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HOW TO INVEST LONG TERM WITHOUT LOSING YOUR FANNIE ... MAE
The analysts at Elliott Wave International are often wrong, but their errors have the distinct virtue of being interesting. Founder Robert Prechter began predicting the current credit crunch around 1995 when, if memory serves, the first edition of At the Crest of the Tidal Wave: A Forecast for the Great Bear Market was published. (The "Year 2000 edition" has since been released, conveniently burying the first edition.) They were early, not wrong. (View from the Top of the Grand Supercycle serves as a mea culpa, as Prechter & Co. own up to a failure to properly adjust to the strength of the late 1990s mania.) And the essentials of the analysis stand. This is of little consolation to traders, but does speak well of the quality of thinking within the walls of EWI.
A major successful recommendation of EWI's that derived from their view that the credit bubble would eventually burst was their recommended sale of Fannie Mae. Repeatedly when the stock was trading for over $70, they warned that the stock was near a long-term top. Almost six years elapsed between the first warning in 2002 and FNM's collapse to $20 earlier this year, but -- interestingly in light of the strong performance of banks and other financials through 2006 or so -- the stock never rose enough to squeeze out anyone who might have shorted it at $70+. So credit EWI with a win. Here is a blow-by-blow of sorts.
In the news bag this [last] week, we learned that Fannie Mae, the largest provider of U.S. mortgages, reported a third straight quarterly loss. Not long after, Moody's Investors Service downgraded its bank financial strength rating on the Federal National Mortgage Corp. (aka Fannie Mae) by one notch to "B" from "B-plus," as reported by Reuters in its story, "Fannie Mae Bank Rating Cut". The two other rating agencies, Standard & Poor's and Fitch Ratings, warned that they may cut Fannie Mae's preferred stock rating.
How times have changed. Seven years ago, Fannie Mae's stock was riding high. As the U.S. economy slipped into recession in late 2000 and early 2001, the financial press cited the resiliency of a few mortgage giants. American Banker in December 2000 noted that stocks like Fannie Mae were a "good place to be because they are safe havens." Fannie&'s profits zoomed higher to reach an all-time peak that same month. After net income jumped 69% in the fourth quarter of 2001, a Goldman Sachs analyst said, "Fannie Mae right now is a company riding a galloping stallion." Money magazine called Fannie Mae's CEO Franklin Raines the "most confident man in America." Countless analysts put its stock on their recommendation lists. With a gain of more than 1000% from a low of $6 in 1990, who could blame them?
But The Elliott Wave Financial Forecast offered a different take in April 2002. With the stock at $80 – within 10% of its December 2000 all-time high of $89.38 -- EWFF stated that Fannie Mae was "extremely vulnerable," adding that it would get the worst of an unfolding "downturn from every angle." Based on the structure of its rise into its 2000 high, our analysts called for a "final burst to one more new high. ... After that, it will be all downhill."
When that final burst failed to appear, the August 2002 issue of EWFF asserted that the top was in place: "In March, we were looking for one more new high, but Fannie's break of 75 suggests that it has entered a long-term decline."
Here is a chart that shows how the Wave Principle helped us to prepare subscribers for the aftermath of Fannie Mae's huge bull market.
In May 2002, Elliott Wave International's founder, Bob Prechter, published an investment primer on the unfolding bear market, called Conquer the Crash, in which he noted that Fannie Mae and the Federal Home Loan Mortgage Corp. had extended $3 trillion worth of mortgage credit. "Major financial institutions actually invest in huge packages of these mortgages, an investment that they and their clients (which may include you) will surely regret," he wrote. Regarding Raines's confidence, he added, "Certainly his stockholders, clients and mortgage-package investors had better share that feeling, because confidence is the only thing holding up this giant house of cards."
"Our bearish stance on Fannie is well known, and our view has not changed," added our Short Term Update on September 5, 2003.
In July 2004, we made clear just how negative we were on the stock: "Fannie Mae may survive, but probably not without a complete round trip to $1 a share, which is where it was at the beginning of the bull market."
Finally, in October 2004, as federal investigations and auditors were storming the enterprise, The Financial Forecast noted, "Fannie will now be forced to scale back the lending and securitization effort that has pumped trillions into the economy over the course of the long bull market. [It] is a portrait of a bull market icon being overcome by bear market forces."
The "Damage to Date" chart below shows the result. The big move was a drop from more than $70 in August 2007 to less than $20 in March 2008.
The key thing to keep in mind is that this forecast did not happen overnight. Reaping the windfall benefits of a sharp decline in Fannie Mae's shares took patience, tenacity and some follow-up analysis. First and foremost, it took a willingness to look for the opportunity that lies on the flip side of every rising market. As The Elliott Wave Financial Forecast revealed in its March 2008 Special Section, "The Long Un-Winding Road," a long-term strategy must account for big moves in both directions. Fannie's break to below $20 is a perfect example of how it can work on the downside -- in a big-time way.
WHAT IS IN STORE FOR THE MEGA-RICH IN A BEAR MARKET
"A bear market is nature's way of redistributing wealth," said a recent issue of The Elliott Wave Financial Forecast. And one does not need to look back to the 1930s for corroborating evidence. The dot-com bust of 2000-03 saw a dramatic decline in the top percentile's share of total income.
The headline in the Wall Street Journal's Wealth Report blog caught my eye: "10 Things the Wealthy Should Leave Their Kids -- Besides Money" (May 12, 2008). The list comes courtesy of Peter White, who has counseled wealthy families for 20 years. Here is the short version of White's list, which he calls The 10 Elements of Care:
An admirable list. I think we can all agree that every parent -- not just wealthy parents -- would do well to care for their children this way. And that is what many people wrote in the comments section. But there were two comments that stood out from the rest:
- Necessaries (food, clothing, shelter, medical attention, basic education)
- Affirmation and support
- Guidance (in both behavior and beliefs)
- Religion or spirituality
- Letting go (“This is the most difficult and along with Necessaries and Affection, the most important. We must say to our kids, ‘I've done the lion's share of the motherly or fatherly work, and I'm here and will be here for you as long as I can be; but the responsibility for you is now yours.’”)
Which brought to mind immediately a section in our most recent Elliott Wave Financial Forecast about the future for the mega-rich in a bear market. Our analysts compare income inequality in 1929 with the current rising inequality in the United States to explain that the "rich get ravaged."
- "Here is one for the rich parents: Leave them a world without huge income disparity, a world where there [sic] little precious rich a**es won't be shot off during the revolution."
- "Look out your window. That large crowd with the torches and pitchforks aren't at your place for a BBQ."
******************[Excerpted from The Elliott Wave Financial Forecast, May 2008]
The Rich Get Ravaged
Wealth tends to skew toward a few well-positioned financiers in high-degree fifth waves. At the very end of such moves, income distribution becomes extremely lopsided and emerging bear market sentiments against the rich start to become more pronounced. One of the ways to identify the completion of a fifth wave is that skewed wealth becomes a hot topic. Here is how The Elliott Wave Financial Forecast spotted one such moment in November 1999:
As a percentage of GDP, the wealth of the 50 richest Americans is 4.5 times the level of the top 50 in 1982. In the 1930s, the wealth distribution problem was “solved” by a falling market and tax rates of better than 90% for the wealthiest Americans. In the second half of 1999, the same social forces can be seen stirring, as the “growing gulf between the haves and the have-nots” has suddenly become an issue. The seeds of a new social movement are visible in a rash of headlines like this one: “Income Inequalities Reach ‘Grotesque’ Gap, U.N. Says.”
In recent weeks, the media, once again, noticed that the very richest are getting richer and ever more exclusive. The chart below from the April 16, 2006, issue of the Financial Times shows that 1% of the population accounted for almost 25% of total income in 2006.
Given the additional market gains in 2007, 1929's record high was probably surpassed last year. "There is anger about a system that permits bankers to earn huge bonuses when finance booms while taxpayers pick up the bill when banks fail," says the Financial Times [in an April 8, 2008, article].
Even wealthy financiers seem to agree that the rich are just too rich these days. "Now is the time to admit that for the rich, for the mega-rich of this country, that enough is never enough, and it is therefore incumbent upon government to rectify today's imbalances," says the manager of the world's biggest bond fund. Warren Buffett, the world's richest man, advocates tax hikes and steep inheritance taxes for the super rich. Efforts to correct the imbalance through taxes are completely unnecessary.
As The Elliott Wave Financial Forecast noted in November 1999, "A bear market is nature's way of redistributing wealth." This effect is clearly evident by the sharp plunge on the chart, from 2000 to 2003. The picture now shows an apparently completed five-wave rise from the 1970s, which is one more reason to believe that income distribution will be equalized by a bear market. Of course, that won't stop the politicians from piling on as mood positions the crowd against those that prospered most during the bull market. "Progressive" tax policies will prove regressive in the years ahead.
GENERAL ELECTRIC: BELLWETHER FOR A GLOBAL BEAR MARKET
If GE is a "bellwether" U.S. stock then its price performance ought to give one pause. It never came close to matching its 2000 high during the 2003-07 stock market rally, and now it has plunged anew -- nominally due to disappointment over its latest earnings announcement.
Worldwide infrastructure appears to be the next big investment magnet, and General Electric Co. is in the news today [May 12] for having raised $5.64 billion with its partner, Credit Suisse Group, in a large private-equity venture called Global Infrastructure Partners. According to a report in Bloomberg, GE and its partner will "invest in airports, waste-management companies and energy facilities." Global Infrastructure Partners has already used some of that $5.64 billion to purchase a U.K. landfill operator and trash collector, Biffa Plc.
This announcement of its successful global infrastructure deal is far happier than GE's announcement in mid-April that it had badly missed its expected earnings, resulting in the stock losing $47 billion in one day on April 11, 2008. As an article in The Economist (April 17, 2008) put it, "This is not what investors expect from one of the few remaining triple-A-rated companies, famed for hitting its targets."
But while many investors and many in the financial press see global infrastructure investment as GE's savior, our analysts here at Elliott Wave International look at GE's price chart and see a different story -- that the big bear is back for GE, making it a bellwether not for the emergence of infrastructure investment but rather for a global bear market. Here is what our analysts said in the most recent issue of The Elliott Wave Financial Forecast, along with a monthly chart of GE's stock:
The General Casts Its Lot
Back in 2000, the first leg of the bear market did not really sink its teeth in until the fall months. One sure sign of a more serious bear market was a peak in the most venerable Dow stock, General Electric. In November 2000, The Elliott Wave Financial Forecast showed a long-term picture of an exquisite Fibonacci rise in "the only original member of the Dow Jones Industrial Average," and stated, "GE is going to go way down."
The chart shows the 65% decline that followed over the next 28 months. It also shows a corrective rally that had retraced 50% of the decline before an October 2, 2007 peak, which should be the end of GE's b-wave advance. A c-wave decline should take GE well below its February 2003 low of $21.30, so another even more serious plunge has probably begun.
Once again, the weakness in GE probably heralds stormy weather ahead for the market as a whole; or should we say, "hole"? GE gapped over 11% lower on April 11 after it fell short of its own earnings estimates. The fall was attributed to its exposure to the financial sector, which is certainly substantial. But GE is also broadly diversified globally, and we suspect that the sell-off resulted at least as much from the first hint of shrinkage in GE's global growth rates. As Conquer the Crash says, "Make no mistake about it: It's a global story." And no firm is a better global bellwether than GE. And if the dollar has bottomed, revenues from overseas sales should decline as well. ...
So, while the recent announcement of its Global Infrastructure Partners seems to put GE back in its own bright lights, our analysts see GE as a bellwether of darker days ahead in the form of a global bear market. This kind of analysis, based on wave patterns, outlines a view of the future contrary to the more common view that the worst is over for the 30 stocks that make up the Dow Jones Industrial Average, such as GE.
HOUSING MARKET: FALLEN HORSE
What do the tragedy of the sudden demise of filly Eight Belles at this year's Kentucky Derby and the collapse of the U.S. housing bubble have in common? The sudden turn from euphoria to horror, yes. But the collapse of housing was expected by some, unlike Eight Belles's fate.
On May 3, the U.S. Kentucky Derby witnessed the worst tragedy of the event's 134-year history: Shortly after crossing the finish line and placing second, the race's only filly and beloved crowd favorite Eight Belles fractured her two front ankles and buckled to the ground with "catastrophic injuries," ultimately forcing Derby vets to euthanize the horse right there on the open infield.
All politics aside, one fact remains indisputable: No one could have foreseen such a terrible outcome to the day's competition; that the dream would abruptly turn to nightmare, the euphoric high of the crowd to utter horror, and triumph to tragedy.
In many ways, the Derby disaster is not unlike the fateful events unfolding in the U.S. real estate market, otherwise known as the mournful Housing Race. At its peak, the 5-year undefeated housing BULL made history by sprinting across the finish line in record time, leaving all contenders in the dust. As the victory flag was raised, the mainstream spectators (speculators) popped off their champagne corks and tossed their hats in the air in celebration of many more conquests to come.
"There is a new paradigm in housing in which prices rise indefinitely," exclaimed one March 2005 CBS column, while a June 2005 Time Magazine cover story titled "Home $weet Home" reaffirmed the get-rich-quick nature of real estate. By 2005's end, hybrid-adjustable rate mortgages made up 42% of home financing versus 1.9% in 2001, as officials praised "creative" debt for its ability to give "poor-credit buyers ... the home of their dreams." (Associated Press, January 2005)
In a devastating turn that seemed, for many, to come out of nowhere, the subprime boom went bust in 2007. The housing bull's legs were broken, and the animal continued tumbling in the worst downturn since the Great Depression. All the while, the mainstream public sat in stunned horror as home values came to a crippling low.
This, however, is truly a horse of a different color: The downfall of the housing bull did NOT come out of nowhere. It was not a "freak accident," unforeseeable until the damage was already done. In truth, it was the fulfillment of the long-term outlook presented in Bob Prechter's Conquer The Crash, published 2002. There, Bob warned that the real estate bull would not be fit to run the Housing race on debt alone. In his own word: "What screams 'bubble,' giant historic bubble, in real estate is the system-wide extension of massive amounts of credit to finance property purchases ... When prices begin to fall, lenders will experience a rising number of defaults on the mortgages they hold."
Three years later, the animal spirits surrounding the U.S. housing bull had become stronger than the animal itself. Our analysts saw the potential for a serious breakdown and issued the following alerts:
March 2005 Elliott Wave Financial Forecast: "The Real Estate Bust Begins ... The next phase of the housing market will see weakening demand and supply spikes higher. As the most aggressive dispensers of credit to the housing industry, [sub-prime] firms are on the front edge of the housing bubble."
July 2005 EWFF: "There's no mistaking it ... Now is the most dangerous time to get on board the Housing bandwagon."
That year, the S&P Home Builders Index peaked to confirm the end of the housing bull's record run. The house has fallen. Whether it will soon recover and return to the financial track is not a future to gamble on.
WHAT WOULD GEORGE BAILEY DO ABOUT THE MORTGAGE CRISIS?
Any plan to right the housing market should put families first, not Wall Street.
Behind all the crisis of subprime mortgages, jumbo mortages, and mumbo-jumbo derivatives roiling the world financial markets now there are real families being kicked out of their homes, correct? Some, certainly. But how many?
This very interesting article from The American Conservative delves into the history and -- something we rarely see -- the sociology of the mortgage crisis. It poses a reasonable question, whether all the bailouts being proposed are effectively targeting those who -- most would agree -- should be targeted: actual families living in their primary residence who happened to get caught short in the conflagration. Most would also agree that investors, speculators, vacation home owners, homebuilders, realtors, mortgage brokers, and bankers should be left to endure the consequences of their decisions. This, the author guesses, would be in line with the thinking of the fictional protagonist of It's a Wonderful Life, George Bailey.
HENRY POTTER: Have you put any real pressure on these people of yours to pay those mortgages?
PETER BAILEY: Times are bad, Mr. Potter. A lot of these people are out of work.
POTTER: Then foreclose!
BAILEY: I can't do that. These families have children.
POTTER: They're not my children.
BAILEY: But they're somebody's children, Mr. Potter.
POTTER: Are you running a business or a charity ward?
Mr. Potter's questions from the 1946 film It's a Wonderful Life now haunt American politics. The contemporary mortgage crisis has destabilized the American and global economies, imperiled great banking enterprises, and threatened hundreds of thousands of American households with the loss of their homes. Washington politicians on both sides of the aisle have in recent weeks essentially answered Mr. Potter's final query, affirming the federal government's role as "charity ward" of last resort, this time for both threatened homeowners and endangered financiers.
Regarding the former, the legislators' actions might be viewed as more than a craven quest for votes. They could be understood as responding to an echo of another quote from It's a Wonderful Life, this time by Peter Bailey's more famous son, George:
Just remember this, Mr. Potter, that this rabble you're talking about ... they do most of the working and paying and living and dying in this community. Well, is it too much to have them work and pay and live and die in a couple of decent rooms and a bath?
Our own politicos shout "no!" while approving billions to refinance delinquent loans. (Meanwhile, the Federal Reserve uses public dollars to save Bear Stearns.)
During the 1930s and 1940s, filmland's Bailey Building and Loan had built lovely suburban homes for struggling families and had weathered several financial crises, albeit always through private rather than public means. How would George Bailey, the fictional saint of the mortgage industry, view the current crisis and federal response? Put another way: What would George Bailey do?
Some real history may help here. The classic Savings and Loan association portrayed in the film grew out of the "friendly society" tradition of 19th-century America. Often associated with ethnic groups -- two of my great-grandfathers were founders of the Skandia Society serving Swedish immigrants in Des Moines, Iowa -- these early mutual savings banks encouraged thrift and made loans to responsible and credit-worthy borrowers. Depositors and borrowers alike were members of the society, with voting and oversight rights. This ensured that those who took out loans were carefully scrutinized and personally monitored by the lenders.
Congress stabilized, and to some degree nationalized, the system through the Federal Home Loan Bank Act of 1932. This measure regularized the long-term, amortized mortgage for home purchases, mobilized capital toward this end, and allowed Savings and Loans to pay higher interest than commercial banks on savings deposits. The chartering of the Federal National Mortgage Association (Fannie Mae) came in 1938, funneling still more money into the system. Tax reforms made the interest on home mortgages deductible, turning houses into a favored form of capital investment.
After World War II, the mortgage business soared. The Serviceman's Readjustment Act of 1944 guaranteed VA home loans for veterans at up to 100% of the selling price. President Harry Truman told the National Conference on Family Life that "children and dogs are as necessary to the welfare of this country as is Wall Street and the railroads." The sweeping Housing Act of 1949 committed the country to providing "a decent home ... for every American family." Federal Housing Administration loan guarantees also came into play. In 1949 alone, the industry recorded 1,466,000 housing starts, an unprecedented number.
This housing boom had its own sociology. Nearly all the new VA- and FHA-insured loans went to young married couples starting their families. As the official Fannie Mae history of housing explains, federal mortgage programs "made home ownership available to many families who could never have considered it otherwise." They allowed Americans to express their preference "for bringing up children in the 'wholesome, clean-air' environment of the suburbs."
Importantly, calculations of mortgage eligibility during this era counted only a husband's income. Underwriters saw young married women as potential dropouts from the labor market once they became pregnant. This policy also had the unintended effect of holding housing prices down.
Americans responded to this favorable policy environment. Between 1945 and 1960, there was a 90% increase in the number of owner-occupied homes. The marriage rate climbed sharply, the fertility rate soared, and even the divorce rate fell steadily after 1946. By the early 1960s, the government's pro-family housing policy could be judged a success. To be sure, there were problems: a broad national over-investment in housing, which retarded other forms of capital investment; a discouraging conformity in suburban housing design; and a design preference for the "companionate" model of marriage and home life, which abandoned the function-rich family. All the same, George Bailey would surely have been proud.
The housing and mortgage markets, however, began operating in weird new ways around 1970. A massive investment in housing continued, with total non-farm mortgage debt climbing from $358 billion in 1970 to $2.2 trillion by 1987, an after-inflation increase of 311%. The number of housing units climbed from 65 million to 90 million. Yet the number of young married couples (husband aged 25-34) in homes actually fell by 2% over these years. The number of child-rich households with six or more persons plunged by 57%.
What was happening? In short, the family-centered nature of the American housing boom had unraveled. Policy changes were part of the dynamic. Under feminist legal pressures, the "husband-only" income rule for determining the maximum of a family's mortgage disappeared. A wife's income must also be counted. Results included upward pressure on housing prices and a disincentive to be a stay-at-home mother. Housing officials exhibited new interest in providing shelter for nontraditional households, explaining that there was no longer a "standard family" guiding housing demand. They introduced easier eligibility standards, and the proportion of new FHA mortgages going to married-couple households with children fell sharply. Government publications stressed that houses were increasingly purchased with "resalability" rather than "livability" in mind. This meant that housing was now more a form of investment and a hedge against inflation than a refuge from the elements.
Housing analysts George Sternlieb and James Hughes pointed to an even stranger development: while the number of distinct housing units climbed by 38% between 1970 and 1987, the average household size fell from 3.14 to 2.64 members, a decline of 16%. This meant that "the nation's population is diffusing itself into an expanding supply network." More darkly, they concluded that "the very decline in the size of household" may be "a consequence of the availability and costs of housing units generally."
Translated from academese, this meant that America's very success in building homes now perversely encouraged family breakup through separation and divorce. Direct and indirect subsidies also encouraged home ownership among singles by substituting government help for the economic gains, such as economies of scale, once provided by marriage and family living.
In addition, your friendly neighborhood Savings and Loan societies changed. In the late 1970s, they gained the ability to offer checking accounts and shed many state regulations. In 1980, Congress gave the "thrifts" power to make commercial loans, issue credit cards, and otherwise behave like regular banks. The result was disaster: a series of speculative loans and investments brought on the infamous Savings and Loan crisis of the 1986-95 period. Half of the nation's savings and loans went out of business. Taxpayers took over about $125 billion in bad debt. And George Bailey rolled over in his Hollywood grave. At great public cost, stability returned to the housing and mortgage markets by the later 1990s.
Our current crisis was a product of the new century, a fairly conventional speculative bubble involving legislators, regulators, lenders, great financial houses, and borrowers in roughly equal culpability. Under the mantra that "housing prices in America have never gone down," modest eligibility standards for taking out mortgages were essentially scrapped. Risk was "shared" -- read hidden -- by the relatively new process of bundling mortgages for resale to investors. As housing prices soared, the rush to get into the game produced all the usual assurances from the financial talking heads, until the inevitable collapse.
So what would George Bailey do now? First of all, I think he would want to examine the sociology of the crisis. How many of the imperiled homebuyers are actually young families with children? These he would want to help. How many are singletons who used this speculative opportunity to jump onto the housing escalator? How many are empty-nesters who rode the bubble to move into a McMansion? How many are would-be investors looking for quick turnarounds in a rising market? There would be little sympathy for these latter cases, I suspect.
To help threatened families with children, George Bailey would support private and public efforts that put them first in line for access to renegotiated and publicly guaranteed mortgages. "Households with dependent children" would serve as the defining criterion. He would also probably agree with guidelines recently offered by the Heritage Foundation, including:
All government-assisted refinancing should go only to homeowners who use that home as their primary residence.
No help should be given to investors, speculators, owners of vacation homes, homebuilders, realtors, mortgage brokers, or bankers.
Help should also be denied to anyone who lied or made misrepresentations on their original mortgage applications.
George Bailey would surely marvel at the stupidity and greed of our current crop of great financiers, who make Mr. Potter look like a genius -- even a humanitarian. George Bailey knew truly good capitalists: his friend Sam Wainwright earned money through manufacturing useful products (including, yes, war materiel). He would shake his head, though, at Wall Street's more recent "Masters of the Universe," who claimed their vast personal incomes and stock options simply by piling onto the latest investment fad. He would want to see these sham geniuses and their boards of directors held personally liable to stockholders and investors. He would expect criminal fraud to be vigorously investigated as well.
I doubt, too, that George Bailey would support a quasi-public bailout of Bear Stearns or any other threatened financial giant. He would probably agree with many contemporary analysts that Bear Stearns has been an unusually nasty company without a shred of public-spiritedness. In its failure, it would merely have reaped what it had sown. Bailey would dismiss as preposterous claims that the fate of the American and world economies hinged on this rogue company's survival.
Over the long haul, George Bailey would probably try to return the housing and mortgage industries to their real purpose: providing homes to families. He would support limiting the tax deduction on home-mortgage interest to one principal residence per family. He might even favor a cap on the amount that could be deducted, so that only good shelter -- not princely luxury -- enjoyed favored tax treatment. And he would probably redistribute tax benefits to families according to their number of dependent children, raising either the child tax credit or the per-capita deduction for children -- or both.
As his father had noted, "These families have children." That, I believe, would be George Bailey's touchstone for reform.
INSURED BY WHOM?
Fixed income money manager and Forbes columnist Marilyn Cohen sifts through the rubble resulting from the destruction of credibility of the municipal bond insurers who foolishly ventured into insuring mortgages. With their capital depleted by making good on already-defaulting mortgages, how much will be left down the line to make whole investors in defaulted municipal bonds? Good question. Not much, perhaps. Perhaps nothing.
Many municipal bonds came to market with no independent rating of their own. They relied solely on the rating of their insurer. What happens when that insurer's rating goes down the tubes? The market will eventually appraise the riskiness of the muni issue based on its own merits alone. And if it is unrated, an extra discount may be assigned. Logically, then, Ms. Cohen advises those with munis in their portfolio to take a good look at exactly what they hold. A good idea in any case, but this is an area where acting quickly and decisively can pay off.
When you shop for groceries, the checkout clerk asks, "Paper or plastic?" When your broker calls to sell you municipal bonds in the depths of the credit crisis, he should ask, "Insured or uninsured?" Your correct answer: "Uninsured, and what is the credit rating?"
The once big-three municipal bond insurers, Ambac Financial Group, MBIA and Financial Guaranty Insurance Co., desecrated their businesses by taking up a sideline that had nothing to do with municipal finance. They insured collateralized debt obligations. Those securities typically contained rotten components like subprime mortgages. Last October, as the CDO market wobbled, institutional municipal bond managers and traders came to realize that insured munis were in for a shock. Their insurers were on the hook for tens of billions in CDOs. What insurance would be left for a defaulting municipality?
The municipal market's response to this situation was swift: It became a two-tier market, with one level for insured munis with no underlying ratings and one for uninsured bonds with good credit quality. We who manage municipal portfolios care a lot about credit ratings and give credence to insurance from just three firms: Financial Security Assurance, which carefully managed its exposure to CDOs; Berkshire Hathaway (BRKA), the new insurer on the block; and, to a lesser extent, Assured Guaranty (AGO), which just received an infusion of capital from W.L. Ross & Co.
Ambac, MBIA and FGIC are not writing any new business right now, but they and other insurers are backstopping $1.2 trillion of munis issued before the CDO meltdown. At least 1/3 of the bonds issued in the last couple of years did not get ratings of their own; the issuers relied entirely on the insurance to make their bonds marketable. Avoid nonrated munis insured by these three companies as if they were Typhoid Mary.
Dig into your muni portfolio. Check each bond for its rating. If some bonds are not rated and have insurance slapped on them, have your broker explain where their interest payments come from. From highway tolls? Water and sewer revenues? Courthouse or prison leases? If you are comfortable with the source and expected consistency of payments, keep the bond. If the source is questionable -- say, property tax payments in an area rife with foreclosures -- try to sell. However, the bid you get may be many points lower than was shown on your last brokerage statement. Or you may get no bid at all.
For months now, good-quality uninsured municipal bonds, A-rated or better, have yielded less than insured ones. The fact is, no one in the business gives any value to the insurance coverage, and you should not either.
Take, for example, Palm Desert (California) Tax Allocation bonds, issued for a redevelopment project, which have a 4.75% coupon and mature on Aug. 1, 2017. Because these bonds have no underlying credit rating and are MBIA-insured, they trade like an unrated security. The bonds are secured by a pledge of, and first lien on, property tax revenues. Priced at 98.15, the Palm Desert bonds yield 5% to maturity. A California resident would have to purchase an A-rated muni maturing in 30 years to earn the same 5%.
Yet that Californian would be far better off with a California General Obligation 4% due April 1, 2017, rated A+ and yielding 4% to maturity. Even with an estimated $14 billion budget deficit for the fiscal year starting in July, the state, backed by an unlimited taxing power, is a sounder borrower than the Palm Desert Financing Authority.
Many New York City residents like Puerto Rico municipal bonds for their triple tax exemption. The Puerto Rico Commonwealth Public Improvement General Obligation 5.5%, due July 1, 2020, is MBIA-insured with underlying ratings of Baa3 from Moody's and BBB-- from Standard & Poor's. It yields 4.58% to maturity. I would not own such a low-rated bond. New Yorkers would be better off with general obligation bonds from the state or the city; these both carry ratings of Aa3 from Moody's and AA from Standard & Poor's. For a 12-year maturity, the city's bonds yield 4.15% and the state's yield 4%.
Do not reach for yield. If you must venture beyond general obligation debt, look for reliable revenue sources such as water and sewer payments. A New York Metropolitan Transportation Authority bond rated A yields 4% to a 2012 call and 4.6% to maturity in 2020. The MTA taps transit revenues to pay the debt, so as long as New Yorkers do not start hitchhiking to work, you can rely on the coupon payments.
As Will Rogers once put it: Worry about the return of your capital before return on your capital.
BULLY FOR OBAMA
Perma-semioptimist Ken Fisher counsels everyone not to fear an Obama presidency. Both Democrats and Republicans are phonies. Democratic never mean most of what they say in their populist campaigns. And Republican presidents do not do much for the economy or for investors. This leads to different post-inaugural stock market patterns on average, as people first act on their hopes or fears, and later realize they were unjustified. But in either case, there is little point in worrying about who is going to end up getting elected.
Buy very large capitalization stocks with low P/E rations and decent dividend yields, advises Fisher. Sounds reasonable to us.
I get the sense, talking to investors, that a lot of you are terrified of what an Obama presidency would do to your portfolio. You should not be. Election outcomes do not affect markets the way you expect them to. We have a long history of elections and S&P 500 returns, and the pattern is pretty clear. First, years in which Democrats capture the White House are usually bullish years for the stock market. Second, inaugural years following a Democratic win in November are better than Republican inaugural years. There is a reason for this pattern. The market expects the worst of a Democratic President and then discovers that he is not so bad for investors. It tends to rebound after the initial premonitions that a Democrat will win. On the other hand, Wall Street expects the most of a Republican and is disillusioned after the election.
The average performance for years with Democrats elected is dragged down by two exceptional years. One was 1932, as FDR won and the Great Depression bottomed. The S&P slipped 8.9% that year (including dividends). The other year was 1940, another FDR win, this time with war under way in Europe. The market was off 10%. Take away those two bad years and you find that election years with Democrats winning have always been positive for the market.
If we elect Obama and history's pattern prevails, expect 2008 to be positive but below average and 2009 to be above average. If we elect McCain, 2008 will not be so bad, but 2009 will be a disappointment. Republican inaugural years (there have been 10 since 1925) have delivered an average 0.5% loss for the market. Only three Republican inaugural years were positive; seven were negative. Loser years include the first years in both of Eisenhower's and Nixon's two terms and in Reagan's first term, George W. Bush's first term and, of course, Hoover's single term.
In inaugural years we discover that Democratic presidents are phonies and never meant most of what they said in their populist, anticapitalist campaigns. They could never get reelected if they really delivered on their campaign promises. Inaugural years for Republican presidents remind us that they are phonies, too. They do not do much for the economy or for investors. We get disappointed and pummel stock prices.
Another example of the continual triumph of hope over experience.
The three-month period ending in January gave us the first big global market correction since 1998. Investors and the media still fear their own shadows. Stocks should rise regardless of who winds up in the White House. Here are some megacap stocks of the sort I have been favoring for 2008.
Banco Bilbao Vizcaya (22, BBV), with a market cap of $85 billion, is among the few big banks still positioned for growth. It has 45% of its profits coming from emerging Hispanic-American markets and a tiny U.S. exposure, with an appetite to grow in America via acquisition. This full-service bank with headquarters in Spain deserves to sell at much more than eight times earnings. It has a 4.8% dividend yield.
The Swiss firm Novartis (49, NVS) has branded and generic pharmaceuticals, vaccines and diagnostic tools. It also has a long line of nonprescription drugs like Bufferin, Excedrin, Desenex and Maalox. It just bought 25% of eye-care leader Alcon, with a right to buy control. At 12 times 2008 earnings this $111 billion (market value) growth company has lots of upside potential. The dividend is 3%.
Daimler's acquisition and sale of Chrysler was stupid. But now Daimler (78, DAI) returns to its Mercedes brand, the essence of quality. The high end of autos, like housing, is holding up better than the overall industry. You are paying nine times estimated 2009 earnings. The $82 billion market value is 50% of sales. You get a 4% dividend.
All three of these stocks seem like conservative investments at reasonable prices.
The experts are telling us that lower oil prices lie ahead. I am not so sanguine about that forecast, partly because I am bullish about the world's economy and expect that demand for oil will be surprisingly strong. Hence I like Royal Dutch Shell (RDSA), with a $239 billion market value. The company is comparable to ExxonMobil, but its A shares (RDS.A), and B shares (RDS.B ) -- which are virtually identical for an American investor -- are cheaper than Exxon shares at eight times likely 2008 earnings and 70% of annual sales. The A shares yield 3.7%, the B shares 3.8%.
A smaller and more speculative investment is Sara Lee (13, SLE). This poorly managed and slowly melting block of ice has great brand names. Even in a cooled-down takeover market it seems to me a likely target. It sells at 14 times likely 2008 earnings and 80% of sales. Market capitalization is $9.8 billon, yield 3%.
If you still own Chinese shares, sell.
In stark contrast to last week's postings featuring bulling assessments of China, comes Forbes columist A. Gary Shilling's very bearing appraisal. If we may paraphrase: The adjustment from an export-driven to internally-driven economy is not going to be quick or pretty. Its economy remains very much "coupled" with the U.S.'s. There is a lot of fluff and malinvestments that are going to end up being written off. The stock market bubble has more deflating to do. Any substantial correction in the market or further inflation could lead to social unrest.
On December 4, 2007, on a Forbes investor cruise, I suggested selling Chinese stocks. Since then the Shanghai Composite Index has fallen 37% (33% in U.S. dollar terms). If you missed that boat, do not think Forbes reserves all its wisdom for people on cruises. The magazine's Beijing correspondent had, a week earlier, published a story that asked, "How do you say 'irrational exuberance' in Chinese?"
And do not think it is too late to respond to our advice. If you still own Chinese shares, sell. If you are daring, short-sell an exchange-traded fund of Chinese shares.
China is very vulnerable in the unfolding global recession. The downturn that started in the U.S. late last year with the subprime mess and quickly spread to overleveraged Wall Street now has American home prices sliding toward my long-held forecast of 25% off their peak. That will eliminate the home equity of most people with a mortgage, and with it the fuel for consumer spending. Europe and Japan are also headed for recession, as their exports to the U.S. drop, their own housing bubbles collapse and their consumers retrench. Despite what many have hoped, emerging economies do remain coupled to the U.S., as it buys most of their exports, directly or indirectly.
China's exports account for 38% of its GDP, versus 12% for America's. In the first quarter Chinese exports of U.S.-bound products were up 5.4% from 2007. Not too long ago 30% growth was the norm. Without export growth and the foreign investment it brings, China's economy is in trouble. You need to make at least $5,000 a year there to have meaningful discretionary spending power. Some 110 million Chinese do, but they account for only 8% of the population. In the U.S. it takes at least $26,000, and 80% qualify.
The Chinese save 30% of their income, which puts them just about 30 percentage points ahead of Americans. Consumer spending is only 36% of GDP, against 71% in America. Where do they put all those savings? Not in the state banks, with their regulated deposit rate of 4.1%, which is less than half the current rate of inflation. Real estate is not attractive. The government has been moving to cut off housing speculation for several years now. Chinese are not allowed to invest abroad. So stocks have gotten the play. Despite the recent downturn, the Shanghai Composite Index was up 435% from the beginning of 2006 to the peak last October.
Slower export growth and higher materials costs are already depressing profit margins. In the first two months of this year profits grew 16.5% from a year earlier, down from 36.7% growth from 2006 to 2007. At the same time, the government has moved to quash booming capital spending and inflation. Bank reserve requirements have been raised 13 times since early 2007, and further tightening is likely as the state tries to curb lending and slow the growth of the M2 money supply, which was up 16.3% in March from a year earlier.
Capacity utilization is tight, but it takes a lot of steel and cement to build more steel and cement plants. When the bubble breaks, the use of these materials in new factories will collapse suddenly. In the first two months of 2008 real urban fixed investment, the benchmark measure of capital spending, rose 18% from a year earlier. Annual growth ranged between 23% and 25% over most of 2007.
As loans dry up, heavily leveraged real estate developers are finding themselves strapped for cash and unable to build on the land they have acquired, so real estate prices are starting to fall. Furthermore, heavy construction spending for the Beijing Olympic Games is winding down. To be sure, with $1.68 trillion in reserves and a budget surplus, the government can stimulate the economy by spending on social services and on infrastructure. But reversing gears takes time.
Meanwhile, the government is trying to beat down inflation. February's food costs were up 23% from a year earlier. Recall that the 1989 Tiananmen Square uprising was caused partly by inflation fears. The coming hard landing could similarly provoke social unrest. Economic growth could drop from its recent annual rate of 11% to a recessionary 5% or 6%. What is more, further declines in Chinese stocks will rile the 100 million Chinese who have invested in equities with the government's encouragement, and since most public companies are state-owned, those investors may blame the state for their price collapses.
China forbids short-selling. But many companies are dual-listed in Hong Kong, and those H-shares can be shorted. So can exchange-traded funds that own Chinese shares and trade in the U.S., and there are at least four of them.
A LESSON ON WHY BANKERS SHOULD STAY OUT OF THE JEWELRY BUSINESS
When money is loose, finance companies will look for any excuse to lend it out. The fact that they do not know what they are doing seldom enters into the equation.
Merrill Lynch is dealing with $30 billion in mortgage-related writedowns and axing 3,000 jobs. But a little $180 million loan it made a few years ago is proving embarrassing in its own way.
In 2006 deluxe-jewelry dealer Ralph Esmerian, 68, bought retailer Fred Leighton, with stores in New York and Las Vegas and customers like Nicole Kidman and Elizabeth Taylor. Esmerian turned to Merrill to finance the $110 million purchase. It ended up lending him $177 million (now $180 million with interest and costs), with a trove of jewels as collateral. Jewelry industry insiders think it was the first time Merrill had loaned against jewelry, but the firm wil not comment on that.
A half-dozen sources in the jewelry and art business tell us Merrill was clueless about the jewelry market. It turned to New York gem merchant Benjamin Zucker, a longtime Esmerian associate, who valued a significant portion of the collateral at $89 million. But his appraisal was based on selling the jewels retail, where gems can fetch a lot more than when sold at auction under financial duress. Ian Peck, head of Art Capital Group, a boutique art lender, says, "Our appraisal standard is a low-end auction estimate." Zucker did not return calls seeking comment.
Once Esmerian took over Fred Leighton in April 2006, the business started to founder, and by September 2007 he was defaulting on loan payments. Merrill cut a deal with Christie's to auction off 115 choice lots that Esmerian maintains are worth at least $75 million. But Christie's estimated their worth at between $23 million and $34 million.
Merrill says it is confident it will get its money back. Maybe, except that now the fate of the jewels rests with a bankruptcy judge. Esmerian's firm filed for bankruptcy in New York just before Christie's was about to conduct the auction.
NOT YOUR FATHER’S RECESSION
Sell America, sell its money, sell its property, sell its shares, sell its foreign policy, sell its bonds.
There are only so many ways to say "we're screwed," we supposed. But you have to credit Bill Bonner and company with their inventiveness in finding new ways get the message across -- or should we say, the medicine to go down, given their prognostications. This piece, however, required no ingenuity of expression. It is a useful summary of their fundamental bear case on America.
The piece also explains, by implication, why the current recession, or whatever one wants to call it, is not just the average system partial cleanout before going on to bigger and better things of times past. When the secular trend is down, cyclical recoveries are not as robust as when the reverse holds. And the recovery high may be lower than the past recovery high. By many measures, this is what we are observing today.
"Recession, and its vicious-cycle effect on employment and consumer spending, remains a threat," says Bill Gross of PIMCO. "This recession, though currently mild, and, as of yet, not even officially validated, may not be your garden-variety, father's-Oldsmobile type of downturn."
Has the Dow seen its lows for the year, as Richard Russell says? Is the housing crisis over, as the Wall Street Journal says? Is the credit crunch over, as Warren Buffett says?
As the song says, "It ain't necessarily so." House prices are going down. They will take the American consumer down with them. The "crises" may be over, but the long, slow, slump is still ahead.
We left Paris this morning on the 6:43 train. The train glides out of the Gare du Nord, then eases its way out of the city. Once clear of the suburbs, the Eurostar's Casey Jones opens up the throttle. Pretty soon, the train is traveling at more than 200 mph -- so fast that if you try to look at something out of the window, it is gone before you have a chance to study it. ...
Americans ought to get out more. We have been living and traveling outside the U.S. for the last 14 years. It is a big world. There is a lot to see. And what we see is a world that is changing fast ... growing ... evolving ... experimenting ... and leaving America behind.
We do not know whether high speed trains are a good idea or not, from an investment standpoint that is, but American infrastructure seems to be on "a pot-holed highway to hell," as an English writer put it in the Financial Times last week. In the Eisenhower years, the interstate highway system was the envy of the world. Now, foreigners laugh at U.S. infrastructure.
"While the U.S. real estate market cools, India, Singapore, Korea, Malaysia are all building like mad," Free Market Investor's Christopher Hancock tells us. "And demanding dazzling amounts of concrete and steel to make it happen. China alone plans to add another 1,000 skyscrapers to the Shanghai skyline by 2011, and to double its demand for steel by 2031. That's equal to using all the steel sold in the West today! ...
The lack of high-speed trains is just emblematic of a deeper problem in the United Sates -- a lack of savings and investment for the future. The Daily Reckoning does not pussyfoot around the implications of it. Sell America, sell its money, sell its property, sell its shares, sell its foreign policy, sell its bonds. Yahoos and members of Congress will say we are "unpatriotic". Investment pundits will say we are stupid. Selling America is not a smart thing to do, as the greatest investor of all time, Warren Buffett, reminds us.
But as to these charges, we deny the first and await the market's judgment on the second. America needs a correction; it would be unpatriotic to deny it to her. Besides she will be a better, strong, more decent and civilized place when people stop spending more than they afford, start saving again, and return to minding their own business. And Buffett, himself, is now coming to Europe looking for places to put his money.
In the short run, we could see a revival of the dollar. European interest rates held steady -- with the key lending rate of the European Central Bank at 4% -- while Bernanke cut the Fed's rate seven times. Under those conditions, it is amazing that the dollar did not fall more.
Now, inflation has dipped down in Europe, allowing the ECB to cut, if it chooses, while the Fed's rate cuts seem to have come to an end. With no more obvious reasons for the dollar to fall, it has stabilized. Next, it will fall for reasons that are less obvious and more important.
But our view on America is long term. It comes tethered to our views on inflation and oil, and practically everything else. So let us begin by looking at Philadelphia. The City of Brotherly Love used to make things and sell them at a profit. From this healthy exchange, Philadelphians, like so many other Americans, were able to raise their own wages and living standards to not only the highest levels in the world, but the highest levels the world had ever seen. Never before in human history were ordinary people so rich.
Naturally, this led to a certain amount of self-satisfaction ... which led to complacency ... which led people to think they had be all right no matter what they did. Then came a series of events and trends that seemed to prove they were right. China began making things at much lower cost. Wal-Mart distributed these things to Americans at low prices. Instead of keeping merchandise in inventory, retailers switched to "just-in-time" systems, which further allowed them to cut costs. In real terms, prices of raw materials plummeted too.
Then, the Fed lent money below the rate of inflation. Normally, the Fed's easy money policies -- in addition to lending at 1%, it has been increasing the money supply twice as fast as GDP for 20 years -- would cause consumer prices to soar. But after Paul Volcker wrung inflation out of the system in the 1980s, China helped keep the squeeze on -- holding prices down despite a huge increase in the supply of dollars.
Wall Street played an important role too. It came up with innovative ways to pass the Fed's money along to American households -- allowing them to spend money they never earned. The whole thing was almost too wonderful. No matter how much Americans spent, it seemed as though there was always more where that came from. From 1980 to the present, the savings rate fell from over 10% to under 1%. Debt grew twice as fast as incomes -- except for financial debt, which grew three times as fast.
Now, the factory jobs have packed up and moved to Asia. There are few left in the Philly area. In their place, are jobs in health, education and finance -- that is to say, in the service industry. And today, we get word from Philadelphia that inflation-adjusted wages are down from $17.25 per hour in 2001 to only $16.59 today. More people are forced to take part-time work -- because they cannot find fulltime jobs. And the number of hours worked by Americans is falling nationwide.
In Europe, wages are substantially higher -- in part because the euro is high, and in part because unemployment is high (fewer low-wage jobs exist). Not only that, Europeans work fewer hours. As reported in this space, the average salary in America is now about $38,000, compared to $42,000 in France. But the typical American also only gets two weeks off, whereas the typical Frenchman gets five weeks of holiday. Doing the math crudely, which is the only way we do math, we find an hourly average wage in France of $25.50!
Today's Financial Times mentions a 36-year-old man in Philadelphia who has had to take a job at a deli counter, earning only $7 an hour. Our two daughters, meanwhile, both hold unskilled, part-time jobs in London -- working at a pub and a health food store -- where they both earn $12 an hour. And both are eligible for free public health care. ...
The fundamental conceit of Americans over the last 50 years was that the foreigners were so hopelessly incompetent that even if we gave them a helping hand they could never challenge us. But now they are challenging us, and beating us at our own game. They invest more, save more, and produce more than we do -- even the communists. Meanwhile, we focus on soft service industries -- health, finance, and education -- where the actual return on investment is hard to measure and often negative.
THE MEANING OF STAGE II OF THE FINANCIAL CRISIS
"Federal government-backed finance" supplants "Wall Street-backed finance."
Doug Noland argues that what he calls the first phase of the financial crisis has passed, and now the second awaits us. The central banks and national governments pulled out all the stops to stabilize the financial system when the wild party virtually turned on a dime and threatened to collapse into a black hole.
Noland enumerates the following measures taken to stem the implosion: a Fed-orchestrated bailout of Bear Stearns, the opening of the discount window to the securities firms, the implementation of massive liquidity facilities at home and abroad, the promotion of mortgage securities as collateral for borrowings from the Fed, assurances of enormous market intervention (mortgage purchases and guarantees) by the already reeling Freddie Mac and Fannie Mae, the imposition of significantly negative real short-term rates, and open-ended federal government stimulus and financial guarantees.
For those who would maintain that the sum and substance of these measures might be dramatic but not world changing, Noland would counter that there is not longer any uncertainly about how far policymakers would go to avoid a breakdown in the credit system and sustain the U.S. "bubble economy". There are no bounds on government intervention, and it will be invoked at the drop of a (bubble-pricking) pin. "Washington had no alternative but to explicitly and implicitly nationalize both system credit and liquidity risk."
With some measure of confidence -- enthusiasm, even -- returning to the markets, credit conditions are loosening meaningfully. So, "Stage II -- the dynamics, excesses, distortions and imbalances leading to the inevitable 'second phase' of crisis -- is now off and running." For what this might mean specifically, read on. But this line from the aricle -- "I believe U.S. policymakers are today unknowingly risking global financial and economic catastrophe" -- is a telling preview.
The U.S. credit bubble was punctured this past summer, as the mortgage crisis escalated from the confines of subprime to the expansive marketplace for Wall Street "private-label" ABS and MBS. Especially with the bursting of the Florida and then California housing bubbles, literally $trillions of mortgages, sophisticated debt structures, credit insurance, various financial guarantees, leveraged speculative positions, and bloated Wall Street balance sheets were in almost immediate peril. Contagious deleveraging overwhelmed the system. In a brief period of only several months the U.S. credit system went from unmatched expansion and speculative excess to the brink of implosion.
Last week, I made the case for thinking in terms of the end of the first stage of the financial crisis. The epicenter of this initial upheaval was in highly leveraged positions in mortgage credit exposure -- encompassing mortgage-related securities positions (i.e., ABS and MBS); sophisticated credit structures (i.e., CDOs, "SIVs," REITs, etc.); various derivatives exposures (i.e., subprime ABX indices, credit default swaps, synthetic CDOs, etc.); and a broad assortment of financial guarantees and liquidity agreements (monolines, mortgage insurance, asset-backed CP, cash-equivalent funds, etc.). I have referred to this as the breakdown in Wall Street-backed finance.
This collapse had reached the cusp of bringing down the entire credit system. In stark contrast to traditional credit crises, this one engulfed the entire system before the general economy so much as succumbed to a negative quarter of GDP contraction. To stem the implosion required nothing less than a Fed-orchestrated bailout of a major Wall Street firm, the opening of the discount window to the securities firms, the implementation of massive liquidity facilities at home and abroad, the promotion of mortgage securities as collateral for borrowings from the Fed, assurances of enormous market intervention (mortgage purchases and guarantees) by the troubled Government Sponsored Enterprises [Freddie, Fannie], the imposition of significantly negative real short-term rates, and open-ended federal government stimulus and financial guarantees.
An argument could be made that, while dramatic, these measures were not world changing. I would counter that such measures gave assurances to the marketplace that the Federal Reserve (along with global central bankers) and our government policymakers were willing take any and all measures necessary to stabilize the credit system and sustain the U.S. bubble economy. There were no longer any bounds on government intervention.
I have referred to these policy measures as the supplanting -- or underpinning - of "Wall Street-backed finance" with "federal government-backed finance." Or, perhaps somewhat less analytically ambiguous, to avoid implosion Washington had no alternative but to explicitly and implicitly nationalize both system credit and liquidity risk. It was desperate policymaking in the extreme. It was bold and it was historic. It reworked the rules of our credit apparatus, and the markets have for more than a month now grappled with the ramifications of these changes.
To be sure, each week of relative credit system stability has provided various troubled players the opportunity to raise new capital, others to pare problem positions, and many to adjust various risk exposures. Importantly, the unwinding of "bearish" speculations and hedges is now playing an instrumental role in the resurgence in marketplace liquidity.
According to Bloomberg data, this week saw an all-time record $43.3 billion of U.S. corporate debt issuance (compared to a y-t-d weekly average of $18 billion). Issuers included Citigroup, Merrill Lynch, Bank of America, Wachovia and Goldman Sachs -- and much of their issuance was in the form of new hybrid "equity capital." Investment grade bond spreads narrowed this week to the lowest level since mid-January, junk bond spreads to early-March levels, and leverage loan prices recovered this week all the way back to December levels.
Many -- including seasoned strategists -- are today arguing that the worst of the financial crisis is now behind us. I disagree, of course. Yet from an analytical perspective it is imperative to appreciate that ... we still very much operate in a unique period of Market-Based credit. The ebb and flow of market perceptions -- of greed and fear -- continue to have an outsized impact on credit availability and marketplace liquidity -- hence economic performance. Not many weeks ago the system was seizing up in the face of collapsing confidence and fears of systemic failure. Today, with confidence and greed regaining some of their "flow", credit conditions are loosening meaningfully -- which does wonders for reigniting marketplace enthusiasm (not to mention short covering). So, Stage II -- the dynamics, excesses, distortions and imbalances leading to the inevitable "second phase" of crisis -- is now off and running.
Does Stage II Mean the credit bubble has returned? No. Does Stage II mean credit losses will no longer trouble the system? Definitely not. Does Stage II mean the reemergence of Wall Street-backed finance? No. Does Stage II Mean the reigniting of U.S. asset inflation? No, at least not generally. Does Stage II mean the leveraged speculating community has been granted a new lease on life? Don't bet against it. Does Stage II mean the U.S. bubble economy could take on some additional air? Perhaps. Does Stage II mean the exacerbation of global credit bubble excesses? Most certainly. Do global credit bubble dynamics impact our credit and economic systems? Of course -- more than ever.
I have written much on the issues of monetary processes and inflation dynamics. These themes now should play crucial roles in how we analyze the many complexities of today's financial and economic landscape. Prior to the bust, the rampant expansion of Wall Street-backed finance was directly fueling U.S. asset inflation and bubbles -- housing in particular. Today, post-crash, no amount of policymaker intervention can repair broken confidence in all facets of Wall Street finance, including subprime and "exotic" mortgages, the "monoline" financial guarantee business, CDOs, "private label" MBS, auction-rate securities, and so forth. Indeed, their problems are poised to only worsen as the economy falters.
It is one thing to stem implosion and something altogether different when it comes to restoring the Wall Street credit mechanism to the point of fostering new bubbles. Wall Street "alchemy" is a spent force unless it melds in some type of government obligation. The best policymakers can do today is place a federal government guarantee on 90% of new mortgage debt and hope this somewhat stabilizes U.S. housing.
Faltering housing markets and waning consumer confidence will place increased strains on economic performance. That is not at issue. At the same time, the finance-driven bubble economy is unmistakably on more stable footing now compared to its perilous perch a month earlier. Recognizing the ebb and flow of contemporary market-based credit (and the reality that today's "flow" could easily be augmented in the short-run by the unwind of "bearish" positions), I will remain mindful of the potential for a meaningful loosening of credit conditions. To be sure, outside of housing and finance, the U.S. economy is still demonstrating some powerful inflationary biases and impulses. And inflationary biases spur credit growth that spurs heightened inflationary pressures. That is the way it works.
The blobal credit bubble must factor into our analysis. Most conspicuously, powerful price pressures throughout global energy, food, and commodities markets are stoking growth in various sectors of our economy. Our export sector continues to boom. Less obvious, I would argue that rampant global financial excess is a contributing factor in our financial institutions' capacity to raise new "capital" from the global markets -- and more generally in bolstering marketplace liquidity in the face of the collapse of Wall Street-backed finance. Foreign demand for our assets is a not insignificant issue. Moreover, the global leveraged speculating community -- and international liquidity flows more generally -- are a major Stage II wildcard.
Otherwise intelligent financial commentators argue that today's rising energy and food prices are not a "monetary phenomenon." Instead, these price pressures are said to be due to strong demand from China and India -- wealthier consumers choosing to upgrade their diets. But both the Chinese and Indian economies (and many others) are now operating with virtually unlimited credit -- a unique combination of rampant domestic credit growth coupled with massive foreign financial inflows. As I have explained ad nauseam, U.S. current account deficits and dollar impairment are the root cause of scores of runaway domestic credit systemic that these days comprise the global credit bubble. This historic bubble is everywhere and in every way a monetary (credit) phenomenon.
It is my argument that Stage II Means another year of massive U.S. current account deficits. This would mean, for one, a prolonging of the massive flow of liquidity into international central bank reserves (creating domestic credit in the process), sovereign wealth funds, and (to a lesser extent) the hedge fund community. The consequences from a further ballooning of this unwieldy global pool of speculative finance are not at all clear. Secondly, another year of U.S. deficits would mean another year of excessive liquidity flows into the already overheated economies throughout Asia, the Middle East and elsewhere. These flows are hitting economies with already acute inflation pressures and related problems. Importantly, these monetary processes and inflationary dynamics are by now well entrenched and extraordinarily powerful after years of unrelenting excess. Resulting monetary disorder should be expected to go to increasingly destabilizing extremes (think NASDAQ 1999 and subprime 2006!) -- and indeed we are seeing evidence of as much in near $120 crude, the global food price spike and related hoarding, and wildly unstable and speculative global financial markets.
It is in this context that I believe U.S. policymakers are today unknowingly risking global financial and economic catastrophe. They are, of course, fixated on domestic concerns and are willing to do any and everything in a desperate attempt to sustain the U.S. bubble economy. They are oblivious to both the heightened risks associated with today's current account deficits and to the various linkages of their policies to heightened international monetary disorder. Stage II is fraught with great but not easily recognizable risks.
It is my view that there are significant risks associated with postponing the inevitable adjustment to the U.S. bubble economy. As I have attempted to explain previously, the amount of credit necessary to sustain our uniquely maladjusted economic structure is unmanageable. It is unmanageable for our troubled banking system, for our troubled GSEs, and for the expansive money-fund complex -- for risk intermediation generally. Stage II means great risk to the heart of contemporary "money". The problem rests on the reality that "pre-adjustment" credit -- borrowings associated with many businesses and enterprises that will be uneconomic come the arrival of the post-bubble backdrop -- is inherently weak and vulnerable. And as discussed above, today's U.S. credit is extraordinarily destabilizing in its effects upon the global credit bubble and resulting monetary disorder.
I am at this point more convinced than ever that only a severe crisis will instigate the necessary adjustment to the distorted and imbalanced U.S. and global economies. One is then left with the disconcerting view that Stage II will lead our authorities to exhaust all policy measures in a futile attempt to sustain the unsustainable. The obvious question: how long does the lead up to crisis Stage II last? I would today guess a number of months, although I would not at all be surprised if it was rather short. What will be the impetus for crisis stage II? A spike in interest rates, a run from U.S. Treasury and agency debt, a disorderly drop in the dollar, another bout of derivative and credit market implosion, or acute global financial tumult should be considered leading candidates based upon Stage II ramifications. Or it could easily be something completely unexpected, perhaps even war.
REVISTING FINANCIAL ARBITRAGE CAPITALISM
Doug Noland writes: "The title 'Financial Arbitrage Capitalism' is fitting for a credit system and economy now dominated by an expansive 'leveraged speculating community' seeking profits from variations and permutations of 'borrowing cheap and lending dear', by bond and investment fund managers whose entire focus is beating some indexed return, by rapidly expanding Wall Street balance sheets and influence, and by the entire wave of new credit instruments, derivatives, and sophisticated models and strategies used for the paramount purpose of capturing 'above-market' returns and resulting huge financial rewards."
Needless to say, he does not view the current credit system as promoting a healthy economy. And regarding the heroic efforts by policy makers to keep the system afloat: "Validating the current structure of Financial Arbitrage Capitalism simply perpetuates the same dysfunctional incentives that got us into this mess. It may in the short-term spur the necessary credit growth to buoy household incomes, corporate cash-flows and profits, government revenues, and securities and asset prices -- but it will add relatively little in the way of real economic wealth creating capacity. And, in the end, it is only real economy fundamentals that will determine the soundness and sustainability of a system's credit and financial structures."
And the greater risk from the pursuit of stability at any cost?: "[W]ith acute inflationary effects prevailing throughout global markets for food, energy, and commodities, one should be prepared for the likes of problematic supply bottlenecks and shocks, hoarding, trade frictions and interruptions, and generally heightened geopolitical instability."
I will admit to occasionally being annoyed by the clan over at PIMCO. [A very large fixed-income manager whose head, Bill Gross, is frequently quoted] Clearly, there is more than a little envy at work here. They are extremely smart, master market operators and skilled theoreticians. Those guys are really good at articulating the financial issue de jour, as well as backing it up with some reasonable-sounding solutions. But do they somehow not appreciate that they are part of the problem?
PIMCO is -- here we go again - the most vocal Wall Street proponent for strong reflationary policy measures and government interventions to battle so-called "deflation" risk. Back in 2002, they were the head cheerleader for reflationary measures that historians will surely view as a monetary policy blunder for the ages. Then, the deflation threat was said to reside with downside risk to the general price level; today it is with sinking home prices. Overwhelming force is again prescribed to fight the latest symptoms, while sidestepping diagnosis of the underlying ailment.
Furthermore, as someone who incorporates Minskian analysis deep into my analytical framework, I view their (and others') application of Minsky's work as largely superficial -- and rather self-serving at that. For one, the often referred Minskian concept of "stability is destabilizing" simply has not been relevant to the U.S. credit system in several decades. More importantly, implementing the Keynesian/Minskian policy toolkit to perpetuate bubbles and existing malignant structures and processes -- in contrast to instruments that would help buttress the system through arduous post-bubble adjustment periods -- has been a momentous analytical and policymaking failure over recent years.
I believe strongly that if Hyman Minsky were alive today he would see the huge investment fund managers, the hedge fund community, and Wall Street firms as the fundamental force behind today's acute financial and economic fragility. He would surely see the current financial order as dysfunctional and unsustainable. And I am quite confident he would view the current trajectory of financial system and policy development as laying the groundwork for the next crash and depression.
Back in late-2001, I titled a Credit Bubble Bulletin "Financial Arbitrage Capitalism". I coined this term in what I referred to at the time as "updating" Minsky's stages of financial capitalism. Minsky theorized that a troubling stage of "Money Manager Capitalism" had evolved from the earlier manifestations of Manager Capitalism, Financial Capitalism, and Commercial Capitalism.
Minksy on "Money Manager Capitalism":
"The emergence of return and capital-gains-oriented block of managed money resulted in financial markets once again being a major influence in determining the performance of the economy. However, unlike the earlier epoch of finance capitalism, the emphasis was not upon the capital development of the economy but rather upon the quick turn of the speculator, upon trading profits ...
As managed money grew in relative importance, more and more of the market for financial instruments was characterized by position-taking by financial intermediaries. These positions were bank-financed. The main financial houses became highly-leveraged dealers in securities, beholden to banks for continued refinancing. A peculiar regime emerged in which the main business in the financial markets became far removed from the financing of the capital development of the country. Furthermore, the main purpose of those who controlled corporations was no longer making profits from production and trade but rather to assure that the liabilities of the corporations were fully priced in the financial market. ... The question of whether a financial structure that commits a large part of cash flows to debt validation leads to a debacle such as took place between 1929 and 1933 is now an open question ...
"In the present stage of development the financiers are not acting as the ephors [ed: in effect a head of state] of the economy, editing the financing that takes place so that the capital development of the economy is promoted. Today's managers of money are but little concerned with the development of the capital asset of an economy. Today's narrowly-focused financiers do not conform to Schumpeter's vision of bankers as the ephors of capitalism who assure that finance serves progress. Today's financial structure is more akin to Keynes's characterization of the financial arrangements of advanced capitalism as a casino. The Schumpeter-Keynes vision of the economy as evolving under the stimulus of perceived profit possibilities remains valid. However, we must recognize that evolution is not necessarily a progressive process: the financing evolution of the past decade may well have been retrograde." (Minsky, 1993)
Minsky undoubtedly saw the LBO/buyout mania of the 1980s, among other symptoms, as a sign of the ascendance of "Money Manager Capitalism".
I am even more convinced today than some six years ago that a whole new financial structure has evolved -- and that it is definitely "retrograde." The title "Financial Arbitrage Capitalism" is fitting for a credit system and economy now dominated by an expansive "leveraged speculating community" seeking profits from variations and permutations of "borrowing cheap and lending dear", by bond and investment fund managers whose entire focus is beating some indexed return, by rapidly expanding Wall Street balance sheets and influence, and by the entire wave of new credit instruments, derivatives, and sophisticated models and strategies used for the paramount purpose of capturing "above-market" returns and resulting huge financial rewards.
The current system has experienced a broad transformation to a credit mechanism dominated by market-based instruments, in contrast to the traditional predominant position held by the banking system all the way through Minsky's "Money Manager" era. Today, the financial apparatus is "beholden" -- not to a coherent banking system but instead -- to an ambiguous thing called "marketplace liquidity" and the unwavering confidence such a mechanism requires. Importantly, momentous changes to the prevailing incentive system are also consistent with designating a new phase of Minskian capitalism. Late in Minsky's life, he expounded upon the role rising stock and corporate debt prices were playing in dictating various behaviors in the credit system, markets and real economy. With "Financial Arbitrage Capitalism," the bounty of seemingly limitless (until recently) speculative profits has created a reward system encouraging unprecedented debt creation, leveraging, and myriad forms and layers of financial intermediation.
I have labeled this current stage with the Minsky term "retrograde" specifically because only through the expansion of all facets of this credit bubble -- debt creation, leveraging, and risk intermediation -- will adequate new "profits" and debt service capacities validate and sustain the ever-increasing layers of debt and financial "arbitrage". Minsky noted a fundamental weakness of Money Manager Capitalism: "Unlike the earlier epoch of finance capitalism, the emphasis was not upon the capital development of the economy but rather upon the quick turn of the speculator, upon trading profits."
Financial Arbitrage Capitalism takes these defects to an entirely new level. Today, the major financial incentives dictating behavior are largely disengaged from the process of "capital development" and, furthermore, operate completely divorced from real economic profits overall. Or, more simply stated, current rewards spur the over-expansion of non-productive credit -- specifically debt instruments not supported by underlying wealth-creating assets (think subprime and high-yielding mortgages generally).
Mortgage credit is the bedrock of "Financial Arbitrage Capitalism." The Mortgage Finance bubble provided -- and continues offering to this day -- the greatest bounty of speculative profits the financial world has ever known. It comes as no surprise that PIMCO and Wall Street are these days fixated on home values and the pricing of mortgage-backed and mortgage-related securities and derivatives. That $trillions of real and financial resources were so badly misallocated through the mortgage finance bubble years will definitely not dissuade those arguing that $trillions more will be necessary to avert the scourge of "deflation". Apparently, the more egregious the misallocation and resulting impairment to the financial and economic structures, the more imperative it is to throw more non-productive credit inflation at the problem -- the mandatory fight to avert "deflation".
This puts the irony and absurdity of the whole sitation in high relief: the more mistakes you make, the more effort you have to expend to keep the mistakes from coming back to bite you. This is not expected when one considers that the whole system is a government baby. When a privately-run enterprise bleeds cash while failing to produced results, the natural reaction is to cut costs and, if necessary, close it down. Contrariwise, when the same situation arises with a government-run enterprise, the call goes out for more resources to "get the job done". The fight against the alleged awful consequences of deflation is basically your standard government program in this respect.
For some time now, it has been my view that "Financial Arbitrage Capitalism" was sowing the seeds of its own destruction. The incentive structures were so deeply flawed, the analyses of the inner workings of this system were critically flawed, and policymaking was devastatingly flawed. The combination of rampant non-productive credit growth, unprecedented system leveraging and speculative excesses, and resulting economic maladjustment ensured untenable system fragility. Still, the more apparent the underlying fragility becomes the greater the impetus to sustain the existing financial and economic order. And the more conspicuous previous analytical and policy mistakes appear the greater the tendency to see no other alternative than to compound them. Mistakes beget ever-bigger mistakes. There is a desperate need to step back and come to grips with how dysfunctional this has all become.
Some seven or so weeks ago the existing Financial and Economic Order was in perilous jeopardy. Wall Street-backed finance was collapsing, and this implosion was about to invalidate our system's underlying debt structure as well as the structure of the underlying bubble economy. But the Federal Reserve and Washington policymakers stepped in with radical measures. These included the Federal Reserve's guarantee of ample liquidity for the Wall Street firms and virtually limitless "marketplace liquidity" throughout, as well as explicit and implicit federal backing for much of our mortgage credit system. It may not have appeared momentous to most, but it basically placed Fed and federal government backing on trillions of securities and market liquidity risk more generally. In Minsky terminology, these measures at least temporarily "validated" the existing structure of "Financial Arbitrage Capitalism."
Will policymaking succeed over the intermediate- and long-term? Not a chance. Policymakers do today retain capacity to convince the marketplace of their power to inflate the value of debt securities and asset prices more generally. But reflationary polices and other assurances will not rescue the system, specifically because there is today nothing to stem the ongoing distortions to the underlying real economy. Validating the current structure of Financial Arbitrage Capitalism simply perpetuates the same dysfunctional incentives that got us into this mess. It may in the short-term spur the necessary credit growth to buoy household incomes, corporate cash-flows and profits, government revenues, and securities and asset prices -- but it will add relatively little in the way of real economic wealth creating capacity. And, in the end, it is only real economy fundamentals that will determine the soundness and sustainability of a system's credit and financial structures.
Additional non-productive debt growth will definitely not alleviate the acute fragility associated with "Ponzi Finance" credit system dynamics. Additional non-productive debt growth will also not stabilize dollar devaluation, nor will it help in stabilizing myriad problems at home and abroad associated with our monstrous current account deficits. Instead, any extension of this period of Financial Arbitrage Capitalism will ensure the prolonging of borrowing and consuming excess, the gross misallocation of resources, massive trade deficits, a ballooning international pool of unwieldy speculative finance, and even wilder global monetary disorder.
Indeed, Washington's validation of the current dysfunctional credit system structure could very well lay the groundwork for extreme global price distortions, volatility, and social/political unrest. On the current course of things, it is difficult for me to not think in terms of NASDAQ 1999 or subprime 2006. Throw additional liquidity on overheated credit, inflationary, and speculative "biases" and be prepared for the spectacular. When Financial Arbitrage Capitalism's excesses were spurring acute U.S. securities market inflation, the system enjoyed a period of perceived rising wealth to go with a boom in Wall Street securities issuance (helping somewhat to offset inflated demand). When this Structure's excesses were directed at the mortgage finance bubble, the upshots were inflating home prices along with attendant construction and consumption booms. Now, however, with acute inflationary effects prevailing throughout global markets for food, energy, and commodities, one should be prepared for the likes of problematic supply bottlenecks and shocks, hoarding, trade frictions and interruptions, and generally heightened geopolitical instability.
I argued back in 2002 that the overriding systemic issue was not "deflation" but rather myriad risks associated with an unfolding U.S. credit bubble. Now, some years later, these risks have expanded alarmingly, as runaway credit bubbles have ballooned both at home and abroad.
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