and total bank lending. Indeed, any remnant of that relationship was wiped out in the early 1990's, when reserve requirements were removed on all bank deposits other than checking accounts.
- [ Normxxx Here: And, shortly thereafter, even from checking accounts by a technique invented by the banks of "sweeping" 'excess' cash from the checking accounts. ]
The notion of a powerful Fed is not knowledge born of analysis, but belief born of repetition [[and propaganda— 'assurances' by the most respected 'talking heads': normxxx]]. Stop to think about how you learned that the Fed controls the economy. Not that interest rates are important (which is certainly true), but specifically, that the Fed is important. I learned it in college, from the "money multiplier" theory that links bank reserves and bank lending (obsolete since the early 1990's when reserve requirements were largely eliminated). Some investors learn it by hearing that the Fed "controls interest rates" and by quietly equating "interest rates" with "Federal Reserve." Some investors learn it by seeing economic outcomes that follow Fed moves "with a long and variable lag" (as one would learn that the sun rises because the rooster crows).
Once we believe that the Fed is important, we look for confirmation in the same way people read their horoscopes and remember only the accurate ones. If recessions follow expansions and expansions follow recessions, then any magical spell that is routinely invoked during recessions will also be routinely followed by expansions (though perhaps with [[some indefinite: normxxx]] lag). Similarly, any wave of the wand that routinely accompanies late-stage expansions near full capacity (as Fed tightenings do) will typically be followed by economic softness.
Correlation doesn't imply causation. We need to ask: what is the mechanism by which Fed actions have these effects? If we're convinced that the Fed matters, we can't stop at belief or argument— we need consider reasonable mechanisms, and then actually test them against data. If investors don't do this, they have nothing but superstition. They quietly equate the black cat, or the ladder, or the broken mirror, or Ben Bernanke with an outcome, without looking for any testable relationships that link cause and effect.
So let's look at the data. All figures are in billions of U.S. dollars.
Billions of $U.S. CURRENT YEAR-AGO 2000 1990
Total Reserves $ 44.9 $ 45.1 $ 38.7 $ 41.8
at U.S. Banks
(Federal Funds)
Total Borrowings of 3.2 0.6 0.2 0.9
U.S. Depository
Institutions from
Federal Reserve
(Discount Window)
U.S. Currency 808.6 789.4 574.1 262.3
in Circulation
Monetary Base 853.5 834.6 612.8 304.1
Real Estate Loans 3422.2 3130.6 1658.8 856.7
at U.S. Comm. Banks
Total Loans at 6325.4 5790.0 3874.4 2120.5
U.S. Comm. Banks
Federal Debt: 4943.0 4797.5 3413.5 2536.5
held by public
(of which) 2220.0 1879.6 1034.2 487.1
Federal Debt:
foreign held
U.S. GDP $13774.7 $13155.0 $9953.6 $5848.8
Source: http://research.stlouisfed.org/fred2
A few notes. The Federal Funds Rate is the overnight rate at which banks lend their excess reserves to other banks. Excess reserves are typically only about $2 billion of the roughly $45 billion in total reserves. Meanwhile the Discount Rate is the interest rate on funds lent [[directly: normxxx]] by the Fed to U.S. banks. That amount is presently about $3 billion. These are the quantities and interest rates over which Wall Street is obsessing.
The Federal Reserve controls one monetary aggregate— the U.S. monetary base, the vast majority of which represents currency in circulation. In a nutshell, the Fed buys U.S. government debt and creates "base money" in the form of either bank reserves or currency. Of the $552.4 billion in securities purchased by the Fed since 1990 to create new base money, $546.3 billion— about 99%— represents currency in circulation; the pieces of paper in your pocket that have "Federal Reserve Note" printed on top.
In general, "injections" of base money by the Federal Reserve into the banking system don't stay in the banking system at all. The vast majority of base money created by the Fed is not used for new bank lending, but to provide a reasonably steady $30-50 billion a year in new currency that predictably gets drawn out of the banking system and stays there.
Total U.S. 'bank reserves' have grown by only $3.1 billion since 1990, to a total of $44.9 billion. Again, it is the day-to-day trading between banks of this amount (and actually, only of "excess reserves"— typically about $2 billion dollars) that determines the Federal Funds rate.
The Federal Reserve lowered the "discount rate" and opened the "discount window" a few weeks ago. Total borrowings from the Fed have increased from about $360 million in July, to $3.2 billion currently. While some analysts have breathlessly noted that "borrowings from the Fed have soared to the highest level in years," the total amount of this "fresh liquidity" is about the same as the total assets of the [Hussman] Strategic Growth Fund.
In contrast to about $2 billion in excess reserves that is the basis for the Federal Funds Rate, and about $3 billion that is currently being lent at the Discount Rate, the U.S. banking system presently carries about $3.4 trillion in real estate loans, and $6.3 trillion in total loans. Gross domestic product is currently about $13.8 trillion.
While the Fed has purchased a total of $240.7 billion in U.S. government securities since 2000, mostly to create currency, foreign investors have purchased $1,185.8 billion in Treasuries alone. Indeed, foreign purchases have absorbed all of the increase in U.S. Treasury debt over the past year (and then some). It makes a great deal of sense to pay attention to foreign capital flows and the U.S. current account. In contrast, except for the psychological effect on investors, it is a mistake to believe that Federal Reserve operations control the economy.
The Fed is, at best, a square-dance caller— the guy who by mutual consent gets to holler out when to swing your partner and when to do-si-do. The Fed provides coordination, but it is a mistake to think it has power. When the barn is on fire and people no longer find it in their best interests to follow along, you can bet they'll dance to their own tune (as we're starting to see in the Eurocurrency market, where LIBOR has significantly diverged from the Fed Funds rate being "called out"). The Fed can provide a modest amount of liquidity to the banking system, but it can't provide solvency to the mortgage market. It's dangerous to believe that a reduction in the Fed Funds rate or the Discount Rate will materially change credit conditions here.
Still, we'll all be gathered there under Ben's helicopter on Tuesday, hoping for a sprinkling of magical pixie dust.
Off to Neverland!
Market Climate
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. The Strategic Growth Fund continues to hold a fully hedged investment stance— fully invested in a diversified portfolio of individual stocks, with an offsetting short position in the S&P 500 and Russell 2000 indices to mute the impact of market fluctuations. As usual, when the Fund is fully hedged, the primary source of expected returns is the difference in performance between the stocks held by the Fund and the indices we use to hedge.
The Fund is emphatically not hedged based on a forecast or expectation of a major market decline here. It is hedged because— on average— the S&P 500 and other indices have lagged Treasury bills under similar [market] conditions. If market internals were to improve materially (without establishing a steeply overbought condition), we would remove a portion of our hedges and accept some amount of "speculative" exposure, despite valuations that I view as rich.
Though observed P/E ratios may not appear extreme, these multiples implicitly assume that record profit margins will be sustained indefinitely, and that earnings will permanently remain at the top of the long-term growth channel that has connected earnings peaks across past economic cycles. Historically, when earnings have been similarly elevated, the price/peak-earnings ratio on the S&P 500 averaged less than 11, and the price/forward-operating-earnings ratio would have been closer to 9. A "modestly elevated" P/E on record earnings at record profit margins is an exorbitant multiple on normalized earnings. Investors will learn this [[once again: normxxx]] over the complete cycle.
Credit spreads remain wide, and risk-sensitive spreads like 6-month commercial paper to 6-month Treasury bill yields and LIBOR to Treasury bills (the "TED" spread) are particularly concerning. While recession risks are elevated, we still don't have sufficient evidence to expect a recession as a probable outcome. A further weakening of the stock market coupled with a drop in the ISM Purchasing Managers Index would dramatically increase the risk of imminent recession.
Bonds have behaved well, but with a relatively flat yield curve, low yields at longer maturities, and a wide spread between Treasury bill yields and the Fed Funds rate, it's not at all clear that reductions in Fed controlled interest rates must or will translate into lower market interest rates. Indeed, yields on longer-term Treasuries are low enough that even modest yield increases (within a normal band of trading fluctuation) could wipe out the entire annual total return— even if yields remain in a general downtrend from a longer-term perspective. Suffice it to say that we would be much more inclined to extend our durations on bond price weakness (i.e. higher yields), even given the increasing recession risks. The Strategic Total Return Fund continues to carry a duration of about 2 years, mostly in TIPS, with about 10% of assets in precious metals shares, where the Market Climate continues to appear favorable on our measures.
New From Bill Hester: Recessions and Bear Markets
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Saturday, September 15, 2007
Camelot's End? Are the Banks in Trouble?
Are the Banks in Trouble? [¹]
http://www.atlanticfreepress.com/content/view/2354/81/
By Mike Whitney | Monday, 10 September 2007 | 11 September 2007
About a month ago, I wrote an article "Stock Market Brushfire: Will there be a run on the banks?" which showed how the collapse in the housing market and the deterioration in mortgage-backed bonds (CDOs) in the secondary market was creating difficulties for the banking system. Now these problems are becoming more apparent.
From the Wall Street Journal:
"The rising interbank lending rates are a proxy of sorts for the increased risk that some banks, somewhere, may go belly up." (Editorial; WSJ, 9-6-07)
Ironically, the WSJ editorial staff— which normally defends deregulation and laissez faire economics "tooth-n-nail"— is now calling for regulators to make sure they are "on top of the banks they are supposed to be regulating, so we don’t get any surprise bank failures that spook the markets and confirm the worst fears being whispered about."
"Surprise bank failures?"
Henry Liu sums it up like this in his article, "The Rise of the non-bank system"— required reading for anyone who wants to understand why a stock market crash is imminent:
That's right; nearly $1 trillion in worthless asset-backed paper is clogging the system— putting the kybosh on the big private equity deals and spreading panic through the money markets. It's a slow-motion train wreck and there's not a thing the Fed can do about it.
This isn't a liquidity problem that can be fixed by lowering the Fed's fund rate and creating more easy credit. This is a solvency crisis: the underlying assets upon which this world of "structured finance" is built has been found to have no established market value, therefore— as Jim Sinclair suggests— they're worthless. That means that the trillions of dollars which have been leveraged against these shaky assets— in the form of credit default swaps (CDSs) and numerous other bizarre-sounding derivatives— will begin to cascade down, wiping out trillions in market value.
How serious is it? Economist Liu puts it like this:
Overview
Credit standards are tightening and banks are increasingly reluctant to loan money to each other not knowing who may be sitting on billions of dollars in toxic mortgage-backed debt. (Collateralized debt obligations) It makes no difference that the "underlying economy is sound" as Bernanke likes to say. When banks hesitate to loan money to each other; it shows that there is real uncertainty about the solvency of the other banks. It slows down commerce and the gears on the economic machine begin to [lock up and] rust in place.
The banks woes have been exacerbated by the flight of investors from money market funds, many of which are backed by Mortgage-backed Securities (MBS). Wary investors are running for the safety of US Treasuries even though yields there have declined at a record pace. This is causing problems in the Commercial Paper market as well as for the lesser-know SIVs and "conduits". These abstruse-sounding investment vehicles are the essential plumbing that maintains normalcy in the markets. Commercial paper is a $2.2 trillion market. When it shrinks by more than $200 billion— as it has in the last 3 weeks— the effects can be felt through the entire system.
The credit crunch has spread across the whole gamut of commercial paper and low-grade debt. Banks are hoarding cash and refusing loans to even credit-worthy applicants. The collapse in subprime loans is just part of the story. More than 50% of all mortgages in the last two years have been unconventional loans— no down payment, no verification of income "no doc", interest-only, negative amortization, piggyback, 2-28s, teaser rates, adjustable rate mortgages "ARMs". All of these reflect the shoddy lending standards of the past few years and all are contributing to the unprecedented rate of defaults. Now the banks are holding [[are stuck with: normxxx]] $300 billion of these "unmarketable" mortgage-backed CDOs and another $200 billion in equally-suspect CLOs. (Collateralized loan obligations; the CDOs corporate-twin).
Even more worrisome, the large investment banks have myriad "off-book" operations which are in distress. This has forced the banks to circle the wagons and reduce their issuance of any loans, however credit-worthy— which is accelerating the downturn in housing. Typically, housing bubbles unwind very slowly over a 5 to 10 year period. That won’t be the case this time. The surge in inventory, the financial distress of many homeowners and the complete breakdown in loan-origination (due to the growing credit crunch) ensures that the housing market will crash-land sometime in late 2008 or early 2009. The banks are expected to write-off a considerable portion of their CDO-debt at the end of the 3rd Quarter rather than keep the losses on their books. This will further hasten the decline in housing prices.
The banks are also suffering from the sudden sluggishness in leveraged buyouts (LBOs). Credit problems have slowed private equity deals to a dribble. In July there were $579 billion in LBOs. In August that number shrunk to a paltry $222 billion. By September those figures will deteriorate to double-digits. The big deals aren’t getting done and debt is not rolling over. More than $1 trillion in debt will have to be refinanced in the next 5 weeks. In the present climate, that doesn’t look likely. Something’s has got to give. The market has frozen and the Fed’s $60 billion repo-lifeline has done nothing to help.
In the first 7 months of 2007, LBOs accounted for "$37 of every $100 spent on deals in the US".
37%! How will the financial giants make up for the windfall profits that these deals generated?
Answer: They won’t. Just as they won’t make up for the enormous origination fees they made from "securitizing" mortgages and selling them off to credulous pension funds, insurance companies and foreign banks.
As Steven Rattner of DLJ Merchant Banking said, "It’s become nearly impossible to finance a private equity transaction of over $1 billion." (WSJ) The Golden Era of Acquisitions and Mega-mergers is coming to an end. We can expect that the financial giants will probably follow the same trajectory as the Dot.coms following the 2001 NASDAQ-rout.
The investment banks are also facing potentially enormous losses from liabilities that "operate off their balance sheets" In David Reilly’s article "Conduit Risks are hovering over Citigroup" (WSJ 9-5-07) Reilly points out that "banks such as Citigroup Inc. could find themselves burdened by affiliated investment vehicles that issue tens of billions of dollars in short-term debt known as commercial paper"… Citigroup, for example, owns about 25% of the market for SIVs, representing nearly $100 billion of assets under management. The largest Citigroup SIV is Centauri Corp., which had $21 billion in outstanding debt as of February 2007, according to a Citigroup research report. There is NO MENTION OF CENTAURI IN ITS 2006 ANNUAL FILING with the Securities and Exchange Commission.
Yet some investors worry that if vehicles such as Centauri stumble, either failing to sell commercial paper or suffering severe losses in the assets it holds, Citibank could wind up having to help by lending funds to keep the vehicle operating or even taking on some losses.
So, many investors don’t know that Citigroup could be holding the bag for "$21 billion in outstanding debt"? Or, perhaps, the entire $100 billion is red ink; who knows? (Citigroup’s stock dropped by more than 2% after this report appeared in the WSJ.)
Another report which appeared in CNN Money further adds to the suspicion that the banks’ "brokerage affiliates" may be in trouble:
Does this mean that the other large banks are involved in the same type of "hide-n-seek" strategies?
Sounds a lot like Enron’s "off-the-books" shenanigans, doesn’t it?
Wall Street Journal:
Still think the banks are on solid ground?
Yes; and how many of these "assets" are in fact corporate debt, auto loans, credit card debt, and student loans that have been securitized and are now under extreme pressure in a slumping market?
In an "up market" such loans can provide a valuable income-stream that that transforms someone else’s debt into a valuable asset. In a down-market, however, ('toxic waste') defaults can wipe out trillions in market capitalization overnight.
How Did We Get Into This Mess?
More than 20 years of dogged lobbying from the financial industry finally paid off with the repeal of the Glass-Steagall Act which was passed by Congress following the 1929 stock market crash. The bill that was specifically written to isolate and limit the conflicts of interest that are bound to occur when commercial banks are permitted to underwrite stocks and bonds.
The financial industry whittled away at Glass-Steagall for years before finally breaking down its regulatory restrictions completely.
This expansion of the loophole created by the Fed's 1987 reinterpretation of Section 20 of Glass-Steagall effectively rendered Glass-Steagall obsolete. ("The Long Demise of Glass Steagall", Frontline, PBS)
In 1999, after 25 years and $300 million of lobbying efforts, Congress aided by President Bill Clinton, finally repealed what remained of Glass-Steagall. This paved the way for the problems we are now facing.
Another contributing factor to the current banking-muddle is the Basel rules. According to the BIS (Bank of International Settlements) website:
The Basel Committee on Banking (Basel 2) requires "banks to boost the capital they hold in reserve against the loans on their books."
Sounds like a good thing, doesn’t it? This protects the overall financial system as well as the individual depositor. Unfortunately, the banks found a way to circumvent the rules for minimum reserves by "securitizing" pools of mortgages (MBS) rather than holding individual mortgages. (which called for more reserves) This provided lavish origination and distribution fees for banks, but shifted much of the risk of default to Wall Street investors. Now, the banks are saddled with roughly $300 billion in mortgage-backed debt (CDOs) that no one wants and it is uncertain whether they have sufficient remaining reserves to cover their losses.
By October, we should know how this will all play out. As David Wessel points out in "New Bank Capital requirements helped to Spread Credit Woes":
The downside of this is that once that banks write off these toxic MBSs and CDOs; the hedge funds, insurance companies and pension funds will be forced to do the same— dumping boatloads of this bond-sludge on the market driving down prices and triggering a panic-sell-off. This is what the Fed is trying to prevent through its $60 billion repo-bailout.
Regrettably, even the Fed cannot hope to remove a half-trillion of bad debt from the balance sheets of the banks or forestall the collapse of related financial institutions and funds which are loaded with these "unmarketable" time-bombs. Besides, most of the mortgage derivatives (CDOs) have been massively enhanced with low interest leverage from the "carry trade". When the value of these CDOs is finally determined— which we expect will happen sometime before the end of the 3rd Quarter— we can expect the stock market to fall sharply and the housing recession to turn into a full-blown economic crisis.
Alan Greenspan: The Fifth Horseman?
So, who’s to blame? The finger-pointing [[and lawsuits: normxxx]] has already begun and more and more people are beginning to see how this massive economy-busting equity bubble originated at the Federal Reserve— it is the logical corollary of former Fed-chief Alan Greenspan's "easy money" policies.
Henry C K Liu sums up Greenspan’s tenure at the Fed in his article "Why the Subprime Bust will Spread":
"The greatest expansion of speculative finance in history".
That says it all.
But no one makes the case against Greenspan better than Greenspan himself. Here are some of his comments at the Federal Reserve System’s Fourth Annual Community Affairs Research Conference, Washington, D.C. April 8, 2005. They show that Greenspan "rubber stamped" every one of the policies which have since metastasized throughout the entire US economy.
Greenspan: Champion of Subprime loans:
Greenspan: Main Proponent of Toxic CDOs
Greenspan: Supporter of Loans to People with Bad Credit
Greenspan: Big Fan of "Structural Changes" which increase Consumer Debt
Greenspan’s own words are the most powerful indictment against him. They show that he played a deliberate and central role in our impending disaster. The effort on the part of media pundits, talking heads, and so-called experts to foist the blame on the rating agencies, predatory lenders or gullible mortgage applicants misses the point entirely. The problems began at the Federal Reserve and that’s where the responsibility lies.
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
http://www.atlanticfreepress.com/content/view/2354/81/
By Mike Whitney | Monday, 10 September 2007 | 11 September 2007
"The new capitalist gods must love the poor— they are making so many more of them."
— Bill Bonner, "The Daily Reckoning"
"The hope of every central bank is that the real problem can be kept from public view. The truth is that the public— even professionals on Wall Street— have no clue what the real problem is. They know it has something to do with derivatives, but none of them realize that it’s more than a $20 trillion mountain of unfunded, unregulated paper that has just been discovered not to have a market and, therefore, no real value… When the dollar realizes the seriousness of the situation— be that now or sometime soon— the bottom will drop out."
— Jim Sinclair, Investment analyst
About a month ago, I wrote an article "Stock Market Brushfire: Will there be a run on the banks?" which showed how the collapse in the housing market and the deterioration in mortgage-backed bonds (CDOs) in the secondary market was creating difficulties for the banking system. Now these problems are becoming more apparent.
From the Wall Street Journal:
"The rising interbank lending rates are a proxy of sorts for the increased risk that some banks, somewhere, may go belly up." (Editorial; WSJ, 9-6-07)
Ironically, the WSJ editorial staff— which normally defends deregulation and laissez faire economics "tooth-n-nail"— is now calling for regulators to make sure they are "on top of the banks they are supposed to be regulating, so we don’t get any surprise bank failures that spook the markets and confirm the worst fears being whispered about."
"Surprise bank failures?"
Henry Liu sums it up like this in his article, "The Rise of the non-bank system"— required reading for anyone who wants to understand why a stock market crash is imminent:
"Banks worldwide now reportedly face risk exposure of US$891 billion in asset-backed commercial paper facilities (ABCP) due to callable bank credit agreements with borrowers designed to ensure ABCP investors are paid back when the short-term debt matures, even if banks cannot sell new ABCP on behalf of the issuing companies to roll over the matured debt because the market views the assets behind the paper as of [increasingly] uncertain market value.
This signifies that the crisis is no longer one of liquidity, but of deteriorating creditworthiness systemwide that restoring liquidity alone cannot cure. The liquidity crunch is a symptom, not the disease. The disease is a decade of permissive tolerance for credit abuse in which the banks, regulators and rating agencies were willing accomplices." (Henry Liu,"The Rise of the Non-bank System”, Asia Times)
[ Normxxx Here: The crisis is one of CREDIBILITY! ]
That's right; nearly $1 trillion in worthless asset-backed paper is clogging the system— putting the kybosh on the big private equity deals and spreading panic through the money markets. It's a slow-motion train wreck and there's not a thing the Fed can do about it.
This isn't a liquidity problem that can be fixed by lowering the Fed's fund rate and creating more easy credit. This is a solvency crisis: the underlying assets upon which this world of "structured finance" is built has been found to have no established market value, therefore— as Jim Sinclair suggests— they're worthless. That means that the trillions of dollars which have been leveraged against these shaky assets— in the form of credit default swaps (CDSs) and numerous other bizarre-sounding derivatives— will begin to cascade down, wiping out trillions in market value.
How serious is it? Economist Liu puts it like this:
- "Even if the Fed bails out the banks by easing bank reserve [[What bank reserves? We've already emptied that well!: normxxx]] and capital requirements to absorb that massive amount, the raging forest fire in the non-bank financial system will still present finance capitalism with its greatest test in eight decades."
Overview
Credit standards are tightening and banks are increasingly reluctant to loan money to each other not knowing who may be sitting on billions of dollars in toxic mortgage-backed debt. (Collateralized debt obligations) It makes no difference that the "underlying economy is sound" as Bernanke likes to say. When banks hesitate to loan money to each other; it shows that there is real uncertainty about the solvency of the other banks. It slows down commerce and the gears on the economic machine begin to [lock up and] rust in place.
The banks woes have been exacerbated by the flight of investors from money market funds, many of which are backed by Mortgage-backed Securities (MBS). Wary investors are running for the safety of US Treasuries even though yields there have declined at a record pace. This is causing problems in the Commercial Paper market as well as for the lesser-know SIVs and "conduits". These abstruse-sounding investment vehicles are the essential plumbing that maintains normalcy in the markets. Commercial paper is a $2.2 trillion market. When it shrinks by more than $200 billion— as it has in the last 3 weeks— the effects can be felt through the entire system.
The credit crunch has spread across the whole gamut of commercial paper and low-grade debt. Banks are hoarding cash and refusing loans to even credit-worthy applicants. The collapse in subprime loans is just part of the story. More than 50% of all mortgages in the last two years have been unconventional loans— no down payment, no verification of income "no doc", interest-only, negative amortization, piggyback, 2-28s, teaser rates, adjustable rate mortgages "ARMs". All of these reflect the shoddy lending standards of the past few years and all are contributing to the unprecedented rate of defaults. Now the banks are holding [[are stuck with: normxxx]] $300 billion of these "unmarketable" mortgage-backed CDOs and another $200 billion in equally-suspect CLOs. (Collateralized loan obligations; the CDOs corporate-twin).
Even more worrisome, the large investment banks have myriad "off-book" operations which are in distress. This has forced the banks to circle the wagons and reduce their issuance of any loans, however credit-worthy— which is accelerating the downturn in housing. Typically, housing bubbles unwind very slowly over a 5 to 10 year period. That won’t be the case this time. The surge in inventory, the financial distress of many homeowners and the complete breakdown in loan-origination (due to the growing credit crunch) ensures that the housing market will crash-land sometime in late 2008 or early 2009. The banks are expected to write-off a considerable portion of their CDO-debt at the end of the 3rd Quarter rather than keep the losses on their books. This will further hasten the decline in housing prices.
The banks are also suffering from the sudden sluggishness in leveraged buyouts (LBOs). Credit problems have slowed private equity deals to a dribble. In July there were $579 billion in LBOs. In August that number shrunk to a paltry $222 billion. By September those figures will deteriorate to double-digits. The big deals aren’t getting done and debt is not rolling over. More than $1 trillion in debt will have to be refinanced in the next 5 weeks. In the present climate, that doesn’t look likely. Something’s has got to give. The market has frozen and the Fed’s $60 billion repo-lifeline has done nothing to help.
In the first 7 months of 2007, LBOs accounted for "$37 of every $100 spent on deals in the US".
37%! How will the financial giants make up for the windfall profits that these deals generated?
Answer: They won’t. Just as they won’t make up for the enormous origination fees they made from "securitizing" mortgages and selling them off to credulous pension funds, insurance companies and foreign banks.
- [ Normxxx Here: Using those incredible credit ratings provided by Moody's, S&P, Fitch, etc.— for a fat fee, of course. ]
As Steven Rattner of DLJ Merchant Banking said, "It’s become nearly impossible to finance a private equity transaction of over $1 billion." (WSJ) The Golden Era of Acquisitions and Mega-mergers is coming to an end. We can expect that the financial giants will probably follow the same trajectory as the Dot.coms following the 2001 NASDAQ-rout.
The investment banks are also facing potentially enormous losses from liabilities that "operate off their balance sheets" In David Reilly’s article "Conduit Risks are hovering over Citigroup" (WSJ 9-5-07) Reilly points out that "banks such as Citigroup Inc. could find themselves burdened by affiliated investment vehicles that issue tens of billions of dollars in short-term debt known as commercial paper"… Citigroup, for example, owns about 25% of the market for SIVs, representing nearly $100 billion of assets under management. The largest Citigroup SIV is Centauri Corp., which had $21 billion in outstanding debt as of February 2007, according to a Citigroup research report. There is NO MENTION OF CENTAURI IN ITS 2006 ANNUAL FILING with the Securities and Exchange Commission.
Yet some investors worry that if vehicles such as Centauri stumble, either failing to sell commercial paper or suffering severe losses in the assets it holds, Citibank could wind up having to help by lending funds to keep the vehicle operating or even taking on some losses.
So, many investors don’t know that Citigroup could be holding the bag for "$21 billion in outstanding debt"? Or, perhaps, the entire $100 billion is red ink; who knows? (Citigroup’s stock dropped by more than 2% after this report appeared in the WSJ.)
Another report which appeared in CNN Money further adds to the suspicion that the banks’ "brokerage affiliates" may be in trouble:
- "The Aug. 20 letters from the Fed to Citigroup and Bank of America state that the Fed, which regulates large parts of the U.S. financial system, has agreed to exempt both banks from rules that effectively limit the amount of lending that their federally-insured banks can do with their brokerage affiliates. The exemption, which is temporary, means, for example, that Citigroup's Citibank entity can substantially increase funding to Citigroup Global Markets, its brokerage subsidiary. Citigroup and Bank of America requested the exemptions, according to the letters, to provide liquidity to those holding mortgage loans, mortgage-backed securities, and other securities…This unusual move by the Fed shows that the largest Wall Street firms are continuing to have problems funding operations during the current market difficulties." (CNN Money)
Does this mean that the other large banks are involved in the same type of "hide-n-seek" strategies?
Sounds a lot like Enron’s "off-the-books" shenanigans, doesn’t it?
Wall Street Journal:
- "Any off-balance-sheet issues are traditionally POORLY DISCLOSED, so to some extent, you're dependent on the insight that management is willing to provide you and that, frankly, is very limited," says Mark Fitzgibbon, director of research at Sandler O'Neill & Partners."…..Accounting rules DON’T REQUIRE BANKS TO SEPARATELY RECORD ANYTHING RELATED TO THE RISK that they will have to loan the entities money to keep them functioning during a markets crisis.”….” The vehicles (SIVs and conduits) ARE OFTEN ESTABLISHED IN A TAX HAVEN AND ARE RUN SOLEY FOR INVESTMENT PURPOSES AS OPPOSED TO TYPICAL CORPORATE ACTIVITIES.”
Still think the banks are on solid ground?
- "Citigroup, is the nation's largest bank as measured by market value and assets. Its latest financial results showed that it administers off-balance-sheet, conduit vehicles used to issue commercial paper that have assets of about $77 BILLION.
Citigroup is also affiliated with structured investment vehicles, or SIVs that have "nearly $100 billion" in assets, according to a letter Citigroup wrote to some investors in these vehicles last month." (IBID)
Yes; and how many of these "assets" are in fact corporate debt, auto loans, credit card debt, and student loans that have been securitized and are now under extreme pressure in a slumping market?
In an "up market" such loans can provide a valuable income-stream that that transforms someone else’s debt into a valuable asset. In a down-market, however, ('toxic waste') defaults can wipe out trillions in market capitalization overnight.
How Did We Get Into This Mess?
More than 20 years of dogged lobbying from the financial industry finally paid off with the repeal of the Glass-Steagall Act which was passed by Congress following the 1929 stock market crash. The bill that was specifically written to isolate and limit the conflicts of interest that are bound to occur when commercial banks are permitted to underwrite stocks and bonds.
The financial industry whittled away at Glass-Steagall for years before finally breaking down its regulatory restrictions completely.
- In August 1987, Alan Greenspan— formerly a director of J.P. Morgan and a proponent of banking deregulation— became chairman of the Federal Reserve Board. In 1990, J.P. Morgan became the first bank to receive permission from the Federal Reserve to underwrite securities, so long as its underwriting business [did] not exceed the 10 percent limit. In December 1996, with the support of Chairman Alan Greenspan, the Federal Reserve Board [issued] a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with [as much as] 25 percent of their business in securities underwriting (up from 10 percent).
This expansion of the loophole created by the Fed's 1987 reinterpretation of Section 20 of Glass-Steagall effectively rendered Glass-Steagall obsolete. ("The Long Demise of Glass Steagall", Frontline, PBS)
In 1999, after 25 years and $300 million of lobbying efforts, Congress aided by President Bill Clinton, finally repealed what remained of Glass-Steagall. This paved the way for the problems we are now facing.
Another contributing factor to the current banking-muddle is the Basel rules. According to the BIS (Bank of International Settlements) website:
- “The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. At times, the Committee uses this common understanding to develop guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision."
The Basel Committee on Banking (Basel 2) requires "banks to boost the capital they hold in reserve against the loans on their books."
Sounds like a good thing, doesn’t it? This protects the overall financial system as well as the individual depositor. Unfortunately, the banks found a way to circumvent the rules for minimum reserves by "securitizing" pools of mortgages (MBS) rather than holding individual mortgages. (which called for more reserves) This provided lavish origination and distribution fees for banks, but shifted much of the risk of default to Wall Street investors. Now, the banks are saddled with roughly $300 billion in mortgage-backed debt (CDOs) that no one wants and it is uncertain whether they have sufficient remaining reserves to cover their losses.
By October, we should know how this will all play out. As David Wessel points out in "New Bank Capital requirements helped to Spread Credit Woes":
- "Banks now behave more like securities firms, more likely to mark down the value of assets when market prices fall— even to distressed levels— rather than sitting on bad loans for a decade and pretending they’ll be paid back."
The downside of this is that once that banks write off these toxic MBSs and CDOs; the hedge funds, insurance companies and pension funds will be forced to do the same— dumping boatloads of this bond-sludge on the market driving down prices and triggering a panic-sell-off. This is what the Fed is trying to prevent through its $60 billion repo-bailout.
Regrettably, even the Fed cannot hope to remove a half-trillion of bad debt from the balance sheets of the banks or forestall the collapse of related financial institutions and funds which are loaded with these "unmarketable" time-bombs. Besides, most of the mortgage derivatives (CDOs) have been massively enhanced with low interest leverage from the "carry trade". When the value of these CDOs is finally determined— which we expect will happen sometime before the end of the 3rd Quarter— we can expect the stock market to fall sharply and the housing recession to turn into a full-blown economic crisis.
- [ Normxxx Here: Don't underestimate the ability of the Fed and others to patch things and drag this out for another year or so. ]
Alan Greenspan: The Fifth Horseman?
So, who’s to blame? The finger-pointing [[and lawsuits: normxxx]] has already begun and more and more people are beginning to see how this massive economy-busting equity bubble originated at the Federal Reserve— it is the logical corollary of former Fed-chief Alan Greenspan's "easy money" policies.
Henry C K Liu sums up Greenspan’s tenure at the Fed in his article "Why the Subprime Bust will Spread":
- "Greenspan presided over the greatest expansion of speculative finance in history, including a trillion-dollar hedge-fund industry, bloated Wall Street-firm balance sheets approaching $2 trillion, a $3.3 trillion repo (repurchase agreement) market, and a global derivatives market with notional values surpassing an unfathomable $220 trillion.
On Greenspan's 18-year watch, assets of US government-sponsored enterprises (GSEs) ballooned 830%, from $346 billion to $2.872 trillion. GSEs are financing entities created by the US Congress to fund subsidized loans to certain groups of borrowers such as middle— and low-income homeowners, farmers and students. Agency mortgage-backed securities (MBSs) surged 670% to $3.55 trillion. Outstanding asset-backed securities (ABSs) exploded from $75 billion to more than $2.7 trillion." (Henry Liu, "Why the Subprime Bust will Spread", Asia Times)
"The greatest expansion of speculative finance in history".
That says it all.
But no one makes the case against Greenspan better than Greenspan himself. Here are some of his comments at the Federal Reserve System’s Fourth Annual Community Affairs Research Conference, Washington, D.C. April 8, 2005. They show that Greenspan "rubber stamped" every one of the policies which have since metastasized throughout the entire US economy.
Greenspan: Champion of Subprime loans:
- "Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country. With these advance in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers."
Greenspan: Main Proponent of Toxic CDOs
- "The development of a broad-based secondary market for mortgage loans also greatly expanded consumer access to credit. By reducing the risk of making long-term, fixed-rate loans and ensuring liquidity for mortgage lenders, the secondary market helped stimulate widespread competition in the mortgage business. The mortgage-backed security helped create a national and even an international market for mortgages, and market support for a wider variety of home mortgage loan products became commonplace. This led to securitization of a variety of other consumer loan products, such as auto and credit card loans."
Greenspan: Supporter of Loans to People with Bad Credit
- "Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately.
These improvements have led to the rapid growth in SUBPRIME mortgage lending…fostering constructive innovation that is both responsive to market demand and beneficial to consumers."
"Improved access to credit for consumers, and especially these more-recent developments, has had significant benefits.
Unquestionably, innovation and deregulation have vastly expanded credit availability to virtually all income classes. Access to credit has enabled families to purchase homes, deal with emergencies, and obtain goods and services. Home ownership is at a record high, and the number of home mortgage loans to low— and moderate-income and minority families has risen rapidly over the past five years. Credit cards and installment loans are also available to the vast majority of households"
Greenspan: Big Fan of "Structural Changes" which increase Consumer Debt
- "As we reflect on the evolution of consumer credit in the United States, we must conclude that innovation and structural change in the financial services industry have been critical in providing expanded access to credit for the vast majority of consumers, including those of limited means. Without these forces, it would have been impossible for lower-income consumers to have the degree of access to credit markets that they now have.
This fact underscores the importance of our roles as policymakers, researchers, bankers, and consumer advocates in fostering constructive innovation that is both responsive to market demand and beneficial to consumers.” (Federal Reserve Chairman, Alan Greenspan; Federal Reserve System’s Fourth Annual Community Affairs Research Conference, Washington, D.C. April 8, 2005)
Greenspan’s own words are the most powerful indictment against him. They show that he played a deliberate and central role in our impending disaster. The effort on the part of media pundits, talking heads, and so-called experts to foist the blame on the rating agencies, predatory lenders or gullible mortgage applicants misses the point entirely. The problems began at the Federal Reserve and that’s where the responsibility lies.
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Web Trend Map 2007
Web Trend Map 2007, Version 2.0 [¹]
By TheBigPicture | 11 September 2007
Way cool: The 200 most successful websites on the web, ordered by category, proximity, success, popularity and perspective:
Click Here, or on the image, to see a larger, undistorted image.
Real Homes of Genius
Real Homes of Genius: Today we Salute you Downey. $100,000 off in 3 Months. [¹]
By Dr. HousingBubble | 15 September 2007
We’ve all heard about the reluctance of sellers to lower their prices even with the onslaught of negative housing news. Well today, we have a bank owned property that has no problem with dropping prices and dropping them fast. You may wonder why the median price in Los Angeles County is so outrageously high. Some out of state folks just assume everyone in this county of 10,000,000 people is making $200,000 a year and has no problem paying $547,500 for a starter home. Well we are quickly realizing as the tide pulls out that many recent homeowners bought places with convoluted mortgages that would make the Louisiana Purchase read like a kid’s book. In a previous post, we discussed that it is very easy for some families to fall into the debt trap. And the primordial need to own one’s place in America is so deep seated that some families will pay anything for having their name on the deed even if prices make absolutely no sense. So today per a reader’s request, we will examine the city of Downey. Today we Salute you Downey, with our Real Homes of Genius Award.
This home is a nice sized 3 bedroom home with 2 baths. Something that you would consider as a starter home in many parts of the country. So what is the price tag? $300,000? Nope. $400,000? Closer. $500,000? Let us give it to you straight. The price of this home was initially listed at a whopping $727,500! This works out to $553 per square foot for a home that is listed at 1,315 square feet. This home is nearly 60 years old and is in a middle class area of Los Angeles. This isn’t a prime location like Santa Monica or Manhattan Beach. You are not overlooking the Pacific Ocean or nestling the hills in Pasadena. So why are they listing the home at 3 quarters of a million dollars? Welcome to Wonderland USA. We’ve already seen many homes get knocked down in price in Southern California. Very little is moving in lower to middle class neighborhoods even with price drops. Sales last month dropped a whopping 50 percent year-over-year in the region.
Let us take a look at the massive pricing action on this bank owned home:
Price Reduced: 06/01/07 — $727,500 to $686,800
Price Reduced: 07/13/07 — $686,800 to $652,500
Price Reduced: 09/02/07 — $652,500 to $619,875
In the span of 3 months, this home is lowered by $107,625, or $37,875 per month. Now think about this for one second. Did this property actually lose $107,625 over the summer? Of course not. This again is the pie in the sky dreaming of banks trying to unload properties looking at yesteryear appraisals. Let us take a look at the sales history:
Sale History
02/21/2007: $23,600 [added refi]
01/19/2006: $640,000
08/24/2005: $542,500
We are quickly approaching the 2005 sales price. The 2006 sales price is absurd. Again, we are seeing the famed mortgage equity withdrawal action going on here with the $23,600 2nd taken out earlier this year. Assuming this home was purchased in 2006 with zero down, some lenders are probably out to the tune of $663,600. Yet people in Los Angeles make incomes to support this price right? Well let us look at the average household income for this immediate area:
Average/Household: $75,523
Keep in mind this income level is important because these are the people that will be buying these homes in the future. Let us humor the current lower sales price and run the numbers:
PITI: $4,367 - with 5 percent down ($30,993) and current jumbo rates on a 30 year fixed
Monthly Net Income: $4,904 (filing as married with 2 exemptions)
So this family is left with a disposable income of $537 after the housing payment. We haven't factored any other monthly revolving costs. They are spending 89 percent of their net income only on servicing their home! Everyone should take a look at the new rules being proposed by the FHASecure Act. Here is a piece from the CNN article:
- It used to be you couldn't refinance into an FHA loan if you'd been delinquent in your payments for any reason. But with the FHASecure Act, delinquent homeowners qualify for an FHA-insured refi if they have:
- A history of on-time payments for at least six months before their loans reset to higher rates
- Interest rates scheduled to reset between June 2005 and December 2009
- 3 percent equity in their home, or the cash equivalent
- A sustained history of employment
- Sufficient income to make their FHA-insured mortgage payment and all other obligations
Wow. Many folks in California are currently underwater. Meaning they have negative equity. Since most people in the last few years went 0, 3, or 5 percent down, that equity is now lost. Does that mean they don’t qualify? And what do they mean sufficient income? Does that mean they can have housing payments up to 99.9 percent of their net income and still qualify? Reading these guidelines, it seems like 100 percent of California isn’t going to participate in this bailout party. Here is another gem from the article:
- The FHA will still insist that lenders verify borrowers' income and ensure that their total debt payments don't exceed 43 percent of their income or that their mortgage payment won't exceed 31 percent of income. If those ratios are exceeded, the lender must explain how the homeowner can compensate for that.
- "[B]y stimulating the demand for housing, autos and other consumer durables; by encouraging a more competitive dollar to stimulate increased net exports; by raising share prices to increase both business investment and consumer spending; and by freeing up spendable cash for homeowners with adjustable-rate mortgages."
Kevin does highlight other important bubble antics in the post and I recommend you read it if you have not done so. As you can see from the above perma-bull argument, we are now in some sort of claptrap; try to follow this convoluted logic, now that people are acknowledging a credit bubble the solution for all of this is for the Fed to cut rates and thus encourage further debt spending? What a fantastic plan! But wait, isn't massive speculation in housing and the credit markets the reason we are experiencing this credit crunch? Why doesn’t the Fed just drop rates to 0 and be done with the dollar? They want to institutionalize a new paradigm of credit induced spending. No one seems to notice that oil is at an all time high and gold is at multi-decade highs. I wonder if inflation has anything to do with it? Not according to these data gatekeepers.
The last article generated a lot of buzz and polarized readers. The data used was pulled from the Census Bureau, Edmunds, and other public sources. It wasn't made up as some readers thought; you can verify the data yourself. The minutia is besides the point. The main message of the article was to highlight some reasons people go into major debt especially in high priced metro areas. Some readers from other states saw this as typical overspending by Californians and said, "what does this have to do with me?" Quite a bit. Many mortgage, construction, finance, and retail sectors that are getting impacted are located in multiple states throughout this country.
And with 36,457,549 people or 12.17 percent of the entire US population, California has a large impact on many neighboring states (look at Nevada and Arizona for immediate results). Some folks jumped to the conclusion that everyone spends like this and this was the prototypical household budget; not everyone spends like this, but many do. And yes, not all debt is bad. For example, using a mortgage to buy rental property that yields cash flows. This is good debt. Buying a $50,000 car that depreciates once you leave the lot is bad debt. Paying for a top rated university education, good debt. Buying a Real Home of Genius, bad debt. You get the point.
Many factors are converging to pop this housing bubble especially in California. This Real Home of Genius demonstrates that many banks are going to get aggressive in their price-cutting to move inventory. We can coin this as the post-summer housing blues. Since summer is typically the strongest selling season and many sellers figured they would have a time horizon from June to September, we are now going to see a rush to unload short-sales and REOs during the worst selling seasons, fall and winter. Compound that with the current credit crunch, peyote induced housing prices, and growing inventory and you have a recipe for a housing bear market.
Many sellers may be oblivious to all that is going on around them. I doubt the majority of folks spend their time scouring housing reports and digging into government data to time the housing market. Even though the majority of the population gets their housing knowledge from mainstream outlets, banks and lenders have a better overall picture of what is going to happen (after all, these are the people that will now need to unload massive amounts of inventory). Why do you think major housing lenders are trimming down to a barebones model? They are gearing up for survival mode. And this particular home isn’t an exception so get ready for some aggressive pricing moves in the next few months which will knock the median prices even lower. I already went on record saying that each Southern California County will have a negative year-over-year median price according to DataQuick by the end of the year. How can the outcome be any different?
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Recession 2007?
The Recession is Here [¹]
By Richard Benson | 15 September 2007
You don't have to be Sherlock Holmes to see the signs of a recession bursting through in economic data, particularly in the August Employment Report. One general coincident indicator for a slowing economy is in the decline in tax receipts. Because taxes are based on income, if less income is reported, lower tax revenues are received. Tax receipts are falling for the US Treasury and the for state and local tax authorities [[probably a reason for the drop in local and state employment in August: normxxx]].
Other recessionary indicators are popping up everywhere, from a weak transportation industry (if you can't sell it, why ship and stock it), to manufacturing and retailing. All of these industries have begun to institute the usual desperate measures to boost sales. One recent example of this was when Apple cut the price of their iPod by 30 percent because inventory was building up. This move angered many of their loyal customers who stood in line for days so they could be one of the first to purchase one early on, at full price.
Some other methods used lately are by the auto manufacturers who are offering 0 percent financing, again, for 60 months, and by department stores advertising "no payments for a full year on anything bought today". The Target store wants to sell its $7 billion in-house credit portfolio even though past credit increased sales. Why? Because it's likely that many of Target's loans were made to subprime customers and will probably never be paid back. These drastic measures indicate that final demand is very weak, and, without it, there is little incentive to produce. This results in layoffs rather than hiring. A healthy cyclical recovery will only occur when inventory has been cleared out, and wage earners have once again built up their savings, and have a pent up demand for goods and services.
If you have read your shrunken newspapers lately, you may have noticed that over 150 mortgage companies have either shut down or filed for bankruptcy. Countrywide, as one example, is laying-off 12,000 workers in their first round of job cuts. Unfortunately, many laid-off workers will not be able to receive COBRA health benefits because the company they worked for doesn't exist anymore. Inside sources from Wall Street are saying that hedge fund and Wall Street job losses could approach 20 percent.
Real estate agents could really begin to feel the effects of a downturn. The number of agents ballooned over the past few years from 500,000 to over 1,300,000. With new and existing home sales collapsing, many agents are effectively unemployed because they're not earning anything. However, they're not eligible to collect unemployment benefits because they are independent commissioned sales people. Nationwide, the demand for anyone working in the housing sector (including mortgage bankers, construction workers, and building suppliers) will slow down considerably and result in many big drops in the employment numbers in the months ahead.
Finally, the smoking gun for a slowing economy is really reflected in the employment numbers. The Bureau of Labor Statistics ("BLS") household survey showed a drop of 360,000 jobs in the September report for August. The unemployment rate would have gone up except for the fact that an equal number of potential workers gave up looking for work and dropped out of the labor force; a clear sign they knew there were no jobs for them. Reinforcing this view is the fact that employment for temporary workers has turned down. Temporary workers, not surprisingly, are the first to be hired when the economy picks up, and the first to be let go as production is cut back.
The BLS is mindful of how politically sensitive any reported job data is to the White House, so there is a strong bias for the government bureaucrats to publish a favorable jobs report. Job growth is currently facilitated by using a computer model, the [[now infamous: normxxx]] BLS Birth Death model, to estimate jobs that have been 'created' but are not counted in the payroll survey. The computer-created jobs are then added to the total jobs number before 'seasonal' adjustment.
The effect of the model is, of course, perverse. Such models just blindly project the past into the future. Take a look at the table below:
February to August 2007
Month Jobs Created by BLS Payroll Job Growth Job Growth Without
Birth Death Reported by BLS Adding Computer
Computer Model Modeled Estimates
February 118,000 90,000 - 28,000
March 128,000 175,000 53,000
April 317,000 122,000 -195,000
May 203,000 188,000 - 15,000
June 156,000 69,000 - 87,000
July 26,000 68,000 42,000
August 120,000 - 4,000 -124,000
Total 1,068,000 708,000 -360,000
Without the Birth Death model, the BLS would have reported 124,000 job losses (not 4,000 losses) in the August employment report. Since February, there has very likely been a drop in employment (due to the effects of the housing and mortgage mess) not job growth of over 700,000. That's why we are convinced the recession is already here!
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
The Blackstone Peak
The Blackstone Peak and the Turning of the Worms*
(The Slow Motion Train Wreck Continues) [¹]
By Jeremy Grantham | 27 August 2007
GMO 7-Year Asset Class Return Forecasts
GMO Second Quarterly Update 2007
- * “The Worm Turns,” from Henry VI, Part III, “The smallest worm will turn being trodden on,” is an English expression implying that the downtrodden finally snap back. It is closest to “The Revenge of the Nerds” in American.
- Since mergers and acquisitions, to use a quaint old term, often involve painful layoffs, this talk of vast new wealth has given plenty of ammunition to politicians and union leaders who think union members are paying the price for the wealth accumulation of others. I don’t think it would be exaggerating, in fact, to say that the rest of the world, that is the real world, is getting fed up with the financial world. We make more and more money and they in round numbers do not. Where we see clever global deals, they see excessive deal profits and job losses. They see themselves paying full income tax and the billionaires of private equity and some hedge fund managers paying 10% or 15% tax. And they have a point! Just as real estate developers have to pay income tax, as opposed to capital gains tax, on property sales because it is a routine part of their stock-in-trade, surely buying and selling companies is the stock-in-trade of private equity. If it is not, what is?
Remarkably, the rest of the world that grows irritated by excesses in the financial world even includes some financial insiders. For example, a recent talk show on National Public Radio featured a successful grand-old-man of private equity criticizing the new guys at Blackstone, stating that they had lost the standards set by earlier deals in private equity. In the good old days, he claimed, private equity managers improved the acquired companies with sound long-term strategies and had real societal value that Blackstone appeared to have lost. Blackstone’s focus, it was suggested, had narrowed to simply how much money could be made. Even the mother of a private equity mogul was quoted to the effect that money was the only way her son graded himself. (Whether she said this admiringly or not was not revealed!)
A very powerful suggestion was that no real fundamental value was being added by the new guys. Adding to this internecine warfare, a private equity leader in Britain said 2 weeks ago that he could see no reason at all why he paid a lower tax rate than a cleaning lady! When industry leaders speak out like this against the excesses of other leaders, it is easy to believe that all is not entirely well.
As we featured in an earlier quarterly letter, average real hourly wages in the U.S. have barely budged for 40 years while European and Japanese hourly rates have more than doubled. Income distribution around the world, but particularly in the U.S., has become more skewed toward the rich. In the U.S. it has indeed risen to levels not seen since 1929 and before that in the Gilded Age. And like readers then, we are treated to descriptions of 60,000-square-foot new houses that rival in size, if not sheer splendor, the Newport "cottages" of the Vanderbilts and Astors.
Whatever the reasons for income distribution shifting toward the rich— you’ve seen the data, it’s all about the top 1% and even the top .1% and .01%— it can always be addressed by shifts in the progressiveness of income tax. But, we have addressed it by "piling on": we have reinforced the natural global forces that are moving more wealth to the wealthy by shifting more of the tax load to sales and income taxes of average taxpayers and away from the capital gains and dividend taxes of the wealthy. The argument for not interfering with the steady tilting of income toward the rich is that it is the natural outcome of global economics. This is completely true for the distribution of pre-tax income, but completely irrelevant for the distribution of post-tax income, which has been decided for the last 100 years or so since serious taxes began by more or less deliberate political decision.
To allow the natural global drift to income concentration to remain is to cede an important societal and political decision to such vagaries as how many Chinese farmers are willing to move to town and how fast! This would be a strange way to make such an important decision. The unavoidable increase in job insecurity caused by plugging China, the developing world, and the former Communist world into the global system also has been exaggerated by the wave of deals and cost cutting. If the Chinese don’t get you, KKR will, is the union leader’s nightmare.
Well if you are rich and the natural drift of global economics is on your side, and the administration is oddly pushing in your favor too, and the working stiffs are not doing particularly well, you would be very well advised to keep your head down. And some have, but in general, no such luck! Extravagant houses, flashy parties, well-observed frenzies of art purchasing, ill-advised justifications of low taxes paid, and the nice coincidence of some very visible public offerings that have underlined the immense scale of the new wealth have all served to create an important watershed event, a defining moment perhaps of this global financial bubble. From now on we should count on politicians bearing down on this issue. And they have a lot to get their teeth into.
It is not just that income distribution has become so much less evenly divided in the last 20 years and the tax load for the rich so much lighter than it was. Corporate taxes are also declining almost everywhere as a percentage of total taxes. Now I’m no fan of corporate tax, or sales tax for that matter. Taxes are paid in the end by human beings and corporate entities merely pass taxes on. (In the U.K., for example, Exxon collects, say, $3 a gallon tax for the government and here in the U.S. merely $1, but it has no effect on their return.) Corporations are driven by net returns on capital after tax. But if a society decides, for political reasons, that corporate tax looks and sounds fairer, even if it’s in fact regressive, then how odd to allow higher risk taking through higher debt to determine your tax level. It almost makes it a voluntary tax.
If you have a portfolio of companies, you can keep increasing your leverage just up to the point, say, where you calculate that a small percentage will go bankrupt in a 50-year economic flood. In aggregate your interest payments increase and increase until little or no corporate tax is paid at all. And this situation is so easily fixed and so temptingly fixable in the more combative environment we have created: phase out over 5 years or so, the deductibility of debt in excess of, say, 50% of total capital. Corporate taxes will rise and overpriced private equity deals will be far less common. Corporate tax has always been a tax on efficiency— be less efficient, make less money, and you’ll pay less tax. But now it has also become a tax on conservatism and prudence.
The more reckless you are, the more you borrow, and the more interest you deduct, the less tax you pay. Not a good idea in the long run. (The more economically rational way of removing this tax on prudence, which would appeal to the other side of the political spectrum, is to simply do away with corporate tax entirely and replace it with, say, a mix of sales and income tax, with whatever progressivity is desired. With the tax subsidy on interest removed, excess leverage and silly private equity deals will be much reduced in number even more effectively than by limiting deductibility as suggested above.)
A particularly tempting target for higher taxes is the carried interest of private equity and hedge funds that pay 10% and 15% rates of tax on what is really earned income. The use of offshore funds to postpone even these lower rates is perhaps even more tempting. Given what you can read in the press in the U.S., Germany, and the U.K., these targets will not be ignored. And what particularly bad timing this issue faces here in the U.S. with the Democrats smarting from the loss of two close elections and the new Chairman of the Financial Services Committee, Barney Frank, saddled up and ready to right as many wrongs as he can get his hands on.
As I write this, more proof that the worms have turned has been presented by the conviction for fraud and obstruction of justice of Lord Black— with a name like that it must have been obvious to the jury that he, like Darth Vader, had gone over to the Dark Side. Notable for conspicuous consumption, he was "not prepared," he said, "to re-enact the French Revolution’s renunciation of the rights of nobility." Wow! No wonder the "little people" are getting antsy.
- The increased taxes that politicians will aim at the super-rich private equity guys may well turn out to be justified, but the bad news for us other well-heeled-but-fully-income-taxpaying-obviously-innocent bystanders is that we may get thrown out with the bathwater. Oh, what a world! What a world! The point here, in case you’ve missed it, is that the global financial bubble faces a new negative in the rapidly growing hostility of politicians and the general public. This will probably result in increased taxes on capital gains and dividends as well as redefinitions of what income really is, and may easily include increases in the top rates of ordinary income tax as well. In total this will not be good for the animal spirits of investors, which are in the end the most important input into maintaining a bubble.
No, what we have to worry about is whether we are reaching a broad-based level of financial metal fatigue in which bolt after bolt will fail with ultimately disastrous consequences. The scary part is that this global financial structure is faith based, held together by unprecedented amounts of animal spirits. If the faith starts to fail it is, "sauve qui peut" (the old cry as a ship foundered), or "every man for himself." The Blackstone Peak argument of growing hostility to the financial world is just the kind of slow burning negative that, with plenty of help from other negatives, can finally bring the bridge down or sink the ship.
The other persistent problem dating back to February is, of course, the slowly increasing trouble with subprime mortgages. In the fixed income markets the disease— best characterized as the questioning of previously blind faith— slowly spreads: a little widening of the junk bond spread here and a little tightening of private equity credit there. But as yet the equity market seems totally unaffected with volatile and risky stocks still making the running. Although the brontosaurus has been bitten on the tail, the message has not yet reached its tiny brain, but is proceeding up the long backbone, one vertebra at a time.
The housing market also refuses to cooperate with the bulls and seems highly likely to remain uncooperative for some considerable time. Even with flat prices, mortgages roll over their honeymoon rates and are repriced up by up to 2½ points, sometimes for holders who were already stretched. Steadily increasing defaults make it harder for house prices to stabilize. The inventory of unsold houses seems likely to break out above 9 months’ supply where 4 months’ would be a strong market. Yet we are told on all sides, even by the Secretary of the Treasury, that even for the subprime market all is "contained." We have to wonder if the container, in this case, will turn out to be Pandora’s.
Additionally, the strength of the U.S. economy has been, at least temporarily, impacted by the housing weakness: first quarter growth was down to 0.7% annualized and, of the 45 countries covered by The Economist magazine in June, the 12-month increase of 1.9% was dead last. Global economic growth remains high but is estimated to be declining this year from the remarkable level of the last 2 years. And concern with inflation is rising: it is persistently a little higher than desired in the U.S. and the U.K. It is a lot higher in India where wages in high tech and other international services are exploding to such an extent that outsourced jobs are either jumping from India to Vietnam or the Philippines (amongst others) for even cheaper wages, or more recently returning to California because wage savings in India are no longer sufficient.
Commodity prices, led by oil at over $73/barrel, and now agricultural prices, boosted recently by ethanol production, have either risen to new highs or stayed on a high plateau, putting further pressure on inflation. Oil and agricultural prices seem likely to be a persistent problem and in general are underestimated like many other negatives in today’s feel-good market. It is not surprising that unparalleled global growth has created substantial pressure on commodity prices and inflation. Quite the reverse. What is surprising is how low aggregate inflation has been. If 50 leading economists had sat down 5 years ago and been told how strong global growth would be, I am sure the estimate for inflation today would have been at least 1.5% or so higher than it has actually been.
It should not be at all surprising, therefore, that global inflation should start to rise, for as discussed in earlier letters, the argument that global low inflation was owed directly to millions of new Chinese workers never seemed entirely convincing to us as Chinese imports constituted only 2% of our GNP and what you don’t understand should never, perhaps, be relied on. (For the record, the global impact of cheap Chinese labor is felt powerfully as its percentage of global exports rises. If a rising trade surplus causes its share to merely stabilize and not fall, most of its inflation mitigating effect disappears. In fact, if its local labor costs rise faster than productivity, as they have begun to now, then it begins to export inflation.)
And then we come to the curious case of the jump in fixed income rates. In just 3 or 4 weeks in June the 10-year bond rate jumped by 60 basis points. This was not, we are assured on all sides, caused by inflation— although a June survey of investment managers did indeed show a sharp jump where 45% of them were concerned about inflation. No, it was caused by an increase in "growth," whatever that means. What was impressive and surprising, though, was the similar rate increase for 10-year TIPS, which moved rapidly from 2.1% to 2.8%. So we can understand some odd theories coming out.
But rising TIPS means that the broad cost of capital or the risk-free rate has risen, and by a lot! This of course should cause an immediate and severe sell-off in all asset class prices as well, for in theory they are affected by changes in the real discount rate more reliably than anything else. But, in practice they did not fall, for as always the real world is merely an inconvenient special case. Indeed, emerging market equities surged in precisely the same 4-week period, gaining almost 10% against other equities.
To rub it in, volatile stocks in most markets, but particularly in the U.S., beat the pants off safe stocks, thumbing their noses at any suggestion that they were impressed by the increased appreciation of risk by their fixed income colleagues. We wonder if this will come to seem like the behavior of headless chickens: the equity guys are often the last to know they’re dead. But it has always seemed likely that this would be a global equity market that would die hard. (In fact I toyed with the idea, in honor of Bruce Willis’s new movie and a true die-hard market, of calling this quarterly letter, "The Live Carefree and Die Very Hard Market.")
The argument offered for the odd strength of equities was that since the increased rates were based on growth expectations rising, and since the growth rate for stocks would rise equally to offset the rising discount rate, there was no need for lower stock prices (see Jeremy Siegel on Yahoo). The bad news here is the data are just incompatible with the conclusion. For, real interest rates in a given year have a slightly negative correlation with the following year’s GNP growth. Even across broader time periods— 5 and 10-year periods— there is a slightly negative correlation between GNP growth and real rates. Finally, while the interest rate increase is a fact, there is, of course, no guarantee anyway that an offsetting increase in growth will occur!
So two of the three great asset classes are having the wobblies in some of their components. First, real estate is looking rather weak here and very, very weak in Spain, which moved into first place in the bubble league by building more houses than France, Germany, and the U.K. combined. (And talk about headless chickens! Their stock market continues to go up despite the housing crash and construction having risen to 13% of GNP!) And second, low-grade debt, especially real estate related but increasingly including corporate loans and private equity funding, is getting nervous. But the third great asset class, stocks, seems bound and determined to make it through this third year of the Presidential Cycle— a year that has never declined materially and should be considered the bane of short sellers everywhere.
In summary, a few more bolts in the bridge may fail, but in the end you have to bet that the bridge will hold, supported by amazing animal spirits. At least until October. Even then the fourth year of the Presidential Cycle (which begins in October) is typically a quiet year. The odds of failure rise but they probably don’t become high until October 2008. At that time, a new administration with its new broom and new taxes and new antipathy to the financial world's rich, coupled with tighter credit and credit problems, we will have a very typical time, based on history, to have a bear market, and I for one am betting on it.
Today’s Portfolio
In terms of current portfolio positioning, we are certainly grateful in this global drought for cheap assets that U.S. TIPS have dropped in price. Back 7 years ago when they came out yielding 4.2%, we were very heavy buyers, having decided that fair value was at most 2.7%. Now, our Bonds are assumed to be 2.9% real. Inflation risk over 10 years is clearly not insubstantial and the removal of that risk should lower return. We cannot argue for less than a 30-basis-point discount, which would take the equilibrium yield on 10-year TIPS to 2.6%, a little below where they are today.
And, if pushed, 2.5% or even 2.4% does not seem unreasonable. So in recent weeks with 10-year TIPS selling between 2.6% and 2.8%, we have that rarest of rare birds, a genuinely cheap asset.
- [ Normxxx Here: Needless to say, he is assuming no underestimate of inflation by our economic lords in Washington. ]
Our last discretionary risk exposure is on emerging market equity, which has been brilliant beyond belief and seems on course to fulfill my 3-year-old prediction that it would sell at a premium P/E to the S&P before the cycle ends. Unlike our normally premature asset allocation moves, the dazzling fundamentals of emerging market equities have enabled us to hold our overweighting and hold it and hold it. And we still have an overweighting, but the P/E differential is down to 15%. Still, all good things must eventually come to an end.
The Anti-risk Bet in Perspective: A Once or Twice in a Career Opportunity
In 40 years I believe I have been offered three obvious and extreme opportunities to make or at least save money. The first in 1974 was presented by the extreme undervaluation of small cap stocks in absolute terms— many were below 5x earnings and even more yielded over 10%. And compared to the Nifty Fifty— the great high quality franchise stocks— they were almost ludicrously underpriced.
The second opportunity was in 1999 and 2000 when the extraordinary overpricing in absolute terms of growth stocks, especially technology and the internet, meant that in round numbers everything else was relatively reasonable and some assets, notably real estate and U.S. TIPS, were simply very cheap, even in absolute terms.
Well the third great opportunity is now upon us in my opinion, and that is anti-risk. It is almost certainly the most important of the three because of its diffusion across assets and countries. That is the good news, for most of the time we have to make do with modest opportunities and this one is the real McCoy. The bad news is that for equity managers the first two opportunities were easy to spot and easy to execute. Anti-risk in comparison is a diffused and complicated opportunity, and is as much or more in fixed income with all its new complexities as it is in equities.
The ideal way of playing this third great opportunity is perhaps to create a basket of a dozen or more different anti-risk bets, for to speak the truth none of us can know how this unprecedented risk bubble with its new levels of leverage and new instruments will precisely deflate. Some components, like subprime and junk bonds, may go early and some equity risk spreads may go later. Some will prove unexpectedly rewarding and some, no doubt, will be disappointingly modest. Such uncertainties would be moderated by a complicated package approach.
It will not be very easy, but some of the best hedge funds will, I’m sure, pull it off even as most of them pay the price for too much risk taking. Where we have the funds, the mandates, and the skill we will also try our very best to capture the spirit of the exercise.
To conclude, I have been trying to come up with a simple statement that would capture how serious the situation is for the overstretched, overleveraged financial system, and this is it: In 5 years I expect that at least one major "bank" (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist.
I have often been too bearish about the U.S. equity markets in the last 12 years (although bullish on emerging equity markets), but I think it is fair to say that my language has almost never been this dire. The feeling I have today is that of watching a very slow motion train wreck.**
- ** An exception was in the last great market aberration. In a late spring issue of Forbes in 2000, I debated Henry Blodget on the future of internet stocks. I argued that it was not about losing money, but survival: "80% of these companies will cease to exist."
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Florida Real Estate
Is It Time to Buy Florida Real Estate? [¹]
By Chris Weber | 15 September 2007
I think it is still way too early to buy Florida, in general.
There have been some large price declines in some areas. For instance, in Lake Worth, close to where I used to live (and still spend some of each winter) in Palm Beach, I just heard of one house, which had been on the market as high as $799,900 finally selling for $450,000. That's a decline of nearly 44% from the asking high. On that same street, another house which had an asking high of $750,000 recently sold for $436,050, a nearly 42% decline.
But my rule for buying real estate— especially property that you are not going to live in yourself— would strike people as pretty stark. I ask myself, "Would the return I get from rent— the net return after all the taxes, insurance, and other expenses— be at least 10% a year? Would it even be much higher than the rate I could get on T bills, eurodollars, etc?"
I was recently offered a small apartment building in another part of Florida— Bonita Springs, between Naples and Ft. Myers. I know the place because relatives used to rent there.
The average rent is about $900 per month. That's $10,800 annually. The apartments had been on the market for as high as $325,000 a piece. Similar ones in the area had actually sold for around this price at the peak about two years ago. The sellers have put the price down to $199,900.
Now, does this price make sense? Assuming I'm just paying cash and have no mortgage interest payments to make, the gross amount I would get based on that asking price works out to an annual return of 5.4%. But this is before federal income taxes, Florida property taxes, insurance (it is on a canal that leads to the sea), and general maintenance.
Even if I could write off some of this on taxes, you'd conservatively have to reduce this 5.4% return by at least one third. That reduces the return to 3.6%... and I think I am being quite generous. It would probably end up being less. Indeed, I'd be surprised if it were much over 2.5%. And then you get the headaches of being responsible for repairs, etc.
Of course, most people don't think in these terms. They have bought based not on numbers like these, but in the firm belief that they could resell the property at a much higher price. What is happening has put a big dent in that belief.
I told the seller that I would not pay more than $100,000 per unit. At that price the gross would be 10.8%. Of course, I could try to get more rent, but with the demographic in apartments like these (retired people whose prime income is their Social Security payments), there is very little room to raise.
And my net, even if the seller accepted my offer, would be a percentage return around what I could get by staying in safe cash instruments, which come with none of the maintenance worry.
So I'm saying that even at that drastically reduced offer (which the seller laughed at), I still would not rush to buy. Maybe I would, but it is not certain. What would the buying price have to be to get a net return of 10%? I'd say around $75,000. That would give a gross return of 14.4%.
But an apartment that had been as high as $325,000 being sold at $75,000? That's a price reduction of 77%. Impossible? Well, during Japan's real estate crash of the 1990s, property ended up selling for as much as 90% from peak prices.
The seller in this particular case has had no offers at all, other then mine. I actually did not want to give it, but he kept asking me. My intention was not to be a "vulture," but to come up with a number that made some kind of sense on a financial return basis.
I think we are facing years where one cannot count on higher prices in Florida real estate. Now this doesn't mean that you can't get good prices even now. But you just can't expect to turn around and resell at a higher price within a period of several years. And if you are buying for income, the average prices are still much too high for me.
Too many sellers are holding out for prices that are not going to be met. The process just needs time to become more realistic. How much time? The aftermath of the last huge boom in Florida real estate needed 30 years (1920s to 1950s) until prices got back to peak levels.
Let's hope it doesn't take that long this time.
Good investing,
Chris Weber
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Friday, September 14, 2007
WHAT FUTURE DOES THE CREDIT CRUNCH BRING?
WHAT FUTURE DOES THE CREDIT CRUNCH BRING?
When you have too much debt, how can you be confident?
http://www.minyanville.com/articles/HOG-BCS-SIVS-ABCP-Greenspan/index/a/14021
by Mr Practical Sep 07, 2007
As the general public is fed old financial news day in and day out by TV, news of what happened already, let’s look at some FORWARD-LOOKING current facts.
The most important data release yesterday was the weekly Federal Reserve commercial paper outstanding number. Asset-backed commercial paper fell a further 3.1% for the week to $966.7 bln. Overall commercial paper outstanding fell by $54.1 bln. TOTAL COMMERCIAL PAPER OUTSTANDING HAS FALLEN 13.4% IN JUST ONE MONTH. During the 2001 downturn, commercial paper peaked in November 2000 and slid through to December 2003. Over that entire three-year period it declined by only 22%.
15-day commercial paper is yielding 6.3%, 90 basis points higher than a month ago. Treasuries are 200 basis points below these levels. CREDIT IN THE SYSTEM IS CONTRACTING FAST. As a result, signs of weakness in the economy will appear fast. LIBOR RATES REMAIN AT EXTREMELY ELEVATED LEVELS, also suggesting that the credit crunch in debt markets is as bad as it has been despite more liquidity injections from the ECB. Something is very wrong in the financial system.
[[The time is out of joint: O cursed spite, That ever I was born to set it right! :William Shakespeare, "Hamlet"; Act I; scene V]]
Does that not have vast implications for an economy that is built on the financial industry with over 30% of all S&P 500 earnings based on financial companies?
SP Weekly initial jobless claims dropped from 337K to 318K (normal volatility but the 4-week moving average is in a steady uptrend) while continuing claims were worse than expected.
The labor market is slowly weakening from the very bogus numbers we are fed by the BLS: “birth / death adjustments” and total employment “assumptions” have severely distorted the employment picture.
In August in the U.S., ONE-THIRD OF AGREED MORTGAGES FAILED TO CLOSE. Either the borrower walked away or the lender didn't like what he saw. On top of the pending home sales numbers released on Wednesday THIS SHOULD ADD UP TO HOME SALES DATA THAT ARE TRULY SHOCKING WHEN RELEASED LATE SEPTEMBER. A huge portion of the past five years' economic growth has been based on the housing and mortgage industries. It is not hard to see the implications.
CONTINUED AT: http://www.minyanville.com/articles/HOG-BCS-SIVS-ABCP-Greenspan/index/a/14021
When you have too much debt, how can you be confident?
http://www.minyanville.com/articles/HOG-BCS-SIVS-ABCP-Greenspan/index/a/14021
by Mr Practical Sep 07, 2007
As the general public is fed old financial news day in and day out by TV, news of what happened already, let’s look at some FORWARD-LOOKING current facts.
The most important data release yesterday was the weekly Federal Reserve commercial paper outstanding number. Asset-backed commercial paper fell a further 3.1% for the week to $966.7 bln. Overall commercial paper outstanding fell by $54.1 bln. TOTAL COMMERCIAL PAPER OUTSTANDING HAS FALLEN 13.4% IN JUST ONE MONTH. During the 2001 downturn, commercial paper peaked in November 2000 and slid through to December 2003. Over that entire three-year period it declined by only 22%.
15-day commercial paper is yielding 6.3%, 90 basis points higher than a month ago. Treasuries are 200 basis points below these levels. CREDIT IN THE SYSTEM IS CONTRACTING FAST. As a result, signs of weakness in the economy will appear fast. LIBOR RATES REMAIN AT EXTREMELY ELEVATED LEVELS, also suggesting that the credit crunch in debt markets is as bad as it has been despite more liquidity injections from the ECB. Something is very wrong in the financial system.
[[The time is out of joint: O cursed spite, That ever I was born to set it right! :William Shakespeare, "Hamlet"; Act I; scene V]]
Does that not have vast implications for an economy that is built on the financial industry with over 30% of all S&P 500 earnings based on financial companies?
SP Weekly initial jobless claims dropped from 337K to 318K (normal volatility but the 4-week moving average is in a steady uptrend) while continuing claims were worse than expected.
The labor market is slowly weakening from the very bogus numbers we are fed by the BLS: “birth / death adjustments” and total employment “assumptions” have severely distorted the employment picture.
In August in the U.S., ONE-THIRD OF AGREED MORTGAGES FAILED TO CLOSE. Either the borrower walked away or the lender didn't like what he saw. On top of the pending home sales numbers released on Wednesday THIS SHOULD ADD UP TO HOME SALES DATA THAT ARE TRULY SHOCKING WHEN RELEASED LATE SEPTEMBER. A huge portion of the past five years' economic growth has been based on the housing and mortgage industries. It is not hard to see the implications.
CONTINUED AT: http://www.minyanville.com/articles/HOG-BCS-SIVS-ABCP-Greenspan/index/a/14021
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