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FINANCIAL STOCKS: WHERE WILL THEY GO ONCE INVESTORS SOBER UP?
Financial stocks had been in a decades-long secular bull market through 2006 or so. As the writer of this article points out, their percentage of the S&P 500's total capitalization went from 5% in 1970 to 22% in 2003. Financials rode on the back of the great credit inflation.
With the pounding financial stocks have taken in the last two years, especially the last year, contrarian types are tempted to buy in. How smart is this -- in effect a bet that we have been witnessing a bull market correction rather than a secular top preceeding a multi-year period of underperformance? To us the top looked like a full scale mania, a la energy and resource stocks in late 1980, small technology stocks in the spring of 1983, and dot-com stocks in the late 1990s. After a mania top it takes years for the group to recover. The phenomenon can be ascribed both to investor psychology and to the overinvestment that occurs in the industry as a consequence of the cheap capital that comes with stocks sporting high multiples.
Add to this the affinity financial businesses have for leverage. Part of the adjustment process following a mania is the marking down to true value all the assets purchased or built while spirits were running high. Companies and investors gradually realize those assets are not producing the financial returns originally expected, and are not going to for a good long while. The values are accordingly revalued down, like a 5% coupon bond after prevailing rates have gone up to 10%. Now what if those assets were bought using 5-to-1 or greater leverage? The residual equity value disappears. Such leverage is routine for financial companies -- commercial banks, investment banks, etc.
Undoubtedly opportunities in the vast sector will appear. As for the large, generic financials: color us uninterested. Graham Summers, founder of and managing editor for investment newsletter firm GPS Capital Research makes the equivalent case against the financial sector. He believes that lower lows are ahead.
Financial stocks, like homebuilders, have become a favorite investment for contrarians. Drawn by the large dividend yields and low P/Es, investors have begun piling into the sector even as sovereign wealth funds -- the guys who bailed out these stocks last fall -- tell the banks to take a hike.
Financials have certainly experienced a temporary bottom as far as sentiment goes. Starting with their failure to establish a new low in mid-March, financial shares have rallied strongly as investors piled in and investment bank CEOs announced, "the worst is over!"
Much has been written about the market's ability to discount the future. Personally I have never believed this myth. We have seen several major mis-pricings in the last three years alone. The housing bust was obvious to anyone as early as 2005. But it was not until the second quarter of 2006 that homebuilder stocks starting tanking. The same can be said of mortgage lenders. Everyone knew 2-year adjustable rate mortgages would begin resetting in 2006. Yet mortgage lending stocks plugged along just fine until the first batch of subprime lenders went belly-up in February 2006.
Simply put, the market does not always discount the future accurately. It certainly believed the worst was over for financial stocks back in August 2007 -- between August and October the sector rallied more than 10%. Investors who bought have since been taken to the cleaners.
What we are witnessing today in financials stocks is not merely a matter of corrections and rallies. Instead, this is a multi-decade long bubble. From 1970 until 2003, financials' market capitalization as a percentage of the S&P 500 rose from less than 5% to 22%. Over the same period, financials' earnings as a percentage of the S&P 500's total earnings rose from less than 10% to 31%.
We have seen these kind of imbalances before. It happened with Energy stocks in the early '80s, when that sector's market capitalization rose to 26% of the S&P 500. It happened again in the late '90s when Tech stocks' market capitalizations rose to 32% of the S&P 500. In both situations, when these bubbles burst there was a fundamental shift in market climate for these sectors. Things never again returned to the peak, though investors were seduced numerous times into believing they would.
Just as they are now.
Financials, for all their writedowns and plunging share prices, are still 17% of the S&P 500's total market capitalization. The expected losses from the credit bubble have risen from $100 billion to $1 trillion in the last six months. Investments banks that were just as exposed to mortgage backed securities as Bear Stearns -- most notably Lehman Brothers -- have a long way to go downwards.
No one knows, including these firms' managements, what is sitting on their balance sheets. When you are leveraged by 33 to 1, with credit derivatives totaling trillions of dollars, raising a few billion here and there is not going to end your problems.
Financials have had a nice rally. But investors will sober up quickly when they realize the true fundamental shift that has occurred for these businesses. Dividends will be cut if not discontinued. Banks will go under. And financial stocks will plunge again to new lows, wiping out these gains.
Still Too Early For Banks
Jim Cramer recently wrote that the bearish "graybeards" were "dead wrong" with their prognostications for more pain ahead for financials. David Merkel does not come out and say Cramer is wrong -- perish the thought. He just outlines what has to go right for Cramer to be right. In effect, the day of credit reckoning would have to be delayed for so long people could forget it is coming yet again.
Now, [Cramer] might be right, and me wrong on this point (with my gray beard, though I am younger than he is). But let me point out what has to go right for his forecast to be correct.
(1) The inventory of vacant homes has to start declining. Still rising for now, another new record. Beyond that, you have a lot of what I call lurking sellers around, waiting to put more inventory out onto the market, if prices rise a little. They will have to wait a while, and many will lose patience and sell anyway. There is still to much debt financing our housing stock, and though most of the subprime shock is gone, much of the shock from other non-subprime ARMs that will reset remains. Will prices drop from here by 20%? I think it will be more like 12%, but if it is 20% there will be many more foreclosures, absent some change in foreclosure laws. ...
(2) We still have to reconcile a lot of junk corporate debt issued from 2004-2007, much of which is quite weak. Credit bear markets do not end before you take a lot of junk defaults, and we have barely been nicked. Yes, we have had a sharp rally in credit spreads over the last five weeks, but bear market rallies in credit are typically short, sharp, and common, keeping the shorts/underweighters on their toes. You typically get several of them before the real turn comes.
(3) We have not rationalized a significant amount of the excess synthetic leverage in the derivatives market. With derivatives for every loser, there is a winner, but the question is how good the confidence in creditworthiness between the major investment banks remains. Away from that, Wall Street will be less profitable for some time as securitization, and other leveraged businesses will recover slowly.
(4) Credit statistics for the U.S. consumer continue to deteriorate -- if not the first lien mortgages, look at the stats on home equity loans, auto loans, and credit cards. All are doing worse.
(5) Weakness in the real economy is increasing as a result of consumer stress. Will real GDP growth remain positive? I have tended to be more bullish than most here, but the economy is looking weaker. Let's watch the next few months of data, and see what wanders in ... I do not see a sharp move down, but measured move into very low growth in 2008.
(6) What does the Fed do? Perhaps they can take a page from Cramer, and look at the progress from private repair of the financial system through equity and debt issuance. It is a start, at least. But the Fed has increasingly encumbered is balance sheet with lower quality paper. Two issues: (a) if there are more lending market crises, the Fed cannot do a lot more -- maybe an amount equal to what they have currently done. (b) What happens when they begin to collapse the added leverage? Okay, so they will not do it, unless demand goes slack ... that still leaves the first issue. There are limits to the balance sheet of the Fed.
Beyond that, the Fed faces a weak economy, and rising inflation. Again, what does the Fed do?
(7) Much of the inflation pressures are global in nature, and there is increasing unwillingness to buy dollar denominated fixed income assets. The books have to balance -- our current account deficit must be balanced by a capital account surplus; the question is at what level of the dollar do they start buying U.S. goods and services, rather than bonds?
(8) Oh, almost forgot -- more weakness is coming in commercial real estate, and little of that effect has been felt by the investment banks yet.
As a result, I see a need for more capital raising at the investment banks, and more true equity in the capital raised. Debt can help in the short run, but can leave the bank more vulnerable when losses come. The investment banks need to delever more, and prepare for more losses arising from junk corporates and loans, housing related securities, and the weak consumer.
LOOKING BEYOND THE BAILOUT
David Dreman, long-running Forbes columnist and author of a couple of good books on value/contrarian investing, is one of the contrarians cited in the articles above who find the financials intriguing. Here he makes the case -- for selected banks he thinks will survive a contraction whose magnitude he does not sugar-coat.
The article is confusing. One on hand the Fed will have to step in and save a desperate situation. That the bailout will work as intended is a foregone conclusion. As we all know, governments are always successful in their major undertakings. And this makes bank stocks "dirt cheap because of the market's large overreaction." Yes, markets overreact. But every big selloff is not an overreaction, especially if it is correcting an "overreaction" on the upside. If a sell that was overvalued at $X goes to $3X in a year and then falls back to $X in three weeks, the decline was not an "overreaction". It was an insufficient reaction.
The market right now is as tricky a one as we have seen since the implosion of the high-tech bubble eight years ago. Federal Reserve Chairman Ben S. Bernanke has a problem on his hands: a very wide-ranging panic surrounding financial institutions. This is a problem that mere cuts in interest rates cannot cure.
The panic is writ large in the prices of financial stocks, whether of brokerage firms, banks or steeply leveraged real estate investment trusts. The exceptionally low interest rates of the early and mid-2000s created enormous temptations to buy assets with borrowed funds. Some of the assets were subprime and Alt-A (almost prime) mortgages, now worth less, often considerably less, than their par value. Other purchases were of derivatives constructed atop these mortgages.
Now there is a desperate race to deleverage at almost any price. But buyers have grown scarce. One subprime index, the ABX-HE-BBB-- 06-2, was trading at 100 in July 2006 and hit a low of 10 this March. Bear Stearns closed at $57 on March 13 and is now in the process of being sold to JPMorgan Chase for $10, and that is with $29 billion of Bear's mortgage portfolio being guaranteed by the Fed. We are in a liquidity crisis the magnitude of which we have not seen since before World War II.
Commercial and investment banks sitting on illiquid assets such as mortgages and private equity loans cannot sell them, and that means they do not have the cash with which to make new loans. The lack of liquidity is chilling the economy. Moreover, for banks and brokers to strengthen their balance sheets by deleveraging would devastate the economy and make what might be only a mild recession into one far worse and longer-lasting.
Hence the bailout by the Fed, in the form of longer-term financing at the discount window. The government, that is, is lending cash to financial institutions while taking as collateral the less salable of their subprime mortgages and related securities. The financial middlemen are supposed to take the cash borrowed from the Fed and lend it back out again, this time to higher-quality borrowers.
The government rescue of overleveraged financiers and underwater homeowners is still only beginning, and the signs that it will get bigger are manifold. The Federal Housing Administration has spent $21 billion since September staving off foreclosures. The House Financial Services Committee has proposed letting the FHA underwrite up to $300 billion in loans to borrowers. The last time the federal government stepped so directly into the mortgage business was at the bottom of the Great Depression.
Congressmen from both parties are working on legislation to provide tax breaks and other help to much of the stressed homeowner population. The Administration has been reluctant to get involved in anything it would consider a bailout, but the rapidly darkening credit situation may leave it with no choice.
If this scenario plays out, how will it affect investors? First, we should see a big rally in the stocks of financial institutions that are survivors but are for the moment dirt cheap because of the market's large overreaction. I would look at Marshall & Ilsley Corp. (MI) and Fifth Third Bancorp (FITB).
If you can take the heat of greater volatility, consider Comerica (CMA). This midcap bank headquartered in Texas is trading at eight times trailing earnings, in part because it has had to set aside money to cover bad loans. Still, the company has a strong capital base and yields over 7%. I expect a rebound over the next several years.
Do not buy bonds. The inflation driven by rising prices of oil, precious metals, raw materials and agricultural products has not run its course. That is, commodity prices have not fully worked their way into the prices of pizzas, ball bearings and trash bags. When they do, the CPI growth rate will go up, interest rates will go up and bond prices will go down.
The stock market historically has reacted badly, in the short run, to unexpected increases in the rate of inflation. But over time it has more than succeeded in keeping up with rising prices. Another inflation hedge is real estate. If you do not own a home or are thinking about trading up, now is a good time to make a move.
Dreman has been an effective exponent of the idea that, the 1970s notwithstanding, stocks are a good inflation hedge. The home buying recommendation needs far more accompanying explanation than is given (i.e., none).
Frightening as the markets look today, there will come a time when the liquidity crisis ends and today's prices for bank stocks look, in retrospect, like bargains.
THE IMPENDING MORTGAGE CRISIS
Michael Goode argues that we ain't seen nothing yet in the way of housing price declines and the corollary havoc that will wreak on the rest of the economy. We are coming off a mania that ended with housing prices at unprecedented highs versus rents. He expects that "the cataclysm" will come within the next couple years. Most of the evidence for his thesis has been seen piecemeal before. Goode lays it out in one place.
If you read the papers and watch the news, you may believe that we are in and have been in a subprime mortgage crisis for the last year or so. That is true. Many pundits are also saying that the subprime crisis is nearing its end. That is also true, to a point. Subprime mortgage troubles will not inflict that much more damage on the broader economy. However, prime and Alt-A mortgages with toxic features will cause troubles that will make the current troubles look like a walk in the park. Furthermore, broad-based declines in housing prices will start to wreak havoc on housing markets across the country.
The problem with the housing market bulls is that they are thinking within the framework of past housing downturns. The current downturn is unlike any other since the Great Depression, and no other downturn has started with houses so overpriced relative to rents. Few downturns started with such reasonable interest rates, and no other downturn saw double-digit house price declines across the country. This downturn is different, and it is going to lead homeowners (or homedebtors, as the Irvine Housing Blog calls those who have little equity) to change their behavior in ways that only the pessimists, such as myself, anticipate.
The problem with most predictions is that they are linear extrapolations of the past into the future. Have global temperatures been rising? They will continue to rise at the same rate. Has crime been increasing? It will continue to increase at a similar rate. The problem is that significant change often comes suddenly. ... In the case of housing, the cataclysm will come within the next couple years. It will be fueled by two factors: option ARM mortgage recasts and house price declines.
House prices are elevated relative to rents and relative to incomes, especially in the hottest markets, such as California, Nevada, Florida, and Arizona. However, price increases in middle America have been no less astonishing. One example with which I am all too familiar is the house I just sold in the Saint Louis suburb of Maplewood. Zillow has a decent graph of the house's value, although it is not completely correct. If you look at the county assessor's website (and search by the address) you can see that the house sold for $100k back in 1997 and then for $188k in 2004. I just sold it for $165k. Over this period of time few renovations of note were done on the property, the neighborhood did not improve significantly, and the employment situation in the area did not change. So, from 1997 to 2004 the house appreciated by 88%, while between 1990 and 1997, during great economic times, the house appreciated by only 25%. In relation to both rents and area incomes, the house is still probably 20% overvalued.
Moving from the anecdotal to the statistical, we can see that this is not an isolated situation. [This chart] shows housing starts and permits for the last 30 years. Over this period the population has increased at a fairly steady rate. Since 1993, too many houses have been built, and this will inevitably lead to falling prices.
If you look at the ratio of income to house prices in [this graph] (from Piggington's Econo-Almanac), you will see that house prices are significantly higher than they should be relative to incomes (while this graph is for one area of California, prices are elevated relative to incomes across most of the country). While creative financing can lead to a bubble in prices, there is no way for house prices to remain unaffordable indefinitely.
Another thing to consider is that, over the long term, house prices remain tethered to rental prices. If renting is cheaper than buying, people will choose to rent rather than buy and house prices will fall. House prices have never been so much higher than rental prices than they are now. [Here is a chart] of the ratio of the OFHEO house price index to the CPI-Owner’s equivalent rent.
Another factor weighing on prices is the increase in foreclosures. Banks that own foreclosed houses are motivated sellers, and they will cut the prices so that they can sell their inventory. Increasing foreclosures will increase supply and decrease prices of transactions. Why pay $200k for a house when your neighbor got his out of foreclosure for $140k? Foreclosures are actually understated because banks often do not have the manpower necessary to foreclose and sell delinquent properties.
The foreclosure problem will soon get much worse. Considering that it often takes over half a year (and can take much longer) between when a homedebtor falls behind on a mortgage and when the house is repossessed, the current wave of foreclosures began before house prices had fallen significantly. With prices now down 20% in many areas and 30% or more in some areas, the rate of foreclosures will increase drastically over the next year. Those that need to sell and who have little equity will be unable to sell for more than they owe. Short sales are difficult, so foreclosure will be the last resort for many who need to move.
Even though asking prices for houses have fallen dramatically already, they have not fallen nearly enough: witness the low volume of house sales relative to prior years. In [this graph] we can see that the spring selling season in San Diego has been a bust, as it has been elsewhere in the country (image from the Bubble Markets Inventory Tracker blog).
In addition to falling house prices, another factor in the coming mortgage crisis is the coming recasts of millions of option ARM mortgages. Most of you will be familiar with the problem of interest rate resets on ARMs (adjustable rate mortgages) [see graph]. This problem is well-known. Almost all ARMs have fixed rates for the first couple years and then the rates reset to market rates. Considering the current low interest rate environment, this problem is likely overblown.
The greater problem, however, is recasts. Option ARMs allow for the choice of the size of the payment. Homedebtors can choose to pay an amortizing payment (such that their mortgage balance is reduced), an interest-only payment, or a negative-amortizing payment, where their mortgage balance increases. Recent data from Countrywide (CFC) indicates that 71% of borrowers with option ARMs are only making the minimum, negative-amortizing payment. Option ARMs have provisions such that when the mortgage balance exceeds the original mortgage by 10% to 15%, the loan converts into a fully self-amortizing loan. Considering that many of these loans were made over the last few years (beginning in 2005), we should start to see a number of recasts. When a mortgage recasts, the payment size can easily double or triple. Those who could afford their payments before will no longer be able to do so.
Option ARMs are highly prevalent, especially in the most bubbly markets. See this map (courtesy of the Irvine Housing Blog).
The coming crisis will be caused by option ARM recasts, falling prices, and banks' increasing reluctance to lend. The crisis will manifest itself in people simply walking away from houses where their mortgage is worth more than the house. Considering how many people have used home equity loans to remove equity, how many have had negative amortization in their loans, and considering how small down payments became over the last few years, very few homeowners will be left with equity in their houses. Economy.com currently estimates that 9 million households have negative equity. That figure could easily double or triple as house prices fall by another 20% to 30%.
The assumption on the part of mortgage lenders, regulators, and housing market optimists is that as long as people can afford to pay their mortgages, they will. But homedebtors faced with 20% to 30% negative equity will be much better off going through foreclosure than they will paying off their debts. Helping them is the fact that in a number of states, purchase money mortgages are non-recourse debt, meaning that banks cannot sue to recover the money they lose. The sheer number of foreclosures will mean that banks will not have the manpower to go after domedebtors even when they want to do so.
The rising tide of foreclosures caused by people walking away from houses in which they have negative equity will act as part of a positive-feedback loop to increase the rate of price declines. The housing market is not getting better anytime soon and it will soon get much, much worse.
FAR FROM DEAD: THE CASE FOR 3 NEWSPAPER STOCKS
Is the newspaper industry down for the count, destined to ulimately by put away by the internet? A lot of value buyers and students of Warren Buffett have been surprised by how fast the economics of the business has deteriorated. But deteriorating economics is not the same thing as death. It is still a $45 billion industry. Many a lucrative business has been created out of declining industries that started from far lower levels. Max Zeledon makes the case that the industry has some life in it yet, and that several stocks in particular are worthy of investment.
The digital age has not been kind to the newspaper industry. Not too long ago owning a newspaper was a lucrative enterprise synonymous with large circulation numbers, huge profit margins, and historically high stock prices. The newspaper industry, the second oldest mass media enterprise in the U.S. with more than three centuries of existence, had no outside competition because its structure was practically a monopoly and its core business highly localized.
This was before the newspaper business model was mercilessly dismantled by the web and its three-headed monster: Craigslist, Google, and the culture of free content. With the accelerated growth of the internet via the Web browser in 1996, newspaper profit margins began to shrink at faster rates than ever before. Suddenly, news audiences and advertisers had a new platform and the desirability for print newspapers declined. The story is a familiar one but there are a lot of myths.
By 2006, big city newspapers such as The Philadelphia Inquirer, The Los Angeles Times, The Mercury News, and The Chicago Tribune were in serious financial trouble. Circulation numbers and balance sheets were a horror show and soon layoffs and leverage buyouts became the norm. Yet, the newspaper industry continues to be profitable accounting for more than $45 billion in annual sales. The level of consolidation has also increased to reduce high printing and personnel costs, but newspapers continue to be extremely vulnerable to economic downturns, declining readership levels, and new digital players that have an adverse effect on advertising revenues.
As a result, media pundits (among them Michael Wolff, Dave Winer and Robert Scoble), and a growing number of investors, are convinced the newspaper industry is dead and whatever steps some newspapers take to increase profits are seen as desperate attempts to revive a moribund industry. This perception or view is outright apocalyptic if not shortsighted and lazy simply because it fails to recognize one of the fundamental characteristics of the information industry -- disruption as the result of innovation and new business models are nothing new to newspapers (newspapers survived radio, TV, and cable) and the fact that we now have multiple distribution channels will benefit newspapers in the long run.
New technologies made newspapers better in the past by increasing the speed of layout and printing. With the web the issue is about distribution and audience retention. However, newspaper executives did not anticipate the digital threat, and when they finally woke up to the cruel hyper realities of blogging, linking, digging, googleling, and twittering, they took too long to react, believing that their old-fashioned, monastic content model would keep the digital barbarians at bay. It did not. But despite the lack of adaptability and declining ad dollars, the newspaper industry remains profitable.
I also suspect a lot of savvy investors are keeping an eye on it, waiting for the right opportunities to present themselves. For example, Gannett (GCI) and News Corp. (NWS) are making a profit, but they are overshadowed by the under-performing players and a few sensational financial flops that make juicy headlines. But it is a skewed picture. Surely, the stock prices of many newspaper companies will continue to fall, but it does not mean this will continue indefinitely. At some point this industry will figure it out. Further consolidation is also a likely scenario in order to cut costs and improve operating efficiency. There will be more victims, but this industry will not disappear, not in my lifetime at least. The industry will change and companies may have to get rid of printing operations altogether, but their core product and mission—to provide news and information to the public -- will remain the same. ...
Nevertheless, bottoms are hard to predict in an evolving industry and recent purchases such as Sam Zell's Tribune deal are perfect examples of what can happen when eager investors looking for bargains ignore the complexities of the newspaper industry and decide to buy media properties at inflated prices with borrowed money. Retrofitting newspapers is not just about numbers and financial formulas -- the industry is deeply embedded in tradition and multilayered editorial structures and hierarchies and its many stakeholders do not necessarily see growth, profitability, and return on assets as the only way to measure performance. That is why the dog-eat-dog approach Zell is so used to will not work if he continues to cut his newsroom staff. Yes, labor is the main expense for newspapers -- taking about 40% of operating revenue -- but it is also its main resource. Zell now runs the risk of becoming a liquidator rather than a savior of newspapers.
Journalists are not just middlemen as Dave Winer suggests, thus cutting your best people is not only a sign of bad management -- it is a self-defeating short-term strategy. You cannot replace skill, industry knowledge, analysis, and insight with technology in an industry where credibility is your main product. Many newsrooms are demoralized because job cuts have done nothing to remedy the financial picture, but they have progressively reduced the quality of reporting. Moreover, editorial concerns have been overshadowed by investor complains and managerial blunders. But one thing is now clear: Cost cutting alone will not save the newspaper industry -- it will take creativity, innovation, and competent management to succeed. The bad news for investors: Very few companies exhibit these qualities at the moment.
Three publicly traded newspaper companies that I think are well positioned to thrive in the near future despite the growing problems that besiege the newspaper industry are News Corp. [NWS], Gannett [GCI], and The New York Times Co. [NYT] I base by opinion on the following criteria: (a) Ability to monetize and exploit current and emerging web technologies. (b) Improved operating efficiency. (c) Strong brand. ...
Those who persist on writing obituaries on behalf of the newspaper industry are dead wrong. Robert Scoble's moronic hyperbole has no substance and exhibits a fundamental misunderstanding on how transformations in communication and media occur from a historical and technological standpoint. I personally believe the industry is finally adopting and will eventually catch up to the digital age, but the structural changes will be painful. The newspaper industry failed to recognize the extent and magnitude of the digital revolution and what it would do to its business model. The web was different than radio, TV, and cable -- it was far more disruptive not just because it transformed the way content was distributed but because it took out the classified revenue in a short amount of time. But the idea that newspapers will disappear is unfounded.
The three companies I discussed here are all responding to the challenges of the digital age by incorporating online strategies that are already yielding results. But how do you debunk the myth that incumbent industries cannot adopt to change? You do it by doing your own research. Those who do stand to make huge profits.
Zeledon's major point -- perhaps a bit of a straw man -- that the newspaper industry is not going to disappear into a black hole is reasonable enough. Valuing a cash flow stream that is declining at a variable rate over time is a tricky busines, and we suggest leaving it to those who really know what they are doing. The papers have some competitive advantage. It is just hard to know what they are worth in the context of declining revenues and the high cost of producing their primary product. And what values to place on the business plans to move distribution over time onto the lower-cost Web is not clear. But, if you are willing to do the work, and are willing to wait for your price ...
ZEN AND THE ART OF MONETARY MAYHEM
Money supplies have been surging worldwide in the last year. In the late 1970s, financial market participants used to eagerly await the latest money supply (especially M2) numbers. Fed chairman Paul Volker had taken Milton Friedman's advice to heart and started explicitly targeting growth in money supply in order to curb the then raging inflation. High money supply number reports meant more tightening by Volker and company -- a bad thing as far as traders were concerned -- while low numbers meant monetary loosening was coming -- a good thing, as everybody knows.
The Volker purgative had its effects. The commodities and gold price bubbles were decisively deflated. Consumer price inflation plunged. And the U.S. sustained the highest unemployment numbers since the end of World War II. People were sufficiently angry about Volcker's policies that he was burnt in effigy on the steps of the Capitol building in Washington. Volker finally relented when the Latin American countries -- after former Citicorp chairman Walter Wriston had famously declared that "Countries don't go bankrupt" -- threatened to default on their debts to the U.S. money center banks.
Even the stanchest of monetary hawks at the Fed can be counted on the save their banking system buddies when the going gets tough. The monetary spigots were opened -- triggering a bull market in financial assets for the ages which topped out in either 2000 or 2006-7, depending on your yardstick. July or August 1982 was more or less the last time anyone paid any attention to money supply numbers for a generation. Thanks to Volker's medicine and a variety of favorable developments in the world economy, out-of-control 1970's-style inflation ceased to be a major concern for 20-odd years. Now it is back. And perhaps it is time to start paying attention to money supply numbers again. Perhaps it is time for Mr. Bernanke and collegues to start paying attention to them as well.
Professor Tim Besley, one of the nine people chosen to set interest-rate policy at the Bank of England in London, gave a speech on Tuesday [April 22] about "Inflation and the Global Economy." For a central banker talking about commodity prices and the cost of living, he managed a remarkable feat. He did not use the word "money" once.
Nor did his BoE colleague Charles Bean when he spoke about the "prospects for the U.K. economy" on 17th April. Nor did the deputy governor, John Gieve, when he spoke on "global imbalances" at the Sovereign Wealth Fund conference in London last month.
In fact, if you ignore the phrase "money market(s)," seven different members of the Bank's policy team used the word "money" just three times in nine speeches over the last 10 weeks. Their chosen topics included "policy dilemmas," "the return of the credit cycle," and even ... "Sterling and monetary policy." But of money itself, the very thing the Old Lady issues? It got three name-checks only.
The Federal Reserve seems to have Britney-sized "issues" with its core stock-in-trade, too. Issues verging on the neurotic, in fact. Allowing for one bizarre exception (in which Fred Mishkin claimed that the Dollar's forex collapse will not create any Main Street inflation), some 23 speeches from five Fed policy-makers since mid-February mentioned "money" a total of only eight times. Four of those mentions came in the phrase "money market(s)."
And this from a team charged with providing a "flexible currency" -- meaning money, of course -- to the citizens of the United States. So why hide from the issue? Is the Fed scared of naming its very purpose? It cannot surely fear a pile of paper, can it?
The Fed's Open Market Committee wields so much power, according to Robert Reich, former U.S. secretary of labor, it should be classed the "fourth branch of government." Forget about Congress, the White House, the courts; the Fed holds "more power over your daily life than your congressman and senator, maybe even your president," Reich writes in his blog.
In short, the Federal Reserve "can do amazing things ..." according to Reich, but from our review of Fed speeches, it cannot talk about money. Things like:
This last super-heroic ability, notes Reich -- now professor of public policy at Berkeley -- "has made the Dollar drop further and faster, which means you're paying more for gas and food. Can you imagine if Congress caused this to happen?"
- "Decide one big bank, JP Morgan, is going to take over another, Bear Stearns, backed by $29 billion of taxpayer money ..."
- "Expose taxpayers to hundreds of billions of dollars of potential losses without a single appropriation hearing, as it did when it allowed Wall Street's major investment banks to exchange tainted mortgage-backed securities for nice clean loans from the Treasury ..."
- "Deciding the threat of recession is bigger than inflation, so it's been lowering interest rates."
A cynic might add that Congress does plenty to depress the value of dollars as well. But if you cannot guess what would happen in Washington if Congress set out to destroy the currency, the Fed most likely can. It simply needs to turn history upside down for a moment.
At the start of the 1980s, former chairman Paul Volcker was burnt in effigy by an angry crowd on the steps of the Capitol for hiking short-term interest rates to 19%. His policies aimed to quell inflation, of course, defending the value of dollars. Looking at Ben Bernanke's decisions today, you may wonder if he intends precisely the opposite.
Volcker's infamous weekend announcement of sharp hikes in the cost of money -- and therefore in its future discounted value -- was a huge political gamble. Already sliding into recession, could the U.S. bear such a high cost of borrowing? To judge just what was at stake, ask if America could bear it today.
So to hold America's nose and get his strong medicine down, Volcker made plain he was in fact looking to target not growth but "money" -- meaning the quantity of credit and cash flowing through the economy. He was simply following the monetarist tactics of the German and Swiss central banks, stemming the flood of cheap credit and reducing the excess piled up during the 1970s. As the value of each remaining dollar bill stopped falling, the cost of living would ease off. And at first, it worked like a charm.
Breaking out of the lecture theatre, the idea of whipping the money supply made sense to politicians and voters alike. It had first been put forward by the "Bullion School" of British economists at the start of the 19th century. Milton Friedman confirmed it with his "monetarist" theories of the 1950s. The German Bundesbank and Swiss National Bank then applied it -- successfully -- to keep inflation at bay right through the late 1970s. U.S. and U.K. households, meantime, suffered double-digit growth in the cost of living each year.
Now in spring 2008, Zimbabwe offers the latest example of monetary inflation in action. There the cost of living is rising by 165,000% per year as the central bank prints 10 million-dollar notes. But here in the developed West's inflation-free dream world, the idea of targeting money itself -- its supply and quantity -- has lost out entirely to the idea of controlling its outcome, the cost of living, instead.
"Most people think economics is the study of money, but there is a paradox in the role of money in economic policy," as Mervyn King, now governor at the Bank of England, noted in a lecture first given at the University of Birmingham, England, in October 2001.
King repeated his findings the following spring at the Banque de France in Paris. But not even he was listening. "As central banks became more and more focused on achieving price stability [in the 1980s and '90s], less and less attention was paid to movements in money," he explained. "Indeed, the decline of interest in money appeared to go hand in hand with success in maintaining low and stable inflation."
This Zen Buddhist approach to monetary policy -- ignoring money and thereby controlling it -- was also noted by Prof. Glyn Davies in his A History of Money (University of Wales, 2002). During "the overt acceptance of monetarist policies, inflation [was] far worse than when Keynesian policies prevailed." Overlooking the money supply seems the answer to delivering low, stable inflation.
Well, stable in a way that nobody noticed. The U.S. Dollar, along with the Pound Sterling, still lost half its value for consumers and savers between 1981 and today. But annual rates of inflation held below 3%, with occasional dips towards 1% growing evermore frequent at the start of this decade.
And all this while, with no one daring to mention it beyond a few cranks at the European Central Bank in Frankfurt, the supply of money worldwide has surged once again. Over the last 12 months, the money supply in Australia has expanded by 16%, in Canada by 13% and in the United Kingdom by 12%. China's supply of money grew 18%, Singapore's 14%, and in both India and Saudi Arabia it grew 22%.
The Eurozone, stuck with those old Bundesbank cranks, got a mere 11% surge in money supplies. The United States, which stopped reporting such outdated things in March of 2006, is estimated to have got a 15% expansion.
Might it matter? On Mervyn King's analysis, yes. The correlation between annual money-supply growth and rates of inflation, he found, reaches 0.99 if you track the 3-decade period ending in 1999. It would stand at 1.00 if they moved absolutely in lock-step. But that research was done before King got top-dog position at the Bank of England. Since then, he has overseen (and overlooked?) double-digit growth in the U.K.'s money supply, running now for a full 37 months.
"Habits of speech not only reflect habits of thinking, they influence them too," King went on in that long-forgotten speech about money. "So the way in which central banks talk about money is important.
"My own belief is that the absence of money in the standard models which economists use will cause problems in future. ... It would be unfortunate if the change in the way we talk led to the erroneous belief that we could turn Milton Friedman on his head, and think that 'Inflation is always and everywhere a real phenomenon.'
"Money, I conjecture, will regain an important place in the conversation of economists," the current Bank of England chief concluded six years ago.
That day still remains a long way off yet. Meaning there is plenty more room for mayhem in money ahead.
OIL IN 2012: $200 OR $50?
Those who remember the late 1970s/early '80s will recall the predictions that the oil price was going to go through the proverbial roof. Which is exactly what did not happen. The price declined in nominal and real terms for the next 20 years. It took the 2003 Iraq invasion and a pull-out-the-stops credit expansion to get oil back to its old nominal -- and approximate real - highs.
Martin Hutchinson argues we are seeing and will see a rerun of that scenario. Once the central banks are forced to reign in their profligate expansionist policies and raise interest rates, the leverage available to the international speculator community will be curtailed and the speculative fluff removed from the oil price. This equates to $50 oil, not the $200 some predict. "As in 1981-86 will be a decline in oil prices," he writes, "gradual at first but probably accelerating until a floor is reached at which new exploration becomes pointless and the oil price is once again as far below its long term marginal cost as it is today above it."
CIBC World Markets analysts recently predicted that oil would sell for $200 a barrel in 2012, as oil supplies grow ever tighter relative to demand. That would imply a continued global boom for the next four years, which would bring inflation, perhaps validating CIBC's prophesy as the dollar went the way of the 1923 Reichsmark. All the same, that is not the way I would bet. I think $50 is more likely. We are probably not quite at the end of this unprecedented oil and commodities bubble, but we are surely getting close.
To take the hyperinflationary possibility first: The St. Louis Federal Reserve has since 1991 calculated a monetary statistic "money of zero maturity" which is M2 minus small time deposits plus institutional money market funds. In the absence of M3 statistics, discontinued by the Federal Reserve in March 2006, St. Louis's MZM is a decent measure of broad money supply. MZM increased by a moderate 9.2% in 2007. However in the three months to April 14 2008, it has increased at an astounding annual rate of 30.3% reflecting the massively expansionary monetary policy the Fed has followed since January.
If the Fed keeps up that rate of growth for the next 4 1/2 years then since prices follow monetary growth, by the end of 2012 prices would have risen by about 236%. In other words to have the same real price as today's $115, oil would sell for $386 per barrel. A price of $200 per barrel would then represent a moderate oil price, reflecting a decline in real oil prices to little more than half today's level in real terms. Needless to say, if the U.S. dollar had been alone in suffering this level of inflation, the euro would in 2012 be selling at over $5 and the yen would be running at $1 = 28 yen.
So how likely is this hyperinflationary scenario, and how likely is $200 oil without it? The hyperinflationary scenario depends on the Fed continuing to increase money supply by around 31% per annum for the next 4 years. That is not quite impossible. Consider a world in which Fed Chairman Ben Bernanke has little or no fear of inflation, but where house prices are an essential political measure of the Fed's success. In that case, to prevent house prices from catastrophic decline, Bernanke might continue to indulge in stimulatory policies, lowering interest rates as far as practicable towards zero, buying essentially unlimited quantities of dodgy housing debt from the banking system, and assisting in bailouts of any banks that got into trouble.
A sloppy populist administration, were such to be elected in November, might ally with the Fed in devise a series of ever more expansionary "stimulus packages" while prevailing on the Fed to support the Treasury bond market to help it fund its trillion dollar deficits. It might assist the process by erecting trade barriers against Third World imports, which would be seen as taking away jobs. Such barriers would restore few jobs but might well produce huge increases in import prices. The rest of the world would doubtless go into recession as the U.S. withdrew partially from the world market, so oil and other commodity prices would decline in real terms, but the dollar prices of non-oil imports could be rising so rapidly that the overall price level continued to inflate.
Sound horribly plausible? I am rather afraid it is. The 2008 campaign has shown that the quality of economic thought among both the U.S. primary electorate and the political class has deteriorated markedly in the last decade, so that there are few barriers today to rampant protectionism, rising inflation and ever-increasing government spending. There are counterproductive policies of the 1930s through the 1970s that would probably be avoided today, but not many of them.
There are thus only two factors that may save us from 30% inflation and $200 oil by 2012: a revival of good sense by the Fed and the politicians (very unlikely) or a full scale revolt by dealers in the U.S. Treasury bond market. The latter is not at all improbable. The government's borrowing is increasing substantially, with the current year's deficit heading towards $500 billion even before recession has properly taken hold, so bond markets are going to be asked to absorb a LOT of debt. At some point, even with the Bureau of Labor Statistics doing everything it can to massage inflation figures, bondholders and dealers will come to realize that they are being asked to buy Treasury bonds that yield less than zero in real terms.
Good healthy "buyers strike" would then push up Treasury bond yields, probably forcing Bernanke's resignation (as it did the resignation of his predecessor G. William Miller in 1979) and force a tighter monetary and fiscal policy on the U.S. powers that be. It is a consummation devoutly to be wished. One's only doubt is that inflation has been rising steadily now for several years and yet Treasury bond yields remain stubbornly around their levels of 2004. Continued heavy buying by the less than stellar intellects of Middle Eastern and Asian cash rich central banks could prevent a catharsis that all should desire.
Assuming that we get a "buyers strike" in the Treasury bond market or (less likely) a revival of good sense in the Fed and Treasury, inflation is unlikely to soar to over 30% and thus oil is unlikely to trade around $200. In such an event, interest rates would be increased to begin the lengthy task of wringing inflationary forces out of the system. That would reduce the flood of liquidity in international markets, which would have two effects. First, it would reduce the rate of world growth, affecting particularly those countries such as India and Latin America whose fiscal (India) or balance of payments (most of Latin America) position was already somewhat weak.
Second, it would greatly reduce the loan capital available to international speculators, which have been an increasingly important factor in rising oil, gold and commodity prices in the last year. There are reports that hedge funds have already been compelled to reduce their leverage to a maximum of five times capital. I would tend to be skeptical of such reports, but clearly if interest rates were forced upwards the arithmetic both for hedge funds and for those who lend to them would change radically.
That scenario, of slowing world growth, particularly in markets with heavy real estate exposure (such as the U.S., Britain, Spain and Ireland) or in over-leveraged emerging markets, would be devastating for commodities markets. Speculative demand would quickly be removed from them, partly because of the bankruptcy of the speculators, and real demand would also be somewhat reduced. Commodity prices would fall towards equilibrium levels.
In the case of soft commodities, the fall towards historic levels would be rapid. Production is already being ramped up because of current high prices, so it is likely that in 12 months time there will be a glut of most crops. The ethanol from corn politically-inspired disaster is registering even in the minds of U.S. politicians, so even if the bizarre and counterproductive U.S. subsidies for that process are not repealed, they will not be extended. World food consumption is increasing only relatively slowly, with some change in mix as wealthier Indians and Chinese eat more meat, so with a further slowing in consumption growth it will take very little time for production to catch up.
For gold and silver, the trend depends on the outlook for global inflation. If low interest rates are allowed to persist until inflation has got a real grip, it is likely that inflationary expectations will worsen, driving up gold and silver prices further. Even when interest rates are raised, confidence in government's firmness against inflation will probably be slow to revive, so speculators and investors may continue to hold gold and silver as a hedge -- after all, with rising interest rates stock and bond prices will be declining, so there will not be an obvious alternative home for their money. Thus the equivalent 2012 prediction to $200 oil, $2,000 gold, may very well be possible, although it is likely that such a price will be seen only early in the year, with the overall trend by then, perhaps two years into the fight against inflation, being firmly downwards.
Finally, the oil price itself. Two factors have been driving the rise in oil prices. One, rising demand, has been discussed in relation to food and can be expected to follow the same pattern. As the world economy slows, demand will increase more slowly, while the speculators will be squeezed out of the market by higher interest rates. Nevertheless, absent changes on the supply side, one might still postulate 2012's oil prices to be close to current levels.
It is on the supply side that a global recession makes the most difference. Here the continually rising price of oil over the last five years has awakened primitive nationalism in oil-producing countries, causing them to maltreat foreign oil companies and attempt to squeeze as much government revenue as possible out of the oil goose that is laying so many golden eggs. New oil discoveries are becoming more and more difficult, because in only a few countries are oil companies with modern exploration techniques given the right incentives to search aggressively for oil. Even Russia, the white hope for greater oil production five years ago, has seen its production begin to decline in 2008, while Mexico (closed oil sector), Venezuela (socialist fruitcake) and Nigeria (kleptomaniac government that taxes oil revenues at 98%) have all seen oil production decline by more than 10% since 2006.
There are a few counterexamples: Iraq's oil reserves have doubled since that country was reopened to international exploration in 2003, while Brazil, whose Petrobras enters freely into joint venture agreements with Big Oil, has made major new oil discoveries recently. However, while oil prices continue to rise the search for new oil sources is likely to be restricted to only a limited number of geologically promising areas.
Once oil demand starts to tail off and interest rates rise, the current situation will reverse. Badly run countries such as Venezuela and Nigeria will quickly run out of money. Current policy will then be reversed, and the major oil companies will once again be allowed to explore and produce on an efficient and profitable basis.
Oil prices will then decline more rapidly, and wealthier and better run oil producers such as Russia and Saudi Arabia will also find themselves in difficulty, and become less recalcitrant in international politics and less resistant to help from the multinational oil companies. Slackening oil demand will also give time for new supply to come on stream, and for environmental objections to massive supply from tar sands and oil shale to be overcome. The result, as in 1981-86 will be a decline in oil prices, gradual at first but probably accelerating until a floor is reached at which new exploration becomes pointless and the oil price is once again as far below its long term marginal cost as it is today above it.
By 2012 that process will only have gone part way. Nevertheless an oil price of $50 before the end of that year seems probable. Oil prices may well be on a long term upward trend, as supplies become restricted to geologically and politically more difficult areas, but $50 per barrel is already (absent hyperinflation) well above the real oil price in 1986-2002 and should easily prove sufficient to reward both efficient exploration and more intensive production from the tar sands of Orinoco and Athabasca.
Just as in stocks and housing, the price of oil cannot go up forever.
THE GREENSPAN EPISODE
With Alan Greenspan in spin overdrive defending his pathetic legacy, a clear-eyed analyis of what went wrong under his watch is urgently required. This Credit Bubble Bulletin writer Doug Noland is willing -- anxious even -- to do.
April 8 -- Dow Jones (Charlene Lee): "Former Federal Reserve Chairman Alan Greenspan continued to defend his legacy Tuesday, saying he has 'no regrets' over Fed policy conducted during his tenure. He added that there was little the central bank or regulators could've done to avert the U.S. housing crisis. 'I have said to many questions of this nature that I have no regrets on any of the Federal Reserve policies that we initiated back then because I think they were very professionally done,' Greenspan said in an interview on CNBC."
Well, Mr. Greenspan is not going to be of much help when it comes to the critical issue of exploring what went terribly wrong with monetary policy and the financial system. Interestingly, some are rallying to his defense. From the Financial Times's Martin Wolf: "Mr. Greenspan remains the most successful central banker of modern times. More important, blame distracts from the challenge, which is to understand what happened, why it happened and what we should do.
We do not want to get distracted. But "the most successful banker of modern times"? While the scope of the unfolding disaster has yet to be recognized by Mr. Wolf or others, Mr. Greenspan was the undisputed governor, architect -- the promulgator of what will be recognized as an epic failure in central banking. After all, he was for about 18 years the appointed guardian over a financial system that perpetrated the greatest credit and speculative excess in history. He dominated monetary policy like no other central banker in history. Chairman Greenspan not only negligently failed to act to reign in dangerous excesses, he became a vocal proponent for virtually all aspects of "Wall Street finance".
Anyone that has read history related to central banking appreciates that Alan Greenspan conveniently made up new rules as he went along. He evolved into the absolute "maestro" at concocting sophisticated rationale for seemingly every troubling development that took root in contemporary ("wildcat") finance. Greenspan was an outspoken proponent of securities-based finance; of models-based risk management; of the great benefits provided by derivatives markets; of the liquidity benefits of leveraged speculation; of asymetrical "telegraphed baby-step" monetary management except when Wall Street demanded big and rapid cuts; and a proponent of "risk management"-based monetary management, (i.e. ease aggressively to forestall even a low probability of "deflation").
He trumpeted the profound benefits emanating from the capacity for contemporary finance to better quantify, manage and disburse risk -- in the process creating a more stable financial sector. Most importantly, he championed the notion that it was preferable for the system to let credit booms and asset bubbles run their course -- and then to treat their busts aggressively with monetary stimulus to ensure little negative impact the real economy. He claimed bubbles were only recognizable after the fact.
He evolved into the ultimate activist and micromanaging central banker, wrapped bizarrely in the cloth of a free market ideologue. It was a most precarious amalgamation. On his watch transpired historic ballooning of the government-sponsored enterprises, of Wall Street balance sheets, and of the size, power and influence of the leveraged speculating community. Worse yet, it is my view that he used these sectors as key inflationary mechanisms. The Greenspan Episode will be seen from a historical perspective as central banking lunacy. It was the exact intoxicant for market participants and politicians to wallow in during a spectacular credit-induced boom.
The inherent instability of money and credit was the dominant focus from the earliest thinking on matters of monetary management and central banking. The U.S. Federal Reserve was (belatedly) created specifically to reign in recurring boom and bust cycles, of which it failed spectacularly during the 1920s. Even today, the ECB and other central banks (read pronouncements from the Reserve Bank of New Zealand!) remain steadfast in their focus on money and credit analysis as a fundamental pillar in their mandate to maintaining system stability. Somehow, the Greenspan "New Age" doctrine was to completely disregard credit -- and disregard it they did during a period of unprecedented innovation, experimentation, and gross over-issuance of contemporary electronic and market-based "money" and credit. In their distorted view, monetary instability is a dynamic of the bust and not the preceding boom.
It was a policymaking regime destined for failure. Go back and read some of the speeches by ECB officials -- Bundesbank and ECB executive Otmar Issing, in particular. It has been for awhile somewhat a battle of central banking philosophies -- the well-grounded and traditionalist ECB vs. the "New Age" Greenspan Fed. The ECB is clearly the victor, with "euroland" citizens (with their valuable euros) winning in the process.
Excerpting from Dr. Issing's February 2004 Wall Street Journal op-ed piece (highlighted in the 2/19/2004 CBB, "Issing v. Greenspan"):
"Huge swings in asset valuations can imply significant misallocations of resources in the economy and furthermore create problems for monetary policy. Not every strong decline in asset prices causes deflation, but all major deflations in the world were related to a sudden, continuing and substantial fall in values of assets. The consequences for banks, companies and households can be tremendous ... Prevention is the best way to minimize costs for society from a longer-term perspective. Central banks are confronted with this responsibility, but there is no easy answer to this challenge. So far, only some tentative conclusions can be drawn. First, in their communication, central banks should certainly avoid contributing to unsustainable collective euphoria and might even signal concerns about developments in the valuation of assets. Second, the argument that monetary policy should consider a rather long horizon is strengthened by the need to take into account movements of asset prices. Finally, it should not be overlooked that most exceptional increases in prices for stocks and real estate in history were accompanied by strong expansions of money and/or credit. Just as consumer-price inflation is often described as a situation of 'too much money chasing too few goods,' asset-price inflation could similarly be characterized as 'too much money chasing too few assets.'"
This was the focal point of an historic debate. Dr. Issing and the ECB had history and sound analysis firmly on their side. The Fed had hope. And I do believe that as runaway credit excess and asset bubbles gained only further momentum -- and as the consequences of dealing with these bubbles became increasingly more problematic for our central bankers, the financial sector, and real economy -- the Greenspan Fed became only more intransigent with respect to their flawed doctrine. They would not act. Wall Street knew they would not take the punch bowl away, and the Credit Bubble's "terminal phase" was let to run its own fateful course. While decisions at the Fed may have been made "professionally," they were nonetheless made from a deeply flawed analytical framework with predictable results.
Even today, Greenspan chooses to avoid a meaningful discussion about credit. From his op-ed piece in [the] Financial Times ("The Fed is blameless on the property Bubble"): "I am puzzled why the remarkably similar housing bubbles that emerged in more than two dozen countries between 2001 and 2006 are not seen to have a common cause. The dramatic fall in real long-term interest rates statistically explains, and is the most likely major cause ..." He goes on refute those that place blame on the Fed for the housing bubble, including arguing against the claim that the Fed's 1% funds rate triggered "a massive credit ... expansion." Greenspan wrote: "Both the monetary base and the M2 indicator rose less than 5 per cent in the subsequent year, scarcely tinder for a massive credit expansion."
Tinder or no tinder, what transpired was indeed unprecedented credit expansion. The Greenspan Fed cut rates aggressively in 2001, and total mortgage debt (TMD) growth accelerated to what should have been an alarming rate of 10.4%. With rates dropping to as low as 1.25% in 2002, TMD expanded 12.1%. With rates dropping to 1.0% in 2003, TMD increased another 11.9%. Despite TMD increasing by a stunning 38% in three years, Fed funds remained at 1% through the first half of 2004. TMD growth surged to 13.5% in 2004, followed by 13.4% in 2005, and 11.6% in 2006. The Greenspan Fed sat idly as mortgage credit doubled in just six years.
Meanwhile, "massive Credit expansion" led, characteristically, to ballooning current account deficits. After averaging a large $122 billion annually during the '90s, the deficit swelled to more than one-half trillion during 2003. It then jumped to $640 billion in 2004, $755 billion in 2005, $811 billion in 2006, and $739 billion in 2007. As a consequence (and in combination with speculative dollar outflows to play attendant dollar devaluation/global asset and commodities inflation), Rest of World (RoW) holdings of U.S. Financial Assets -- after increasing on average $374 billion annually during the '90s ... surged to $8.0 trillion, doubling in just five years. Conspicuous excess in mortgage credit, current account deficits, and RoW holdings should have been a focal point of monetary policy -- flashing clear warnings of the looseness of monetary policy.
The above data are from the Federal Reserve's Z.1 "flow of funds," a report I can only assume Dr. Greenspan is intimately familiar with (yet curiously never addresses). That he can today cite moderate growth in the monetary base and M2 and imply the Fed was not culpable for the credit bubble is beyond me. Greenspan blames the worldwide "dramatic fall in real long-term rates." Even the FT's Martin Wolf concurs: "So what might explain these bubbles? I would point to four causes: very low long-term real interest rates, because of the global savings glut; low nominal interest rates, because of both low real rates and the benign inflationary environment; the lengthy experience of economic stability; and, above all, the liberalisation of mortgage finance in many countries."
First, I am surprised the "global savings glut" thesis is still being bandied about. This was a notion (concoction) of Greenspan/Bernanke "New Age" central banking that was happily adopted by Wall Street. And Greenspan still refers to the interest-rate "conundrum". There was none, but instead a global liquidity glut that was foremost a product of the massive credit bubble-induced dollar outflows (represented well enough by the Rest of World accumulation of our financial claims). Not only did this massive dollar "recycling" exercise significant pressure on our long-term rates and currency, the unrelenting accumulation of dollar reserves globally proved a major impetus for overheated domestic credit systems the world over -- creating even greater liquidity excess in the process.
I find it repulsive today that Mr. Greenspan claims global forces were at work. In reality, the Federal Reserves disregard for credit excess, current account deficits, and the dollar's role as the world's "reserve currency" rest at the heart of what remains today escalating global monetary disorder.
Not surprisingly, Greenspan is content to frame the debate in an "academic" context -- ensuring any resolution (proof) is impossible. The Wall Street Journal article (Greg Ip's) highlighted a disagreement between Greenspan and Stanford's (and former Treasury official) John Taylor on the "global savings glut" thesis. Taylor claims his data show that global investment equaled savings, hence there's no "glut." Greenspan counters that Taylor uses actual investment when it should be "expected" -- that is anyway unquantifiable. As Mr. Ip wrote, "vintage Greenspan." Please note the clear language used by Otmar Issing above to communicate clear thinking assessable to the interested laymen.
Fundamentally, the Federal Reserve "pegged" short-term interest rates, inviting leveraged speculation. I am not of the view that there is a specific interest-rate that is "right" for the system. But exceptionally low rates telegraphed to the leveraged speculating community for the purposes of stimulating the acquisition of risk assets and reinflating asset markets is nefarious central banking. And never combine telegraphed "pegged" low interest rates with assurances that the Fed will always be there to sustain marketplace liquidity (underwrite securities prices), while cutting rates aggressively to mitigate bursting bubbles. Once that path is taken there is no turning back. The central bank is held hostage by the fragility associated with escalating system leverage, speculative excess, and an increasingly maladjusted and vulnerable real economy. One monetary policy mistake ensures a series of compounding errors.
Greenspan now warns against over-zealous regulation and the intrusion of governments into the competitive marketplace. Well, he should have considered these inevitable consequences when he disregarded credit and asset bubbles. And to admit to such mistakes to ensure a sounder monetary policy regime going forward would be statesmanlike -- which he apparently is not. And while the focus these days is on myriad government stimulus programs, creative liquidity arrangements for Wall Street, and regulatory reform, it is my hope that meaningful discussion emerges with regard to a sound "money" and credit-based "analytical framework" for our central bank. Unfortunately, Greenspan was lionized. It now becomes difficult to separate the cult of Greenspan -- an individual I view as single-handedly more responsible for credit and asset bubbles than anyone else in history - from Federal Reserve policymaking philosophy and "analytical framework." Chairman Bernanke has referred to the understanding of the Great Depression as the "holy grail" of economics. The pursuit of the "grail" will now be assessing, interpreting and drawing lessons from the Greenspan Episode.
Setting the Backdrop for Stage Two
The “first stage” of the crisis has concluded. What does the second stage have in store?
Following up the analysis of what went wrong during the Greenspan era, Doug Noland expounds of what is currently going wrong currently during the Bernanke era. To wit: To stem a credit implosion the Fed and U.S. government have effectively nationalized or otherwise underwritten a significant part of the credit market. The "Greenspan Put" -- the speculator community's presumption that the former Fed chairman would prop up the markets before their losses became intolerable -- has become de facto announced official policy. How to reign in excessive risk taking, guys.
"I could not be more pessimistic with regard to our economy's prognosis," Noland writes. "And certainly much more severe credit problems lay ahead. I could argue further that recent credit system developments are indeed consistent with the unfolding 'worst-case scenario'."
Martin Feldstein, Harvard professor and former chairman of the President's Council of Economic Advisors, wrote an op-ed piece in [the] Wall Street Journal -- "Enough with Interest Rate Cuts" -- worthy of comment.
"It's time for the Federal Reserve to stop reducing the federal funds rate, because the likely benefit is small compared to the potential damage. Lower interest rates could raise the already high prices of energy and food, which are already triggering riots in developing countries. In order to offset the inflationary impact of higher imported commodity prices, central banks in those countries may raise interest rates. Such contractionary policies would reduce real incomes and exacerbate political instability.
"The impact of low interest rates on commodity-price inflation is different from the traditional inflationary effect of easy money. The usual concern is that lowering interest rates stimulates economic activity to a point at which labor and product markets cause wages and prices to rise. That is unlikely to happen in the U.S. in the coming year. The general weakness of the economy will keep most wages and prices from rising more rapidly. But high unemployment and low capacity utilization would not prevent lower interest rates from driving up commodity prices.
"Many factors have contributed to the recent rise in the prices of oil and food, especially the increased demand from China, India and other rapidly growing countries. Lower interest rates also add to the upward pressure on these commodity prices -- by making it less costly for commodity investors and commodity speculators to hold larger inventories of oil and food grains. Lower interest rates induce investors to add commodities to their portfolios. When rates are low, portfolio investors will bid up the prices of oil and other commodities to levels at which the expected future returns are in line with the lower rates. An interest rate-induced rise in the price of oil also contributes indirectly to higher prices of food grains. It does so by making it profitable for farmers to devote more farm land to growing corn for ethanol."
While I concur with the basic premise of the article (stop the cuts!), the substance of Mr. Feldstein's analysis leaves much to be desired. First of all, I find it strange than he would address the issues of overly accommodative Federal Reserve policy, commodity price risk, and inflationary pressures without so much as a cursory mention of our weak currency. The word "dollar" is nowhere to be found -- not a mention of our current account deficits. The focus is only on interest rates -- and such one-dimensional analysis just does not pass muster in our complex world.
Most remain comfortably oblivious to today's inflation dynamics. Mr. Feldstein mentions increased demand from China and India. He seems to imply, however, that portfolio buying (financed by low interest rates) by "commodity investors and speculators" is providing the major impetus to rising inflationary pressures generally. Perhaps price gains could have something to do with the $2.5 trillion increase in global official reserve positions over the past two years (85% growth). I would also counter that destabilizing speculative activity is an inevitable consequence -- rather than a cause -- of an alarmingly inflationary global backdrop.
I will remind readers that we live in a unique world of unregulated credit. Excess has evolved to the point of being endemic to an apparatus that operates without any mechanism for adjustment or self-correction. There is, of course, no gold reserve system to restrain domestic monetary expansions. Some years back the dollar-based Bretton Woods global monetary regime lost its relevance. And, importantly, the market-based disciplining mechanism ("king dollar") that emerged at times to ruthlessly punish financial profligacy around the globe throughout the '90s has morphed into a dysfunctional dynamic that these days nurtures self-reinforcing excesses. The "recycling" of our "bubble dollars" (in the process inflating local credit systems, asset markets, commodities and economies across the globe) directly back into our securities markets rests at the epicenter of global monetary dysfunction.
A historic inflation in dollar financial claims was the undoing of anything resembling a global monetary system, and now this anchorless "system" of wildcat finance is the bane of financial and economic stability. To be sure, massive and unrelenting U.S. current account deficits and resulting dollar impairment have unleashed domestic credit systems around the globe to expand uncontrollably. Today, virtually any major credit system can and does inflate domestic credit to create the purchasing power to procure inflating global food, energy, and commodities prices.
The long-overdue U.S. credit contraction and economic adjustment could change this dynamic. But for now there are reasons to expect this uninhibited global credit bubble to instead run to precarious extremes -- and for resulting monetary disorder to become increasingly problematic. Destabilizing price movements and myriad inflationary effects are poised to worsen. The specter of yet another year of near-$800 billion current account deficits coupled with huge speculative flows out of dollars is just too much for an acutely overheated and unstable global currency and economic "system" to cope with.
I hear pundits still referring to a "deflationary credit collapse." Well, the U.S. credit system implosion was largely stopped in its tracks last month. The Fed bailed out Bear Stearns, opened wide its discount window to Wall Street, and implemented unprecedented liquidity facilities for the benefit of the marketplace overall. Central banks around the globe executed unparalleled concerted market liquidity operations. Here at home, the GSEs' regulator spoke publicly about Fannie and Freddie having the capacity to add $200 billion of mortgages to their balances sheets, with the possibility of increasing their guarantee business as much as $2 trillion this year (certainly including "jumbo" mortgages). The Federal Home Loan Bank system was given the OK to continue aggressive liquidity injections and balloon its balance sheet in the process. And now we see that the Federal Housing Administration (with its new mandate and $729,550 loan limit) is likely to increase federal government mortgage insurance by as much as $200 billion this year, while Washington's Ginnie Mae is in the midst of a securitization boom.
Together, the Fed and Washington have effectively nationalized a large portion of both mortgage and market liquidity risk. It is, as well, worth noting that JPMorgan Chase expanded assets by $80.7 billion during the first quarter (20.7% annualized) to $1.642 trillion, with 6-month growth of $163.3 billion (22.1% annualized). Goldman Sachs expanded its balance sheets by $69.2 billion during Q1 (24.7% annualized) to $1.189 trillion, with half-year growth of $143.2 billion (27.4%). Even Wells Fargo grew assets at an almost 14% pace this past quarter. And we know that bank credit overall has expanded at a 12.6% rate over the past 38 weeks. Meanwhile, GSE MBS issuance has been ramped up to a record pace.
And let us not forget the credit intermediation function now being carried out by the money fund complex -- with assets having increased an unprecedented $371 billion y-t-d (41.3% annualized) and $900 billion over the past 38 weeks (47.7% annualized). It is also worth noting the $184 billion y-t-d increase (29% annualized) in foreign "custody" holdings held at the Fed. Sure, the credit system remains under significant stress, with additional mortgage and corporate credit deterioration in the offing. But, at least for now, policymakers have successfully stemmed systemic deleveraging. The credit system is simply not in deflationary collapse mode.
Clearly policy makers have the capacity to jointly stop a nominal credit contraction, no matter what the market sentiment or tendency is.
I could not be more pessimistic with regard to our economy's prognosis. And certainly much more severe credit problems lay ahead. I could argue further that recent credit system developments are indeed consistent with the unfolding "worst-case scenario". Yet I tend this evening to see benefits from analyzing the current backdrop in terms of the conclusion of the first stage of the crisis. The key aspect of this "first stage" was a breakdown in Wall Street's highly leveraged risk intermediation and securities speculation markets. The speed and force of the unwind was extraordinary and in notable contrast to traditional banking crises that track real economy developments. "Resolution" came only through the Federal Reserve and federal government assuming unprecedented risk -- and at a cost of a policymaking mix of interest-rate cuts, marketplace interventions, and government guarantees. It is worth pondering some of the near-term ramifications.
First of all -- and as the market recognized this week -- yields have been driven to excessively low levels. Fed funds are today ridiculously priced in comparison both to the inflationary backdrop and to global rates. Mr. Feldstein is calling for a halt to rate cuts when it would be more appropriate for the Fed to move immediately to return rates to a more reasonable level. They, of course, would not contemplate as much. So I will presume that today's non-imploding credit system -- replete with government-backed mortgage securitizations, government-guaranteed bank credit, presumed government-backstopped money funds and a recovering debt issuance apparatus -- will suffice in the near-term in generating credit sufficient to perpetuate our enormous current account deficits. This is no minor point.
I have in past Bulletins made the case that U.S. credit and economic bubbles had become untenable -- the scope of credit and risk intermediation necessary to support the maladjusted economy had become too large. Extraordinary measures to effectively "nationalize" mortgage and market liquidity risk change somewhat the direction of the analysis. I would today argue that the risk of a precipitous economic downturn has been reduced in the near-term. As a consequence, U.S. credit growth could surprise on the upside with risks to global Price Instability increasing markedly. I would argue firmly that -- in the face of a rapidly weakening economic backdrop - global inflation dynamics coupled with our highly maladjusted economy ensure intractable trade deficits. I would further argue that the current inflationary backdrop will prove an impetus to credit creation -- that then begets only more heightened inflationary pressures. There are certainly indications that the over-liquefied global "system" is not well situated today to handle more dollar liquidity (akin to throwing gas on a fire). Inflation and its consequences have quickly become major issues around the world.
With crude hitting a record $117 today, there is every reason to expect that newly created global liquidity will further inflate energy, food, and commodity prices generally. The Goldman Sachs Commodities index has gained 21% already this year. But when it comes to monetary instability, our financial markets might just prove the unappreciated wildcard. When the Fed and Washington radically altered the rules of U.S. finance last month, they placed in jeopardy huge positions that had been put in place to hedge against and profit from systemic crisis. With the end of "stage one" arises a major short squeeze in the credit, equities, and derivatives markets. And when it comes to contemplating the scope and ramifications of today's "hedging" activities, we are clearly in uncharted waters. It is not beyond reason that a disorderly unwind of "bearish" credit market positions could incite a mini bout of liquidity, speculation, and credit excess that exacerbates global monetary instability -- while setting the backdrop for stage two of the crisis.
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