Sunday, December 23, 2007

Economic And Market Considerations

Considerations Of Our Current Economic And Market Climates

Questions by [BoltonCT]; Answers largely by normxxx | 16 December 2007

    [BoltonCT]: Norm, Al and others... what do you think we need to do to get the economy back on track? We hear contradictory analysis. The FED says they are increasing liquidity. Others say the facts show they are not. They are only maintaining current liquidity.

The question of what the Fed is doing was answered above. But I will begin by expanding on my comment, "Note that neither John nor Gary seems to be considering the non-bank money centers, which have been the Principal source of money for mortgages, etc."

Consider first the invention of mortgage backed securities, which has since morphed into asset backed securities of every stripe. In 1968, Congress established the Government National Mortgage Association, commonly known as Ginnie Mae, as a government-owned corporation within the Department of Housing and Urban Development (HUD). Even today, Ginnie Mae securities are the only mortgage-backed securities (MBSs) that offer the full faith and credit guaranty of the United States government. These MBSs were created to solve a problem: a lack of available, consistently priced capital, which put a ceiling on the number of new mortgages that Ginnie Mae could issue, since the mortgages generally don't return much of the principal until they are near due— for perhaps 20 years or so.

Ginnie Mae solved this problem and revolutionized the American housing industry in 1970 by pioneering the issuance of mortgage-backed securities. Today, 'intermediate lenders' (such as Fannie Mae and Freddie Mac) pool packages of 'qualifying' FHA, VA, RHS or PIH mortgages and convert them into securities (the lesser mortages are packaged by the banks and other 'private' creators of MBSs and CDOs), which are then resold to the final lenders (pension funds and the like). Ginnie Mae guarantees investors the timely payment of principal and interest on these securities (the 'private' packagers may use 'private' insurers).

In a single step, the issuance of mortgage-backed securities converted individual mortgages into liquid securities for investors around the world. It would not be a large leap for others to do the same with mortgages and other forms of debt. All manner of debt had become fungible! For what happened next, see We're heading toward financial chaos

By immediately selling off their mortgages (or other loans) as packages of MBSs/ABSs to others, including "off-the-books" Funds (such as SIVs and similar) set up by the banks themselves explicitly for that purpose, the banks were immediately able to relend the same money over and over again to other mortgagees. What did the banks gain in such a transaction? Fees. These became so profitable, as the money turnover sped up, that even the really "prime" mortgages, which the banks had retained simply to collect the "safe" interest on, were eventually sold to regain funds with which to turn over other mortgages and loans. Banks had become mortgage and loan "originators" only— and no longer figured very prominently in a loan once it was sold.

The description of how the "fractional reserve" money and banking system works is well described by Gary and John for as far as it goes. But it neglects this direct access of the commercial money markets by banks and others in order to gain funds to support highly risky ventures. These funds were never loaned out under the auspices of the "fractional reserve" money system, since the money was used either simply to replace funds that were part of the system— by the reserve banks— or was just directly re-lent by non-[reserve]bank 'money centers', e.g., F&F, Countrywide, etc. who were never part of the system. All of this was outside of the "fractional reserve" money and banking system!

In the diagram below, start with the bank and follow the arrows around to gain some idea of how this "off-the-books" process worked— until it didn't. The picture is the similar for the non-bank money centers such as F&F, and the so-called "mortgage brokers" (e.g., Countrywide), which act a bit like banks and a bit like the Funds set up by the banks, except that they cannot call on a parent bank or the CB when there is a run on their assets— so they go bankrupt! (Though I seriously don't think that F&F will go BK.)

Click Here, or on the image, to see a larger, undistorted image.

The source of low cost short-term funding for all of these extra-bank and non-bank money center lending was the commercial paper market, until it largely imploded. The SIVs fell back on funds from their parent or other banks; the smaller non-bank money centers have largely gone bankrupt; the rest are hanging on by a thread.

So the banks (the newly created "loan originators") neatly bypassed/circumvented the Fed/bank money system so carefully described by Gary and John. And F&F and the many lesser non-bank money centers (such as Countrywide) were never part of that banking system, but still originated loans and lent out money— until they suddenly could not sell any more MBSs or CDOs, to anybody.

See Conduits, SIVs, cash-hoarding, commercial paper restructuring and such for a handle on how the banks' sponsored funds are doing currently.

    [BoltonCT]: Premise 1 There is a worldwide imbalance and polarization between saving (East) and investment (West).

Only partly true. In the past, even the most supposedly "risk free" investments in third world countries carried plenty of risk, so it was fairly common for the rich folk in those countries and in the developed countries to send their funds to supposedly "safe havens"— such as the U.S. and other Western countries. These funds were then mostly locally relent (in the developed world, that is). I doubt if that trend will survive this credit collapse. See Citibank SIVs Hit Norway Townships— Several Norway townships are caught up in the international credit crisis.

    [BoltonCT]: Premise 2 There is now a reported worldwide credit crunch.

So far, it has been mostly contained to MBSs in the commercial paper market; but even bank "paper" and other so-called "safe" funds are rapidly drying up or are being subjected to far greater scrutiny and suspicion. The CP market has become a shadow of what it was just a year or so ago. See Calculated Risk: Discount Rate Spread Increases, America’s shrinking asset-backed market tells us…., Market looks to Fed as commercial paper falls and The Great Commercial Paper Meltdown of 2007

    [BoltonCT]: Premise 3 Greenspan is right in saying the sub-prime collapse is the trigger not the cause of the crunch and that the crunch was an accident waiting to happen. The credit markets melted down in August because "risk had become increasingly under priced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction."

Yes, but "Easy Al" still was a large proximate cause of the present collapse. It is amazing how wild "financiers" can get with 'almost free' money! Al's artificially easy money (at 1%) was the immediate cause of the "risk [becoming] increasingly under priced as market euphoria gained cumulative traction." The overall risk has been growing for over 20 years (gee; just about as long as Al was Fed Head!) and was the reason that I predicted TEOTWAWKI in 2009 during the last market meltdown, which I rightly averred was not IT (aka, "the BIG one")!

    [BoltonCT]: Premise 4 The FED and world banks are trying to ease credit.

Well, they're trying to ease the "credit crunch." But, it is unclear how they can do that. The problem is not so much a loss of direct bank liquidity as that investors (and even other banks!) have lost trust in the system! When "AAA" rated securities can drop by half of face value, or even default, whom or what can you trust[!?!]

    [BoltonCT]: Premise 5 Dr. Hussman concludes that no new money is actually flowing to ease the credit crunch.

That's largely true. The problem with this credit crunch, however, is that it is largely due to major investors holding back funds from the credit markets (better safe than sorry). And this lending is many times what the banks can lend.

    [BoltonCT]: Therefore QED:
    Conclusion 1, This is a similar situation to the Great Depression where the FED/Banks push on a string and nothing happens. Reducing interest rates have no effect when risk gets too high. The crunch may be a lack of demand and not lack of supply for solid investments. When risk is too high only the credit unworthy still want credit. Logic-Why buy a house now when prices will be lower in 2 years?

There is a certain truth to what you say. But, today, the problem is not a lack of demand, but the lack of a way to close the gap between the investors with the money and those who need it, that the investors can trust! However, the Great Depression also saw deflation, and deflation causes real interest rates to rise (even as nominal interest rates go to zero), so it is easier/safer just to hold on to your money. That is not yet true today.

    [BoltonCT]: Conclusion 2, Risk is now either properly priced or over priced and lowering the discount rate cannot ease the crunch or help the stock market any more. It can only weaken the dollar.

The only purpose to lowering the discount rate is to increase the spread between short term and long term rates (a common panacea when the banks get into trouble), so the banks can earn more money with which to pay off their liabilities. In any event, risk is still way underpriced, which is why we have a "credit crunch." At seriously higher long rates, there would be enough lenders; but how many ARM mortgagees, credit card holders, and marginal businesses set up during the 'easy money' era could afford those much higher rates? This is known as a vicious circle!

    [BoltonCT]: Conclusion 3, Fiscal (Keynesian) policy (deficit spending) can no longer stimulate spending and investment because of the risk overhang of bubbles ready to burst. The financial mine field practically guarantees a loss on future investments.

I am not sure I understand the gist of this conclusion. But the problem as I see it is that income for those below the top 5% - 1% has stagnated since about 2000. So there is no way that current mortgagees can afford the houses they are now living in if they bought in the last several years or so (or if they foolishly tapped it as a source of funds to spend on 'free' living— pun intended). Moreover, now that we can no longer tap our houses for loans, or our credit cards, etc., we may just have to live within that stagnated income. But that sounds like a repeat of the '30s in the current economy; we have lived for too many years on the savings of foreigners— that well is now dry.

Just printing money will no longer work because we are at the point where inflation would rise as fast as (or faster than) the increase in money supply.

For a theory of endless bubbles, see iTulip's Ka-Poom Theory. (The 2006 update is shown at the bottom, with a long description of the theory here: "Ka-Poom Is A Rhyme Not A Repeat Of History". See "Dollar’s Last Lap As The Only Anchor Currency" for the most recent comments on the theory.)

    [BoltonCT]: Conclusion 4, The U.S. currency will likely come under attack as the East-West balance is resolved as long as America continues to lower interest rates and maintain deficits. Current policies are making the situation worse causing inflation.

It depends on which calamity you are considering. The fascinating dilemas of the end-game are such that addressing one invariably makes another— equally dire— get worse. The usual approach (à la Alan Greenspan) was/is to leave inflation as the last thing to address, since "it is something we know how to control"[!?!] Unfortunately, while that may have been true for Paul Volcker, it was never true for AG. All of the paper currencies are inflating, just at different rates. Invest in physical assets, but be prepared for wild swings as we reverbrate from boom to bust and then finally reach some sort of equilibrium. For a beautiful explanation of hyperinflation, deflation, and how they are related, see Hyperinflation: Creating Repulsive Money by Paul Tustain.

    [BoltonCT]: Conclusion 5, Bailouts place America in the Japanese conundrum. They postpone reckoning so they never put risk behind them. They just face perpetual economic risk. Bailouts are how governments create a legacy of corrupt and ineffective polices as can be seen throughout much of the world.

While that is largely true, if we get to deflation, then the Fed (or other CB, such as the BoJ) has lost control, and we have a repeat of our 'never ending '30s' in the U.S. or Japan's 17 year off-again on-again off-again economy. That was why AG was so terrified of deflation (even a hint got him to drop rates to 1% and seemingly hold them there forever.) The Fed is most comfortable with an inflation rate between 1% and 2%, and gets mightily nervous if it drops below 1% or rises above 2%. However, the "doctored" inflation rate of recent years is running around 4% to 6% higher than the "historical" (pre-Clinton) rates. See How do You Spell Stagflation? by John Mauldin. The pre-Clinton rates probably were/are somewhat high— as long as we can out-source to Asia and others at below domestic costs— but now I believe we have overcompensated in the other direction.

    [BoltonCT]: Potential solutions:
    Potential Solution 1:
    "There are also, I should admit, forces which one might fairly well call automatic which operate under any normal monetary system in the direction of restoring a long-run equilibrium between saving and investment[[1]]. The point which I cast into doubt— though the contrary is generally believed— is whether these `automatic' forces will... tend to bring about not only an equilibrium between saving and investment but also an optimum level of production.[[2]]" (John Maynard Keynes, Collected Writings, Vol. 13, 1973: p.395)

    This probably will not help, for while America under-saves, China, Japan, and Germany balance it out globally. In the high-risk environment it is better not to have anything worth losing individually. But America has a lot to lose corporately. America is becoming more vulnerable to China and others buying our corporate natural resources and suppliers with cheap dollars under current FED policies. The danger is inflation.

[[1]] You have largely answered this first assertion: under "globalization" of trade, the economy has gone global. But as the wages and costs in the second and third world countries rise (and the credit they extend to us falls), the costs of those imports to Americans will rise— so, we are net-net no longer importing deflation, but exporting inflation!

[[2]] Keynes was concerned with overproduction due to limited demand. Incomes in the '30s among the vast numbers of consumers, just as now in the U.S. (with the cut-off of credit), had gotten too low— it took WWII to raise wages and pent up demand so that the economy was able to take off and never look back from the late '40s on.

Currently, we are again (temporarily?) suffering from overproduction in the second and third world countries.

However, as the 'boomers' in Europe, the U.S., and Japan retire, demand in these countries will swell— more than enough to keep the second and third world countries— with their huge under 30 populations— producing happily. But what thing of value do we give them in exchange for their production?

    [BoltonCT]: Potential Solution 2:
    [[1]] Let it go and get the correction behind us. Fear of high and increasing economic and social risks from other meltdowns is the probable cause of the credit crunch that results in little demand for new investments. Who wants to invest in a house now when in two years a 25% decline can wipe out the owner's entire equity? Yes new money is drying up but who wants to invest it in a guaranteed loss as the stock market and other bubbles pop. Ultimately a recession is necessary to clear out the waste and corruption. The recession in 2001 was mild and corrected the market distortions and popped all the bubbles.

    [[2]] Raise the FED rate and let the stock market bubbles pop around the world. The EU is maintaining their rate, as we should be doing. China's bubble is the biggest and the threat of them controlling world resources would pop just as Japan's threat popped 17 years ago. Unlike Japan we should put our economic cleansing behind us and virtually eliminate risk in the USA as we have done in the past. Then unlike Japan our economy will grow rapidly again. Much of the Old World cannot part with the legacy of fears and hatreds they harbor from their past.

[[1]] This is a question that I have raised before:how do you let go of "the tail of the tiger" without risk of being eaten before you can make good an escape[!?!] I think you misread the temper of the average American today; conditions such as the '30s would surely incite a revolution (as they very nearly did in the early '30s). You can argue that if FDR had "toughed it out," the depression would have been over with probably no later than '35 or '36. But would there still have been a U.S. by then? Japan and the Japanese may be 'suffering'— but you'd hardly notice it. Between the natural acceptance of things as they are by the Japanese (and the abhorrence of any sort of radical protest) and their 'social welfare' programs, things never got/get so bad that there is much protest. Much the same is true in the EU, which is why they can tolerate unemployment of around 10% for years and years. Our social catastrophe nets are full of holes!

    [BoltonCT]: Who wants to invest in a house now when in two years a 25% decline can wipe out the owner's entire equity?

Despite what you may think; there is no lack of demand; only a lack of the wherewithal. And, I don't think we will once again try to put people into homes with mortgages they cannot afford (once the teaser rates run out) on the insane assumption that house prices can only rise, and so the increased value of the home will allow them to refinance on more favorable terms. But you are right in the sense that the lenders will no longer lend to someone "in a house now when in two years a 25% decline can wipe out" a good chunk of the lender's "equity?" So, you'd better have a hefty downpayment and golden credit, especially if you are looking for a Jumbo mortgage loan.

    [BoltonCT]: The recession in 2001 was mild and corrected the market distortions and popped all the bubbles.

Well, it was the popping of the bubble that brought on the puny recession of 2001; but beyond that it was not deep enough nor long enough to clear out many (if any) market distortions. Just look how eager and quickly "investers" were once again to jump into the stock market once the housing market really took off! If there had been a serious correction, it would have taken about a half to a full generation (10 to 20 years) to get the stock market going again!

    [BoltonCT]: [[2]] Raise the FED rate and let the stock market bubbles pop around the world[!?!]

[[2]] Disabuse yourself of the notion that the Fed is looking out for the housing or stock markets, or even the economy; there is only one thing the Fed concerns itself with: the health of the banks of which it is made up. (Remember that famous 'old' saying [only slightly altered] "What's good for the banks is good for the USA") Remember, also, the only government official in the Fed (outside of the worker peons) is the Fed Head. All of the other members are heads of private banks.

As I noted above in answer to a previous point, "The only purpose to lowering the discount rate is to increase the spread between short term and long term rates (a common panacea when the banks get into trouble), so the banks can earn more money with which to pay off their liabilities."

But, aside from that, how long do you think Congress and/or the President would sit still if the Fed were seen to raise rates during a recession? Volcker got away with it, because (1) everyone was suffering from the runaway inflation, (2) Volcker only raised rates to an extreme for a very brief period (shock therapy), and (3) President Reagan (the man of iron convictions) was willing to go along and back him! (But the howls were still ferocious, and Reagan lost his Republican Senate!)

    [BoltonCT]: The USA prospers because we have the most transparent and uncorrupted political and economic systems in the world. The Japanese laughed at us in the early 90's and said we had "Cowboy Economics" when we started downsizing as the building and banking bubbles were popping. It is time for this cowboy to pull in the belt again and start another fresh uncorrupted economic expansion.

I am uncomfortable with "the most ... uncorrupted political and economic systems in the world." Would you settle for least corrupted "political and economic systems in the world"?

My money on why we have prospered so (above and beyond what a cornucopia of natural resources have bought us) is that no other region in the world promotes, rewards, and treasures its innovators like the U.S.— From those who "made do" on the frontiers, to Eli Whitney, to Thomas A. Edison, to the computer innovators, to the internet and innovators, to the banking and other financial innovators who gave us our present alphabet soup of financial products (yes, even if they did overdo it— 'originators' operate without brakes— which is why we need government or somebody to slow things down when they get too heated)! Moreover, our society is attuned to novelty (possibly too much so) and change. And, yes, as a country we were never worried much about "saving face" when it came to cleaning up after financial or other disasters (such as slavery or Jim Crow).

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