Insight: We Are In For The Mother Of All Bear Market Rallies
By Barton Biggs | 24 November 2008
Before we all are swept away into total despair, let’s take a step back and imagine what could get stocks around the world going up for a while. Bear in mind that I am hedge fund manager, have been wrong on the severity and duration of this panic, and that at this moment I am close to shore. In other words— I have little risk on.
First, let me point out that by definition the bottom of a bear market has to be the point of maximum bearishness. Thus sentiment becomes a crucial indicator. The systematic work that we do on measuring sentiment (and we monitor about twenty indicators for the US and a dozen or so for other equity markets) show very extreme and in many cases record levels of bearishness. Obviously not every indicator is at an all-time high, and in some the history is short, but the message is powerful. Furthermore there is compelling evidence that investors, hedge funds, pension and mutual funds, and the public are not just talking bearish, they have raised astounding amounts of cash.
I am chastened by the fact that all the data we look at are from the last forty years which was really just one great magnificent secular bull market of wealth creation marked by periodic bears that were buying opportunities. No one knows what levels of pessimism were necessary to spawn the 40 per cent 1929 rally during a massive secular bear market. [[Note: the 1966-1982 secular bear was every bit as bad as the 1929-1946 secular bear, inflation adjusted! : normxxx]]. Nevertheless I’ve never seen capitulation and despair like this. We must be pretty close to maximum bearishness.
Second, valuations are cheap. There’s no point in going into an elaborate dissertation; it’s an inexact science. Using the best historic measures, normalised earnings, book value, and free cash flow, stocks around the world are very cheap, but not as cheap in absolute terms or versus interest rates as they were in the 1930s or at the 1974 bottom. Nevertheless, the 4 per cent dividend return on the S&P 500 exceeds the yield on the ten and thirty year Treasury bonds for the first time in fifty years. If emerging market equities, where the growth is, at six to eight times earnings are not cheap I don’t know what is.
Third, stock markets have been obliterated and are deeply oversold. Even dead cats bounce. The Dow has had the steepest decline since the 1930s, and the spread between the price and the 200 day moving average at 34 per cent is the greatest since July 19, 1932. The US market is down almost 50 per cent from its highs, Europe is off 55 per cent, and emerging markets, 65 per cent with some unfortunates like Russia off 70 per cent. History shows that even in enduring, secular bear markets there are not just 20 per cent bounces, but usually one 30 to 50 per cent rally [[which usually comes about now, ie, just after the huge initial drop: normxxx]]. We should be due.
As far as the economic fundamentals are concerned, investor and consumer confidence have been ravaged by the sudden violence of the global recession. It is going to be deep and it may be long lasting. The bears say at best it will be like Japan’s on-going slow death. At worst, it will be a replay of the 1930s.
I think both these outcomes are highly unlikely. The so-called authorities have learned[!?!] from the policy errors of the past, and the response this time, while not perfect, has been faster and far bigger [[and, so far, to no obvious effect: normxxx]]. The effects are just beginning to be felt[!?!] In fact the stimulus has been unprecedented and there is almost sure to be more on the way beginning with the new Obama Administration. The authorities seem to understand that they have to risk overkill.
And the fabric for economic healing is developing. In the US, average hourly earnings are rising at a 3 per cent annual rate and the CPI is probably declining at a 5 per cent rate thanks to the fall in gasoline, fuel, and food prices, so real average hourly earnings are rising at an 8 per cent pace. The savings rate is rising. The sharp collapse in the price of oil while hurtful to parts of the world, is very beneficial to the US, Europe, and Asia. The consumer spending collapse we are experiencing may be short-lived but that doesn’t mean a boom is coming either.
Finally, my guess, and it’s nothing more than a guess, is that the deleveraging that has caused such heavy selling is two thirds done. In listed equities, it may be 80 per cent finished. Hedge fund redemptions are substantial and will continue into next year, but hedge fund liquidity is at a record high and hedge funds’ gross exposure and net long is at a record low. Conversely investor liquidity is at a record high. All good contrary indicators.
If I’m bullish why aren’t I in there now? Because I would like to see the credit markets unclog and spreads come in more. At the bottom of a panic, the news doesn’t have to be good for stocks to rally, it just has to be less bad than what has already been discounted. I want the markets to stop going down on bad corporate and macro-economic news. The fact that it still does shows the bad news has not yet been fully discounted. I have no idea when the next bull market starts, but I do think we are setting up for the mother of all bear market rallies.
The writer is managing partner at Traxis Partners, a New York based hedge fund, and the author of Hedgehogging.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Saturday, November 29, 2008
Friday, November 28, 2008
Little Solace in Bonds
Seeking Solace? You’ll Find Little In The Bond Market
By Jeff Sommer | 22 November 2008
A worker outside the London office of Lehman Brothers. The firm’s collapse forced liquidations of bond holdings by major institutions— and investors became wary of many classes of bonds.
It’s bad enough that the stock market has plummeted. Even with a late-day rally on Friday, the Standard & Poor’s 500-stock index is down more than 45 percent for the year to date. Stocks have not declined that much in a full year since 1931.
But see First Year Of Major Correction [Right] (Dow, as percentage, since 1900) Source: ChartoftheDay
But bonds? They’re supposed to be the Steady Eddies of a well-diversified portfolio— safe, boring and a necessary part of an investor’s diet, like spinach, Mr. Sommers notes. The excitement— and risk— in a portfolio should come from stocks. If bonds fluctuate at all, they are expected to rise in value when stocks decline, buffering a portfolio’s returns in a rocky market. That, at least, is the common expectation, said Robert L. Rodriguez, chief executive of First Pacific Advisors and co-manager of the FPA New Income mutual fund.
But the global credit crisis has shattered the expectations of many investors in fixed-income as well as equity markets. With forced liquidations of bond holdings still under way by major institutions in the wake of the Lehman Brothers failure in September, even the slightest whiff of risk in a bond has put off investors, resulting in big losses. And bonds are certainly not a sideshow: Much of the turmoil in the financial sector and the overall economy has emanated from the credit markets.
So far, only the most unimpeachably safe fixed-income securities— for the most part, those issued by the Treasury or otherwise backed by the United States government, directly or indirectly— have generally held their value. "Investors are confused, and they have a lot of misconceptions," Mr. Rodriguez told The Times. "You have to get to the basic question, and that is, which bonds do you actually own?"
Long-term corporate bonds, for example, declined in value by more than 18 percent, on average, through October, according to Ibbotson Associates, a Morningstar subsidiary. That’s worse than any full-year decline on its records going back to 1926. The rout in corporate bonds, particularly high-yield or junk bonds, has been worse, by some measures, than even the distressed market of the Great Depression, said William H. Gross, co-chief investment officer of the Pacific Investment Management Company. Junk-bond yields— which move in the opposite direction of prices— recently soared above 20 percent.
"These are unheard-of, unseen yields that have never taken place in anyone’s lifetime," Mr. Gross, who manages Pimco Total Return, the country’s largest bond fund, told The Times. "Even during the Depression, corporate bonds did not trade at these particular yield spreads," or premiums over yields of comparable Treasuries, Mr. Gross added. On the positive side, long-term government funds tracked by Morningstar were up 9.2 percent for the year through Thursday.
But in many parts of the market, the returns for bond mutual funds are sobering, with performances that would be abysmal even for stock funds in a typical year. High-yield bond funds were down 29.6 percent for the year through Thursday, emerging-market bond funds were off 26.5 percent, and bank loan funds were down 24.7 percent. Even intermediate-term bond funds, a middle-of-the-road category often used as a core holding for portfolio balancing, were down 9 percent.
This is no typical year, however, not by a long shot, Mr. Sommers says. "Never before, in 25 years, have I seen conditions like this," Mary J. Miller, the director of T. Rowe Price’s fixed-income division, told The Times. "It’s not just credit risk," she said. "Some parts of the market are liquidity-impaired— there just aren’t enough buyers out there."
Municipal bonds have been "considerably punished," she said, because of a lack of buyers and the "acute risk aversion" that has permeated the market. Most municipal bonds are, in fact, creditworthy, she said, but their prices have gone down anyway. The loss of independent firms that functioned as market makers— like Bear Stearns, Lehman Brothers, Merrill Lynch and Wachovia— has disrupted markets, she said, and so has the continued unwinding of leveraged bets, often packaged as complex derivatives, taken by hedge funds.
Mr. Gross of Pimco described the wave of selling by hedge funds as akin to "a margin call" in which bond holders are forced to sell securities at lower and lower prices. Still, some bond funds marketed as core holdings for buy-and-hold investors have held their own this year. In the current market, that means not losing much money, and, in some cases, maybe gaining just a little.
These funds include Pimco Total Return, which was down 0.3 percent through Thursday; the Vanguard Total Bond index fund, up 0.9 percent; the T. Rowe Price New Income fund, down 2.3 percent; and FPA New Income up 3.7 percent. All of these funds are highly rated by both Morningstar and Lipper. This modest performance was possible because these funds did not dabble much, if at all, in risky areas of the market, said Jeff Tjornehoj, senior research analyst for Lipper. "Funds that did well in up-markets by taking on risk have been punished now," he told The Times.
There are many ways of minimizing risk. The Vanguard Total Bond index fund is passively managed, and mirrors what until recently was known as the Lehman Aggregate Bond index— and is now called the Barclay’s Aggregate Bond index, as a consequence of Barclay’s absorption of Lehman’s bond analysts and indexes. Treasuries within the index gained in value while corporate bonds fell, and the results have been "about what you might have expected from a core holding," Fran Kinniry, who runs the investment strategy group at Vanguard, told The Times.
FPA New Income has taken a different approach, holding large quantities of cash and Treasuries, and keeping the average duration— essentially, the time before a security matures— down to about one year. Reducing duration cuts down on the risk of shifts in yields and inflation expectations. Pimco has taken another tack, by buying Treasuries and investing in fixed-income securities of Fannie Mae and Freddie Mac, the mortgage giants that have been bailed out by the federal government. "We’ve essentially made ourselves partners" of the government, Mr. Gross told The Times.
Mr. Gross is taking a similar approach, he said, with investments in the preferred shares of bank holding companies in which the Treasury is injecting capital. With a shortage of liquidity, and an epidemic of risk-aversion, he said, it makes sense "to buy something where you can partner with Uncle Sam as opposed to being left out in the cold."
With commodity prices declining and the Consumer Price Index dropping in October by the greatest amount on record, there are signs of disinflation, perhaps even the possibility of a cycle of declining prices, known as deflation. Bond strategists caution, however, that the current outlook for inflation has been made murky by the attempts of the Federal Reserve, and of central banks and governments around the world, to pump money into the financial system in an effort to strengthen the global economy.
For Mr. Rodriguez, this is a major concern, and further reason to minimize all of his bets. "We may be facing deflation first, and then inflation down the road," he told The Times. "This is a very difficult time." Mr. Gross said that for months to come, he expects the bond market to be struggling to evaluate the risks of both deflation and inflation. "It’s a legitimate debate," he told The Times, "and we don’t have any clear view as to which one wins."
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Jeff Sommer | 22 November 2008
A worker outside the London office of Lehman Brothers. The firm’s collapse forced liquidations of bond holdings by major institutions— and investors became wary of many classes of bonds.
|
It’s bad enough that the stock market has plummeted. Even with a late-day rally on Friday, the Standard & Poor’s 500-stock index is down more than 45 percent for the year to date. Stocks have not declined that much in a full year since 1931.
But see First Year Of Major Correction [Right] (Dow, as percentage, since 1900) Source: ChartoftheDayBut bonds? They’re supposed to be the Steady Eddies of a well-diversified portfolio— safe, boring and a necessary part of an investor’s diet, like spinach, Mr. Sommers notes. The excitement— and risk— in a portfolio should come from stocks. If bonds fluctuate at all, they are expected to rise in value when stocks decline, buffering a portfolio’s returns in a rocky market. That, at least, is the common expectation, said Robert L. Rodriguez, chief executive of First Pacific Advisors and co-manager of the FPA New Income mutual fund.
But the global credit crisis has shattered the expectations of many investors in fixed-income as well as equity markets. With forced liquidations of bond holdings still under way by major institutions in the wake of the Lehman Brothers failure in September, even the slightest whiff of risk in a bond has put off investors, resulting in big losses. And bonds are certainly not a sideshow: Much of the turmoil in the financial sector and the overall economy has emanated from the credit markets.
So far, only the most unimpeachably safe fixed-income securities— for the most part, those issued by the Treasury or otherwise backed by the United States government, directly or indirectly— have generally held their value. "Investors are confused, and they have a lot of misconceptions," Mr. Rodriguez told The Times. "You have to get to the basic question, and that is, which bonds do you actually own?"
Long-term corporate bonds, for example, declined in value by more than 18 percent, on average, through October, according to Ibbotson Associates, a Morningstar subsidiary. That’s worse than any full-year decline on its records going back to 1926. The rout in corporate bonds, particularly high-yield or junk bonds, has been worse, by some measures, than even the distressed market of the Great Depression, said William H. Gross, co-chief investment officer of the Pacific Investment Management Company. Junk-bond yields— which move in the opposite direction of prices— recently soared above 20 percent.
"These are unheard-of, unseen yields that have never taken place in anyone’s lifetime," Mr. Gross, who manages Pimco Total Return, the country’s largest bond fund, told The Times. "Even during the Depression, corporate bonds did not trade at these particular yield spreads," or premiums over yields of comparable Treasuries, Mr. Gross added. On the positive side, long-term government funds tracked by Morningstar were up 9.2 percent for the year through Thursday.
But in many parts of the market, the returns for bond mutual funds are sobering, with performances that would be abysmal even for stock funds in a typical year. High-yield bond funds were down 29.6 percent for the year through Thursday, emerging-market bond funds were off 26.5 percent, and bank loan funds were down 24.7 percent. Even intermediate-term bond funds, a middle-of-the-road category often used as a core holding for portfolio balancing, were down 9 percent.
This is no typical year, however, not by a long shot, Mr. Sommers says. "Never before, in 25 years, have I seen conditions like this," Mary J. Miller, the director of T. Rowe Price’s fixed-income division, told The Times. "It’s not just credit risk," she said. "Some parts of the market are liquidity-impaired— there just aren’t enough buyers out there."
Municipal bonds have been "considerably punished," she said, because of a lack of buyers and the "acute risk aversion" that has permeated the market. Most municipal bonds are, in fact, creditworthy, she said, but their prices have gone down anyway. The loss of independent firms that functioned as market makers— like Bear Stearns, Lehman Brothers, Merrill Lynch and Wachovia— has disrupted markets, she said, and so has the continued unwinding of leveraged bets, often packaged as complex derivatives, taken by hedge funds.
Mr. Gross of Pimco described the wave of selling by hedge funds as akin to "a margin call" in which bond holders are forced to sell securities at lower and lower prices. Still, some bond funds marketed as core holdings for buy-and-hold investors have held their own this year. In the current market, that means not losing much money, and, in some cases, maybe gaining just a little.
These funds include Pimco Total Return, which was down 0.3 percent through Thursday; the Vanguard Total Bond index fund, up 0.9 percent; the T. Rowe Price New Income fund, down 2.3 percent; and FPA New Income up 3.7 percent. All of these funds are highly rated by both Morningstar and Lipper. This modest performance was possible because these funds did not dabble much, if at all, in risky areas of the market, said Jeff Tjornehoj, senior research analyst for Lipper. "Funds that did well in up-markets by taking on risk have been punished now," he told The Times.
There are many ways of minimizing risk. The Vanguard Total Bond index fund is passively managed, and mirrors what until recently was known as the Lehman Aggregate Bond index— and is now called the Barclay’s Aggregate Bond index, as a consequence of Barclay’s absorption of Lehman’s bond analysts and indexes. Treasuries within the index gained in value while corporate bonds fell, and the results have been "about what you might have expected from a core holding," Fran Kinniry, who runs the investment strategy group at Vanguard, told The Times.
FPA New Income has taken a different approach, holding large quantities of cash and Treasuries, and keeping the average duration— essentially, the time before a security matures— down to about one year. Reducing duration cuts down on the risk of shifts in yields and inflation expectations. Pimco has taken another tack, by buying Treasuries and investing in fixed-income securities of Fannie Mae and Freddie Mac, the mortgage giants that have been bailed out by the federal government. "We’ve essentially made ourselves partners" of the government, Mr. Gross told The Times.
Mr. Gross is taking a similar approach, he said, with investments in the preferred shares of bank holding companies in which the Treasury is injecting capital. With a shortage of liquidity, and an epidemic of risk-aversion, he said, it makes sense "to buy something where you can partner with Uncle Sam as opposed to being left out in the cold."
With commodity prices declining and the Consumer Price Index dropping in October by the greatest amount on record, there are signs of disinflation, perhaps even the possibility of a cycle of declining prices, known as deflation. Bond strategists caution, however, that the current outlook for inflation has been made murky by the attempts of the Federal Reserve, and of central banks and governments around the world, to pump money into the financial system in an effort to strengthen the global economy.
For Mr. Rodriguez, this is a major concern, and further reason to minimize all of his bets. "We may be facing deflation first, and then inflation down the road," he told The Times. "This is a very difficult time." Mr. Gross said that for months to come, he expects the bond market to be struggling to evaluate the risks of both deflation and inflation. "It’s a legitimate debate," he told The Times, "and we don’t have any clear view as to which one wins."
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
'It's Just Time'
On Martin Armstrong's 'It's Just Time'
Click here for a link to complete article:
By Seeking Alpha | 28 November 2008
I have had the privilege of reviewing and sharing Martin Armstrong's new essay "It's Just Time," dated October 10th, 2008. As many of you know from last year's NY Times article by Gretchen Morgenson, Martin Armstrong has spent almost nine years in prison for contempt of court, more years than if he had been actually convicted of securities fraud. It's a disturbing tale of injustice involving one of the greatest economic and market minds of our time.
I ran across Martin's work in my original studies of market and economic cycles after the NASDAQ bubble began to burst. While I didn't know it at the time, his Economic Confidence Model encapsulated all the cycles from Kitchin's to Kondrateiff's and could predict market turns almost to the day. I was fascinated enough to cut and paste a copy of his article, "The Business Cycle And The Future" from his Princeton Economics web site. Little did I know that nine years later, Martin would still be in jail and my blog would be one of the last public sources of his Business Cycle essay.
Martin's economic work should have received a Nobel prize by now. Instead, the man is relegated to recording his thoughts on a single-spaced, IBM type writer from prison. His 77 page essay can be accessed here (pdf warning).
In the first part of his new essay, Martin provides a deeper explanation of his economic cycle theories. Traders and investors will be fascinated by his elaboration of the 8.6 month internal cycle, his 224 year political cycle and the 37.33 Month cycle frequency. He also explains the inter-relationship between the shorter 8.6 month cycle and the longer cycles which are currently dominating the economic and market landscape. Finally, Martin offers a brief glimpse into a previously undisclosed volatility cycle called the Schema Frequency.
The second part of the essay is wide ranging and sometimes difficult to comprehend. In it Martin makes references to his own plight while implicating numerous international political and financial figures in a grand conspiracy. I have no way of judging the veracity of Martin's theories as to why he has been jailed for nine years on contempt of court.
His tale is a mix of "Three Days of the Condor" meets "The Man Who Knew Too Much." What I do know is that the facts surrounding his jailing are as unimaginable and unbelievable as the accuracy of his models and predictions. For the sake of the nation's economic well being, his thoughts should be heard by the new Administration not from behind a jail cell, but face to face in the Oval office[!?!]
Having been called on by heads of state and corporate CEOs, Martin follows through by offering his solution for the current financial crisis— a crisis he predicts will end the reign of the United States as the leading financial super power unless drastic action is taken.
Click here for a link to complete article:
By Seeking Alpha | 28 November 2008
I have had the privilege of reviewing and sharing Martin Armstrong's new essay "It's Just Time," dated October 10th, 2008. As many of you know from last year's NY Times article by Gretchen Morgenson, Martin Armstrong has spent almost nine years in prison for contempt of court, more years than if he had been actually convicted of securities fraud. It's a disturbing tale of injustice involving one of the greatest economic and market minds of our time.
|
I ran across Martin's work in my original studies of market and economic cycles after the NASDAQ bubble began to burst. While I didn't know it at the time, his Economic Confidence Model encapsulated all the cycles from Kitchin's to Kondrateiff's and could predict market turns almost to the day. I was fascinated enough to cut and paste a copy of his article, "The Business Cycle And The Future" from his Princeton Economics web site. Little did I know that nine years later, Martin would still be in jail and my blog would be one of the last public sources of his Business Cycle essay.
Martin's economic work should have received a Nobel prize by now. Instead, the man is relegated to recording his thoughts on a single-spaced, IBM type writer from prison. His 77 page essay can be accessed here (pdf warning).
In the first part of his new essay, Martin provides a deeper explanation of his economic cycle theories. Traders and investors will be fascinated by his elaboration of the 8.6 month internal cycle, his 224 year political cycle and the 37.33 Month cycle frequency. He also explains the inter-relationship between the shorter 8.6 month cycle and the longer cycles which are currently dominating the economic and market landscape. Finally, Martin offers a brief glimpse into a previously undisclosed volatility cycle called the Schema Frequency.
The second part of the essay is wide ranging and sometimes difficult to comprehend. In it Martin makes references to his own plight while implicating numerous international political and financial figures in a grand conspiracy. I have no way of judging the veracity of Martin's theories as to why he has been jailed for nine years on contempt of court.
His tale is a mix of "Three Days of the Condor" meets "The Man Who Knew Too Much." What I do know is that the facts surrounding his jailing are as unimaginable and unbelievable as the accuracy of his models and predictions. For the sake of the nation's economic well being, his thoughts should be heard by the new Administration not from behind a jail cell, but face to face in the Oval office[!?!]
Having been called on by heads of state and corporate CEOs, Martin follows through by offering his solution for the current financial crisis— a crisis he predicts will end the reign of the United States as the leading financial super power unless drastic action is taken.
|
Thursday, November 27, 2008
Bush's Recession, Rooted In Self-Interest
Bush's Recession, Rooted In Self-Interest
By Bob Burnett | 28 November 2008
While George Bush ran for President as a born-again Christian and "compassionate conservative," his behavior indicated he was guided not by the principles of Jesus but rather by a narcissistic morality of personal advantage. While making a revealing documentary about the 2000 Bush campaign, filmmaker Alexandra Pelosi asked the candidate why she should vote for him; Bush replied. "It's in your interests." Pelosi observed, "He didn't push the country's interests— but rather, my interests." Bush's primary consideration was 'what's in it for me'?
As President, Bush conflated his personal interests— strengthening his power— with those of the United States and political considerations governed all White House decisions. In late 2001, after leaving his appointment as head of the White House Office of Faith-Based and Community Initiatives, John DiLulio observed: "There is no precedent in any modern White House for what is going on in this one: a complete lack of a policy apparatus. What you've got is everything, and I mean everything, being run by the political arm."
Presidential decisions were determined by a toxic alchemical mixture of power and greed. Major legislative initiatives— energy and healthcare— were written by corporate lobbyists to benefit their own interests at the expense of average Americans [[to this day, vice-president Cheney refuses to reveal what went on behind closed doors in the drafting of the admninistraion's energy bills: normxxx]]. And the President's self-centered attitude influenced both Main Street and Wall Street.
Bush promoted a national culture of profligacy. After 9/11, when asked how Americans should respond, he advised us to "go shopping." Rather than calling on our patriotism [[or ever commiting sufficient resources towards the war: normxxx]], the President [[cut taxes largely for the rich and : normxxx]] appealed to consumerism. Citizens responded by running up huge credit card debts and dipping deeply into their home equity. During the Bush Administration, Americans borrowed $6.2 trillion, doubling their debts and pushing the U.S. into a negative savings rate.
At the same time, the President expressed absolute confidence in the 'wisdom' of the 'free market' and greatly expanded the dangerous deregulation begun during the Clinton era. Among the consequences of Bush's extreme laissez-faire ideology were the accelerated flight of decent-paying jobs from the U.S. and pillaging of the environment. As Americans shopped until they dropped, [[mostly on borrowed money or money withdrawn from a house refi (not uncommonly into an ARM mortgage from a fixed-rate mortgage): normxxx]], financial-sector profits surged: by 2007 the finance industry represented a record 25 percent of US stock-market capitalization.
Aided by the loosening of regulations, banks such as Citgroup, broadened their scope of business and began to engage in a wide variety of financial activities [[a comingling of speculative financial activities with the more essential— which almost destroyed the banking sector in 1930-1933, and which the Glass-Steagall Act corrected for 66 years until its key provisions segregating banking practices were repealed: normxxx]]. With this explosive expansion came problems of control and oversight. The increased size of financial institutions made them more difficult to manage as executives at every level were pressed to make profits well beyond the range historically associated with banks.
At Citigroup, earning pressure caused bond traders to increase their participation in risky markets, particularly collateralized debt obligations (CDO's), which repackaged mortgages— notoriously sub-prime mortgages— with higher quality mortgages for resale to investors. The expansion of this niche business was fueled by its lack of oversight and its profitability— the fees were unusually high, so traders made millions in bonuses.
Because of deregulation, there was no Federal oversight of the CDO marketplace. Financial industry supervision supposedly came from rating agencies, such as Moody's and Standard and Poor's, but they failed to exercise the required due diligence. Nor did the internal auditors, such as Citigroup's "risk managers;" who were impeded both by the Byzantine nature of CDO's and their perceived value as major earnings generators [[and, hence, pressure to justify them regardless of merit. Besides, 'everyone was doing it!' So, what could be the harm?: normxxx]].
As the credit bubble grew, two pernicious moral propositions blinded top managers at Citigroup and other greedy banks to the ever-increasing probability of calamity: 'everyone else is doing it', so it must be okay; and didn't the ends justify the means? [[The money was just rolling in— and nothing bad had happened yet. : normxxx]] Over the course of the Bush Administration, the worldwide CDO market grew to near $500 Billion amd the derivatives market grew from a paltry $88,000 Billion in 2000 to well over $683,725 Billion today, resulting in gigantic executive bonuses and corporate earnings [[often in the Billions— a lot of new Billionaires were made in Bush's eight years, even as the median wage dropped: normxxx]]. Understandably, none of the participants was eager to jump off the gravy boat [[until just before it sank: normxxx]].
Lurking behind this frenzied momentum was a naïve faith in the wisdom of the marketplace: the belief that whenever excesses occurred, the market would 'gracefully adjust'. Recently, financier George Soros criticized "the prevailing theory of financial markets, which... holds that financial markets tend toward equilibrium and that deviations are random and can be attributed to external causes." He observed: "This theory has been used to justify the belief that the pursuit of self-interest should be given free rein."
The President of the United States has a dual responsibility to make key decisions and set a moral tone. By promoting a climate of unfettered self-interest, George Bush precipitated the current economic meltdown. American's eagerness for the onset of the Obama presidency indicates our need for a leader who will establish a public morality that emphasizes the common good.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Bob Burnett | 28 November 2008
|
While George Bush ran for President as a born-again Christian and "compassionate conservative," his behavior indicated he was guided not by the principles of Jesus but rather by a narcissistic morality of personal advantage. While making a revealing documentary about the 2000 Bush campaign, filmmaker Alexandra Pelosi asked the candidate why she should vote for him; Bush replied. "It's in your interests." Pelosi observed, "He didn't push the country's interests— but rather, my interests." Bush's primary consideration was 'what's in it for me'?
As President, Bush conflated his personal interests— strengthening his power— with those of the United States and political considerations governed all White House decisions. In late 2001, after leaving his appointment as head of the White House Office of Faith-Based and Community Initiatives, John DiLulio observed: "There is no precedent in any modern White House for what is going on in this one: a complete lack of a policy apparatus. What you've got is everything, and I mean everything, being run by the political arm."
Presidential decisions were determined by a toxic alchemical mixture of power and greed. Major legislative initiatives— energy and healthcare— were written by corporate lobbyists to benefit their own interests at the expense of average Americans [[to this day, vice-president Cheney refuses to reveal what went on behind closed doors in the drafting of the admninistraion's energy bills: normxxx]]. And the President's self-centered attitude influenced both Main Street and Wall Street.
Bush promoted a national culture of profligacy. After 9/11, when asked how Americans should respond, he advised us to "go shopping." Rather than calling on our patriotism [[or ever commiting sufficient resources towards the war: normxxx]], the President [[cut taxes largely for the rich and : normxxx]] appealed to consumerism. Citizens responded by running up huge credit card debts and dipping deeply into their home equity. During the Bush Administration, Americans borrowed $6.2 trillion, doubling their debts and pushing the U.S. into a negative savings rate.
At the same time, the President expressed absolute confidence in the 'wisdom' of the 'free market' and greatly expanded the dangerous deregulation begun during the Clinton era. Among the consequences of Bush's extreme laissez-faire ideology were the accelerated flight of decent-paying jobs from the U.S. and pillaging of the environment. As Americans shopped until they dropped, [[mostly on borrowed money or money withdrawn from a house refi (not uncommonly into an ARM mortgage from a fixed-rate mortgage): normxxx]], financial-sector profits surged: by 2007 the finance industry represented a record 25 percent of US stock-market capitalization.
Aided by the loosening of regulations, banks such as Citgroup, broadened their scope of business and began to engage in a wide variety of financial activities [[a comingling of speculative financial activities with the more essential— which almost destroyed the banking sector in 1930-1933, and which the Glass-Steagall Act corrected for 66 years until its key provisions segregating banking practices were repealed: normxxx]]. With this explosive expansion came problems of control and oversight. The increased size of financial institutions made them more difficult to manage as executives at every level were pressed to make profits well beyond the range historically associated with banks.
At Citigroup, earning pressure caused bond traders to increase their participation in risky markets, particularly collateralized debt obligations (CDO's), which repackaged mortgages— notoriously sub-prime mortgages— with higher quality mortgages for resale to investors. The expansion of this niche business was fueled by its lack of oversight and its profitability— the fees were unusually high, so traders made millions in bonuses.
Because of deregulation, there was no Federal oversight of the CDO marketplace. Financial industry supervision supposedly came from rating agencies, such as Moody's and Standard and Poor's, but they failed to exercise the required due diligence. Nor did the internal auditors, such as Citigroup's "risk managers;" who were impeded both by the Byzantine nature of CDO's and their perceived value as major earnings generators [[and, hence, pressure to justify them regardless of merit. Besides, 'everyone was doing it!' So, what could be the harm?: normxxx]].
As the credit bubble grew, two pernicious moral propositions blinded top managers at Citigroup and other greedy banks to the ever-increasing probability of calamity: 'everyone else is doing it', so it must be okay; and didn't the ends justify the means? [[The money was just rolling in— and nothing bad had happened yet. : normxxx]] Over the course of the Bush Administration, the worldwide CDO market grew to near $500 Billion amd the derivatives market grew from a paltry $88,000 Billion in 2000 to well over $683,725 Billion today, resulting in gigantic executive bonuses and corporate earnings [[often in the Billions— a lot of new Billionaires were made in Bush's eight years, even as the median wage dropped: normxxx]]. Understandably, none of the participants was eager to jump off the gravy boat [[until just before it sank: normxxx]].
Lurking behind this frenzied momentum was a naïve faith in the wisdom of the marketplace: the belief that whenever excesses occurred, the market would 'gracefully adjust'. Recently, financier George Soros criticized "the prevailing theory of financial markets, which... holds that financial markets tend toward equilibrium and that deviations are random and can be attributed to external causes." He observed: "This theory has been used to justify the belief that the pursuit of self-interest should be given free rein."
The President of the United States has a dual responsibility to make key decisions and set a moral tone. By promoting a climate of unfettered self-interest, George Bush precipitated the current economic meltdown. American's eagerness for the onset of the Obama presidency indicates our need for a leader who will establish a public morality that emphasizes the common good.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
How Obama Is Already Taking Charge
How Obama Is Already Taking Charge
By Robert Reich | 27 November 2008
Obama's immediate challenge is to fill the leadership vacuum created by a lame-duck president with historically-low approval ratings who seems to have lost all interest in his job (at this writing, he's out of the country) and who's disappeared from the media, and a Treasury chief who has all but punted on coming up with any workable solution to the crisis. But Obama doesn't become president until 12 noon eastern standard time on January 20— and the national economy is imploding right now.
How does Obama manage this feat? Two ways: (1) appointing a highly-capable economic team, and (2) telling the nation what he plans to do starting the afternoon of January 20. Specifically:
(1) The members of Obama's new economic team fit the bill. They're reported (I have no inside knowledge) to include Tim Geithner at Treasury, Peter Orszag at the Office of Management and Budget, Jack Lew and Jason Furman at the National Economic Council, and Austan Goolsbee at the Council of Economic Advisors. All have several things in common. They're relatively young, in their late 30s or 40s, representing a generational change and a fresh start. Despite their youth, they're also experienced; almost all were up-and-comers in the Clinton Treasury, NEC, and OMB.
All are pragmatists. Some media have dubbed them "centrists" or "center-right," but in truth they're remarkably free of ideological preconception. All have well-earned reputations as hard workers, well-versed in the technical details of public and private finance.
They are not visible veterans of the old battles over supply-side economics or deficit reduction, nor are they well-known to the public. They are not visionaries but we don't need visionaries when the economic perils are clear and immediate. We need competence. Obama could not appoint a more competent group.
(2) The President-Elect has also signaled the country what he wants to do: enact an "Economic Recovery Plan" that will mean 2.5 million more jobs by January of 2011. In his words (from Saturday's radio address) a plan "big enough to meet the challenges we face ... a two-year, nationwide effort to jumpstart job creation in America and lay the foundation for a strong and growing economy." Again, I have no inside knowledge, but I'd expect it to be about $600 to $700 billion.
Its focus will be on infrastructure of a sort that will not only put people to work but also improve the productivity of the economy. His words: "We’ll put people back to work rebuilding our crumbling roads and bridges, modernizing schools that are failing our children, and building wind farms and solar panels; fuel-efficient cars and the alternative energy technologies that can free us from our dependence on foreign oil and keep our economy competitive in the years ahead."
In short, Obama's job-stimulus plan will be a down-payment on his larger plan to increase the nation's public investment. "These aren’t just steps to pull ourselves out of this immediate crisis," he says, "these are the long-term investments in our economic future that have been ignored for far too long. And they represent an early down payment on the type of reform my Administration will bring to Washington." He could not be more specific, at least while still President-Elect.
At a time when aggregate demand is shriveling because consumers aren't spending and investors have stopped investing, and exports are shrinking, Obama recognizes that government must be the spender of last resort. He will combine old-fashioned Keynesian economics with newly-fashioned public investments to pull the economy out of its slump. By putting his economic team in place barely three weeks after he was elected, and telling the nation what he plans to do immediately after he takes office, the President-Elect is asserting leadership at a time when the the Bush administration has all but abdicated.
By Robert Reich | 27 November 2008
Obama's immediate challenge is to fill the leadership vacuum created by a lame-duck president with historically-low approval ratings who seems to have lost all interest in his job (at this writing, he's out of the country) and who's disappeared from the media, and a Treasury chief who has all but punted on coming up with any workable solution to the crisis. But Obama doesn't become president until 12 noon eastern standard time on January 20— and the national economy is imploding right now.
How does Obama manage this feat? Two ways: (1) appointing a highly-capable economic team, and (2) telling the nation what he plans to do starting the afternoon of January 20. Specifically:
(1) The members of Obama's new economic team fit the bill. They're reported (I have no inside knowledge) to include Tim Geithner at Treasury, Peter Orszag at the Office of Management and Budget, Jack Lew and Jason Furman at the National Economic Council, and Austan Goolsbee at the Council of Economic Advisors. All have several things in common. They're relatively young, in their late 30s or 40s, representing a generational change and a fresh start. Despite their youth, they're also experienced; almost all were up-and-comers in the Clinton Treasury, NEC, and OMB.
All are pragmatists. Some media have dubbed them "centrists" or "center-right," but in truth they're remarkably free of ideological preconception. All have well-earned reputations as hard workers, well-versed in the technical details of public and private finance.
They are not visible veterans of the old battles over supply-side economics or deficit reduction, nor are they well-known to the public. They are not visionaries but we don't need visionaries when the economic perils are clear and immediate. We need competence. Obama could not appoint a more competent group.
(2) The President-Elect has also signaled the country what he wants to do: enact an "Economic Recovery Plan" that will mean 2.5 million more jobs by January of 2011. In his words (from Saturday's radio address) a plan "big enough to meet the challenges we face ... a two-year, nationwide effort to jumpstart job creation in America and lay the foundation for a strong and growing economy." Again, I have no inside knowledge, but I'd expect it to be about $600 to $700 billion.
Its focus will be on infrastructure of a sort that will not only put people to work but also improve the productivity of the economy. His words: "We’ll put people back to work rebuilding our crumbling roads and bridges, modernizing schools that are failing our children, and building wind farms and solar panels; fuel-efficient cars and the alternative energy technologies that can free us from our dependence on foreign oil and keep our economy competitive in the years ahead."
In short, Obama's job-stimulus plan will be a down-payment on his larger plan to increase the nation's public investment. "These aren’t just steps to pull ourselves out of this immediate crisis," he says, "these are the long-term investments in our economic future that have been ignored for far too long. And they represent an early down payment on the type of reform my Administration will bring to Washington." He could not be more specific, at least while still President-Elect.
At a time when aggregate demand is shriveling because consumers aren't spending and investors have stopped investing, and exports are shrinking, Obama recognizes that government must be the spender of last resort. He will combine old-fashioned Keynesian economics with newly-fashioned public investments to pull the economy out of its slump. By putting his economic team in place barely three weeks after he was elected, and telling the nation what he plans to do immediately after he takes office, the President-Elect is asserting leadership at a time when the the Bush administration has all but abdicated.
Volcker Issues Dire Warning
Volcker Issues Dire Warning On Slump
By Ambrose Evans-Pritchard, Telegraph, UK | 17 November 2008
"What this crisis reveals is a broken financial system like no other in my lifetime," he told a conference at Lombard Street Research in London.
His comments come as the blizzard of dire data in the US continues to crush spirits. The Empire State index of manufacturing dropped to minus 24.6 in October, the lowest ever recorded. Paul Ashworth, US economist at Capital Economics, said business spending was now going into "meltdown", compounding the collapse in consumer spending that is already under way.
Mr Volcker, an adviser to President-Elect Barack Obama and head of his Economic Recovery Advisory Board, warned that it is already too late to avoid a severe downturn even if the credit markets stabilise over coming months. "I don't think anybody thinks we're going to get through this recession in a hurry," he said. He advised Mr Obama to tread a fine line, embarking on bold action with a "compelling economic logic" rather than scattering fiscal stimulus or resorting to a wholesale bail-out of Detroit. "He can't just throw money at the auto industry."
Mr Volcker is a towering figure in the US, praised for taming the great inflation of the late 1970s with unpopular monetary rigour. He is no friend of Alan Greenspan, who replaced him at the Fed and presided over credit excess that pushed private debt to 300% of GDP. "There has been leveraging in the economy beyond imagination, and nobody was saying we need to do something," he said. "There are cycles in human nature and it is up to regulators to moderate these excesses. Alan was not a big regulator."
Even so, he said the arch-culprit was the bonus system that allowed bankers to draw forward "tremendous rewards" before the disastrous consequences of their actions became clear, as well as the new means of credit alchemy that let them slice and dice mortgage debt into packages that disguised risk [[and has made equitable mortgage adjustments almost impossible : normxxx]].
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Ambrose Evans-Pritchard, Telegraph, UK | 17 November 2008
|
"What this crisis reveals is a broken financial system like no other in my lifetime," he told a conference at Lombard Street Research in London.
|
His comments come as the blizzard of dire data in the US continues to crush spirits. The Empire State index of manufacturing dropped to minus 24.6 in October, the lowest ever recorded. Paul Ashworth, US economist at Capital Economics, said business spending was now going into "meltdown", compounding the collapse in consumer spending that is already under way.
Mr Volcker, an adviser to President-Elect Barack Obama and head of his Economic Recovery Advisory Board, warned that it is already too late to avoid a severe downturn even if the credit markets stabilise over coming months. "I don't think anybody thinks we're going to get through this recession in a hurry," he said. He advised Mr Obama to tread a fine line, embarking on bold action with a "compelling economic logic" rather than scattering fiscal stimulus or resorting to a wholesale bail-out of Detroit. "He can't just throw money at the auto industry."
Mr Volcker is a towering figure in the US, praised for taming the great inflation of the late 1970s with unpopular monetary rigour. He is no friend of Alan Greenspan, who replaced him at the Fed and presided over credit excess that pushed private debt to 300% of GDP. "There has been leveraging in the economy beyond imagination, and nobody was saying we need to do something," he said. "There are cycles in human nature and it is up to regulators to moderate these excesses. Alan was not a big regulator."
Even so, he said the arch-culprit was the bonus system that allowed bankers to draw forward "tremendous rewards" before the disastrous consequences of their actions became clear, as well as the new means of credit alchemy that let them slice and dice mortgage debt into packages that disguised risk [[and has made equitable mortgage adjustments almost impossible : normxxx]].
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
How To Invest In The Obama Recovery
How To Invest In The Obama Recovery
By Tim Middleton, MSN Money | 27 November 2008
Elected to fix the economy, the incoming president has signaled a commitment to focusing on 3 areas. Savvy investors can follow these trends for personal profit.
It's Always The Economy, Stupid
FDR won the Second World War, but he's better remembered for the New Deal. Ronald Reagan won the Cold War, but his economic reforms are what broke the back of stagflation [[and it's his elimination of steeply progressive tax brackets, unadjusted for inflation that he's remembered for: normxxx]]. Bill Clinton eradicated welfare as we knew it, but he'll be remembered more for free-trade deals that unleashed global prosperity.
Barack Obama won the White House promising to overcome the economic malaise created by his predecessor. He will be the first black president of the United States, but he wasn't elected because he's black. He was elected to fix a badly broken wealth engine. He made his priorities clear enough that we investors can see the outline of the kind of economic recovery he has in mind. We can, therefore, invest alongside these trends to our personal profit.
And though no presidential candidate can explicitly promise his favored constituents that he will give them absolutely anything they want, he can do it implicitly, and Obama has. These are the Three Anythings the incoming Obama administration offers to investors. Accept the invitation by buying:
Alternative energy, municipal bonds and 'infrastructure' are the new Halliburton (HAL), the oil services giant whose stock more than doubled under the watch of its former boss, Vice President Dick Cheney— at least until the bear market came along. In league with global trends that recognize the greenback as the world's only reliable reserve currency, this trio will help restore the U.S. dollar to primacy over the euro. That bodes well for domestic over foreign securities, from stocks to bonds.
Here are the priorities, and how to invest in them, explained:
Go Green
When Sarah Palin cried "Drill, baby, drill!" she showed how clueless her ticket was in this year's election. Petroleum is so Republican. And except at extravagant prices, it is so scarce. (Ignore the current momentary dip; it won't last.) Moreover, so much of it lies beneath land under the sway of people who are not America's friends.
Wind and solar energy are expensive, too, but so was hydroelectricity once. Now it's the cheapest form of energy. Indeed, the Pacific Northwest has become the home to so many high-technology companies— including Microsoft (MSFT), the publisher of MSN Money— because theirs are generally energy-intensive enterprises— and that's where so many rivers were dammed to harness electric generating potential.
And the cost curve of alternative-energy sources is going down, not up. Solar panels exploit the same advantages in engineering as microchips, which makes it possible for them to become "relentlessly cheaper," just as LCD televisions have become, says Kevin M. Landis, the manager of the Firsthand Alternative Energy Fund (ALTEX).
Among the incentives the Obama administration could offer to aid alternative energy would be to expand net metering and time-of-day pricing, strategies already employed in parts of the nation. Under net metering, the excess electricity that power-company customers produce— through solar panels, for example— is bought by the companies at retail prices. Where time-of-day pricing is used, those prices peak in midafternoon during summer, exactly when solar energy is most abundant. The power companies, in turn, are spared the cost of building generating plants just to meet peak demand.
Stocks in this area can be extremely volatile, making funds a better choice for most investors. Relatively few mutual funds are specifically targeted to green energy, but several exchange-traded funds are, including PowerShares WilderHill Clean Energy (PBW), Market Vectors Solar Energy (KWT) and First Trust Global Wind Energy (FAN).
Buy American
The dollar began rallying earlier this year as the whole world dumped risky investments and flocked to U.S. Treasuries, which you can buy only with greenbacks. Demand was so great that three-month T-bills were yielding almost nothing. It was a reminder that, no matter what they say about the U.S., foreigners recognize it is the only superpower— economically as well as militarily.
Also, the U.S. was the first to recognize the current economic malaise and try to deal with it, in part by cutting interest rates. Thus, says Robert J. Froehlich, the chief investment strategist of DWS Investments, U.S. stocks will recover before those of other nations, and everybody knows that— including foreign investors, who will flock to our stock markets at the expense of their own.
The immediate way to play the dollar's rally is PowerShares DB US Dollar Bullish (UUP), up 13.5% for the year, through Nov. 19. The indirect way is to cut back on foreign funds and switch the proceeds to domestic stock funds. Froehlich also recommends Wal-Mart Stores (WMT), which gets only a quarter of its revenue overseas. In contrast, the average company in the Standard & Poor's 500 Index ($INX) is dependent on foreign sales for 41% of revenue.
Buy Government Bonds
Nobody is happier to give away taxpayer money than Congress, which has come perilously close this month to squandering it on the Big Three automakers, the stupidest managers outside the gold industry. The Democrat-controlled Congress will have no inhibitions in granting relief to states and cities, however, and you can invest in them through their bonds. Those bonds currently offer yields that approach 10% when you add in their tax benefits.
"We just bought some New York municipals at a 6.4% yield," marvels Lewis J. Altfest, a financial adviser in Manhattan. These are New York City double-A-rated bonds, which are free of federal, state and city income taxes. "Where does anyone come off giving you triple tax-free for a rate so much above Treasurys?" Altfest asks. "It's not an overstatement to say it's unheard of."
In more normal times, the bonds would yield about 15% less than Treasurys. Since a bond's yield is the reciprocal of its price— opposite ends of a teeter-totter, joined to each other— a return to normal yields would send prices soaring, generating lush capital gains for bond owners. Even federally linked bonds, namely mortgage-backed securities from the likes of the Government National Mortgage Association, aka Ginnie Mae, are selling at distressed prices, and most bonds backed by high-quality mortgages are explicitly or implicitly guaranteed by Uncle Sam.
But don't buy Treasurys. The federal issues are way overpriced because of the fear factor.
Buy Infrastructure
A substantial part of the municipal-bond business is tied directly to infrastructure, in the form of toll roads, airports and sewage treatment plants. Infrastructure is a favorite Obama theme and a perennial favorite of politicians because it can create immediate high-paying blue-collar jobs.
But you can also play infrastructure through equities. "You want to own the things that if you drop them on your foot would hurt— steel and railroads and those sorts of things," says Dennis Gartman, the publisher of an eponymous investment newsletter. "You want to own copper and Caterpillar (CAT), the movers and the makers of stuff. That's what infrastructure is." In usual investment parlance, infrastructure refers to public utilities, which themselves are a decent defensive investment, but doesn't capture the web of suppliers and other vendors in the infrastructure matrix. A better alternative is a fund that targets basic industries, such as Industrial Select Sector SPDR (XLI). This exchange-traded fund's top holdings include General Electric (GE), United Technologies (UTX), United Parcel Service (UPS), 3M (MMM) and Boeing (BA), as well as Caterpillar and Union Pacific (UNP). This is the "stuff" that Gartman is talking about.
Infrastructure isn't just a domestic issue. China has pledged more than $800 billion toward expanding infrastructure into its vast interior. China is roughly the size and shape of the United States, but only China's equivalent of the U.S. East Coast has been modernized. In U.S. terms, everything west of Pittsburgh is still dirt roads and rice paddies.
Saddled with an economic mess that would have tested FDR, Obama will not be free to implement as much of his agenda as he probably would like. And Congress, always fractious, can be counted on to throw up obstacles to success at every opportunity. But what James Carville famously told Bill Clinton's campaign staff in 1991— "It's the economy, stupid"— is just as true now. Obama will certainly fix his attention there, and he's more likely to build bridges than buy bullets. The investment climate will be tough for some time to come, but there will be winning sectors, and these Three Anythings will be among them.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Tim Middleton, MSN Money | 27 November 2008
Elected to fix the economy, the incoming president has signaled a commitment to focusing on 3 areas. Savvy investors can follow these trends for personal profit.
It's Always The Economy, Stupid
FDR won the Second World War, but he's better remembered for the New Deal. Ronald Reagan won the Cold War, but his economic reforms are what broke the back of stagflation [[and it's his elimination of steeply progressive tax brackets, unadjusted for inflation that he's remembered for: normxxx]]. Bill Clinton eradicated welfare as we knew it, but he'll be remembered more for free-trade deals that unleashed global prosperity.
Barack Obama won the White House promising to overcome the economic malaise created by his predecessor. He will be the first black president of the United States, but he wasn't elected because he's black. He was elected to fix a badly broken wealth engine. He made his priorities clear enough that we investors can see the outline of the kind of economic recovery he has in mind. We can, therefore, invest alongside these trends to our personal profit.
And though no presidential candidate can explicitly promise his favored constituents that he will give them absolutely anything they want, he can do it implicitly, and Obama has. These are the Three Anythings the incoming Obama administration offers to investors. Accept the invitation by buying:
- Anything green, including the U.S. dollar.
- Anything with its hand out, especially government itself.
- Anything that would hurt if you dropped it on your foot, like a cement truck.
Alternative energy, municipal bonds and 'infrastructure' are the new Halliburton (HAL), the oil services giant whose stock more than doubled under the watch of its former boss, Vice President Dick Cheney— at least until the bear market came along. In league with global trends that recognize the greenback as the world's only reliable reserve currency, this trio will help restore the U.S. dollar to primacy over the euro. That bodes well for domestic over foreign securities, from stocks to bonds.
Here are the priorities, and how to invest in them, explained:
Go Green
When Sarah Palin cried "Drill, baby, drill!" she showed how clueless her ticket was in this year's election. Petroleum is so Republican. And except at extravagant prices, it is so scarce. (Ignore the current momentary dip; it won't last.) Moreover, so much of it lies beneath land under the sway of people who are not America's friends.
Wind and solar energy are expensive, too, but so was hydroelectricity once. Now it's the cheapest form of energy. Indeed, the Pacific Northwest has become the home to so many high-technology companies— including Microsoft (MSFT), the publisher of MSN Money— because theirs are generally energy-intensive enterprises— and that's where so many rivers were dammed to harness electric generating potential.
And the cost curve of alternative-energy sources is going down, not up. Solar panels exploit the same advantages in engineering as microchips, which makes it possible for them to become "relentlessly cheaper," just as LCD televisions have become, says Kevin M. Landis, the manager of the Firsthand Alternative Energy Fund (ALTEX).
Among the incentives the Obama administration could offer to aid alternative energy would be to expand net metering and time-of-day pricing, strategies already employed in parts of the nation. Under net metering, the excess electricity that power-company customers produce— through solar panels, for example— is bought by the companies at retail prices. Where time-of-day pricing is used, those prices peak in midafternoon during summer, exactly when solar energy is most abundant. The power companies, in turn, are spared the cost of building generating plants just to meet peak demand.
Stocks in this area can be extremely volatile, making funds a better choice for most investors. Relatively few mutual funds are specifically targeted to green energy, but several exchange-traded funds are, including PowerShares WilderHill Clean Energy (PBW), Market Vectors Solar Energy (KWT) and First Trust Global Wind Energy (FAN).
Buy American
The dollar began rallying earlier this year as the whole world dumped risky investments and flocked to U.S. Treasuries, which you can buy only with greenbacks. Demand was so great that three-month T-bills were yielding almost nothing. It was a reminder that, no matter what they say about the U.S., foreigners recognize it is the only superpower— economically as well as militarily.
Also, the U.S. was the first to recognize the current economic malaise and try to deal with it, in part by cutting interest rates. Thus, says Robert J. Froehlich, the chief investment strategist of DWS Investments, U.S. stocks will recover before those of other nations, and everybody knows that— including foreign investors, who will flock to our stock markets at the expense of their own.
The immediate way to play the dollar's rally is PowerShares DB US Dollar Bullish (UUP), up 13.5% for the year, through Nov. 19. The indirect way is to cut back on foreign funds and switch the proceeds to domestic stock funds. Froehlich also recommends Wal-Mart Stores (WMT), which gets only a quarter of its revenue overseas. In contrast, the average company in the Standard & Poor's 500 Index ($INX) is dependent on foreign sales for 41% of revenue.
Buy Government Bonds
Nobody is happier to give away taxpayer money than Congress, which has come perilously close this month to squandering it on the Big Three automakers, the stupidest managers outside the gold industry. The Democrat-controlled Congress will have no inhibitions in granting relief to states and cities, however, and you can invest in them through their bonds. Those bonds currently offer yields that approach 10% when you add in their tax benefits.
"We just bought some New York municipals at a 6.4% yield," marvels Lewis J. Altfest, a financial adviser in Manhattan. These are New York City double-A-rated bonds, which are free of federal, state and city income taxes. "Where does anyone come off giving you triple tax-free for a rate so much above Treasurys?" Altfest asks. "It's not an overstatement to say it's unheard of."
In more normal times, the bonds would yield about 15% less than Treasurys. Since a bond's yield is the reciprocal of its price— opposite ends of a teeter-totter, joined to each other— a return to normal yields would send prices soaring, generating lush capital gains for bond owners. Even federally linked bonds, namely mortgage-backed securities from the likes of the Government National Mortgage Association, aka Ginnie Mae, are selling at distressed prices, and most bonds backed by high-quality mortgages are explicitly or implicitly guaranteed by Uncle Sam.
But don't buy Treasurys. The federal issues are way overpriced because of the fear factor.
Buy Infrastructure
A substantial part of the municipal-bond business is tied directly to infrastructure, in the form of toll roads, airports and sewage treatment plants. Infrastructure is a favorite Obama theme and a perennial favorite of politicians because it can create immediate high-paying blue-collar jobs.
But you can also play infrastructure through equities. "You want to own the things that if you drop them on your foot would hurt— steel and railroads and those sorts of things," says Dennis Gartman, the publisher of an eponymous investment newsletter. "You want to own copper and Caterpillar (CAT), the movers and the makers of stuff. That's what infrastructure is." In usual investment parlance, infrastructure refers to public utilities, which themselves are a decent defensive investment, but doesn't capture the web of suppliers and other vendors in the infrastructure matrix. A better alternative is a fund that targets basic industries, such as Industrial Select Sector SPDR (XLI). This exchange-traded fund's top holdings include General Electric (GE), United Technologies (UTX), United Parcel Service (UPS), 3M (MMM) and Boeing (BA), as well as Caterpillar and Union Pacific (UNP). This is the "stuff" that Gartman is talking about.
Infrastructure isn't just a domestic issue. China has pledged more than $800 billion toward expanding infrastructure into its vast interior. China is roughly the size and shape of the United States, but only China's equivalent of the U.S. East Coast has been modernized. In U.S. terms, everything west of Pittsburgh is still dirt roads and rice paddies.
Saddled with an economic mess that would have tested FDR, Obama will not be free to implement as much of his agenda as he probably would like. And Congress, always fractious, can be counted on to throw up obstacles to success at every opportunity. But what James Carville famously told Bill Clinton's campaign staff in 1991— "It's the economy, stupid"— is just as true now. Obama will certainly fix his attention there, and he's more likely to build bridges than buy bullets. The investment climate will be tough for some time to come, but there will be winning sectors, and these Three Anythings will be among them.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Tuesday, November 25, 2008
"Geithner Gotcha"
Investment Strategy: "Geithner Gotcha"
By Jeffrey Saut | 25 November 2008
As the astute GaveKal organization notes, "Either markets are correct, policy easing will prove to be ineffectual and we are looking at a deflationary depression, or markets are wrong (and) the reflationary policies of the world’s financial leaders will mitigate the credit crisis and put the global economy on the road to recovery. Our readers know that we bet on the latter." Obviously I agree with GaveKal’s views, and while there is no question that the current financial fiasco is likely the most serious since the Great Depression, this is NOT the Great Depression. To be sure, the economy is nowhere near as impaired as it was back in the 1930s, as the following quip from Merrill Lynch makes clear:
While not the Great Depression, we do think there will be a whiff of deflation over the coming few quarters. Recall, however, what Chairman Bernanke said in his 2002 speech about fighting deflation, as reprised by Merrill Lynch:
Plainly Ben Bernanke is using, and/or considering, all the tools in his "toolbox" to dissuade the economy from plunging into a deflationary depression. Still, it appears that a pretty severe recession is in the works with 4Q08 GDP tracking toward a negative 5% reading; and, GDP is unlikely to turn positive before the second half of 2009 [[that "infamous second half" again…: normxxx]]. Adding to the deflationary, and recessionary, environment consumer prices (CPI) registered their largest monthly decline in the 61-year history of the data, ditto the PPI, unemployment claims leaped to their highest level since 2001, housing starts sank to their lowest level ever, permits for new houses also tumbled to their lowest level ever, and all of this caused the LEI (Leading Economic Indicators) to slide 0.8% in October. All of these indicators are setting the stage for an abysmal holiday selling season, telegraphed by last week’s -4.1% (year/year) collapse in nominal retail sales. In fact, according to Ed Hyman’s ISI organization:
Meanwhile, the dour economic backdrop has caused analysts to lower their earnings forecasts on companies to the point whereby only 222 companies in the S&P 1500 have seen their earnings estimates increased. Obviously, this decline in earnings expectations has a caused a recalibration of P/E multiples with an attendant "hit" to stock prices. And last week that "hit" caused the S&P 500 to fall to its lowest closing level since April 1997, while other U.S. indexes set 5½-year lows. Moreover, the Wilshire 5000 index, the broadest measure of the U.S. markets, has now fallen by more than 50% since its peak 13 months ago; and Treasury yields also fell to record lows with the 30-year U.S. Treasury bond declining to lows last seen in the early 1960s.
Interestingly, the combination of lower stock prices and higher Treasury prices caused the dividend yield on the S&P 500 to exceed the yield on the 30-year Treasury bond for the first time since 1958. That means that a shareholder of the S&P 500 needs NO capital gains to outperform the holder of long-dated government bonds. And maybe, just maybe, those valuation metrics are what caused Vivan Watsa, CEO of Fairfax Holding (FFH/$276.68) and one of the few investors who have played this downturn to a tee, turning $500 million into more than $2 billion in the past year, to remove all of his downside stock hedges. Specifically Mr. Watsa stated:
For the past four weeks we too have spoken about finding numerous investment opportunities, citing things like The Wall Street Journal story that stated there are currently one in ten listed companies trading for less than the value of the cash and marketable securities on their balance sheets, as well as a list of companies that have increased their dividend every year for the last 20 years. And then there was this email of two weeks ago from one particularly bright portfolio manager, "I now have over 100 stocks on my watch list that are trading at, or below, book value and with superior fundamentals. Stocks, therefore, are too cheap and I am starting to buy for the first time this year".
Despite such investment opportunities, last week the DJIA slid below its October 10th low of 7882 that I had expected to mark the short/intermediate "low," thus activating downside targets between 7200 (approximately the 2002 low) and 7500 (50% retracement of the 1982 to 2007 Dow Wow). And, on Thursday and Friday of last week the DJIA traveled well into that target zone, leaving only 13 stocks in the S&P 500 above their respective 200-day moving averages, and extremely oversold, as can be seen in the charts. The Wednesday through Friday morning swoon lopped 1000 points off of the senior index, leaving participants in "crash mode," but Friday afternoon ushered in the "Geithner Gotcha".
For the last few weeks we have suggested that President-elect Obama could either adopt the FDR model, which would be disastrous for the economy and the markets, or he could step-up and provide leadership to fill the current leadership vacuum. Again as the GaveKal organization opined:
And, that appears to be precisely what happened late Friday. Hopefully, that mindset will continue this week.
The call for this week: We still think October 10th represented the capitulation "lows," as can be seen in the S&P 500 charts that shows the RSI and MACD indicators at their most oversold levels since the 1982. As Barron’s notes,
And don’t look now, but cold weather has crept into the country, which should be positive for the energy stocks we have been recommending.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Jeffrey Saut | 25 November 2008
|
As the astute GaveKal organization notes, "Either markets are correct, policy easing will prove to be ineffectual and we are looking at a deflationary depression, or markets are wrong (and) the reflationary policies of the world’s financial leaders will mitigate the credit crisis and put the global economy on the road to recovery. Our readers know that we bet on the latter." Obviously I agree with GaveKal’s views, and while there is no question that the current financial fiasco is likely the most serious since the Great Depression, this is NOT the Great Depression. To be sure, the economy is nowhere near as impaired as it was back in the 1930s, as the following quip from Merrill Lynch makes clear:
|
While not the Great Depression, we do think there will be a whiff of deflation over the coming few quarters. Recall, however, what Chairman Bernanke said in his 2002 speech about fighting deflation, as reprised by Merrill Lynch:
|
Plainly Ben Bernanke is using, and/or considering, all the tools in his "toolbox" to dissuade the economy from plunging into a deflationary depression. Still, it appears that a pretty severe recession is in the works with 4Q08 GDP tracking toward a negative 5% reading; and, GDP is unlikely to turn positive before the second half of 2009 [[that "infamous second half" again…: normxxx]]. Adding to the deflationary, and recessionary, environment consumer prices (CPI) registered their largest monthly decline in the 61-year history of the data, ditto the PPI, unemployment claims leaped to their highest level since 2001, housing starts sank to their lowest level ever, permits for new houses also tumbled to their lowest level ever, and all of this caused the LEI (Leading Economic Indicators) to slide 0.8% in October. All of these indicators are setting the stage for an abysmal holiday selling season, telegraphed by last week’s -4.1% (year/year) collapse in nominal retail sales. In fact, according to Ed Hyman’s ISI organization:
|
Meanwhile, the dour economic backdrop has caused analysts to lower their earnings forecasts on companies to the point whereby only 222 companies in the S&P 1500 have seen their earnings estimates increased. Obviously, this decline in earnings expectations has a caused a recalibration of P/E multiples with an attendant "hit" to stock prices. And last week that "hit" caused the S&P 500 to fall to its lowest closing level since April 1997, while other U.S. indexes set 5½-year lows. Moreover, the Wilshire 5000 index, the broadest measure of the U.S. markets, has now fallen by more than 50% since its peak 13 months ago; and Treasury yields also fell to record lows with the 30-year U.S. Treasury bond declining to lows last seen in the early 1960s.
Interestingly, the combination of lower stock prices and higher Treasury prices caused the dividend yield on the S&P 500 to exceed the yield on the 30-year Treasury bond for the first time since 1958. That means that a shareholder of the S&P 500 needs NO capital gains to outperform the holder of long-dated government bonds. And maybe, just maybe, those valuation metrics are what caused Vivan Watsa, CEO of Fairfax Holding (FFH/$276.68) and one of the few investors who have played this downturn to a tee, turning $500 million into more than $2 billion in the past year, to remove all of his downside stock hedges. Specifically Mr. Watsa stated:
|
For the past four weeks we too have spoken about finding numerous investment opportunities, citing things like The Wall Street Journal story that stated there are currently one in ten listed companies trading for less than the value of the cash and marketable securities on their balance sheets, as well as a list of companies that have increased their dividend every year for the last 20 years. And then there was this email of two weeks ago from one particularly bright portfolio manager, "I now have over 100 stocks on my watch list that are trading at, or below, book value and with superior fundamentals. Stocks, therefore, are too cheap and I am starting to buy for the first time this year".
Despite such investment opportunities, last week the DJIA slid below its October 10th low of 7882 that I had expected to mark the short/intermediate "low," thus activating downside targets between 7200 (approximately the 2002 low) and 7500 (50% retracement of the 1982 to 2007 Dow Wow). And, on Thursday and Friday of last week the DJIA traveled well into that target zone, leaving only 13 stocks in the S&P 500 above their respective 200-day moving averages, and extremely oversold, as can be seen in the charts. The Wednesday through Friday morning swoon lopped 1000 points off of the senior index, leaving participants in "crash mode," but Friday afternoon ushered in the "Geithner Gotcha".
For the last few weeks we have suggested that President-elect Obama could either adopt the FDR model, which would be disastrous for the economy and the markets, or he could step-up and provide leadership to fill the current leadership vacuum. Again as the GaveKal organization opined:
|
And, that appears to be precisely what happened late Friday. Hopefully, that mindset will continue this week.
The call for this week: We still think October 10th represented the capitulation "lows," as can be seen in the S&P 500 charts that shows the RSI and MACD indicators at their most oversold levels since the 1982. As Barron’s notes,
|
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Saturday, November 22, 2008
Deflation: Abandon All Hope?
With the exception of Germany (which is not far behind), all of the European countries are now as badly off or worse than the UK!
Abandon All Hope Once You Enter Deflation
By Ambrose Evans-Pritchard, Telegraph, UK | 22 November 2008
Deflation is sometimes likened to Dante's Inferno. "Abandon all hope" once you step into that Hellfire. We are not there yet, but Mervyn King, the Governor of the Bank of England, says it is now "very likely" that the UK retail price index will turn negative next year. This is a drastic reversal of the oil and food price spike that played such havoc with monetary policy just over the summer. "The world changed in September," said the Governor.
The Bank's fan charts point to zero inflation at current interest rates of 3%, but the startling new feature is that price falls could gather pace. This is a clear signal that the Monetary Policy Committee will cut rates again in December— perhaps by a full point to the historic low of 2%, last seen in the Great Depression. Mr King let slip yesterday that there is "obviously" a risk of deflation, although he remains sure it can be averted by a pre-emptive monetary blitz. Let us hope he is right.
A major curse of deflation is that it increases the burden of debts. Incomes fall: debts stay the same. This way lies suffocation. It was bad enough in the early 1930s when US farmers faced a Sisyphean Task trying to meet mortgage payments on their land as crop prices kept sliding. They suffered mass foreclosure and fled West, as recounted in John Steinbeck's Grapes of Wrath.
We forget, however, that overall borrowing was modest in the 1930s. The great credit bubble of the last 20 years has pushed debt levels in Britain, the US and other Western societies to unprecedented heights. UK household debt reached a record 165% of personal income last year. This is almost 50% higher than the burden at the onset of the recession in the early 1990s. Our sensitivity to debt deflation is therefore disproportionately greater.
"It is going to be absolute murder in Britain if inflation turns negative," said Professor Peter Spencer from York University. "The big difference with past episodes is that we are now much more heavily indebted. Few people owned their own houses in 1930s. Debts were miniscule."
Deflation has other insidious traits. It causes shoppers to hold back. They wait for ever lower prices. Once this psychology gains a grip, it can gradually set off a self-feeding spiral that is hard to stop.
It also redistributes wealth— the wrong way. Savings appreciate, which is nice for the "rentiers" with the capital. The effect is a large transfer of income from working people with mortgages to bondholders. (These may be pension funds, of course).
The modern warning to us all is the "Lost Decade" in Japan, a loose term for the on-again, off-again slump that ultimately led to zero interest rates and— when that failed— to the printing of money. After 18 years, the Nikkei stock index is now trading at 8,700— down from its peak of nearly 40,000. House prices have fallen by half. [[It had fallen as low as two-thirds! : normxxx]] Yet after all the stimulus, the country is once again tipping back into deflation.
Governor King said Britain was likely to avoid this fate. "We've taken action much earlier than was the case in Japan," he said. Not everybody agrees, even after the shock and awe cut of 1.5 percentage points by the MPC. Albert Edwards, global strategist at Société Générale, has long warned that central banks in the Anglo-Saxon countries have stored up trouble by stoking credit booms, and may find it harder than they think to engineer a soft-landing.
"This could easily go the way of Japan. It is true that Bank of England has moved faster, but Japan was a local bubble. This time it is the 'great unwind' on a global scale with leverage spaghetti everywhere," he said. "The monetary authorities don't have foggiest idea themselves whether this is going to work. They're crossing their fingers and hoping," he said.
Nor is it clear whether rate cuts are gaining much traction. The average rate of tracker mortgages has risen 72 basis points since last month, and credit card rates have been rocketing. The Bank's transmission mechanism is not working properly. This a variant of the 1930s struggle when the central banks found themselves "pushing on a string", in the words of John Maynard Keynes. He called for 'public works' to lift the economy out of its liquidity trap.
This is more or less what the US, Japan, China, and parts of Europe are now doing— with more in store after the G20 this weekend. Britain has pitifully limited scope on this front. We had a budget deficit of 3% of GDP at the top of the cycle— when we should have been in surplus— and we are heading for over 8%. This is already nearing the danger level. If the Government now lets rip on fiscal policy, we could face a 'gilts strike' as foreign investors retreat from UK debt. [[Sound familiar!?!: normxxx]]
The Bank of England has not run out of ammo yet. It can cut rates to zero if necessary and then escalate to direct infusions of money by purchasing bonds— or indeed by buying a vast range of securities, assets and even houses if necessary. Ultimately it can print money to cover the budget deficit.
As the late Milton Friedman put it, governments can drop bundles of banknotes from helicopters. If they really want to defeat to deflation, they can. Mr Friedman may have overlooked the fact that gunmen can shoot down the helicopter— the Bank of France in October 1931, when it ditched the dollar; perhaps Asian bond investors today?— but that is to quibble.
Professor Spencer says the Bank of England has learned the hard lessons. Without the constraints of the ERM, Gold Standard, or any other fixed exchange system, it retains great freedom of action. "They are very aware of the deflation risk. They are cutting rates very fast, and if necessary they too will turn to helicopters. But in the end they will keep the wolf from the door," he said.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Abandon All Hope Once You Enter Deflation
By Ambrose Evans-Pritchard, Telegraph, UK | 22 November 2008
|
Deflation is sometimes likened to Dante's Inferno. "Abandon all hope" once you step into that Hellfire. We are not there yet, but Mervyn King, the Governor of the Bank of England, says it is now "very likely" that the UK retail price index will turn negative next year. This is a drastic reversal of the oil and food price spike that played such havoc with monetary policy just over the summer. "The world changed in September," said the Governor.
The Bank's fan charts point to zero inflation at current interest rates of 3%, but the startling new feature is that price falls could gather pace. This is a clear signal that the Monetary Policy Committee will cut rates again in December— perhaps by a full point to the historic low of 2%, last seen in the Great Depression. Mr King let slip yesterday that there is "obviously" a risk of deflation, although he remains sure it can be averted by a pre-emptive monetary blitz. Let us hope he is right.
A major curse of deflation is that it increases the burden of debts. Incomes fall: debts stay the same. This way lies suffocation. It was bad enough in the early 1930s when US farmers faced a Sisyphean Task trying to meet mortgage payments on their land as crop prices kept sliding. They suffered mass foreclosure and fled West, as recounted in John Steinbeck's Grapes of Wrath.
We forget, however, that overall borrowing was modest in the 1930s. The great credit bubble of the last 20 years has pushed debt levels in Britain, the US and other Western societies to unprecedented heights. UK household debt reached a record 165% of personal income last year. This is almost 50% higher than the burden at the onset of the recession in the early 1990s. Our sensitivity to debt deflation is therefore disproportionately greater.
"It is going to be absolute murder in Britain if inflation turns negative," said Professor Peter Spencer from York University. "The big difference with past episodes is that we are now much more heavily indebted. Few people owned their own houses in 1930s. Debts were miniscule."
Deflation has other insidious traits. It causes shoppers to hold back. They wait for ever lower prices. Once this psychology gains a grip, it can gradually set off a self-feeding spiral that is hard to stop.
It also redistributes wealth— the wrong way. Savings appreciate, which is nice for the "rentiers" with the capital. The effect is a large transfer of income from working people with mortgages to bondholders. (These may be pension funds, of course).
The modern warning to us all is the "Lost Decade" in Japan, a loose term for the on-again, off-again slump that ultimately led to zero interest rates and— when that failed— to the printing of money. After 18 years, the Nikkei stock index is now trading at 8,700— down from its peak of nearly 40,000. House prices have fallen by half. [[It had fallen as low as two-thirds! : normxxx]] Yet after all the stimulus, the country is once again tipping back into deflation.
Governor King said Britain was likely to avoid this fate. "We've taken action much earlier than was the case in Japan," he said. Not everybody agrees, even after the shock and awe cut of 1.5 percentage points by the MPC. Albert Edwards, global strategist at Société Générale, has long warned that central banks in the Anglo-Saxon countries have stored up trouble by stoking credit booms, and may find it harder than they think to engineer a soft-landing.
"This could easily go the way of Japan. It is true that Bank of England has moved faster, but Japan was a local bubble. This time it is the 'great unwind' on a global scale with leverage spaghetti everywhere," he said. "The monetary authorities don't have foggiest idea themselves whether this is going to work. They're crossing their fingers and hoping," he said.
Nor is it clear whether rate cuts are gaining much traction. The average rate of tracker mortgages has risen 72 basis points since last month, and credit card rates have been rocketing. The Bank's transmission mechanism is not working properly. This a variant of the 1930s struggle when the central banks found themselves "pushing on a string", in the words of John Maynard Keynes. He called for 'public works' to lift the economy out of its liquidity trap.
This is more or less what the US, Japan, China, and parts of Europe are now doing— with more in store after the G20 this weekend. Britain has pitifully limited scope on this front. We had a budget deficit of 3% of GDP at the top of the cycle— when we should have been in surplus— and we are heading for over 8%. This is already nearing the danger level. If the Government now lets rip on fiscal policy, we could face a 'gilts strike' as foreign investors retreat from UK debt. [[Sound familiar!?!: normxxx]]
The Bank of England has not run out of ammo yet. It can cut rates to zero if necessary and then escalate to direct infusions of money by purchasing bonds— or indeed by buying a vast range of securities, assets and even houses if necessary. Ultimately it can print money to cover the budget deficit.
As the late Milton Friedman put it, governments can drop bundles of banknotes from helicopters. If they really want to defeat to deflation, they can. Mr Friedman may have overlooked the fact that gunmen can shoot down the helicopter— the Bank of France in October 1931, when it ditched the dollar; perhaps Asian bond investors today?— but that is to quibble.
Professor Spencer says the Bank of England has learned the hard lessons. Without the constraints of the ERM, Gold Standard, or any other fixed exchange system, it retains great freedom of action. "They are very aware of the deflation risk. They are cutting rates very fast, and if necessary they too will turn to helicopters. But in the end they will keep the wolf from the door," he said.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Russia's Banal Reality
Russia's Banal Reality Lies In Between Energy Superpower And Bankrupt State
By Ambrose Evans-Pritchard, Telegraph, UK | 17 November 2008
A fifth of the Kremlin’s fire-fighting fund has gone before the economic crisis even starts. Would the Medvedev-Putin duo have provoked the West so nonchalantly had they known that global recession would soon cut the price of Urals crude oil to $49.35 a barrel, knocking away the chief prop of Kremlin finance and Russian power? The pace of capital flight quickened last week to $16bn after a botched mini-devaluation by the central bank.
Tinkering with currency bands is hazardous in a country where memories of the 1998 savings wipeout are still fresh. The Kremlin already faces a run on Russia’s banks as depositors rush to switch their roubles into dollars, despite the $200bn financial rescue package. Russia’s Globex bank suspended withdrawals by depositors on Wednesday. Kommersant newspaper reports that the deposit loss from rouble accounts reached 54% at Sobinbank in October, 27% at Globex, 25% at Raiffeisenbank, 24% at Unicredit, and 22% at Alfa.
"The deposit run has intensified to dramatic levels. The government’s attempts to slow panic migration to foreign currencies has failed," said Marina Vlasenko, from Commerzbank. The central bank is caught in a fixed exchange rate trap. Pegs create the illusion of currency stability just long enough to lull everybody into a false sense of security (note Greece and Spain inside EMU). Russia either burns reserves propping up the rouble, or it risks a self-feeding devaluation spiral.
There is a third way, of course. Premier Vladimir Putin issued a veiled threat on Monday to impose capital controls. Money flows out of the country would be strictly monitored, and "corporate egotism, any kind of corruption or abuse" would not be tolerated. Yes, he also said that "legal movement of capital overseas is a civilized financial transaction. There is no question of any state bans". Take your pick.
The cost of insuring against Kremlin default tells us that somebody is worried. Credit default swaps (CDS) on Russia’s debt traded at 827 last week, higher than Hungary’s debt (605) before it secured an IMF rescue. Gazprom debt was off the charts at 1155.
CDS contracts can overstate a case. But investors have rediscovered that the Russia story— stripped of BRIC’s happy talk— is still not much more than a leveraged play on oil and gas. Commodities made up 85% of export revenues at bubble peak in May, just before the RTS index on Moscow’s bourse began its 73% crash. A trillion dollars of paper wealth has vanished.
The government’ spending plan for 2009-2011 is based on a Urals oil price of $95. Finance minister Alexei Kudrin said the state would dip into its Reserve Fund (now 8.2% of GDP) to cover any shortfall. This is not a strategy that can survive the global slump we face next year. The Kremlin lives off energy taxes. It has no other income to speak of. The domestic bond market is tiny.
That is why it had to order oil companies last week to renew export shipments. They were selling at near $10 a barrel in the domestic market because crude prices have fallen to a level that no longer makes it rational to sell abroad given the state’s $40 export tariff. Russia must soon choose: either bleed its oil industry to death, or slash spending and face street riots. It is already mobilizing the apparatus of coercion. The Moscow Times bravely ran the headline "Police get orders to crush crisis unrest".
Interior minister Rashid Nurgaliyev said: "Anti-crisis groups are to be set up in the regions to intercept any early indications of destabilization." Marie Mendras, a Russia advisor to French president Nicolas Sarkozy, said the Kremlin is responding the only way it knows how. "The Putin regime is politically closed, won’t listen, and is incapable of adapting to this sort of financial crisis, so they are resorting to repression," she told a Russia Foundation meeting.
Will Russia go bankrupt again? Unlikely, said Charles Robertson, a strategist at ING. Foreign debt— at both state and private companies— was 10 times reserves before the 1998 default: it is roughly equal this time. While oligarchs and state firms have built up $500bn of dollar and euro liabilities, the volume of short-term loans that must be rolled over within 12 months is modest compared to the Asian and Latin American crises of recent years. The money supply in the banking system is a super-low 1.2 times foreign reserves.
"Today Russia is one of the safest countries in the world. We are aware of no case in history of a significant collapse in the currency with ratios this low," he said. The price of oil will not stay low enough for long enough to destroy the system as it destroyed the Soviet Union in the 1980s. The International Energy Agency warned last week that the world’s oil fields were depleting at an alarming rate. "We will require four new Saudi Arabias by 2030 to meet demand."
The inevitable energy rebound will bail out Russia again, but not enough to restore the country to superpower status soon, if ever. "Does Russia really have energy power?" asked Professor Alan Riley, from City University. "The giant gas fields are running down. Russia must turn to the High North where reserves are 560 kilometers into the Arctic, 360 meters down, and very expensive to extract. This is by an incompetent Russia with a Soviet-style gas system that has not made the investments needed," he said.
Somewhere between yesterday’s inflated talk of Russian riches and today’s talk of Russian bankruptcy lies the banal reality of a mid-ranking nation, run by a dysfunctional elite, with the worst aging crisis in the Western world, that happens to be sitting on a lot of resources.
As the adage goes: Russia is never as strong as she looks; Russia is never as weak as she looks.
.
Russia Lifts Rates To 12% To Save Rouble As Crisis Deepens
By Ambrose Evans-Pritchard, Telegraph, UK | 12 November 2008
The surprise move last night came after the authorities had spent $7bn of foreign reserves in a matter of hours trying to defend the currency, at a lower level. The central bank has now spent $84bn of its reserves over the last month. "The devaluation has begun," said Lars Christensen, Russia strategist at Danske Bank.
"The rouble has fallen out of its basket against the euro and the dollar. Russia is facing a serious confidence crisis and this could set off a self-fulfilling panic. What is clear is that economy is slowing drastically."
Chris Weafer, strategist at UralSib, said there were echoes of the 1998 crisis. "If people lose confidence, we could have a massive run on the banks as we saw twice in the nineties: then the game is up," he told Bloomberg. Russia is battening down the hatches for a deep slump. It has downgraded its oil forecast to $50 a barrel next year, a level that will play havoc with the state finances.
Expecting trouble, the Kremlin has mobilised the police to crush dissent. "If anyone tries to exploit the financial crisis, the authorities should bring criminal charges. We don't want a return to the 1990s when everything was seething," said President Dmitry Medvedev. Interior Minister Rashid Nurgaliyev said "the mounting consequences of the world financial crisis could well have an unpredictable effect.
"Anti-crisis groups have been set up in the regions… to intercept any early indications of destabilization," he said. Donald Jensen, an adviser to the US government, told a Russia Foundation meeting yesterday that the credit crunch posed a grave threat to the Kremlin. "This is pushing the Putin regime towards a crisis. Salaries are being held back and factories are being shut down in major cities. The regime cannot address all the demands that it is faced with," he said.
The Moscow bourse was closed after the RTS index plunged 10%, down over 70% from its peak. Credit default swaps measuring bankruptcy risk on Russian debt jumped 150 basis points to 630 as foreign investors scrambled to hedge exposure. "There is massive deleveraging going on in Russia on all fronts," said Luis Costa, an economist at Commerzbank.
Mr Costa said the oil slide had led to an abrupt change in the fortunes of Russia, which relies on commodities for 80% of its foreign earnings. "They are not going to have a current account surplus any longer. They could swing from plus 7% of GDP to minus 2% to 3% next year, which is quite a reversal," he said.
Any devaluation is a political risk given still fresh memories of the 1998 crisis, when many Russians lost their savings. The state-owned giant Sberbank has lost 2.5% of its deposits over the last month, while smaller lenders have suffered a classic bank run. Fitch Ratings downgraded twelve banks yesterday, warning of an "increased likelihood of a deterioration in the government's ability to provide support".
Russia still has the world's third biggest foreign reserves, but these have shrunk from $598bn to under $480bn due to capital flight since the Georgia war in August. Crucially, Russia's banks, oil producers, miners, and steel companies have amassed $510bn of foreign debt, mostly in short-term loans. Kingsmill Bond, from Russia's investment bank Troika Dialog, said the Kremlin has committed $280bn to shore up these companies.
While it still has some firepower left, it cannot weather a long slump in oil prices. If crude drops to around $50 a barrel, and stays there, the combined losses on Russia's current and capital accounts will reach $110bn a year. "We estimate that the rouble could drop by around 30%", he said.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Ambrose Evans-Pritchard, Telegraph, UK | 17 November 2008
|
Shoppers in downtown Moscow Photo: AP
A fifth of the Kremlin’s fire-fighting fund has gone before the economic crisis even starts. Would the Medvedev-Putin duo have provoked the West so nonchalantly had they known that global recession would soon cut the price of Urals crude oil to $49.35 a barrel, knocking away the chief prop of Kremlin finance and Russian power? The pace of capital flight quickened last week to $16bn after a botched mini-devaluation by the central bank.
Tinkering with currency bands is hazardous in a country where memories of the 1998 savings wipeout are still fresh. The Kremlin already faces a run on Russia’s banks as depositors rush to switch their roubles into dollars, despite the $200bn financial rescue package. Russia’s Globex bank suspended withdrawals by depositors on Wednesday. Kommersant newspaper reports that the deposit loss from rouble accounts reached 54% at Sobinbank in October, 27% at Globex, 25% at Raiffeisenbank, 24% at Unicredit, and 22% at Alfa.
"The deposit run has intensified to dramatic levels. The government’s attempts to slow panic migration to foreign currencies has failed," said Marina Vlasenko, from Commerzbank. The central bank is caught in a fixed exchange rate trap. Pegs create the illusion of currency stability just long enough to lull everybody into a false sense of security (note Greece and Spain inside EMU). Russia either burns reserves propping up the rouble, or it risks a self-feeding devaluation spiral.
There is a third way, of course. Premier Vladimir Putin issued a veiled threat on Monday to impose capital controls. Money flows out of the country would be strictly monitored, and "corporate egotism, any kind of corruption or abuse" would not be tolerated. Yes, he also said that "legal movement of capital overseas is a civilized financial transaction. There is no question of any state bans". Take your pick.
The cost of insuring against Kremlin default tells us that somebody is worried. Credit default swaps (CDS) on Russia’s debt traded at 827 last week, higher than Hungary’s debt (605) before it secured an IMF rescue. Gazprom debt was off the charts at 1155.
CDS contracts can overstate a case. But investors have rediscovered that the Russia story— stripped of BRIC’s happy talk— is still not much more than a leveraged play on oil and gas. Commodities made up 85% of export revenues at bubble peak in May, just before the RTS index on Moscow’s bourse began its 73% crash. A trillion dollars of paper wealth has vanished.
The government’ spending plan for 2009-2011 is based on a Urals oil price of $95. Finance minister Alexei Kudrin said the state would dip into its Reserve Fund (now 8.2% of GDP) to cover any shortfall. This is not a strategy that can survive the global slump we face next year. The Kremlin lives off energy taxes. It has no other income to speak of. The domestic bond market is tiny.
That is why it had to order oil companies last week to renew export shipments. They were selling at near $10 a barrel in the domestic market because crude prices have fallen to a level that no longer makes it rational to sell abroad given the state’s $40 export tariff. Russia must soon choose: either bleed its oil industry to death, or slash spending and face street riots. It is already mobilizing the apparatus of coercion. The Moscow Times bravely ran the headline "Police get orders to crush crisis unrest".
Interior minister Rashid Nurgaliyev said: "Anti-crisis groups are to be set up in the regions to intercept any early indications of destabilization." Marie Mendras, a Russia advisor to French president Nicolas Sarkozy, said the Kremlin is responding the only way it knows how. "The Putin regime is politically closed, won’t listen, and is incapable of adapting to this sort of financial crisis, so they are resorting to repression," she told a Russia Foundation meeting.
Will Russia go bankrupt again? Unlikely, said Charles Robertson, a strategist at ING. Foreign debt— at both state and private companies— was 10 times reserves before the 1998 default: it is roughly equal this time. While oligarchs and state firms have built up $500bn of dollar and euro liabilities, the volume of short-term loans that must be rolled over within 12 months is modest compared to the Asian and Latin American crises of recent years. The money supply in the banking system is a super-low 1.2 times foreign reserves.
"Today Russia is one of the safest countries in the world. We are aware of no case in history of a significant collapse in the currency with ratios this low," he said. The price of oil will not stay low enough for long enough to destroy the system as it destroyed the Soviet Union in the 1980s. The International Energy Agency warned last week that the world’s oil fields were depleting at an alarming rate. "We will require four new Saudi Arabias by 2030 to meet demand."
The inevitable energy rebound will bail out Russia again, but not enough to restore the country to superpower status soon, if ever. "Does Russia really have energy power?" asked Professor Alan Riley, from City University. "The giant gas fields are running down. Russia must turn to the High North where reserves are 560 kilometers into the Arctic, 360 meters down, and very expensive to extract. This is by an incompetent Russia with a Soviet-style gas system that has not made the investments needed," he said.
Somewhere between yesterday’s inflated talk of Russian riches and today’s talk of Russian bankruptcy lies the banal reality of a mid-ranking nation, run by a dysfunctional elite, with the worst aging crisis in the Western world, that happens to be sitting on a lot of resources.
As the adage goes: Russia is never as strong as she looks; Russia is never as weak as she looks.
.
Russia Lifts Rates To 12% To Save Rouble As Crisis Deepens
By Ambrose Evans-Pritchard, Telegraph, UK | 12 November 2008
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The surprise move last night came after the authorities had spent $7bn of foreign reserves in a matter of hours trying to defend the currency, at a lower level. The central bank has now spent $84bn of its reserves over the last month. "The devaluation has begun," said Lars Christensen, Russia strategist at Danske Bank.
"The rouble has fallen out of its basket against the euro and the dollar. Russia is facing a serious confidence crisis and this could set off a self-fulfilling panic. What is clear is that economy is slowing drastically."
Chris Weafer, strategist at UralSib, said there were echoes of the 1998 crisis. "If people lose confidence, we could have a massive run on the banks as we saw twice in the nineties: then the game is up," he told Bloomberg. Russia is battening down the hatches for a deep slump. It has downgraded its oil forecast to $50 a barrel next year, a level that will play havoc with the state finances.
Expecting trouble, the Kremlin has mobilised the police to crush dissent. "If anyone tries to exploit the financial crisis, the authorities should bring criminal charges. We don't want a return to the 1990s when everything was seething," said President Dmitry Medvedev. Interior Minister Rashid Nurgaliyev said "the mounting consequences of the world financial crisis could well have an unpredictable effect.
"Anti-crisis groups have been set up in the regions… to intercept any early indications of destabilization," he said. Donald Jensen, an adviser to the US government, told a Russia Foundation meeting yesterday that the credit crunch posed a grave threat to the Kremlin. "This is pushing the Putin regime towards a crisis. Salaries are being held back and factories are being shut down in major cities. The regime cannot address all the demands that it is faced with," he said.
The Moscow bourse was closed after the RTS index plunged 10%, down over 70% from its peak. Credit default swaps measuring bankruptcy risk on Russian debt jumped 150 basis points to 630 as foreign investors scrambled to hedge exposure. "There is massive deleveraging going on in Russia on all fronts," said Luis Costa, an economist at Commerzbank.
Mr Costa said the oil slide had led to an abrupt change in the fortunes of Russia, which relies on commodities for 80% of its foreign earnings. "They are not going to have a current account surplus any longer. They could swing from plus 7% of GDP to minus 2% to 3% next year, which is quite a reversal," he said.
Any devaluation is a political risk given still fresh memories of the 1998 crisis, when many Russians lost their savings. The state-owned giant Sberbank has lost 2.5% of its deposits over the last month, while smaller lenders have suffered a classic bank run. Fitch Ratings downgraded twelve banks yesterday, warning of an "increased likelihood of a deterioration in the government's ability to provide support".
Russia still has the world's third biggest foreign reserves, but these have shrunk from $598bn to under $480bn due to capital flight since the Georgia war in August. Crucially, Russia's banks, oil producers, miners, and steel companies have amassed $510bn of foreign debt, mostly in short-term loans. Kingsmill Bond, from Russia's investment bank Troika Dialog, said the Kremlin has committed $280bn to shore up these companies.
While it still has some firepower left, it cannot weather a long slump in oil prices. If crude drops to around $50 a barrel, and stays there, the combined losses on Russia's current and capital accounts will reach $110bn a year. "We estimate that the rouble could drop by around 30%", he said.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Trillions Down And Still Bailing
Trillions Down And Still Bailing
By Bill Fleckenstein | 17 November 2008
Unfortunately, despite some 12 financing facilities created by the Treasury and the Fed, massive interest rate cuts and various bailouts, the government has little to show for its attempts to dictate where markets should trade. The Fed's own balance sheet has exploded from roughly $900 billion worth of debt in August to around $2 trillion as of last week. Knowledgeable sources expect that to reach $3 trillion by the end of the year.
That means that it will have grown from approximately 6% of gross domestic product to more than 20% in the space of four months. (For perspective, Japan's balance sheet grew from roughly 9% of GDP to 29% over the 10-year period from 1994 to 2004, as it pursued "quantitative easing," which basically involves the central bank making more cash available to banks to ease lending.) These numbers and rates of growth are so enormous (and unprecedented) as to be utterly incomprehensible. Does anybody actually think the government has any idea what it's doing?
I think it's certainly dawning on folks that when the government "does something," it often creates more problems than it solves. In this case, as it props up poorly managed companies, it may only be allowing them to rain further havoc on the better managed companies in their industry. American International Group (AIG) is an example of this, and I'm sure many other 'rescued' financial entities will turn out to be as well. (As an aside, notice all the idiotic executives, across a wide range of industries, who have bought back hundreds of billions of dollars' worth of shares at stupid prices— a classic example of blowing up their businesses in an attempt to manage the stock price [[and maintain the value of their stock options and bonuses at their shareholder's expense, in the long run: normxxx]].)
Parched For Work In Arid Times
Though the government hasn't admitted it yet, we are in a recession, and in this particular instance, it seems to me that creating jobs will be an unusually severe problem. That's because the economic expansion we saw from 2002 to 2007 was essentially just a function of unconstrained speculation (as I have stated often— and I explain in my book "Greenspan's Bubbles"). I just cannot stop worrying about where the jobs are going to come from prospectively.
When I wrote that book, I pretty much exorcised my own demons regarding my revulsion and anger at the policies of former chief Alan Greenspan and his Federal Reserve. Recently, though, I couldn't help but think how much better off everyone would be had the United States used the time after the equity bubble and the 9/11 attacks to pursue sound policies, as well as encourage folks to save money and prepare themselves for the demographic challenge of Social Security and rising health care costs.
Instead, Greenspan created a multiple-GDP-sized housing bubble, during which folks took on huge amounts of debt instead of actually saving money. It was only ridiculous financing (which has since imploded the banking system) that allowed so many folks to pay absurd prices for houses— and take money out of them at the same time via home-equity loans. Of course, one of the most misguided government ideas was trying to prop up home prices. (Secretary Hank Paulson essentially conceded as much when he announced that the Treasury Department was abandoning its plan to purchase troubled mortgage assets.)
House prices need to come down to where folks can afford them. And prices may have to fall even further than we might have thought in the first place, because there's going to be high levels of unemployment and probably not a lot of wage growth. [[Probably not more wage growth than during "w"'s 8 years in office! He seems to have made certain of that.: normxxx]]
Cut The Wires To His Microphone
This is going to be a very unpleasant period, I'm sorry to say. The outcome we are witnessing is exactly why, during both the stock mania and the housing mania, I was so vociferous in my criticism of Greenspan. [[But he was never so fully 'unleashed' as under "no government" Bush! : normxxx]] He is the one man who continually meddled with the market [[except where he should have: normxxx]] and continually advocated that folks behave in an irresponsible way. [[Like advocating the purchase of ARM mortgages when interest rates were already at rock bottom! : normxxx]]. I find it outrageous that this buffoon is still making speeches (and commanding huge fees) when the entire world, is paying for his crimes against finance.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Bill Fleckenstein | 17 November 2008
|
Unfortunately, despite some 12 financing facilities created by the Treasury and the Fed, massive interest rate cuts and various bailouts, the government has little to show for its attempts to dictate where markets should trade. The Fed's own balance sheet has exploded from roughly $900 billion worth of debt in August to around $2 trillion as of last week. Knowledgeable sources expect that to reach $3 trillion by the end of the year.
That means that it will have grown from approximately 6% of gross domestic product to more than 20% in the space of four months. (For perspective, Japan's balance sheet grew from roughly 9% of GDP to 29% over the 10-year period from 1994 to 2004, as it pursued "quantitative easing," which basically involves the central bank making more cash available to banks to ease lending.) These numbers and rates of growth are so enormous (and unprecedented) as to be utterly incomprehensible. Does anybody actually think the government has any idea what it's doing?
I think it's certainly dawning on folks that when the government "does something," it often creates more problems than it solves. In this case, as it props up poorly managed companies, it may only be allowing them to rain further havoc on the better managed companies in their industry. American International Group (AIG) is an example of this, and I'm sure many other 'rescued' financial entities will turn out to be as well. (As an aside, notice all the idiotic executives, across a wide range of industries, who have bought back hundreds of billions of dollars' worth of shares at stupid prices— a classic example of blowing up their businesses in an attempt to manage the stock price [[and maintain the value of their stock options and bonuses at their shareholder's expense, in the long run: normxxx]].)
Parched For Work In Arid Times
Though the government hasn't admitted it yet, we are in a recession, and in this particular instance, it seems to me that creating jobs will be an unusually severe problem. That's because the economic expansion we saw from 2002 to 2007 was essentially just a function of unconstrained speculation (as I have stated often— and I explain in my book "Greenspan's Bubbles"). I just cannot stop worrying about where the jobs are going to come from prospectively.
When I wrote that book, I pretty much exorcised my own demons regarding my revulsion and anger at the policies of former chief Alan Greenspan and his Federal Reserve. Recently, though, I couldn't help but think how much better off everyone would be had the United States used the time after the equity bubble and the 9/11 attacks to pursue sound policies, as well as encourage folks to save money and prepare themselves for the demographic challenge of Social Security and rising health care costs.
Instead, Greenspan created a multiple-GDP-sized housing bubble, during which folks took on huge amounts of debt instead of actually saving money. It was only ridiculous financing (which has since imploded the banking system) that allowed so many folks to pay absurd prices for houses— and take money out of them at the same time via home-equity loans. Of course, one of the most misguided government ideas was trying to prop up home prices. (Secretary Hank Paulson essentially conceded as much when he announced that the Treasury Department was abandoning its plan to purchase troubled mortgage assets.)
House prices need to come down to where folks can afford them. And prices may have to fall even further than we might have thought in the first place, because there's going to be high levels of unemployment and probably not a lot of wage growth. [[Probably not more wage growth than during "w"'s 8 years in office! He seems to have made certain of that.: normxxx]]
Cut The Wires To His Microphone
This is going to be a very unpleasant period, I'm sorry to say. The outcome we are witnessing is exactly why, during both the stock mania and the housing mania, I was so vociferous in my criticism of Greenspan. [[But he was never so fully 'unleashed' as under "no government" Bush! : normxxx]] He is the one man who continually meddled with the market [[except where he should have: normxxx]] and continually advocated that folks behave in an irresponsible way. [[Like advocating the purchase of ARM mortgages when interest rates were already at rock bottom! : normxxx]]. I find it outrageous that this buffoon is still making speeches (and commanding huge fees) when the entire world, is paying for his crimes against finance.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Friday, November 21, 2008
News For Gold Investors
Three Big Pieces Of News For Gold Investors
By David Galland, Editor, The Casey Report | 22 November 2008
In the past few months, I've read a number of analysts, Jim Rogers even, who have expressed the view that gold could dip to the mid— to low $600 level. As we've seen in the past few months, anything can happen in this market... but there are things happening all over the world that tell me buyers of physical gold are finding any price near $700 to be too cheap to pass up. In other words, there are ready buyers prepared to "keep a floor" under gold at current levels. On that topic, a friend sent this item along last week...
The Saudis have a lot of money to pour into gold. Not just a lot... but a really, really, big, stupendous mountain of the stuff. Oh, and like you and me, they're human. Which means they can't help but glance through the morning's financial news, adjust the reading glasses, and think, "Blessed Mohammed! This is getting really, really serious. Maybe just a little extra gold under the tent right now wouldn't be such a horrible idea."
They aren't alone. We are getting regular reports that at these prices, demand is soaring in India (where price inflation is now running around 11%). And brisk sales have pretty much wiped out physical supplies of small coins and bars in the U.S. and Europe… among other corners of the world. On that score, a few days ago, I received this note from a subscriber. It speaks volumes about the current state of gold:
While we already know $750 is no magic number below which gold cannot fall, I take no small comfort in the fact that there is a clear increase in demand at that price. In time, as the dollar continues to participate in the fiat currency race to the bottom, that number will ratchet higher and higher still. Maybe not overnight, but in the next six months to a year, certainly… or as certain as anyone can be about anything these days…
One thing that could get the show on the road pronto-like has to do with the continuing presence of the other 900-pound gorilla in the room, foreign dollar holders. Like the Saudis, the Chinese have at their fingertips a lot of greenbacks. Actually, not just a lot, but enough to remake the Great Wall. And they, too, are human.
And so, over their morning cup of tea, they finger the abacus while watching the daily financial news and say, "Holy Mao! This is getting really, really serious. Maybe just a little extra gold in the rice jar right now wouldn't be such a horrible idea." On that front, here's some news from Hong Kong.
In another article, from Bloomberg, the head of China's gold association commented that he thought China could triple its reserves. Considering China has around $2 trillion in foreign-exchange reserves [[almost three quarters of a trillion in dollars alone: normxxx]], the country could triple its gold reserves and not even blink. In the final analysis, we can't say with certainty what path gold will take between now and the time this crisis is over. But I see signs all over the world that there is a huge amount of buying interest for gold right now [[which is quite dangerous for the price of gold if things ever settle down: normxxx]]. And until I can see some tangible evidence that it has lost its value as money, I'm a happy holder and, at under $750, a buyer.
ߧ
Normxxx ______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only. The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By David Galland, Editor, The Casey Report | 22 November 2008
In the past few months, I've read a number of analysts, Jim Rogers even, who have expressed the view that gold could dip to the mid— to low $600 level. As we've seen in the past few months, anything can happen in this market... but there are things happening all over the world that tell me buyers of physical gold are finding any price near $700 to be too cheap to pass up. In other words, there are ready buyers prepared to "keep a floor" under gold at current levels. On that topic, a friend sent this item along last week...
|
The Saudis have a lot of money to pour into gold. Not just a lot... but a really, really, big, stupendous mountain of the stuff. Oh, and like you and me, they're human. Which means they can't help but glance through the morning's financial news, adjust the reading glasses, and think, "Blessed Mohammed! This is getting really, really serious. Maybe just a little extra gold under the tent right now wouldn't be such a horrible idea."
They aren't alone. We are getting regular reports that at these prices, demand is soaring in India (where price inflation is now running around 11%). And brisk sales have pretty much wiped out physical supplies of small coins and bars in the U.S. and Europe… among other corners of the world. On that score, a few days ago, I received this note from a subscriber. It speaks volumes about the current state of gold:
|
While we already know $750 is no magic number below which gold cannot fall, I take no small comfort in the fact that there is a clear increase in demand at that price. In time, as the dollar continues to participate in the fiat currency race to the bottom, that number will ratchet higher and higher still. Maybe not overnight, but in the next six months to a year, certainly… or as certain as anyone can be about anything these days…
One thing that could get the show on the road pronto-like has to do with the continuing presence of the other 900-pound gorilla in the room, foreign dollar holders. Like the Saudis, the Chinese have at their fingertips a lot of greenbacks. Actually, not just a lot, but enough to remake the Great Wall. And they, too, are human.
And so, over their morning cup of tea, they finger the abacus while watching the daily financial news and say, "Holy Mao! This is getting really, really serious. Maybe just a little extra gold in the rice jar right now wouldn't be such a horrible idea." On that front, here's some news from Hong Kong.
|
In another article, from Bloomberg, the head of China's gold association commented that he thought China could triple its reserves. Considering China has around $2 trillion in foreign-exchange reserves [[almost three quarters of a trillion in dollars alone: normxxx]], the country could triple its gold reserves and not even blink. In the final analysis, we can't say with certainty what path gold will take between now and the time this crisis is over. But I see signs all over the world that there is a huge amount of buying interest for gold right now [[which is quite dangerous for the price of gold if things ever settle down: normxxx]]. And until I can see some tangible evidence that it has lost its value as money, I'm a happy holder and, at under $750, a buyer.
ߧ
Normxxx ______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only. The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Inflation Or Deflation?
The Bear's Lair: Inflation Or Deflation?
By Martin Hutchinson | 21 November 2008
There is a considerable argument between commentators as to whether, apart from a pretty painful recession, the US economy is in for a bout of inflation or deflation. Both sides have apparently cogent arguments, and maintain their positions with considerable vigor. Robert Samuelson, having recently published a book The Great Inflation that suggested another burst of inflation was inevitable, has now produced an op-ed in the Washington Post warning of the rapidly approaching dangers of DEflation— such are the dangers of publishing schedules! Having in the past suggested that INflation was inevitable, I thought it worth looking at the deflationist case.
Money supply data, first, do not suggest that deflation is imminent, although to some extent they contradict each other. M2, the broadest money supply measure now published by the Federal Reserve, was up 7.4% in the 12 months to November 3 (suggesting a potential inflation rate of 6-7% since gross domestic product growth was around 1% in real terms.) The St Louis Fed's Money of Zero Maturity, the closest we can now get to the old M3, discontinued by the Fed in 2006, is up 10.0% in the last 12 months, suggesting a somewhat faster rate of inflation, perhaps 8-9%. More recently, however, the two measures have diverged; in the eight weeks to November 4, M2 was up at a 19.9% annual rate while MZM rose at a 0.7% annual rate— a huge disparity that has yet to be explained.
Nevertheless, the "gold bugs" who would normally expect to profit substantially from an upsurge in inflation have had a terrible year, indicating that their thesis has in some respects gone horribly wrong. According to Mark Hulbert on CBS Marketwatch, Harry Schultz, Howard Ruff and Jim Dines, the three leading gold-bugs and prognosticators of economic doom, have each lost between 64% and 70% on their investment newsletters during 2008. Since this was the year in which their prognostications of doom finally appear to have come true, one can reasonably ask what went wrong!
Equally the majority view, that the principal danger facing the United States is a Japanese-style stagnation lasting a decade or more with prices declining slightly making real interest rates too high, also seems misguided. Japan was close to deflation even in the early 1990s, and then followed a poisonous mix of policies that failed to recognize the loan losses in its banks while attempting to spend its way out of trouble through the public sector.
The United States is doing the latter but not the former, which it is prevented from doing by "mark-to-market" accounting. While mark-to-market accounting has major defects in prolonging a bubble, since it allows bankers to enter into foolish deals in the hope of short-term [[mostly 'paper': normxxx]] profits but very real bonuses, it is highly salutary in a downturn, preventing any semblance of wishful thinking in assessing value-impaired assets such as mortgage bonds. [[However, BB and the Fed has now permitted banks to 'delay' "mark-to-market" for now!: normxxx]]
That's why the entire US banking system has been forced to turn to Uncle Sam for succor; it is also why that system is now entirely unable to carry on as if nothing had gone wrong as the Japanese banking system did in 1991-98. Thus with a banking system [[more or less: normxxx]] forced into realism, and interest rates that are sharply negative in real terms, deflation seems an unlikely possibility, in spite of Treasury Secretary Hank Paulson's determination to invest every spare nickel in the economy into its most unproductive and valueless assets. [[And that includes the rest of the administration, and congress even more so.: normxxx]]
The difference between the United States and 1990s' Japan is further indicated by the credit crunch [[which is what is putting the brakes on money velocity: normxxx]]— Japan didn't really have one, in the sense of a sudden constipation in normal lending that caused the economy to seize up. That suggests again that the US trajectory going forward is unlikely to resemble 1990s Japan (for good or evil— Japan avoided a really deep recession, though it suffered an appallingly long, albeit shallow, one).
The recent spate of truly terrible economic numbers, such as the 2.8% retail sales decline in October (4.5% down on the previous year) and the 32% decline in automobile sales, suggests that wherever the bottom of the recession is located, we will get there fairly quickly. The US savings rate and the balance of payments both need to be improved by about 5% of gross domestic product, so a top-to-bottom decline in GDP of at least 5% is likely. However there is little reason for GDP to decline more than 5% top-to-bottom, or maybe 7% to allow for a little overshoot. Once GDP gets to its new equilibrium level, powerful factors [will tend to] stabilize it and produce renewed growth— after all, at that new level of GDP the United States is once again internationally competitive, selling goods and services to customers worldwide in a way that has been impossible for a decade.
We are thus not looking at Great Depression II, in which GDP would decline 25%. To reach such an unpleasant re-run we would need a major outbreak of global protectionism, a final withdrawal of confidence by depositors in the US banking system and a [punitive] increase in taxes, eg, more than doubling the top marginal rate. President-elect Barack Obama isn't going to do that. Is he?
If he doesn't, and we avoid a Smoot-Hawley-style attack on world trade, then we will also avoid Great Depression ll. After all, the Great Depression was a primarily US phenomenon, caused and prolonged by egregious US policy errors— it was nothing like so bad in Britain, where economic policy under Chancellor of the Exchequer Neville Chamberlain was highly competent and basically the opposite of US failures. [[But it was arguably worse in Germany until Hitler.: normxxx]]
However, if the recession is to be limited to a drop of 5-7% in GDP (itself somewhat worse than the 1974 and 1979-82 recessions, both around 3.5% of GDP) then at the present rate of decline we will reach bottom pretty quickly, in no more than nine to 12 months. That tallies also with the housing price decline; house prices have already declined more than 20% nationwide, and from valuation considerations probably have no more than another 10% or at most 15% to go.
The banking system has already been bailed out by the Fed and probably won't have to be bailed out again[!?!] but will see a gradual containment of losses in the next few quarters (with one or more huge incompetents finally slithering into bankruptcy.) The stock market has nearly reached its equilibrium of around 7,800 on the Dow (based on its early 1995 level of 4,000, inflated by nominal GDP growth since then). Although the market will doubtless overshoot on the downside, the dollar loss from a further decline to say Dow 5,000 is less than we have already experienced in the decline from 14,165 to below 9,000.
While US GDP is still declining sharply inflation will remain quiescent. Oil, minerals and agricultural prices will be on a generally downward trend, as the rest of the world, in particular the high-population growth centers of China and India, find their growth restricted by declining US demand. However, China has already indicated that it will not allow a US recession to stall its own growth; instead it has announced a two-year stimulus program of US$580 billion, about 15% of GDP. Thus commodity prices will remain supported by the continuing surge in Chinese and to a lesser extent Indian demand. [[And the return of the Chinese hoard of dollars to the international markets, as China's balance of trade veers negative, will assist BB and the Fed's reflation efforts!: normxxx]]
US inflation will slow somewhat from its summer peak of close to 6%, but will not go into reverse, even while output continues its sharp decline. A renewed decline in the dollar, inevitable once US savings rates begin to recover and the flood of foreign capital into US bonds lessens, will cause the recent decline in import price inflation to reverse. Meanwhile cost increases already present in the system will work their way through to prices, causing continued modest upward momentum.
Even if inflation is declining gradually as output declines, it will not have time to become deflation in the nine to 12 months before output reaches bottom— if we were about to experience Great Depression II the decline would be more prolonged, but we're not. Once output has bottomed out, the inflationary picture changes radically. Budget deficits in the United States, the European Union, China, India and Japan will be enormous, causing sharp rises in interest rates as government bonds "crowd out" the private sector. Money supply, which will have been increasing because of the very low nominal interest rates, will now be grossly excessive for the shrunken GDP.
Costs, which were held down by the wave of bankruptcies in the contraction, will once again increase as supply comes once again to balance demand. For one thing, higher interest rates and capital costs (through lower equity prices) will themselves produce a sharp upward ratchet effect on corporate break-evens, both in the US and more especially in emerging markets where capital will be scarce. Lower production volumes against which fixed costs can be amortized will also increase unit costs. The overall effect will be sharp upward pressure on prices— those continuing to sell at a loss to keep the factory at its most efficient output level and with most workers employed will be rapidly driven out of business [[except, perhaps, in China: normxxx]].
Inflation will thus resurge, both domestically and internationally, and will quickly reach the double-digit level at which central bank action to restrain it becomes unavoidable (amusingly, unexpectedly awful inflation figures are likely to appear before the January 2010 end of Federal Reserve chairman Ben Bernanke's term, forcing him to admit while still in office that his "deflation" warnings were hogwash.)
Interest rates will gradually be forced upwards to inflation plus 4% levels in the last months of 2009 and throughout 2010, producing a second "dip" of recession in 2011 and a non-inflationary recovery in 2012-13. The turn from economic decline (but not truly deflation) to inflation will be well indicated by the gold market, which can expect to surge as the economic bottom is approached.
As often happens, the "gold bugs" will turn out to be right in the end, even if their performance during 2008 has been dreadful— for those that survive, 2009 is likely to be a banner year. Deflationists will proclaim each slowing inflation figure in the early months of 2009 to be evidence for their case, though in reality those months will see not true deflation but simply slowing inflation accompanied by sharp descent into recession.
However, in the long run, monetarists will prove to have been right— and the decade of excessive money supply expansion from 1995-2008 will impose its final penalties on the unfortunate US and global public. Monetarists will also have the satisfaction of knowing that higher real interest rates will have become inescapable, and that overexpansion of money supply will never happen again— until some future generation of idiots has forgotten the economic history of these decades.
ߧ
Normxxx
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Martin Hutchinson | 21 November 2008
There is a considerable argument between commentators as to whether, apart from a pretty painful recession, the US economy is in for a bout of inflation or deflation. Both sides have apparently cogent arguments, and maintain their positions with considerable vigor. Robert Samuelson, having recently published a book The Great Inflation that suggested another burst of inflation was inevitable, has now produced an op-ed in the Washington Post warning of the rapidly approaching dangers of DEflation— such are the dangers of publishing schedules! Having in the past suggested that INflation was inevitable, I thought it worth looking at the deflationist case.
Money supply data, first, do not suggest that deflation is imminent, although to some extent they contradict each other. M2, the broadest money supply measure now published by the Federal Reserve, was up 7.4% in the 12 months to November 3 (suggesting a potential inflation rate of 6-7% since gross domestic product growth was around 1% in real terms.) The St Louis Fed's Money of Zero Maturity, the closest we can now get to the old M3, discontinued by the Fed in 2006, is up 10.0% in the last 12 months, suggesting a somewhat faster rate of inflation, perhaps 8-9%. More recently, however, the two measures have diverged; in the eight weeks to November 4, M2 was up at a 19.9% annual rate while MZM rose at a 0.7% annual rate— a huge disparity that has yet to be explained.
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Nevertheless, the "gold bugs" who would normally expect to profit substantially from an upsurge in inflation have had a terrible year, indicating that their thesis has in some respects gone horribly wrong. According to Mark Hulbert on CBS Marketwatch, Harry Schultz, Howard Ruff and Jim Dines, the three leading gold-bugs and prognosticators of economic doom, have each lost between 64% and 70% on their investment newsletters during 2008. Since this was the year in which their prognostications of doom finally appear to have come true, one can reasonably ask what went wrong!
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Equally the majority view, that the principal danger facing the United States is a Japanese-style stagnation lasting a decade or more with prices declining slightly making real interest rates too high, also seems misguided. Japan was close to deflation even in the early 1990s, and then followed a poisonous mix of policies that failed to recognize the loan losses in its banks while attempting to spend its way out of trouble through the public sector.
The United States is doing the latter but not the former, which it is prevented from doing by "mark-to-market" accounting. While mark-to-market accounting has major defects in prolonging a bubble, since it allows bankers to enter into foolish deals in the hope of short-term [[mostly 'paper': normxxx]] profits but very real bonuses, it is highly salutary in a downturn, preventing any semblance of wishful thinking in assessing value-impaired assets such as mortgage bonds. [[However, BB and the Fed has now permitted banks to 'delay' "mark-to-market" for now!: normxxx]]
That's why the entire US banking system has been forced to turn to Uncle Sam for succor; it is also why that system is now entirely unable to carry on as if nothing had gone wrong as the Japanese banking system did in 1991-98. Thus with a banking system [[more or less: normxxx]] forced into realism, and interest rates that are sharply negative in real terms, deflation seems an unlikely possibility, in spite of Treasury Secretary Hank Paulson's determination to invest every spare nickel in the economy into its most unproductive and valueless assets. [[And that includes the rest of the administration, and congress even more so.: normxxx]]
The difference between the United States and 1990s' Japan is further indicated by the credit crunch [[which is what is putting the brakes on money velocity: normxxx]]— Japan didn't really have one, in the sense of a sudden constipation in normal lending that caused the economy to seize up. That suggests again that the US trajectory going forward is unlikely to resemble 1990s Japan (for good or evil— Japan avoided a really deep recession, though it suffered an appallingly long, albeit shallow, one).
The recent spate of truly terrible economic numbers, such as the 2.8% retail sales decline in October (4.5% down on the previous year) and the 32% decline in automobile sales, suggests that wherever the bottom of the recession is located, we will get there fairly quickly. The US savings rate and the balance of payments both need to be improved by about 5% of gross domestic product, so a top-to-bottom decline in GDP of at least 5% is likely. However there is little reason for GDP to decline more than 5% top-to-bottom, or maybe 7% to allow for a little overshoot. Once GDP gets to its new equilibrium level, powerful factors [will tend to] stabilize it and produce renewed growth— after all, at that new level of GDP the United States is once again internationally competitive, selling goods and services to customers worldwide in a way that has been impossible for a decade.
We are thus not looking at Great Depression II, in which GDP would decline 25%. To reach such an unpleasant re-run we would need a major outbreak of global protectionism, a final withdrawal of confidence by depositors in the US banking system and a [punitive] increase in taxes, eg, more than doubling the top marginal rate. President-elect Barack Obama isn't going to do that. Is he?
If he doesn't, and we avoid a Smoot-Hawley-style attack on world trade, then we will also avoid Great Depression ll. After all, the Great Depression was a primarily US phenomenon, caused and prolonged by egregious US policy errors— it was nothing like so bad in Britain, where economic policy under Chancellor of the Exchequer Neville Chamberlain was highly competent and basically the opposite of US failures. [[But it was arguably worse in Germany until Hitler.: normxxx]]
However, if the recession is to be limited to a drop of 5-7% in GDP (itself somewhat worse than the 1974 and 1979-82 recessions, both around 3.5% of GDP) then at the present rate of decline we will reach bottom pretty quickly, in no more than nine to 12 months. That tallies also with the housing price decline; house prices have already declined more than 20% nationwide, and from valuation considerations probably have no more than another 10% or at most 15% to go.
The banking system has already been bailed out by the Fed and probably won't have to be bailed out again[!?!] but will see a gradual containment of losses in the next few quarters (with one or more huge incompetents finally slithering into bankruptcy.) The stock market has nearly reached its equilibrium of around 7,800 on the Dow (based on its early 1995 level of 4,000, inflated by nominal GDP growth since then). Although the market will doubtless overshoot on the downside, the dollar loss from a further decline to say Dow 5,000 is less than we have already experienced in the decline from 14,165 to below 9,000.
While US GDP is still declining sharply inflation will remain quiescent. Oil, minerals and agricultural prices will be on a generally downward trend, as the rest of the world, in particular the high-population growth centers of China and India, find their growth restricted by declining US demand. However, China has already indicated that it will not allow a US recession to stall its own growth; instead it has announced a two-year stimulus program of US$580 billion, about 15% of GDP. Thus commodity prices will remain supported by the continuing surge in Chinese and to a lesser extent Indian demand. [[And the return of the Chinese hoard of dollars to the international markets, as China's balance of trade veers negative, will assist BB and the Fed's reflation efforts!: normxxx]]
US inflation will slow somewhat from its summer peak of close to 6%, but will not go into reverse, even while output continues its sharp decline. A renewed decline in the dollar, inevitable once US savings rates begin to recover and the flood of foreign capital into US bonds lessens, will cause the recent decline in import price inflation to reverse. Meanwhile cost increases already present in the system will work their way through to prices, causing continued modest upward momentum.
Even if inflation is declining gradually as output declines, it will not have time to become deflation in the nine to 12 months before output reaches bottom— if we were about to experience Great Depression II the decline would be more prolonged, but we're not. Once output has bottomed out, the inflationary picture changes radically. Budget deficits in the United States, the European Union, China, India and Japan will be enormous, causing sharp rises in interest rates as government bonds "crowd out" the private sector. Money supply, which will have been increasing because of the very low nominal interest rates, will now be grossly excessive for the shrunken GDP.
Costs, which were held down by the wave of bankruptcies in the contraction, will once again increase as supply comes once again to balance demand. For one thing, higher interest rates and capital costs (through lower equity prices) will themselves produce a sharp upward ratchet effect on corporate break-evens, both in the US and more especially in emerging markets where capital will be scarce. Lower production volumes against which fixed costs can be amortized will also increase unit costs. The overall effect will be sharp upward pressure on prices— those continuing to sell at a loss to keep the factory at its most efficient output level and with most workers employed will be rapidly driven out of business [[except, perhaps, in China: normxxx]].
Inflation will thus resurge, both domestically and internationally, and will quickly reach the double-digit level at which central bank action to restrain it becomes unavoidable (amusingly, unexpectedly awful inflation figures are likely to appear before the January 2010 end of Federal Reserve chairman Ben Bernanke's term, forcing him to admit while still in office that his "deflation" warnings were hogwash.)
Interest rates will gradually be forced upwards to inflation plus 4% levels in the last months of 2009 and throughout 2010, producing a second "dip" of recession in 2011 and a non-inflationary recovery in 2012-13. The turn from economic decline (but not truly deflation) to inflation will be well indicated by the gold market, which can expect to surge as the economic bottom is approached.
As often happens, the "gold bugs" will turn out to be right in the end, even if their performance during 2008 has been dreadful— for those that survive, 2009 is likely to be a banner year. Deflationists will proclaim each slowing inflation figure in the early months of 2009 to be evidence for their case, though in reality those months will see not true deflation but simply slowing inflation accompanied by sharp descent into recession.
However, in the long run, monetarists will prove to have been right— and the decade of excessive money supply expansion from 1995-2008 will impose its final penalties on the unfortunate US and global public. Monetarists will also have the satisfaction of knowing that higher real interest rates will have become inescapable, and that overexpansion of money supply will never happen again— until some future generation of idiots has forgotten the economic history of these decades.
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ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Thursday, November 20, 2008
Wall Street Lays Another Egg
Finance: Wall Street Lays Another Egg
By Niall Ferguson, VanityFair | December 2008
The bigger they come: Uncle Sam and Wall Street take the hardest fall since the Depression. Illustration by Tim Bower.
This year we have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. Two years ago, in 2006, the measured economic output of the entire world was worth around $48.6 trillion. The total market capitalization of the world’s stock markets was $50.6 trillion, 4 percent larger. The total value of domestic and international bonds was $67.9 trillion, 40 percent larger. Planet Finance was beginning to dwarf Planet Earth.
Planet Finance seemed to spin faster, too. Every day $3.1 trillion changed hands on foreign-exchange markets. Every month $5.8 trillion changed hands on global stock markets. And all the time new financial life-forms were evolving. The total annual issuance of mortgage-backed securities, including fancy new "collateralized debt obligations" (C.D.O.’s), rose to more than $1 trillion.
The volume of "derivatives"— contracts such as options and swaps— grew even faster, so that by the end of 2006 their notional value was just over $400 trillion. Before the 1980s, such things were virtually unknown. In the space of a few years their populations exploded. On Planet Finance, the securities outnumbered the people; the transactions outnumbered the relationships.
New institutions also proliferated. In 1990 there were just 610 hedge funds, with $38.9 billion under management. At the end of 2006 there were 9,462, with $1.5 trillion under management. Private-equity partnerships also went forth and multiplied. Banks, meanwhile, set up a host of "conduits" and "structured investment vehicles" (sivs— surely the most apt acronym in financial history) to keep potentially risky assets off their balance sheets. It was as if an entire shadow banking system had come into being.
Then, beginning in the summer of 2007, Planet Finance began to self-destruct in what the International Monetary Fund soon acknowledged to be "the largest financial shock since the Great Depression." Did the crisis of 2007–8 happen because American companies had gotten worse at designing new products? Had the pace of technological innovation or productivity growth suddenly slackened? No. The proximate cause of the economic uncertainty of 2008 was financial: to be precise, a crunch in the credit markets triggered by mounting defaults on a hitherto obscure species of housing loan known euphemistically as "subprime mortgages."
Central banks in the United States and Europe sought to alleviate the pressure on the banks with interest-rate cuts and offers of funds through special "term auction facilities." Yet the market rates at which banks could borrow money, whether by issuing commercial paper, selling bonds, or borrowing from one another, failed to follow the lead of the official federal-funds rate. The banks had to turn not only to Western central banks for short-term assistance to rebuild their reserves but also to Asian and Middle Eastern sovereign-wealth funds for equity injections. When these sources proved insufficient, investors— and speculative short-sellers— began to lose faith.
Beginning with Bear Stearns, Wall Street’s investment banks entered a death spiral that ended with their being either taken over by a commercial bank (as Bear was, followed by Merrill Lynch) or driven into bankruptcy (as Lehman Brothers was). In September the two survivors— Goldman Sachs and Morgan Stanley— formally ceased to be investment banks, signaling the death of a business model that dated back to the Depression. Other institutions deemed "too big to fail" by the U.S. Treasury were effectively taken over by the government, including the mortgage lenders and guarantors Fannie Mae and Freddie Mac and the insurance giant American International Group (A.I.G.).
By September 18 the U.S. financial system was gripped by such panic that the Treasury had to abandon this ad hoc policy. Treasury Secretary Henry Paulson hastily devised a plan whereby the government would be authorized to buy "troubled" securities with up to $700 billion of taxpayers’ money— a figure apparently plucked from the air. When a modified version of the measure was rejected by Congress 11 days later, there was panic. When it was passed four days after that, there was more panic. Now it wasn’t just bank stocks that were tanking.
The entire stock market seemed to be in free fall as fears mounted that the credit crunch was going to trigger a recession. Moreover, the crisis was now clearly global in scale. European banks were in much the same trouble [[or even worse than: normxxx]] their American counterparts, while emerging-market stock markets were crashing. A week of frenetic improvisation by national governments culminated on the weekend of October 11–12, when the United States reluctantly followed the British government’s lead, buying equity stakes in banks rather than just their dodgy assets and offering unprecedented guarantees of banks’ debt and deposits.
Since these events coincided with the final phase of a U.S. presidential-election campaign, it was not surprising that some rather simplistic lessons were soon being touted by candidates and commentators. The crisis, some said, was the result of excessive deregulation of financial markets. Others sought to lay the blame on unscrupulous speculators: short-sellers, who borrowed the stocks of vulnerable banks and sold them in the expectation of further price declines. Still other suspects in the frame were negligent regulators and corrupt congressmen.
This hunt for scapegoats is futile. To understand the downfall of Planet Finance, you need to take several steps back and locate this crisis in the long run of financial history. Only then will you see that we have all played a part in this latest sorry example of what the Victorian journalist Charles Mackay described in his 1841 book, Extraordinary Popular Delusions and the Madness of Crowds.
Nothing New
As long as there have been banks, bond markets, and stock markets, there have been financial crises. Banks went bust in the days of the Medici. There were bond-market panics in the Venice of Shylock’s day. And the world’s first stock-market crash happened in 1720, when the Mississippi Company— the Enron of its day— blew up. According to economists Carmen Reinhart and Kenneth Rogoff, the financial history of the past 800 years is a litany of debt defaults, banking crises, currency crises, and inflationary spikes.
Moreover, financial crises seldom happen without inflicting pain on the wider economy. Another recent paper, co-authored by Rogoff’s Harvard colleague Robert Barro, has identified 148 crises since 1870 in which a country experienced a cumulative decline in gross domestic product (G.D.P.) of at least 10 percent, implying a probability of financial disaster of around 3.6 percent per year.
If stock-market movements followed the normal-distribution, or bell, curve, like human heights, an annual drop of 10 percent or more would happen only once every 500 years, whereas in the case of the Dow Jones Industrial Average it has happened in 20 of the last 100 years. And stock-market plunges of 20 percent or more would be unheard of— rather like people a foot and a half tall— whereas in fact there have been eight such crashes in the past century.
The most famous financial crisis— the Wall Street Crash— is conventionally said to have begun on "Black Thursday," October 24, 1929, when the Dow declined by 2 percent, though in fact the market had been slipping since early September and had suffered a sharp, 6 percent drop on October 23. On "Black Monday," October 28, it plunged by 13 percent, and the next day by a further 12 percent. In the course of the next three years the U.S. stock market declined by a staggering 89 percent, reaching its nadir in July 1932. The index did not regain its 1929 peak until November 1954.
That helps put our current troubles into perspective. From its peak of 14,164, on October 9, 2007, to a dismal level of 8,579, exactly a year later, the Dow declined by 39 percent. By contrast, on a single day just over two decades ago— October 19, 1987— the index fell by 23 percent, one of only four days in history when the index has fallen by more than 10 percent in a single trading session.
This crisis, however, is about much more than just the stock market. It needs to be understood as a fundamental breakdown of the entire financial system, extending from the monetary-and-banking system through the bond market, the stock market, the insurance market, and the real-estate market. It affects not only established financial institutions such as investment banks but also relatively novel ones such as hedge funds. It is global in scope and unfathomable in scale.
Had it not been for the frantic efforts of the Federal Reserve and the Treasury, to say nothing of their counterparts in almost equally afflicted Europe, there would by now have been a repeat of that "great contraction" of credit and economic activity that was the prime mover of the Depression. Back then, the Fed and the Treasury did next to nothing to prevent bank failures from translating into a drastic contraction of credit and hence of business activity and employment. If the more openhanded monetary and fiscal authorities of today are ultimately successful in preventing a comparable slump of output, future historians may end up calling this "the Great Repression." This is the Depression they are hoping to bottle up— a Depression in denial.
To understand why we have come so close to a rerun of the 1930s, we need to begin at the beginning, with banks and the money they make. From the Middle Ages until the mid-20th century, most banks made their money by maximizing the difference between the costs of their liabilities (payments to depositors) and the earnings on their assets (interest and commissions on loans). Some banks also made money by financing trade, discounting the commercial bills issued by merchants.
Others issued and traded bonds and stocks, or dealt in commodities (especially precious metals). But the core business of banking was simple. It consisted, as the third Lord Rothschild pithily put it, "essentially of facilitating the movement of money from Point A, where it is, to Point B, where it is needed."
The system evolved gradually. First came the invention of cashless intra-bank and inter-bank transactions, which allowed debts to be settled between account holders without having money physically change hands. Then came the idea of fractional-reserve banking, whereby banks kept only a small proportion of their existing deposits on hand to satisfy the needs of depositors (who seldom wanted all their money simultaneously), allowing the rest to be lent out profitably. That was followed by the rise of special public banks with monopolies on the issuing of banknotes and other powers and privileges: the first central banks.
With these innovations, money ceased to be understood as precious metal minted into coins. Now it was the sum total of specific liabilities (deposits and reserves) incurred by banks. Credit was the other side of banks’ balance sheets: the total of their assets; in other words, the loans they made. Some of this money might still consist of precious metal, though a rising proportion of that would be held in the central bank’s vault. Most would be made up of banknotes and coins recognized as "legal tender," along with money that was visible only in current— and deposit-account statements.
Until the late 20th century, the system of bank money retained an anchor in the pre-modern conception of money in the form of the 'gold standard': fixed ratios between units of account and quantities of precious metal. As early as 1924, the English economist John Maynard Keynes dismissed the gold standard as a "barbarous relic," but the last vestige of the system did not disappear until August 15, 1971— the day President Richard Nixon closed the so-called gold window, through which foreign central banks could still exchange dollars for gold. With that, the centuries-old link between money and precious metal was broken.
Though we tend to think of money today as being made of paper, in reality most of it now consists of 'bank deposits'. If we measure the ratio of actual money to output in developed economies, it becomes clear that the trend since the 1970s has been for that ratio to rise from around 70 percent, before the closing of the gold window, to more than 100 percent by 2005. The corollary has been a parallel growth of credit on the other side of bank balance sheets.
A significant component of that credit growth has been a surge of lending to consumers. Back in 1952, the ratio of household debt to disposable income was less than 40 percent in the United States. At its peak in 2007, it reached 133 percent, up from 90 percent a decade before. Today Americans carry a total of $2.56 trillion in consumer debt, up by more than a fifth since 2000.
Even more spectacular, however, has been the rising indebtedness of banks themselves. In 1980, bank indebtedness was equivalent to 21 percent of U.S. gross domestic product. In 2007 the figure was 116 percent. Another measure of this was the declining capital adequacy of banks. On the eve of "the Great Repression," average bank capital in Europe was equivalent to less than 10 percent of assets; at the beginning of the 20th century, it was around 25 percent. It was not unusual for investment banks’ balance sheets to be as much as 20 or 30 times larger than their capital, thanks in large part to a 2004 rule change by the Securities and Exchange Commission that exempted the five largest of those banks from the regulation that had capped their debt-to-capital ratio at 12 to 1. The Age of Leverage had truly arrived for Planet Finance.
Credit and money, in other words, have for decades been growing more rapidly than underlying economic activity. Is it any wonder, then, that money has ceased to hold its value the way it did in the era of the gold standard? The motto "In God we trust" was added to the dollar bill in 1957.
Since then its purchasing power, relative to the consumer price index, has declined by a staggering 87 percent. Average annual inflation during that period has been more than 4 percent. A man who decided to put his savings into gold in 1970 could have bought just over 27.8 ounces of the precious metal for $1,000. At the time of writing, with gold trading at $900 an ounce, he could have sold it for around $25,000.
Those few goldbugs who always doubted the soundness of fiat money— paper currency without a metal anchor— have in large measure been vindicated. But why were the rest of us so blinded by money illusion?
Blowing Bubbles
In the immediate aftermath of the death of gold as the anchor of the monetary system, the problem of inflation affected mainly retail prices and wages. Today, only around one out of seven countries has an inflation rate above 10 percent, and only one, Zimbabwe, is afflicted with hyperinflation. But back in 1979 at least 7 countries had an annual inflation rate above 50 percent, and more than 60 countries— including Britain and the United States— had inflation in double digits.
Inflation has come down since then, partly because many of the items we buy— from clothes to computers— have gotten cheaper as a result of technological innovation and the relocation of production to low-wage economies in Asia. It has also been reduced because of a worldwide transformation in monetary policy, which began with the monetarist-inspired increases in short-term rates implemented by the Federal Reserve in 1979. Just as important, some of the structural drivers of inflation, such as powerful trade unions, have also been weakened.
By the 1980s, in any case, more and more people had grasped how to protect their wealth from inflation: by investing it in assets they expected to appreciate in line with, or ahead of, the cost of living. These assets could take multiple forms, from modern art to vintage wine, but the most popular proved to be stocks and real estate. Once it became clear that this formula worked, the Age of Leverage could begin.
For it clearly made sense to borrow to the hilt to maximize your holdings of stocks and real estate if these promised to generate higher rates of return than the interest payments on your borrowings. Between 1990 and 2004, most American households did not see an appreciable improvement in their incomes. Adjusted for inflation, the median household income rose by about 6 percent. But people could raise their living standards by borrowing and investing in stocks and housing.
Nearly all of us did it. And the bankers were there to help. Not only could they borrow more cheaply from one another than we could borrow from them; increasingly they devised all kinds of new mortgages that looked more attractive to us (and promised to be more lucrative to them) than boring old 30-year fixed-rate deals. Moreover, the banks were just as ready to play the asset markets as we were. Proprietary trading soon became the most profitable arm of investment banking: buying and selling assets on the bank’s own account.
Losing our shirt? The problem is that our banks are also losing theirs. Illustration by Barry Blitt.
There was, however, a catch. The Age of Leverage was also an age of bubbles, beginning with the dot-com bubble of the irrationally exuberant 1990s and ending with the real-estate mania of the exuberantly irrational 2000s. Why was this? The future is in large measure uncertain, so our assessments of future asset prices are bound to vary.
If we were all calculating machines, we would simultaneously process all the available information and come to the same conclusion. But we are human beings, and as such are prone to myopia and mood swings. When asset prices surge upward in sync, it is as if investors are gripped by a kind of collective euphoria. Conversely, when their "animal spirits" flip from greed to fear, the bubble that their earlier euphoria inflated can burst with amazing suddenness.
Zoological imagery is an integral part of the culture of Planet Finance. Optimistic buyers are "bulls," pessimistic sellers are "bears." The real point, however, is that stock markets are mirrors of the human psyche. Like Homo sapiens, they can become depressed. They can even suffer complete breakdowns.
This is no new insight. In the 400 years since the first shares were bought and sold on the Amsterdam Beurse, there has been a long succession of financial bubbles. Time and again, asset prices have soared to unsustainable heights only to crash downward again. So familiar is this pattern— described by the economic historian Charles Kindleberger— that it is possible to distill it into five stages:
(1) Displacement: Some change in economic circumstances creates new and profitable opportunities. (2) Euphoria, or overtrading: A feedback process sets in whereby expectation of rising profits leads to rapid growth in asset prices. (3) Mania, or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money. (4) Distress: The insiders discern that profits cannot possibly justify the now exorbitant price of the assets and begin to take profits by selling. (5) Revulsion, or discredit: As asset prices fall, the outsiders stampede for the exits, causing the bubble to burst.
The key point is that without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission and commission of central banks. The bubbles of our time had their origins in the aftermath of the 1987 stock-market crash, when then novice Federal Reserve chairman Alan Greenspan boldly affirmed the Fed’s "readiness to serve as a source of liquidity to support the economic and financial system."
This sent a signal to the markets, particularly the New York banks: if things got really bad, he stood ready to bail them out. Thus was born the "Greenspan put"— the implicit option the Fed gave traders to be able to sell their stocks at today’s prices even in the event of a meltdown tomorrow. Having so contained a panic once, Greenspan thereafter had a dilemma lurking in the back of his mind: whether or not to act pre-emptively the next time— to prevent a panic altogether.
This dilemma came to the fore as a classic stock-market bubble took shape in the mid-90s. The displacement in this case was the explosion of innovation by the technology and software industry as personal computers met the Internet. But, as in all of history’s bubbles, an accommodative monetary policy also played a role. From a peak of 6 percent in February 1995, the federal-funds target rate had been reduced to 5.25 percent by January 1996. It was then cut in steps, in the fall of 1998, down to 4.75 percent, and it remained at that level until June 1999, by which time the Dow had passed the 10,000 mark.
Why did the Fed allow euphoria to run loose in the 1990s? Partly because Greenspan and his colleagues underestimated the momentum of the technology bubble; as early as December 1995, with the Dow just past the 5,000 mark, members of the Fed’s Open Market Committee speculated that the market might be approaching its peak. Partly, also, because Greenspan came to the conclusion that it was not the Fed’s responsibility to worry about asset-price inflation [[which everybody but shortsellers seems to love: normxxx]], only consumer-price inflation, and this, he believed, was being reduced by a major improvement in productivity due precisely to the tech boom.
Greenspan could not postpone a stock-exchange crash indefinitely. After Silicon Valley’s dot-com bubble peaked, in March 2000, the U.S. stock market fell by almost half over the next two and a half years. It was not until May 2007 that investors in the Standard & Poor’s 500 had recouped their losses. [[But that was already quick enough so that all that those investors learned was to at least "hang on" (and maybe do some long term buying) in case of another bad dip: normxxx]] And perhaps the Fed’s response to the sell-off— and the massive shot of liquidity it injected into the financial markets after the 9/11 terrorist attacks— prevented the "correction" from precipitating a depression. [[And perhaps not; perhaps it only post-poned it. : normxxx]]
Not only were the 1930s averted; so too, it seemed, was a repeat of the Japanese experience after 1989, when a conscious effort by the central bank to prick an asset bubble had ended up triggering an 80 percent stock-market sell-off, a horrendous real-estate collapse, and a decade of economic stagnation [[and thoroughly terrifying Greenspan, setting him dead set against any attempt to "deflate" a bubble, ever: normxxx]]. What was not immediately obvious was that Greenspan’s easy-money policy was already generating another bubble— this time in the financial market that a majority of Americans have been encouraged for generations to play: the real-estate market.
The American Dream
Real estate is the English-speaking world’s favorite economic game. No other facet of financial life has such a hold on the popular imagination. The real-estate market is unique. Every adult, no matter how economically illiterate, has a view on its future prospects. Through the evergreen board game Monopoly, even children are taught how to climb the property ladder.
Once upon a time, people saved a portion of their earnings for the proverbial rainy day, stowing the cash in a mattress or a bank safe. The Age of Leverage, as we have seen, brought a growing reliance on borrowing to buy assets in the expectation of their future appreciation in value. For a majority of families, this meant a leveraged investment in a house. That strategy had one very obvious flaw. It represented a one-way, totally unhedged bet on a single asset.
To be sure, investing in housing paid off handsomely for more than half a century, up until 2006. Suppose you had put $100,000 into the U.S. property market back in the first quarter of 1987. According to the Case-Shiller national home-price index, you would have nearly tripled your money by the first quarter of 2007, to $299,000. On the other hand, if you had put the same money into the S&P 500, and had continued to re-invest the dividend income in that index, you would have ended up with $772,000 to play with— more than double what you would have made on bricks and mortar.
There is, obviously, [this] important difference between a house and a stock-market index. You cannot live in a stock-market index. For the sake of a fair comparison, allowance must therefore be made for the rent you save by owning your house (or the rent you can collect if you own a second property). A simple way to proceed is just to leave out both dividends and rents. In that case the difference is somewhat reduced. In the two decades after 1987, the S&P 500, excluding dividends, rose by a factor of just over six, meaning that an investment of $20,000 would be worth some $120,000. But that $100,000 house which we acquired for just $20,000 would still be worth $299,000— or about 14.95 times your original investment. [[Ah, the wonders of leverage in an UP market!: normxxx]]
There are three other considerations to bear in mind when trying to compare housing with other forms of assets. The first is depreciation. Stocks do not wear out and require new roofs; houses do. The second is liquidity. As assets, houses are a great deal more expensive [[and difficult: normxxx]] to convert into cash than stocks. The third is volatility. Housing markets since World War II have been far less volatile than stock markets.
Yet that is not to say that house prices have never deviated from a steady upward path. In Britain between 1989 and 1995, for example, the average house price fell by 18 percent, or, in inflation-adjusted terms, by more than a third— 37 percent. In London, the real decline was closer to 47 percent. In Japan between 1990 and 2000, property prices fell by more than 60 percent.
The recent decline of property prices in the United States should therefore have come as less of a shock than it did. Between July 2006 and June 2008, the Case-Shiller index of home prices in 20 big American cities declined on average by 19 percent. In some of these cities— Phoenix, San Diego, Los Angeles, and Miami— the total decline was as much as a third. Seen in international perspective, those are not unprecedented figures. Seen in the context of the post-2000 bubble, prices have yet to return to their starting point. On average, house prices are still 50 percent higher than they were at the beginning of this process.
So why were we oblivious to the likely bursting of the real-estate bubble? The answer is that for generations we have been brainwashed into thinking that borrowing to buy a house is the only rational financial strategy to pursue. Think of Frank Capra’s classic 1946 movie, It’s a Wonderful Life, which tells the story of the family-owned Bailey Building & Loan, a small-town mortgage firm that George Bailey (played by James Stewart) struggles to keep afloat in the teeth of the Depression.
"You know, George," his father tells him, "I feel that in a small way we are doing something important. It’s satisfying a fundamental urge. It’s deep in the race for a man to want his own roof and walls and fireplace, and we’re helping him get those things in our shabby little office." George gets the message, as he passionately explains to the villainous slumlord Potter after Bailey Sr.’s death: "[My father] never once thought of himself.… But he did help a few people get out of your slums, Mr. Potter. And what’s wrong with that? … Doesn’t it make them better citizens? Doesn’t it make them better customers?"
There, in a nutshell, is one of the key concepts of the 20th century: the notion that property ownership enhances citizenship, and that therefore a property-owning democracy is more socially and politically stable than a democracy divided into an elite of landlords and a majority of property-less tenants. So deeply rooted is this idea in our political culture that it comes as a surprise to learn that it was invented just 70 years ago.
Fannie, Ginnie, And Freddie
Prior to the 1930s, only a minority of Americans owned their own homes. During the Depression, however, the Roosevelt administration created a whole complex of institutions to change that. A Federal Home Loan Bank Board was set up in 1932 to encourage and oversee local mortgage lenders known as savings-and-loans (S&Ls)— mutual associations that took in deposits and lent to homebuyers.
Under the New Deal, the Home Owners’ Loan Corporation stepped in to refinance mortgages on longer terms, up to 15 years. To reassure depositors, who had been traumatized by the thousands of bank failures of the previous three years, Roosevelt introduced federal deposit insurance. And by providing federally backed insurance for mortgage lenders, the Federal Housing Administration (F.H.A.) sought to encourage large (up to 80 percent of the purchase price), long (20— to 25-year), fully amortized, low-interest loans.
By standardizing the long-term mortgage and creating a national system of official inspection and valuation, the F.H.A. laid the foundation for a secondary market in mortgages. This market came to life in 1938, when a new Federal National Mortgage Association— nicknamed Fannie Mae— was authorized to issue bonds and use the proceeds to buy mortgages from the local S&Ls, which were restricted by regulation both in terms of geography (they could not lend to borrowers more than 50 miles from their offices) and in terms of the rates they could offer (the so-called Regulation Q, which imposed a low ceiling on interest paid on deposits). Because these changes tended to reduce the average monthly payment on a mortgage, the F.H.A. made home ownership viable for many more Americans than ever before.
Indeed, it is not too much to say that the modern United States, with its seductively samey suburbs, was born with Fannie Mae. Between 1940 and 1960, the home-ownership rate soared from 43 to 62 percent. These were not the only ways in which the federal government sought to encourage Americans to own their own homes. Mortgage-interest payments were always tax-deductible, from the inception of the federal income tax in 1913. As Ronald Reagan said when the rationality of this tax break was challenged, mortgage-interest relief was "part of the American dream."
In 1968, to broaden the secondary-mortgage market still further, Fannie Mae was split in two— the Government National Mortgage Association (Ginnie Mae), which was to cater to poor borrowers, and a rechartered Fannie Mae, now a privately owned government-sponsored enterprise (G.S.E.). Two years later, to provide competition for Fannie Mae, the Federal Home Loan Mortgage Corporation (Freddie Mac) was set up. In addition, Fannie Mae and Freddie Mac were permitted to buy conventional as well as government-guaranteed mortgages. Later, with the Community Reinvestment Act of 1977, American banks also found themselves under pressure for the first time to lend to poor, minority communities.
These changes presaged a more radical modification to the New Deal system. In the late 1970s, the savings-and-loan industry was hit first by double-digit inflation and then by sharply rising interest rates. This double punch was potentially lethal. The S&Ls were simultaneously losing money on long-term, fixed-rate mortgages, due to inflation, and hemorrhaging deposits to higher-interest money-market funds.
The response in Washington from both the Carter and Reagan administrations was to try to salvage the S&Ls with tax breaks and deregulation. When the new legislation was passed, President Reagan declared, "All in all, I think we hit the jackpot." Some people certainly did.
On the one hand, S&Ls could now invest in whatever they liked, not just local long-term mortgages. Commercial property, stocks, junk bonds— anything was allowed. They could even issue credit cards. On the other, they could now pay whatever interest rate they liked to depositors. Yet all their deposits were still effectively insured, with the maximum covered amount raised from $40,000 to $100,000, thanks to a government regulation two years earlier.
And if ordinary deposits did not suffice, the S&Ls could raise money in the form of brokered deposits from middlemen. What happened next perfectly illustrated the great financial precept first enunciated by William Crawford, the commissioner of the California Department of Savings and Loan: "The best way to rob a bank is to own one." Some S&Ls bet their depositors’ money on highly dubious real-estate developments. Many simply stole the money, as if deregulation meant that the law no longer applied to them at all.
When the ensuing bubble burst, nearly 300 S&Ls collapsed, while another 747 were closed or reorganized under the auspices of the Resolution Trust Corporation, established by Congress in 1989 to clear up the mess. The final cost of the crisis was $153 billion (around 3 percent of the 1989 G.D.P.), of which taxpayers had to pay $124 billion.
But even as the S&Ls were going belly-up, they offered another, very different group of American financial institutions a fast track to megabucks. To the bond traders at Salomon Brothers, the New York investment bank, the breakdown of the New Deal mortgage system was not a crisis but a wonderful opportunity. As profit-hungry as their language was profane, the self-styled "Big Swinging Dicks" at Salomon saw a way of exploiting the gyrating interest rates of the early 1980s.
The idea was to re-invent mortgages by bundling thousands of them together as the backing for new and alluring securities that could then be 'sliced up' and sold as alternatives to traditional government and corporate bonds— in short, to convert mortgages into bonds. Once lumped together, the interest payments due on the mortgages could be subdivided into strips with different maturities and credit risks. The first issue of this new kind of mortgage-backed security (known as a "collateralized mortgage obligation") occurred in June 1983. The dawn of securitization was a necessary prelude to the Age of Leverage.
Once again, however, it was the federal government that stood ready to pick up the tab in a crisis. For the majority of mortgages continued to enjoy an implicit guarantee from the government-sponsored trio of Fannie, Freddie, and Ginnie, meaning that bonds which used those mortgages as collateral could be represented as virtual government bonds and considered "investment grade." Between 1980 and 2007, the volume of such G.S.E.-backed mortgage-backed securities grew from less than $200 billion to more than $4 trillion. In 1980 only 10 percent of the home-mortgage market was securitized; by 2007, 56 percent of it was.
These changes swept away the last vestiges of the business model depicted in 'It’s a Wonderful Life'. Once there had been meaningful social ties between mortgage lenders and borrowers. James Stewart’s character knew both the depositors and the debtors. By contrast, in a securitized market, the interest you paid on your mortgage ultimately went to someone who had no idea you existed. The full implications of this transition for ordinary homeowners would become apparent only 25 years later.
The Lessons Of Detroit
In July 2007, I paid a visit to Detroit, because I had the feeling that what was happening there was the shape of things to come in the United States as a whole. In the space of 10 years, house prices in Detroit, which probably possesses the worst housing stock of any American city other than New Orleans, had risen by more than a third— not much compared with the nationwide bubble, but still hard to explain, given the city’s chronically depressed economic state. As I discovered, the explanation lay in fundamental changes in the rules of the housing game.
I arrived at the end of a borrowing spree. For several years agents and brokers selling subprime mortgages had been flooding Detroit with radio, television, and direct-mail advertisements, offering what sounded like attractive deals. In 2006, for example, subprime lenders pumped more than a billion dollars into 22 Detroit Zip Codes.
These were not the old 30-year fixed-rate mortgages invented in the New Deal. On the contrary, a high proportion were adjustable-rate mortgages— in other words, the interest rate could vary according to changes in short-term lending rates. Many were also interest-only mortgages, without amortization (repayment of principal), even when the principal represented 100 percent of the assessed value of the mortgaged property.
And most had introductory "teaser" periods, whereby the initial interest payments— usually for the first two years— were kept artificially low, with the cost of the loan backloaded. All of these devices were intended to allow an immediate reduction in the debt-servicing costs of the borrower. In Detroit at that time, only a minority of these loans were going to first-time buyers.
They were nearly all refinancing deals, which allowed borrowers to treat their homes as cash machines, converting their existing equity into cash and using the proceeds to pay off credit-card debts, carry out renovations, or buy new consumer durables. However, the combination of declining long-term interest rates and ever more alluring mortgage deals did attract new buyers into the housing market. By 2005, 69 percent of all U.S. householders were homeowners; 10 years earlier it had been 64 percent. About half of that increase could be attributed to the subprime-lending boom.
Significantly, a disproportionate number of subprime borrowers belonged to ethnic minorities. Indeed, I found myself wondering, as I drove around Detroit, if "subprime" was in fact a new financial euphemism for "black." This was no idle supposition. According to a joint study by, among others, the Massachusetts Affordable Housing Alliance, 55 percent of black and Latino borrowers in Boston who had obtained loans for single-family homes in 2005 had been given subprime mortgages; the figure for white borrowers was just 13 percent.
More than three-quarters of black and Latino borrowers from Washington Mutual were classed as subprime, whereas only 17 percent of white borrowers were. According to a report in The Wall Street Journal, minority ownership increased by 3.1 million between 2002 and 2007. Here, surely, was the zenith of the property-owning democracy. It was an achievement that the Bush administration was proud of.
"We want everybody in America to own their own home," President George W. Bush had said in October 2002. Having challenged lenders to create 5.5 million new minority homeowners by the end of the decade, Bush signed the American Dream Downpayment Act in 2003, a measure designed to subsidize first-time house purchases in low-income groups. Between 2000 and 2006, the share of undocumented subprime contracts rose from 17 to 44 percent.
Fannie Mae and Freddie Mac also came under pressure from the Department of Housing and Urban Development to support the subprime market. As Bush put it in December 2003, "It is in our national interest that more people own their own home." Few people dissented.
As a business model, subprime lending worked beautifully— as long, that is, as interest rates stayed low, people kept their jobs, and real-estate prices continued to rise. Such conditions could not be relied upon to last, however, least of all in a city like Detroit. But that did not worry the subprime lenders. They simply followed the trail blazed by mainstream mortgage lenders in the 1980s. Having pocketed fat commissions on the signing of the original loan contracts, they hastily resold their loans in bulk to Wall Street banks.
The banks, in turn, bundled the loans into high-yielding mortgage-backed securities and sold them to investors around the world, all eager for a few hundredths of a percentage point more of return on their capital. Repackaged as C.D.O.’s, these subprime securities could be transformed from risky loans to flaky borrowers into triple-A-rated investment-grade securities. All that was required was certification from one of the rating agencies that at least the top tier of these securities was unlikely to go into default.
The risk was spread across the globe, from American state pension funds to public-hospital networks in Australia, to town councils near the Arctic Circle. In Norway, for example, eight municipalities, including Rana and Hemnes, invested some $120 million of their taxpayers’ money in C.D.O.’s secured on American subprime mortgages.
In Detroit the rise of subprime mortgages had in fact coincided with a new slump in the inexorably declining automobile industry. That anticipated a wider American slowdown, an almost inevitable consequence of a tightening of monetary policy as the Federal Reserve belatedly raised short-term interest rates from 1 percent to 5.25 percent. As soon as the teaser rates expired and mortgages were reset at new and much higher interest rates, hundreds of Detroit households swiftly fell behind in their mortgage payments.
The effect was to burst the real-estate bubble, causing house prices to start falling significantly for the first time since the early 1990s. And the further house prices fell, the more homeowners found themselves with "negative equity"— in other words, owing more money than their homes were worth. The rest— the chain reaction as defaults in Detroit and elsewhere unleashed huge losses on C.D.O.’s in financial institutions all around the world— you know.
Drunk On Derivatives
Do you, however, know about the second-order effects of this crisis in the markets for derivatives? Do you in fact know what a derivative is? Once excoriated by Warren Buffett as "financial weapons of mass destruction," derivatives are what make this crisis both unique and unfathomable in its ramifications. To understand what they are, you need, literally, to go back to the future.
For a farmer planting a crop, nothing is more crucial than the future price it will fetch after it has been harvested and taken to market. A futures contract allows him to protect himself by committing a merchant to buy his crop when it comes to market at a price agreed upon when the seeds are being planted. If the market price on the day of delivery is lower than expected, the farmer is protected.
The earliest forms of protection for farmers were known as forward contracts, which were simply bilateral agreements between seller and buyer. A true futures contract, however, is a standardized instrument issued by a futures exchange and hence tradable. With the development of a standard "to arrive" futures contract, along with a set of rules to enforce settlement and, finally, an effective clearinghouse, the first true futures market was born.
Because they are derived from the value of underlying assets, all futures contracts are forms of derivatives. Closely related, though distinct from futures, are the contracts known as options. In essence, the buyer of a "call" option has the right, but not the obligation, to buy an agreed-upon quantity of a particular commodity or financial asset from the seller ("writer") of the option at a certain time (the expiration date) for a certain price (known as the "strike price").
Clearly, the buyer of a call option expects the price of the underlying instrument to rise in the future. When the price passes the agreed-upon strike price, the option is "in the money"— and so is the smart guy who bought it. A "put" option is just the opposite: the buyer has the right but not the obligation to sell an agreed-upon quantity of something to the seller of the option at an agreed-upon price.
A third kind of derivative is the interest-rate "swap," which is effectively a bet between two parties on the future path of interest rates. A pure interest-rate swap allows two parties already receiving interest payments literally to swap them, allowing someone receiving a variable rate of interest to exchange it for a fixed rate, in case interest rates decline. A credit-default swap (C.D.S.), meanwhile, offers protection against a company’s defaulting on its bonds.
Bringing down the bull: The pain of America’s financial crisis is felt all over the world. Illustration by Brad Holland.
There was a time when derivatives were standardized instruments traded on exchanges such as the Chicago Board of Trade. Now, however, the vast proportion are custom-made and sold "over the counter" (O.T.C.), often by banks, which charge attractive commissions for their services, but also by insurance companies (notably A.I.G.). According to the Bank for International Settlements, the total notional amounts outstanding of O.T.C. derivative contracts— arranged on an ad hoc basis between two parties— reached a staggering $596 trillion in December 2007, [[$684 trillion by June 2008: normxxx]] with a gross market value of just over $14.5 trillion.
But how exactly do you price a derivative? What precisely is an option worth? The answers to those questions required a revolution in financial theory. From an academic point of view, what this revolution achieved was highly impressive. But the events of the 1990s, as the rise of quantitative finance replaced preppies with quants (quantitative analysts) all along Wall Street, revealed a new truth: those whom the gods want to destroy they first teach math.
Working closely with Fischer Black, of the consulting firm Arthur D. Little, M.I.T.’s Myron Scholes invented a groundbreaking new theory of pricing options, to which his colleague Robert Merton also contributed. (Scholes and Merton would share the 1997 Nobel Prize in economics.) They reasoned that a call option’s value depended on six variables: the current market price of the stock (S), the agreed future price at which the stock could be bought (L), the time until the expiration date of the option (t), the risk-free rate of return in the economy as a whole (r), the probability that the option will be exercised (N), and— the crucial variable— the expected volatility of the stock, i.e., the likely fluctuations of its price between the time of purchase and the expiration date(s). With wonderful mathematical wizardry, the quants reduced the price of a call option to this formula (the Black-Scholes formula):
in which:
Feeling a bit baffled? Can’t follow the algebra? That was just fine by the quants. To make money from this magic formula, they needed markets to be full of people who didn’t have a clue about how to price options but relied instead on their (seldom accurate) gut instincts. They also needed a great deal of computing power, a force which had been transforming the financial markets since the early 1980s. Their final requirement was a partner with some market savvy in order to make the leap from the faculty club to the trading floor.
Black, who would soon be struck down by cancer, could not be that partner. But John Meriwether could. The former head of the bond-arbitrage group at Salomon Brothers, Meriwether had made his first fortune in the wake of the S&L meltdown of the late 1980s. The hedge fund he created with Scholes and Merton in 1994 was called Long-Term Capital Management.
In its brief, four-year life, Long-Term was the brightest star in the hedge-fund firmament, generating mind-blowing returns for its elite club of investors and even more money for its founders. Needless to say, the firm did more than just trade options, though selling puts on the stock market became such a big part of its business that it was nicknamed "the central bank of volatility" by banks buying insurance against a big stock-market sell-off.
In fact, the partners were simultaneously pursuing multiple trading strategies, about 100 of them, with a total of 7,600 positions. This conformed to a second key rule of the new mathematical finance: the virtue of diversification, a principle that had been formalized by Harry M. Markowitz, of the Rand Corporation. Diversification was all about having a multitude of uncorrelated positions. One might go wrong, or even [a dozen]. But thousands just could not go wrong simultaneously.
The mathematics were reassuring. According to the firm’s "Value at Risk" models, it would take a 10-s (in other words, a 10-standard-deviation) event to cause the firm to lose all its capital in a single year. But the probability of such an event, according to the quants, was 1 in 1024— or effectively zero. Indeed, the models said the most Long-Term was likely to lose in a single day was $45 million. For that reason, the partners felt no compunction about leveraging their trades. At the end of August 1997, the fund’s capital was $6.7 billion, but the debt-financed assets on its balance sheet amounted to $126 billion, a ratio of assets to capital of 19 to 1.[[Pretty conservative, by today's standards.: normxxx]]
There is no need to rehearse here the story of Long-Term’s downfall, which was precipitated by the Russian debt default. Suffice it to say that on Friday, August 21, 1998, the firm lost $550 million— 15 percent of its entire capital, and vastly more than its mathematical models had said was possible. The key point is to appreciate why the quants were so wrong.
The problem lay with the assumptions that underlie so much of mathematical finance. In order to construct their models, the quants had to postulate a planet where the inhabitants were omniscient and perfectly rational; where they instantly absorbed all new information and used it to maximize profits; where they never stopped trading; where markets were continuous, frictionless, and completely liquid. Financial markets on this planet followed a "random walk," meaning that each day’s prices were quite unrelated to the previous day’s, but reflected no more and no less than all the relevant information currently available.
The returns on this planet’s stock market were normally distributed along the bell curve, with most years clustered closely around the mean, and two-thirds of them within one standard deviation of the mean. On such a planet, a "six standard deviation" sell-off would be about as common as a person shorter than one foot in our world. It would happen only once in four million years of trading.
But Long-Term was not located on Planet Finance. It was based in Greenwich, Connecticut, on Planet Earth, a place inhabited by emotional human beings, always capable of flipping suddenly and en masse from greed to fear. In the case of Long-Term, the herding problem was acute, because many other firms had begun trying to 'copy' Long-Term’s strategies in the hope of replicating its stellar performance.
When things began to go wrong, there was a truly bovine stampede for the exits. The result was a massive, synchronized downturn in virtually all [[of LTCM's: normxxx]] asset markets. Diversification was no defense in such a crisis. As one leading London hedge-fund manager later put it to Meriwether, "John, you were the correlation."
There was, however, another reason why Long-Term failed. The quants’ Value at Risk models had implied that the loss the firm suffered in August 1998 was so unlikely that it ought never to have happened in the entire life of the universe. But that was because the models were working with just five years of data. If they had gone back even 11 years, they would have captured the 1987 stock-market crash. If they had gone back 80 years they would have captured the last great Russian default, after the 1917 revolution.
Meriwether himself, born in 1947, ruefully observed, "If I had lived through the Depression, I would have been in a better position to understand events." To put it bluntly, the Nobel Prize winners knew plenty of mathematics but not enough history. One might assume that, after the catastrophic failure of L.T.C.M., quantitative hedge funds would have vanished from the financial scene, and derivatives such as options would be sold a good deal more circumspectly.
Yet the very reverse happened. Far from declining, in the past 10 years hedge funds of every type have exploded in number and in the volume of assets they manage, with quantitative hedge funds such as Renaissance, Citadel, and D. E. Shaw emerging as leading players. [[Because, in the short run, they made phenomenal amounts of money; and, as John Maynard Keynes put it, "'In the long run' is a misleading guide to current affairs. 'In the long run', we are all dead.": normxxx]] The growth of derivatives has also been spectacular— and it has continued despite the onset of the credit crunch. Between December 2005 and December 2007, the notional amounts outstanding for all derivatives increased from $298 trillion to $596 trillion [[to $684 trillion by June 2008: normxxx]]. Credit-default swaps quadrupled, from $14 trillion to $58 trillion.
An intimation of the problems likely to arise came in September, when the government takeover of Fannie and Freddie cast doubt on the status of derivative contracts protecting the holders of more than $1.4 trillion of their bonds against default. The consequences of the failure of Lehman Brothers were substantially greater, because the firm was the counter-party in so many derivative contracts. The big question is whether those active in the market waited too long to set up some kind of formal clearing mechanism. If, as seems inevitable, there is an upsurge in corporate defaults as the U.S. slides into recession, the whole system could completely seize up.
The China Syndrome
Just 10 years ago, during the Asian crisis of 1997–98, it was conventional wisdom that financial crises were more likely to happen on the periphery of the world economy— in the so-called emerging markets of East Asia and Latin America. Yet the biggest threats to the global financial system in this new century have come not from the periphery but from the core. The explanation for this strange role reversal may in fact lie in the way emerging markets changed their behavior after 1998.
For many decades it was assumed that poor countries could become rich only by borrowing capital from wealthy countries. Recurrent debt crises and currency crises associated with sudden withdrawals of Western money led to a rethinking, inspired largely by the Chinese example. When the Chinese wanted to attract foreign capital, they insisted that it take the form of direct investment.
That meant that instead of borrowing from Western banks to finance its industrial development, as many emerging markets did, China got foreigners to build factories in Chinese enterprise zones— large, lumpy assets that could not easily be withdrawn in a crisis. The crucial point, though, is that the bulk of Chinese investment has been financed from China’s own savings. Cautious after years of instability and unused to the panoply of credit facilities we have in the West, Chinese households save a high proportion of their rising incomes, in marked contrast to Americans, who in recent years have saved almost none at all.
Chinese corporations save an even larger proportion of their soaring profits. The remarkable thing is that a growing share of that savings surplus has ended up being lent to the United States. In effect, the People’s Republic of China has become banker to the United States of America.
The Chinese have not been acting out of altruism. Until very recently, the best way for China to employ its vast population was by exporting manufactured goods to the spendthrift U.S. consumer. To ensure that those exports were irresistibly cheap, China had to fight the tendency for its currency to strengthen against the dollar by buying literally billions of dollars on world markets.
In 2006, Chinese holdings of dollars reached 700 billion. Other Asian and Middle Eastern economies adopted much the same strategy. The benefits for the United States were manifold. Asian imports kept down U.S. inflation. Asian labor kept down U.S. wage costs. Above all, Asian savings kept down U.S. interest rates.
But there was a catch. The more Asia was willing to lend to the United States, the more Americans were willing to borrow. The 'Asian savings glut' was thus the underlying cause of the surge in bank lending, bond issuance, and new derivative contracts that Planet Finance witnessed after 2000. It was the underlying cause of the hedge-fund population explosion. It was the underlying reason why private-equity partnerships were able to borrow money left, right, and center to finance leveraged buyouts.
And it was the underlying reason why the U.S. mortgage market was so awash with cash by 2006 that you could get a 100 percent mortgage with no income, no job, and no assets. Whether or not China is now sufficiently "decoupled" from the United States that it can insulate itself from our credit crunch remains to be seen. At the time of writing, however, it looks very doubtful.
Back To Reality
The modern financial system is the product of centuries of economic evolution. Banks transformed money from metal coins into accounts, allowing ever larger aggregations of borrowing and lending. From the Renaissance on, government bonds introduced the securitization of streams of interest payments.
From the 17th century on, equity in corporations could be bought and sold in public stock markets. From the 18th century on, central banks slowly learned how to moderate or exacerbate the business cycle. From the 19th century on, insurance was supplemented by futures, the first derivatives. And from the 20th century on, households were encouraged by government to skew their portfolios in favor of real estate.
Economies that combined all these institutional innovations performed better over the long run than those that did not, because financial intermediation generally permits a more efficient allocation of resources than, say, feudalism or central planning. For this reason, it is not wholly surprising that the Western financial model tended to spread around the world, first in the guise of imperialism, then in the guise of globalization. Yet money’s ascent has not been, and can never be, a smooth one.
On the contrary, financial history is a roller-coaster ride of ups and downs, bubbles and busts, manias and panics, shocks and crashes. The excesses of the Age of Leverage— the deluge of paper money, the asset-price inflation, the explosion of consumer and bank debt, and the hypertrophic growth of derivatives— were bound sooner or later to produce a really big crisis. It remains unclear whether this crisis will have economic and social effects as disastrous as those of the Great Depression, or whether the monetary and fiscal authorities will succeed in achieving a Great Repression, averting a 1930s-style "great contraction" of credit and output by transferring the as yet unquantifiable losses from banks to taxpayers.
Either way, Planet Finance has now returned to Planet Earth with a bang. The key figures of the Age of Leverage— the lax central bankers, the reckless investment bankers, the hubristic quants— are now feeling the full force of this planet’s gravity. But what about the rest of us, the rank-and-file members of the deluded crowd? Well, we shall now have to question some of our most deeply rooted assumptions— not only about the benefits of paper money but also about the rationale of the property-owning democracy itself.
On Planet Finance it may have made sense to borrow billions of dollars to finance a massive speculation on the future prices of American houses, and then to erect on the back of this trade a vast inverted pyramid of incomprehensible securities and derivatives. But back here on Planet Earth it suddenly seems like an 'extraordinary popular delusion'.
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Normxxx
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Niall Ferguson, VanityFair | December 2008
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The bigger they come: Uncle Sam and Wall Street take the hardest fall since the Depression. Illustration by Tim Bower.
This year we have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. Two years ago, in 2006, the measured economic output of the entire world was worth around $48.6 trillion. The total market capitalization of the world’s stock markets was $50.6 trillion, 4 percent larger. The total value of domestic and international bonds was $67.9 trillion, 40 percent larger. Planet Finance was beginning to dwarf Planet Earth.
Planet Finance seemed to spin faster, too. Every day $3.1 trillion changed hands on foreign-exchange markets. Every month $5.8 trillion changed hands on global stock markets. And all the time new financial life-forms were evolving. The total annual issuance of mortgage-backed securities, including fancy new "collateralized debt obligations" (C.D.O.’s), rose to more than $1 trillion.
The volume of "derivatives"— contracts such as options and swaps— grew even faster, so that by the end of 2006 their notional value was just over $400 trillion. Before the 1980s, such things were virtually unknown. In the space of a few years their populations exploded. On Planet Finance, the securities outnumbered the people; the transactions outnumbered the relationships.
New institutions also proliferated. In 1990 there were just 610 hedge funds, with $38.9 billion under management. At the end of 2006 there were 9,462, with $1.5 trillion under management. Private-equity partnerships also went forth and multiplied. Banks, meanwhile, set up a host of "conduits" and "structured investment vehicles" (sivs— surely the most apt acronym in financial history) to keep potentially risky assets off their balance sheets. It was as if an entire shadow banking system had come into being.
Then, beginning in the summer of 2007, Planet Finance began to self-destruct in what the International Monetary Fund soon acknowledged to be "the largest financial shock since the Great Depression." Did the crisis of 2007–8 happen because American companies had gotten worse at designing new products? Had the pace of technological innovation or productivity growth suddenly slackened? No. The proximate cause of the economic uncertainty of 2008 was financial: to be precise, a crunch in the credit markets triggered by mounting defaults on a hitherto obscure species of housing loan known euphemistically as "subprime mortgages."
Central banks in the United States and Europe sought to alleviate the pressure on the banks with interest-rate cuts and offers of funds through special "term auction facilities." Yet the market rates at which banks could borrow money, whether by issuing commercial paper, selling bonds, or borrowing from one another, failed to follow the lead of the official federal-funds rate. The banks had to turn not only to Western central banks for short-term assistance to rebuild their reserves but also to Asian and Middle Eastern sovereign-wealth funds for equity injections. When these sources proved insufficient, investors— and speculative short-sellers— began to lose faith.
Beginning with Bear Stearns, Wall Street’s investment banks entered a death spiral that ended with their being either taken over by a commercial bank (as Bear was, followed by Merrill Lynch) or driven into bankruptcy (as Lehman Brothers was). In September the two survivors— Goldman Sachs and Morgan Stanley— formally ceased to be investment banks, signaling the death of a business model that dated back to the Depression. Other institutions deemed "too big to fail" by the U.S. Treasury were effectively taken over by the government, including the mortgage lenders and guarantors Fannie Mae and Freddie Mac and the insurance giant American International Group (A.I.G.).
By September 18 the U.S. financial system was gripped by such panic that the Treasury had to abandon this ad hoc policy. Treasury Secretary Henry Paulson hastily devised a plan whereby the government would be authorized to buy "troubled" securities with up to $700 billion of taxpayers’ money— a figure apparently plucked from the air. When a modified version of the measure was rejected by Congress 11 days later, there was panic. When it was passed four days after that, there was more panic. Now it wasn’t just bank stocks that were tanking.
The entire stock market seemed to be in free fall as fears mounted that the credit crunch was going to trigger a recession. Moreover, the crisis was now clearly global in scale. European banks were in much the same trouble [[or even worse than: normxxx]] their American counterparts, while emerging-market stock markets were crashing. A week of frenetic improvisation by national governments culminated on the weekend of October 11–12, when the United States reluctantly followed the British government’s lead, buying equity stakes in banks rather than just their dodgy assets and offering unprecedented guarantees of banks’ debt and deposits.
Since these events coincided with the final phase of a U.S. presidential-election campaign, it was not surprising that some rather simplistic lessons were soon being touted by candidates and commentators. The crisis, some said, was the result of excessive deregulation of financial markets. Others sought to lay the blame on unscrupulous speculators: short-sellers, who borrowed the stocks of vulnerable banks and sold them in the expectation of further price declines. Still other suspects in the frame were negligent regulators and corrupt congressmen.
This hunt for scapegoats is futile. To understand the downfall of Planet Finance, you need to take several steps back and locate this crisis in the long run of financial history. Only then will you see that we have all played a part in this latest sorry example of what the Victorian journalist Charles Mackay described in his 1841 book, Extraordinary Popular Delusions and the Madness of Crowds.
Nothing New
As long as there have been banks, bond markets, and stock markets, there have been financial crises. Banks went bust in the days of the Medici. There were bond-market panics in the Venice of Shylock’s day. And the world’s first stock-market crash happened in 1720, when the Mississippi Company— the Enron of its day— blew up. According to economists Carmen Reinhart and Kenneth Rogoff, the financial history of the past 800 years is a litany of debt defaults, banking crises, currency crises, and inflationary spikes.
Moreover, financial crises seldom happen without inflicting pain on the wider economy. Another recent paper, co-authored by Rogoff’s Harvard colleague Robert Barro, has identified 148 crises since 1870 in which a country experienced a cumulative decline in gross domestic product (G.D.P.) of at least 10 percent, implying a probability of financial disaster of around 3.6 percent per year.
If stock-market movements followed the normal-distribution, or bell, curve, like human heights, an annual drop of 10 percent or more would happen only once every 500 years, whereas in the case of the Dow Jones Industrial Average it has happened in 20 of the last 100 years. And stock-market plunges of 20 percent or more would be unheard of— rather like people a foot and a half tall— whereas in fact there have been eight such crashes in the past century.
The most famous financial crisis— the Wall Street Crash— is conventionally said to have begun on "Black Thursday," October 24, 1929, when the Dow declined by 2 percent, though in fact the market had been slipping since early September and had suffered a sharp, 6 percent drop on October 23. On "Black Monday," October 28, it plunged by 13 percent, and the next day by a further 12 percent. In the course of the next three years the U.S. stock market declined by a staggering 89 percent, reaching its nadir in July 1932. The index did not regain its 1929 peak until November 1954.
That helps put our current troubles into perspective. From its peak of 14,164, on October 9, 2007, to a dismal level of 8,579, exactly a year later, the Dow declined by 39 percent. By contrast, on a single day just over two decades ago— October 19, 1987— the index fell by 23 percent, one of only four days in history when the index has fallen by more than 10 percent in a single trading session.
This crisis, however, is about much more than just the stock market. It needs to be understood as a fundamental breakdown of the entire financial system, extending from the monetary-and-banking system through the bond market, the stock market, the insurance market, and the real-estate market. It affects not only established financial institutions such as investment banks but also relatively novel ones such as hedge funds. It is global in scope and unfathomable in scale.
Had it not been for the frantic efforts of the Federal Reserve and the Treasury, to say nothing of their counterparts in almost equally afflicted Europe, there would by now have been a repeat of that "great contraction" of credit and economic activity that was the prime mover of the Depression. Back then, the Fed and the Treasury did next to nothing to prevent bank failures from translating into a drastic contraction of credit and hence of business activity and employment. If the more openhanded monetary and fiscal authorities of today are ultimately successful in preventing a comparable slump of output, future historians may end up calling this "the Great Repression." This is the Depression they are hoping to bottle up— a Depression in denial.
To understand why we have come so close to a rerun of the 1930s, we need to begin at the beginning, with banks and the money they make. From the Middle Ages until the mid-20th century, most banks made their money by maximizing the difference between the costs of their liabilities (payments to depositors) and the earnings on their assets (interest and commissions on loans). Some banks also made money by financing trade, discounting the commercial bills issued by merchants.
Others issued and traded bonds and stocks, or dealt in commodities (especially precious metals). But the core business of banking was simple. It consisted, as the third Lord Rothschild pithily put it, "essentially of facilitating the movement of money from Point A, where it is, to Point B, where it is needed."
The system evolved gradually. First came the invention of cashless intra-bank and inter-bank transactions, which allowed debts to be settled between account holders without having money physically change hands. Then came the idea of fractional-reserve banking, whereby banks kept only a small proportion of their existing deposits on hand to satisfy the needs of depositors (who seldom wanted all their money simultaneously), allowing the rest to be lent out profitably. That was followed by the rise of special public banks with monopolies on the issuing of banknotes and other powers and privileges: the first central banks.
With these innovations, money ceased to be understood as precious metal minted into coins. Now it was the sum total of specific liabilities (deposits and reserves) incurred by banks. Credit was the other side of banks’ balance sheets: the total of their assets; in other words, the loans they made. Some of this money might still consist of precious metal, though a rising proportion of that would be held in the central bank’s vault. Most would be made up of banknotes and coins recognized as "legal tender," along with money that was visible only in current— and deposit-account statements.
Until the late 20th century, the system of bank money retained an anchor in the pre-modern conception of money in the form of the 'gold standard': fixed ratios between units of account and quantities of precious metal. As early as 1924, the English economist John Maynard Keynes dismissed the gold standard as a "barbarous relic," but the last vestige of the system did not disappear until August 15, 1971— the day President Richard Nixon closed the so-called gold window, through which foreign central banks could still exchange dollars for gold. With that, the centuries-old link between money and precious metal was broken.
Though we tend to think of money today as being made of paper, in reality most of it now consists of 'bank deposits'. If we measure the ratio of actual money to output in developed economies, it becomes clear that the trend since the 1970s has been for that ratio to rise from around 70 percent, before the closing of the gold window, to more than 100 percent by 2005. The corollary has been a parallel growth of credit on the other side of bank balance sheets.
A significant component of that credit growth has been a surge of lending to consumers. Back in 1952, the ratio of household debt to disposable income was less than 40 percent in the United States. At its peak in 2007, it reached 133 percent, up from 90 percent a decade before. Today Americans carry a total of $2.56 trillion in consumer debt, up by more than a fifth since 2000.
Even more spectacular, however, has been the rising indebtedness of banks themselves. In 1980, bank indebtedness was equivalent to 21 percent of U.S. gross domestic product. In 2007 the figure was 116 percent. Another measure of this was the declining capital adequacy of banks. On the eve of "the Great Repression," average bank capital in Europe was equivalent to less than 10 percent of assets; at the beginning of the 20th century, it was around 25 percent. It was not unusual for investment banks’ balance sheets to be as much as 20 or 30 times larger than their capital, thanks in large part to a 2004 rule change by the Securities and Exchange Commission that exempted the five largest of those banks from the regulation that had capped their debt-to-capital ratio at 12 to 1. The Age of Leverage had truly arrived for Planet Finance.
Credit and money, in other words, have for decades been growing more rapidly than underlying economic activity. Is it any wonder, then, that money has ceased to hold its value the way it did in the era of the gold standard? The motto "In God we trust" was added to the dollar bill in 1957.
Since then its purchasing power, relative to the consumer price index, has declined by a staggering 87 percent. Average annual inflation during that period has been more than 4 percent. A man who decided to put his savings into gold in 1970 could have bought just over 27.8 ounces of the precious metal for $1,000. At the time of writing, with gold trading at $900 an ounce, he could have sold it for around $25,000.
Those few goldbugs who always doubted the soundness of fiat money— paper currency without a metal anchor— have in large measure been vindicated. But why were the rest of us so blinded by money illusion?
Blowing Bubbles
In the immediate aftermath of the death of gold as the anchor of the monetary system, the problem of inflation affected mainly retail prices and wages. Today, only around one out of seven countries has an inflation rate above 10 percent, and only one, Zimbabwe, is afflicted with hyperinflation. But back in 1979 at least 7 countries had an annual inflation rate above 50 percent, and more than 60 countries— including Britain and the United States— had inflation in double digits.
Inflation has come down since then, partly because many of the items we buy— from clothes to computers— have gotten cheaper as a result of technological innovation and the relocation of production to low-wage economies in Asia. It has also been reduced because of a worldwide transformation in monetary policy, which began with the monetarist-inspired increases in short-term rates implemented by the Federal Reserve in 1979. Just as important, some of the structural drivers of inflation, such as powerful trade unions, have also been weakened.
By the 1980s, in any case, more and more people had grasped how to protect their wealth from inflation: by investing it in assets they expected to appreciate in line with, or ahead of, the cost of living. These assets could take multiple forms, from modern art to vintage wine, but the most popular proved to be stocks and real estate. Once it became clear that this formula worked, the Age of Leverage could begin.
For it clearly made sense to borrow to the hilt to maximize your holdings of stocks and real estate if these promised to generate higher rates of return than the interest payments on your borrowings. Between 1990 and 2004, most American households did not see an appreciable improvement in their incomes. Adjusted for inflation, the median household income rose by about 6 percent. But people could raise their living standards by borrowing and investing in stocks and housing.
Nearly all of us did it. And the bankers were there to help. Not only could they borrow more cheaply from one another than we could borrow from them; increasingly they devised all kinds of new mortgages that looked more attractive to us (and promised to be more lucrative to them) than boring old 30-year fixed-rate deals. Moreover, the banks were just as ready to play the asset markets as we were. Proprietary trading soon became the most profitable arm of investment banking: buying and selling assets on the bank’s own account.
Losing our shirt? The problem is that our banks are also losing theirs. Illustration by Barry Blitt.
There was, however, a catch. The Age of Leverage was also an age of bubbles, beginning with the dot-com bubble of the irrationally exuberant 1990s and ending with the real-estate mania of the exuberantly irrational 2000s. Why was this? The future is in large measure uncertain, so our assessments of future asset prices are bound to vary.
If we were all calculating machines, we would simultaneously process all the available information and come to the same conclusion. But we are human beings, and as such are prone to myopia and mood swings. When asset prices surge upward in sync, it is as if investors are gripped by a kind of collective euphoria. Conversely, when their "animal spirits" flip from greed to fear, the bubble that their earlier euphoria inflated can burst with amazing suddenness.
Zoological imagery is an integral part of the culture of Planet Finance. Optimistic buyers are "bulls," pessimistic sellers are "bears." The real point, however, is that stock markets are mirrors of the human psyche. Like Homo sapiens, they can become depressed. They can even suffer complete breakdowns.
This is no new insight. In the 400 years since the first shares were bought and sold on the Amsterdam Beurse, there has been a long succession of financial bubbles. Time and again, asset prices have soared to unsustainable heights only to crash downward again. So familiar is this pattern— described by the economic historian Charles Kindleberger— that it is possible to distill it into five stages:
(1) Displacement: Some change in economic circumstances creates new and profitable opportunities. (2) Euphoria, or overtrading: A feedback process sets in whereby expectation of rising profits leads to rapid growth in asset prices. (3) Mania, or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money. (4) Distress: The insiders discern that profits cannot possibly justify the now exorbitant price of the assets and begin to take profits by selling. (5) Revulsion, or discredit: As asset prices fall, the outsiders stampede for the exits, causing the bubble to burst.
The key point is that without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission and commission of central banks. The bubbles of our time had their origins in the aftermath of the 1987 stock-market crash, when then novice Federal Reserve chairman Alan Greenspan boldly affirmed the Fed’s "readiness to serve as a source of liquidity to support the economic and financial system."
This sent a signal to the markets, particularly the New York banks: if things got really bad, he stood ready to bail them out. Thus was born the "Greenspan put"— the implicit option the Fed gave traders to be able to sell their stocks at today’s prices even in the event of a meltdown tomorrow. Having so contained a panic once, Greenspan thereafter had a dilemma lurking in the back of his mind: whether or not to act pre-emptively the next time— to prevent a panic altogether.
This dilemma came to the fore as a classic stock-market bubble took shape in the mid-90s. The displacement in this case was the explosion of innovation by the technology and software industry as personal computers met the Internet. But, as in all of history’s bubbles, an accommodative monetary policy also played a role. From a peak of 6 percent in February 1995, the federal-funds target rate had been reduced to 5.25 percent by January 1996. It was then cut in steps, in the fall of 1998, down to 4.75 percent, and it remained at that level until June 1999, by which time the Dow had passed the 10,000 mark.
Why did the Fed allow euphoria to run loose in the 1990s? Partly because Greenspan and his colleagues underestimated the momentum of the technology bubble; as early as December 1995, with the Dow just past the 5,000 mark, members of the Fed’s Open Market Committee speculated that the market might be approaching its peak. Partly, also, because Greenspan came to the conclusion that it was not the Fed’s responsibility to worry about asset-price inflation [[which everybody but shortsellers seems to love: normxxx]], only consumer-price inflation, and this, he believed, was being reduced by a major improvement in productivity due precisely to the tech boom.
Greenspan could not postpone a stock-exchange crash indefinitely. After Silicon Valley’s dot-com bubble peaked, in March 2000, the U.S. stock market fell by almost half over the next two and a half years. It was not until May 2007 that investors in the Standard & Poor’s 500 had recouped their losses. [[But that was already quick enough so that all that those investors learned was to at least "hang on" (and maybe do some long term buying) in case of another bad dip: normxxx]] And perhaps the Fed’s response to the sell-off— and the massive shot of liquidity it injected into the financial markets after the 9/11 terrorist attacks— prevented the "correction" from precipitating a depression. [[And perhaps not; perhaps it only post-poned it. : normxxx]]
Not only were the 1930s averted; so too, it seemed, was a repeat of the Japanese experience after 1989, when a conscious effort by the central bank to prick an asset bubble had ended up triggering an 80 percent stock-market sell-off, a horrendous real-estate collapse, and a decade of economic stagnation [[and thoroughly terrifying Greenspan, setting him dead set against any attempt to "deflate" a bubble, ever: normxxx]]. What was not immediately obvious was that Greenspan’s easy-money policy was already generating another bubble— this time in the financial market that a majority of Americans have been encouraged for generations to play: the real-estate market.
The American Dream
Real estate is the English-speaking world’s favorite economic game. No other facet of financial life has such a hold on the popular imagination. The real-estate market is unique. Every adult, no matter how economically illiterate, has a view on its future prospects. Through the evergreen board game Monopoly, even children are taught how to climb the property ladder.
Once upon a time, people saved a portion of their earnings for the proverbial rainy day, stowing the cash in a mattress or a bank safe. The Age of Leverage, as we have seen, brought a growing reliance on borrowing to buy assets in the expectation of their future appreciation in value. For a majority of families, this meant a leveraged investment in a house. That strategy had one very obvious flaw. It represented a one-way, totally unhedged bet on a single asset.
To be sure, investing in housing paid off handsomely for more than half a century, up until 2006. Suppose you had put $100,000 into the U.S. property market back in the first quarter of 1987. According to the Case-Shiller national home-price index, you would have nearly tripled your money by the first quarter of 2007, to $299,000. On the other hand, if you had put the same money into the S&P 500, and had continued to re-invest the dividend income in that index, you would have ended up with $772,000 to play with— more than double what you would have made on bricks and mortar.
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There is, obviously, [this] important difference between a house and a stock-market index. You cannot live in a stock-market index. For the sake of a fair comparison, allowance must therefore be made for the rent you save by owning your house (or the rent you can collect if you own a second property). A simple way to proceed is just to leave out both dividends and rents. In that case the difference is somewhat reduced. In the two decades after 1987, the S&P 500, excluding dividends, rose by a factor of just over six, meaning that an investment of $20,000 would be worth some $120,000. But that $100,000 house which we acquired for just $20,000 would still be worth $299,000— or about 14.95 times your original investment. [[Ah, the wonders of leverage in an UP market!: normxxx]]
There are three other considerations to bear in mind when trying to compare housing with other forms of assets. The first is depreciation. Stocks do not wear out and require new roofs; houses do. The second is liquidity. As assets, houses are a great deal more expensive [[and difficult: normxxx]] to convert into cash than stocks. The third is volatility. Housing markets since World War II have been far less volatile than stock markets.
Yet that is not to say that house prices have never deviated from a steady upward path. In Britain between 1989 and 1995, for example, the average house price fell by 18 percent, or, in inflation-adjusted terms, by more than a third— 37 percent. In London, the real decline was closer to 47 percent. In Japan between 1990 and 2000, property prices fell by more than 60 percent.
The recent decline of property prices in the United States should therefore have come as less of a shock than it did. Between July 2006 and June 2008, the Case-Shiller index of home prices in 20 big American cities declined on average by 19 percent. In some of these cities— Phoenix, San Diego, Los Angeles, and Miami— the total decline was as much as a third. Seen in international perspective, those are not unprecedented figures. Seen in the context of the post-2000 bubble, prices have yet to return to their starting point. On average, house prices are still 50 percent higher than they were at the beginning of this process.
So why were we oblivious to the likely bursting of the real-estate bubble? The answer is that for generations we have been brainwashed into thinking that borrowing to buy a house is the only rational financial strategy to pursue. Think of Frank Capra’s classic 1946 movie, It’s a Wonderful Life, which tells the story of the family-owned Bailey Building & Loan, a small-town mortgage firm that George Bailey (played by James Stewart) struggles to keep afloat in the teeth of the Depression.
"You know, George," his father tells him, "I feel that in a small way we are doing something important. It’s satisfying a fundamental urge. It’s deep in the race for a man to want his own roof and walls and fireplace, and we’re helping him get those things in our shabby little office." George gets the message, as he passionately explains to the villainous slumlord Potter after Bailey Sr.’s death: "[My father] never once thought of himself.… But he did help a few people get out of your slums, Mr. Potter. And what’s wrong with that? … Doesn’t it make them better citizens? Doesn’t it make them better customers?"
There, in a nutshell, is one of the key concepts of the 20th century: the notion that property ownership enhances citizenship, and that therefore a property-owning democracy is more socially and politically stable than a democracy divided into an elite of landlords and a majority of property-less tenants. So deeply rooted is this idea in our political culture that it comes as a surprise to learn that it was invented just 70 years ago.
Fannie, Ginnie, And Freddie
Prior to the 1930s, only a minority of Americans owned their own homes. During the Depression, however, the Roosevelt administration created a whole complex of institutions to change that. A Federal Home Loan Bank Board was set up in 1932 to encourage and oversee local mortgage lenders known as savings-and-loans (S&Ls)— mutual associations that took in deposits and lent to homebuyers.
Under the New Deal, the Home Owners’ Loan Corporation stepped in to refinance mortgages on longer terms, up to 15 years. To reassure depositors, who had been traumatized by the thousands of bank failures of the previous three years, Roosevelt introduced federal deposit insurance. And by providing federally backed insurance for mortgage lenders, the Federal Housing Administration (F.H.A.) sought to encourage large (up to 80 percent of the purchase price), long (20— to 25-year), fully amortized, low-interest loans.
By standardizing the long-term mortgage and creating a national system of official inspection and valuation, the F.H.A. laid the foundation for a secondary market in mortgages. This market came to life in 1938, when a new Federal National Mortgage Association— nicknamed Fannie Mae— was authorized to issue bonds and use the proceeds to buy mortgages from the local S&Ls, which were restricted by regulation both in terms of geography (they could not lend to borrowers more than 50 miles from their offices) and in terms of the rates they could offer (the so-called Regulation Q, which imposed a low ceiling on interest paid on deposits). Because these changes tended to reduce the average monthly payment on a mortgage, the F.H.A. made home ownership viable for many more Americans than ever before.
Indeed, it is not too much to say that the modern United States, with its seductively samey suburbs, was born with Fannie Mae. Between 1940 and 1960, the home-ownership rate soared from 43 to 62 percent. These were not the only ways in which the federal government sought to encourage Americans to own their own homes. Mortgage-interest payments were always tax-deductible, from the inception of the federal income tax in 1913. As Ronald Reagan said when the rationality of this tax break was challenged, mortgage-interest relief was "part of the American dream."
In 1968, to broaden the secondary-mortgage market still further, Fannie Mae was split in two— the Government National Mortgage Association (Ginnie Mae), which was to cater to poor borrowers, and a rechartered Fannie Mae, now a privately owned government-sponsored enterprise (G.S.E.). Two years later, to provide competition for Fannie Mae, the Federal Home Loan Mortgage Corporation (Freddie Mac) was set up. In addition, Fannie Mae and Freddie Mac were permitted to buy conventional as well as government-guaranteed mortgages. Later, with the Community Reinvestment Act of 1977, American banks also found themselves under pressure for the first time to lend to poor, minority communities.
These changes presaged a more radical modification to the New Deal system. In the late 1970s, the savings-and-loan industry was hit first by double-digit inflation and then by sharply rising interest rates. This double punch was potentially lethal. The S&Ls were simultaneously losing money on long-term, fixed-rate mortgages, due to inflation, and hemorrhaging deposits to higher-interest money-market funds.
The response in Washington from both the Carter and Reagan administrations was to try to salvage the S&Ls with tax breaks and deregulation. When the new legislation was passed, President Reagan declared, "All in all, I think we hit the jackpot." Some people certainly did.
On the one hand, S&Ls could now invest in whatever they liked, not just local long-term mortgages. Commercial property, stocks, junk bonds— anything was allowed. They could even issue credit cards. On the other, they could now pay whatever interest rate they liked to depositors. Yet all their deposits were still effectively insured, with the maximum covered amount raised from $40,000 to $100,000, thanks to a government regulation two years earlier.
And if ordinary deposits did not suffice, the S&Ls could raise money in the form of brokered deposits from middlemen. What happened next perfectly illustrated the great financial precept first enunciated by William Crawford, the commissioner of the California Department of Savings and Loan: "The best way to rob a bank is to own one." Some S&Ls bet their depositors’ money on highly dubious real-estate developments. Many simply stole the money, as if deregulation meant that the law no longer applied to them at all.
When the ensuing bubble burst, nearly 300 S&Ls collapsed, while another 747 were closed or reorganized under the auspices of the Resolution Trust Corporation, established by Congress in 1989 to clear up the mess. The final cost of the crisis was $153 billion (around 3 percent of the 1989 G.D.P.), of which taxpayers had to pay $124 billion.
But even as the S&Ls were going belly-up, they offered another, very different group of American financial institutions a fast track to megabucks. To the bond traders at Salomon Brothers, the New York investment bank, the breakdown of the New Deal mortgage system was not a crisis but a wonderful opportunity. As profit-hungry as their language was profane, the self-styled "Big Swinging Dicks" at Salomon saw a way of exploiting the gyrating interest rates of the early 1980s.
The idea was to re-invent mortgages by bundling thousands of them together as the backing for new and alluring securities that could then be 'sliced up' and sold as alternatives to traditional government and corporate bonds— in short, to convert mortgages into bonds. Once lumped together, the interest payments due on the mortgages could be subdivided into strips with different maturities and credit risks. The first issue of this new kind of mortgage-backed security (known as a "collateralized mortgage obligation") occurred in June 1983. The dawn of securitization was a necessary prelude to the Age of Leverage.
Once again, however, it was the federal government that stood ready to pick up the tab in a crisis. For the majority of mortgages continued to enjoy an implicit guarantee from the government-sponsored trio of Fannie, Freddie, and Ginnie, meaning that bonds which used those mortgages as collateral could be represented as virtual government bonds and considered "investment grade." Between 1980 and 2007, the volume of such G.S.E.-backed mortgage-backed securities grew from less than $200 billion to more than $4 trillion. In 1980 only 10 percent of the home-mortgage market was securitized; by 2007, 56 percent of it was.
These changes swept away the last vestiges of the business model depicted in 'It’s a Wonderful Life'. Once there had been meaningful social ties between mortgage lenders and borrowers. James Stewart’s character knew both the depositors and the debtors. By contrast, in a securitized market, the interest you paid on your mortgage ultimately went to someone who had no idea you existed. The full implications of this transition for ordinary homeowners would become apparent only 25 years later.
The Lessons Of Detroit
In July 2007, I paid a visit to Detroit, because I had the feeling that what was happening there was the shape of things to come in the United States as a whole. In the space of 10 years, house prices in Detroit, which probably possesses the worst housing stock of any American city other than New Orleans, had risen by more than a third— not much compared with the nationwide bubble, but still hard to explain, given the city’s chronically depressed economic state. As I discovered, the explanation lay in fundamental changes in the rules of the housing game.
I arrived at the end of a borrowing spree. For several years agents and brokers selling subprime mortgages had been flooding Detroit with radio, television, and direct-mail advertisements, offering what sounded like attractive deals. In 2006, for example, subprime lenders pumped more than a billion dollars into 22 Detroit Zip Codes.
These were not the old 30-year fixed-rate mortgages invented in the New Deal. On the contrary, a high proportion were adjustable-rate mortgages— in other words, the interest rate could vary according to changes in short-term lending rates. Many were also interest-only mortgages, without amortization (repayment of principal), even when the principal represented 100 percent of the assessed value of the mortgaged property.
And most had introductory "teaser" periods, whereby the initial interest payments— usually for the first two years— were kept artificially low, with the cost of the loan backloaded. All of these devices were intended to allow an immediate reduction in the debt-servicing costs of the borrower. In Detroit at that time, only a minority of these loans were going to first-time buyers.
They were nearly all refinancing deals, which allowed borrowers to treat their homes as cash machines, converting their existing equity into cash and using the proceeds to pay off credit-card debts, carry out renovations, or buy new consumer durables. However, the combination of declining long-term interest rates and ever more alluring mortgage deals did attract new buyers into the housing market. By 2005, 69 percent of all U.S. householders were homeowners; 10 years earlier it had been 64 percent. About half of that increase could be attributed to the subprime-lending boom.
Significantly, a disproportionate number of subprime borrowers belonged to ethnic minorities. Indeed, I found myself wondering, as I drove around Detroit, if "subprime" was in fact a new financial euphemism for "black." This was no idle supposition. According to a joint study by, among others, the Massachusetts Affordable Housing Alliance, 55 percent of black and Latino borrowers in Boston who had obtained loans for single-family homes in 2005 had been given subprime mortgages; the figure for white borrowers was just 13 percent.
More than three-quarters of black and Latino borrowers from Washington Mutual were classed as subprime, whereas only 17 percent of white borrowers were. According to a report in The Wall Street Journal, minority ownership increased by 3.1 million between 2002 and 2007. Here, surely, was the zenith of the property-owning democracy. It was an achievement that the Bush administration was proud of.
"We want everybody in America to own their own home," President George W. Bush had said in October 2002. Having challenged lenders to create 5.5 million new minority homeowners by the end of the decade, Bush signed the American Dream Downpayment Act in 2003, a measure designed to subsidize first-time house purchases in low-income groups. Between 2000 and 2006, the share of undocumented subprime contracts rose from 17 to 44 percent.
Fannie Mae and Freddie Mac also came under pressure from the Department of Housing and Urban Development to support the subprime market. As Bush put it in December 2003, "It is in our national interest that more people own their own home." Few people dissented.
As a business model, subprime lending worked beautifully— as long, that is, as interest rates stayed low, people kept their jobs, and real-estate prices continued to rise. Such conditions could not be relied upon to last, however, least of all in a city like Detroit. But that did not worry the subprime lenders. They simply followed the trail blazed by mainstream mortgage lenders in the 1980s. Having pocketed fat commissions on the signing of the original loan contracts, they hastily resold their loans in bulk to Wall Street banks.
The banks, in turn, bundled the loans into high-yielding mortgage-backed securities and sold them to investors around the world, all eager for a few hundredths of a percentage point more of return on their capital. Repackaged as C.D.O.’s, these subprime securities could be transformed from risky loans to flaky borrowers into triple-A-rated investment-grade securities. All that was required was certification from one of the rating agencies that at least the top tier of these securities was unlikely to go into default.
The risk was spread across the globe, from American state pension funds to public-hospital networks in Australia, to town councils near the Arctic Circle. In Norway, for example, eight municipalities, including Rana and Hemnes, invested some $120 million of their taxpayers’ money in C.D.O.’s secured on American subprime mortgages.
In Detroit the rise of subprime mortgages had in fact coincided with a new slump in the inexorably declining automobile industry. That anticipated a wider American slowdown, an almost inevitable consequence of a tightening of monetary policy as the Federal Reserve belatedly raised short-term interest rates from 1 percent to 5.25 percent. As soon as the teaser rates expired and mortgages were reset at new and much higher interest rates, hundreds of Detroit households swiftly fell behind in their mortgage payments.
The effect was to burst the real-estate bubble, causing house prices to start falling significantly for the first time since the early 1990s. And the further house prices fell, the more homeowners found themselves with "negative equity"— in other words, owing more money than their homes were worth. The rest— the chain reaction as defaults in Detroit and elsewhere unleashed huge losses on C.D.O.’s in financial institutions all around the world— you know.
Drunk On Derivatives
Do you, however, know about the second-order effects of this crisis in the markets for derivatives? Do you in fact know what a derivative is? Once excoriated by Warren Buffett as "financial weapons of mass destruction," derivatives are what make this crisis both unique and unfathomable in its ramifications. To understand what they are, you need, literally, to go back to the future.
For a farmer planting a crop, nothing is more crucial than the future price it will fetch after it has been harvested and taken to market. A futures contract allows him to protect himself by committing a merchant to buy his crop when it comes to market at a price agreed upon when the seeds are being planted. If the market price on the day of delivery is lower than expected, the farmer is protected.
The earliest forms of protection for farmers were known as forward contracts, which were simply bilateral agreements between seller and buyer. A true futures contract, however, is a standardized instrument issued by a futures exchange and hence tradable. With the development of a standard "to arrive" futures contract, along with a set of rules to enforce settlement and, finally, an effective clearinghouse, the first true futures market was born.
Because they are derived from the value of underlying assets, all futures contracts are forms of derivatives. Closely related, though distinct from futures, are the contracts known as options. In essence, the buyer of a "call" option has the right, but not the obligation, to buy an agreed-upon quantity of a particular commodity or financial asset from the seller ("writer") of the option at a certain time (the expiration date) for a certain price (known as the "strike price").
Clearly, the buyer of a call option expects the price of the underlying instrument to rise in the future. When the price passes the agreed-upon strike price, the option is "in the money"— and so is the smart guy who bought it. A "put" option is just the opposite: the buyer has the right but not the obligation to sell an agreed-upon quantity of something to the seller of the option at an agreed-upon price.
A third kind of derivative is the interest-rate "swap," which is effectively a bet between two parties on the future path of interest rates. A pure interest-rate swap allows two parties already receiving interest payments literally to swap them, allowing someone receiving a variable rate of interest to exchange it for a fixed rate, in case interest rates decline. A credit-default swap (C.D.S.), meanwhile, offers protection against a company’s defaulting on its bonds.
Bringing down the bull: The pain of America’s financial crisis is felt all over the world. Illustration by Brad Holland.
There was a time when derivatives were standardized instruments traded on exchanges such as the Chicago Board of Trade. Now, however, the vast proportion are custom-made and sold "over the counter" (O.T.C.), often by banks, which charge attractive commissions for their services, but also by insurance companies (notably A.I.G.). According to the Bank for International Settlements, the total notional amounts outstanding of O.T.C. derivative contracts— arranged on an ad hoc basis between two parties— reached a staggering $596 trillion in December 2007, [[$684 trillion by June 2008: normxxx]] with a gross market value of just over $14.5 trillion.
But how exactly do you price a derivative? What precisely is an option worth? The answers to those questions required a revolution in financial theory. From an academic point of view, what this revolution achieved was highly impressive. But the events of the 1990s, as the rise of quantitative finance replaced preppies with quants (quantitative analysts) all along Wall Street, revealed a new truth: those whom the gods want to destroy they first teach math.
Working closely with Fischer Black, of the consulting firm Arthur D. Little, M.I.T.’s Myron Scholes invented a groundbreaking new theory of pricing options, to which his colleague Robert Merton also contributed. (Scholes and Merton would share the 1997 Nobel Prize in economics.) They reasoned that a call option’s value depended on six variables: the current market price of the stock (S), the agreed future price at which the stock could be bought (L), the time until the expiration date of the option (t), the risk-free rate of return in the economy as a whole (r), the probability that the option will be exercised (N), and— the crucial variable— the expected volatility of the stock, i.e., the likely fluctuations of its price between the time of purchase and the expiration date(s). With wonderful mathematical wizardry, the quants reduced the price of a call option to this formula (the Black-Scholes formula):
in which:
Feeling a bit baffled? Can’t follow the algebra? That was just fine by the quants. To make money from this magic formula, they needed markets to be full of people who didn’t have a clue about how to price options but relied instead on their (seldom accurate) gut instincts. They also needed a great deal of computing power, a force which had been transforming the financial markets since the early 1980s. Their final requirement was a partner with some market savvy in order to make the leap from the faculty club to the trading floor.
Black, who would soon be struck down by cancer, could not be that partner. But John Meriwether could. The former head of the bond-arbitrage group at Salomon Brothers, Meriwether had made his first fortune in the wake of the S&L meltdown of the late 1980s. The hedge fund he created with Scholes and Merton in 1994 was called Long-Term Capital Management.
In its brief, four-year life, Long-Term was the brightest star in the hedge-fund firmament, generating mind-blowing returns for its elite club of investors and even more money for its founders. Needless to say, the firm did more than just trade options, though selling puts on the stock market became such a big part of its business that it was nicknamed "the central bank of volatility" by banks buying insurance against a big stock-market sell-off.
In fact, the partners were simultaneously pursuing multiple trading strategies, about 100 of them, with a total of 7,600 positions. This conformed to a second key rule of the new mathematical finance: the virtue of diversification, a principle that had been formalized by Harry M. Markowitz, of the Rand Corporation. Diversification was all about having a multitude of uncorrelated positions. One might go wrong, or even [a dozen]. But thousands just could not go wrong simultaneously.
The mathematics were reassuring. According to the firm’s "Value at Risk" models, it would take a 10-s (in other words, a 10-standard-deviation) event to cause the firm to lose all its capital in a single year. But the probability of such an event, according to the quants, was 1 in 1024— or effectively zero. Indeed, the models said the most Long-Term was likely to lose in a single day was $45 million. For that reason, the partners felt no compunction about leveraging their trades. At the end of August 1997, the fund’s capital was $6.7 billion, but the debt-financed assets on its balance sheet amounted to $126 billion, a ratio of assets to capital of 19 to 1.[[Pretty conservative, by today's standards.: normxxx]]
There is no need to rehearse here the story of Long-Term’s downfall, which was precipitated by the Russian debt default. Suffice it to say that on Friday, August 21, 1998, the firm lost $550 million— 15 percent of its entire capital, and vastly more than its mathematical models had said was possible. The key point is to appreciate why the quants were so wrong.
The problem lay with the assumptions that underlie so much of mathematical finance. In order to construct their models, the quants had to postulate a planet where the inhabitants were omniscient and perfectly rational; where they instantly absorbed all new information and used it to maximize profits; where they never stopped trading; where markets were continuous, frictionless, and completely liquid. Financial markets on this planet followed a "random walk," meaning that each day’s prices were quite unrelated to the previous day’s, but reflected no more and no less than all the relevant information currently available.
The returns on this planet’s stock market were normally distributed along the bell curve, with most years clustered closely around the mean, and two-thirds of them within one standard deviation of the mean. On such a planet, a "six standard deviation" sell-off would be about as common as a person shorter than one foot in our world. It would happen only once in four million years of trading.
But Long-Term was not located on Planet Finance. It was based in Greenwich, Connecticut, on Planet Earth, a place inhabited by emotional human beings, always capable of flipping suddenly and en masse from greed to fear. In the case of Long-Term, the herding problem was acute, because many other firms had begun trying to 'copy' Long-Term’s strategies in the hope of replicating its stellar performance.
When things began to go wrong, there was a truly bovine stampede for the exits. The result was a massive, synchronized downturn in virtually all [[of LTCM's: normxxx]] asset markets. Diversification was no defense in such a crisis. As one leading London hedge-fund manager later put it to Meriwether, "John, you were the correlation."
There was, however, another reason why Long-Term failed. The quants’ Value at Risk models had implied that the loss the firm suffered in August 1998 was so unlikely that it ought never to have happened in the entire life of the universe. But that was because the models were working with just five years of data. If they had gone back even 11 years, they would have captured the 1987 stock-market crash. If they had gone back 80 years they would have captured the last great Russian default, after the 1917 revolution.
Meriwether himself, born in 1947, ruefully observed, "If I had lived through the Depression, I would have been in a better position to understand events." To put it bluntly, the Nobel Prize winners knew plenty of mathematics but not enough history. One might assume that, after the catastrophic failure of L.T.C.M., quantitative hedge funds would have vanished from the financial scene, and derivatives such as options would be sold a good deal more circumspectly.
Yet the very reverse happened. Far from declining, in the past 10 years hedge funds of every type have exploded in number and in the volume of assets they manage, with quantitative hedge funds such as Renaissance, Citadel, and D. E. Shaw emerging as leading players. [[Because, in the short run, they made phenomenal amounts of money; and, as John Maynard Keynes put it, "'In the long run' is a misleading guide to current affairs. 'In the long run', we are all dead.": normxxx]] The growth of derivatives has also been spectacular— and it has continued despite the onset of the credit crunch. Between December 2005 and December 2007, the notional amounts outstanding for all derivatives increased from $298 trillion to $596 trillion [[to $684 trillion by June 2008: normxxx]]. Credit-default swaps quadrupled, from $14 trillion to $58 trillion.
An intimation of the problems likely to arise came in September, when the government takeover of Fannie and Freddie cast doubt on the status of derivative contracts protecting the holders of more than $1.4 trillion of their bonds against default. The consequences of the failure of Lehman Brothers were substantially greater, because the firm was the counter-party in so many derivative contracts. The big question is whether those active in the market waited too long to set up some kind of formal clearing mechanism. If, as seems inevitable, there is an upsurge in corporate defaults as the U.S. slides into recession, the whole system could completely seize up.
The China Syndrome
Just 10 years ago, during the Asian crisis of 1997–98, it was conventional wisdom that financial crises were more likely to happen on the periphery of the world economy— in the so-called emerging markets of East Asia and Latin America. Yet the biggest threats to the global financial system in this new century have come not from the periphery but from the core. The explanation for this strange role reversal may in fact lie in the way emerging markets changed their behavior after 1998.
For many decades it was assumed that poor countries could become rich only by borrowing capital from wealthy countries. Recurrent debt crises and currency crises associated with sudden withdrawals of Western money led to a rethinking, inspired largely by the Chinese example. When the Chinese wanted to attract foreign capital, they insisted that it take the form of direct investment.
That meant that instead of borrowing from Western banks to finance its industrial development, as many emerging markets did, China got foreigners to build factories in Chinese enterprise zones— large, lumpy assets that could not easily be withdrawn in a crisis. The crucial point, though, is that the bulk of Chinese investment has been financed from China’s own savings. Cautious after years of instability and unused to the panoply of credit facilities we have in the West, Chinese households save a high proportion of their rising incomes, in marked contrast to Americans, who in recent years have saved almost none at all.
Chinese corporations save an even larger proportion of their soaring profits. The remarkable thing is that a growing share of that savings surplus has ended up being lent to the United States. In effect, the People’s Republic of China has become banker to the United States of America.
The Chinese have not been acting out of altruism. Until very recently, the best way for China to employ its vast population was by exporting manufactured goods to the spendthrift U.S. consumer. To ensure that those exports were irresistibly cheap, China had to fight the tendency for its currency to strengthen against the dollar by buying literally billions of dollars on world markets.
In 2006, Chinese holdings of dollars reached 700 billion. Other Asian and Middle Eastern economies adopted much the same strategy. The benefits for the United States were manifold. Asian imports kept down U.S. inflation. Asian labor kept down U.S. wage costs. Above all, Asian savings kept down U.S. interest rates.
But there was a catch. The more Asia was willing to lend to the United States, the more Americans were willing to borrow. The 'Asian savings glut' was thus the underlying cause of the surge in bank lending, bond issuance, and new derivative contracts that Planet Finance witnessed after 2000. It was the underlying cause of the hedge-fund population explosion. It was the underlying reason why private-equity partnerships were able to borrow money left, right, and center to finance leveraged buyouts.
And it was the underlying reason why the U.S. mortgage market was so awash with cash by 2006 that you could get a 100 percent mortgage with no income, no job, and no assets. Whether or not China is now sufficiently "decoupled" from the United States that it can insulate itself from our credit crunch remains to be seen. At the time of writing, however, it looks very doubtful.
Back To Reality
The modern financial system is the product of centuries of economic evolution. Banks transformed money from metal coins into accounts, allowing ever larger aggregations of borrowing and lending. From the Renaissance on, government bonds introduced the securitization of streams of interest payments.
From the 17th century on, equity in corporations could be bought and sold in public stock markets. From the 18th century on, central banks slowly learned how to moderate or exacerbate the business cycle. From the 19th century on, insurance was supplemented by futures, the first derivatives. And from the 20th century on, households were encouraged by government to skew their portfolios in favor of real estate.
Economies that combined all these institutional innovations performed better over the long run than those that did not, because financial intermediation generally permits a more efficient allocation of resources than, say, feudalism or central planning. For this reason, it is not wholly surprising that the Western financial model tended to spread around the world, first in the guise of imperialism, then in the guise of globalization. Yet money’s ascent has not been, and can never be, a smooth one.
On the contrary, financial history is a roller-coaster ride of ups and downs, bubbles and busts, manias and panics, shocks and crashes. The excesses of the Age of Leverage— the deluge of paper money, the asset-price inflation, the explosion of consumer and bank debt, and the hypertrophic growth of derivatives— were bound sooner or later to produce a really big crisis. It remains unclear whether this crisis will have economic and social effects as disastrous as those of the Great Depression, or whether the monetary and fiscal authorities will succeed in achieving a Great Repression, averting a 1930s-style "great contraction" of credit and output by transferring the as yet unquantifiable losses from banks to taxpayers.
Either way, Planet Finance has now returned to Planet Earth with a bang. The key figures of the Age of Leverage— the lax central bankers, the reckless investment bankers, the hubristic quants— are now feeling the full force of this planet’s gravity. But what about the rest of us, the rank-and-file members of the deluded crowd? Well, we shall now have to question some of our most deeply rooted assumptions— not only about the benefits of paper money but also about the rationale of the property-owning democracy itself.
On Planet Finance it may have made sense to borrow billions of dollars to finance a massive speculation on the future prices of American houses, and then to erect on the back of this trade a vast inverted pyramid of incomprehensible securities and derivatives. But back here on Planet Earth it suddenly seems like an 'extraordinary popular delusion'.
ߧ
Normxxx
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The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Depression 2009: What Would It Look Like?
Depression 2009: What Would It Look Like?
Long Lines At The ER, A Television Boom, Emptying Suburbs. A New Catastrophic Economic Downturn Would Feel Nothing Like The Last One.
By Drake Bennett | 16 November 2008
Over the past few months, Americans have been hearing the word "depression" with unfamiliar and alarming regularity. The financial crisis tearing through Wall Street is routinely described as the worst since the Great Depression, and the recession into which we are sinking looks deep enough, financial commentators warn, that a few poor policy decisions could put us in a depression of our own.
It's a frightening possibility, but also in many ways an abstraction. The country has gone so long without a depression that it's hard to know what it would be like to live through one. Most of us, of course, think we know what a depression looks like. Open a history book and the images will be familiar.
Mobs lined up at the banks and lines at soup kitchens; stockbrokers in suits selling apples on the street; families piled with all their belongings into jalopies. Families scrimping on coffee and flour and sugar, rinsing off tinfoil to reuse it and mending and re-mending their pants and dresses. A desperate government mobilizes legions of the unemployed to build bridges, roads, and airports, to blaze trails in national forests, to put on traveling plays and paint social-realist murals.
Today, however, whatever a depression would look like, that's not it. We are separated from the 1930s by decades of profound economic, technological, and political change, and a modern landscape of scarcity would reflect that. What, then, would we see instead? And how would we even know a depression had started?
It's not a topic that professional observers of the economy study much. And there's no single answer, because there's no one way a depression might unfold. But it's nonetheless an important question to consider— there's no way to make informed decisions about the present without understanding, in some detail, the worst-case scenario about the future.
By looking at what we know about how society and commerce would slow down, and how people respond, it's possible to envision what we might face. Unlike the 1930s, when food and clothing were far more expensive, today we spend much of our remaining money on healthcare, child care, and education— and we'd see uncomfortable changes in those parts of our lives. The lines wouldn't be outside soup kitchens, but at emergency rooms; and rather than itinerant farmers, we could see waves of laid-off office workers leaving homes to foreclosure and heading for areas of the country where there's more work— or just a relative with a free room over the garage. Already hollowed-out manufacturing cities could be all but deserted, and suburban neighborhoods would be left checkerboarded, with abandoned houses next to overcrowded ones.
And above all, a depression circa 2009 might be a less visible and altogether more isolating experience. With the diminishing price of televisions and the proliferation of channels, it's getting easier and easier to kill time alone— isolated from the rest of the community— and free time is one thing a 21st-century depression would create in abundance. Instead of dusty farm families, the icon of a modern-day depression might be something as subtle as the flickering glow of millions of televisions glimpsed through living room windows, as the nation's unemployed sit at home filling their days with the cheapest form of distraction available.
The odds are, most economists say, we will yet avoid a full-blown depression— the world's policy makers, they argue, have learned enough not to repeat the mistakes of the 1930s. Still, in a country that has known little but economic growth for 50 years, it matters to think about what life would look like without it.
. . .
There is, in fact, no agreed-upon definition of what a depression is. Economists are unanimous that the Great Depression was the worst economic downturn the industrial world has ever seen, and that we haven't had a 'depression' since, but beyond that there is not a consensus. Recessions have an official definition from the National Bureau of Economic Research, but the bureau pointedly declines to define a depression.
What sets a depression apart, most economists would agree, are duration and the scale of joblessness. To be worthy of the name, a depression needs to be more than a few years long— far longer than the eight-month average of our recent recessions— and it needs to put a lot of people out of work. The Great Depression lasted a decade by some measures, and at its worst, one in four American workers was out of a job. (By comparison, unemployment now is at a 14-year high of 'merely' 6.5 percent— or possibly twice that by the old accounting.)
In a modern depression, the swelling ranks of the unemployed would likely change the landscape of the country, uprooting people who would rather stay where they are and trapping people who want to move. In the 1930s, this took the visible form of waves of displaced tenant farmers washing into California, but it also had another, subtler effect: it froze the movement of the middle class. The suburbanization that was to define the post-World-War-II years had in fact started in the 1920s, only to be brought sharply to a halt when the economy collapsed.
Today, a depression could reverse that process altogether. In a deep and sustained downturn, home prices would likely sink further and not rise, dimming the appeal of homeownership, a large part of suburbia's draw. Renting an apartment— perhaps in a city, where commuting costs are lower— might be more tempting. And although city crime might increase, the sense of safety that attracted city-dwellers to the suburbs might suffer, too, in a downturn.
Many suburban areas have already seen upticks in crime in recent years, which would only get worse as tax-poor towns spent less money on policing and public services. "You could have a sort of desuburbanization phenomenon," suggests Michael Bernstein, a historian of the Depression and the provost of Tulane University.
The migrations kicked off by a depression wouldn't be in just one direction, but a tangle of demographic crosscurrents: young families moving back to their hometowns to live with the grandparents when they can no longer afford to live on their own, parents moving in with their adult children when their postretirement fixed incomes can no longer support them.
Some parts of the country, especially the Rust Belt, could see a wholesale depopulation as the last remnants of the American heavy-manufacturing base die out. "There will be some cities like Detroit that in a real depression could just become ghost towns," says Jeffrey Frankel, a Harvard economist and member of the National Bureau of Economic Research committee that declares recessions. (Frankel does not, he emphasizes, think we are headed for a depression.)
. . .
At the household level, the look of want is different today than during the last prolonged downturn. The government helps the unemployed and the poor with programs that didn't exist when the Great Depression hit— unemployment insurance, Medicaid, food stamps, Social Security for seniors. Beyond that, two of the basics of existence— food and clothing— are a lot cheaper today, thanks to industrial agriculture and overseas labor. The average middle-class man in the late 1920s, according to the writer and cultural critic Virginia Postrel, could afford just six outfits, and his wife nine— by comparison, the average woman today has seven pairs of jeans alone. So we're less likely to see one of the iconic images of the Great Depression: Formerly middle-class workers in threadbare clothes lining up for free food. [[Although our private charity soup kitchens have already reported sizable upticks in the numbers visiting their facilities.: normxxx]]
If we look closely, however, we might see more former lawyers wearing knockoffs, doing their back-to-school shopping at Target or Wal-Mart rather than Banana Republic and Abercrombie & Fitch. Lean times might kill off much of the taboo of visiting thrift shops and buying used items, and with modern distribution networks— and a push from the reduce-reuse-recycle mind-set of environmentalism— we might see the development of nationwide used-clothing chains. "Seconds" and "irregular" shops would flourish again; as would "thrifts" of every variety.
In general, novelty would lose some of its luster. It's not simply that we'd buy less, we'd look for different qualities in what we buy. New technology would grow less seductive, basic reliability more important. "Throw-away" items would disappear (or undergo a face-lift). We'd see more products like Nextel phones and the Panasonic Toughbook laptop, which trade on their sturdiness, and fewer like the iPhone— beautiful, cleverly designed, but not noted for durability. The neighborhood appliance shop could reappear in a new form— unlicensed, with hacked cellphones and rebuilt computers.
And while very few would starve, a depression would change how we eat. Food costs remain far below what they were for a family in the 1920s and 1930s, but they have been rising in recent years, and many people already on the edge of poverty would be unable to feed themselves on their own in a harsh economic climate— soup kitchens are already seeing an uptick in attendance. At the high end of the market, specialty and organic foods— which drove the success of chains like Whole Foods— would seem pointlessly and needlessly expensive; the booming organic food movement could suffer as people start to see specially grown produce as more of a luxury than a moral choice. New England's surviving farmers would be particularly hard-hit, as demand for their seasonal, relatively high-cost products dried up.
According to Marion Nestle, a food and public health professor at New York University, people low on cash and with more time on their hands will cook more rather than go out. They may also, Nestle suggests, try their hands at growing and even raising more of their own food, if they have any way of doing so. Among the green lawns of suburbia, kitchen gardens would spring up. And it might go well beyond just growing your own tomatoes: early last month, the English bookstore chain Waterstone's reported a 200 percent increase in the sales of books on keeping chickens.
At the same time, the cheapest option for many is decidedly less rustic: meals like packaged macaroni and cheese, and drive-through fast food. And we're likely to see a move, as well, toward cheaper, easier calories. If so, lean times could have the odd effect of making the population fatter, as more Americans eat like today's poor.
. . .
To understand where a depression would hit hardest, however, look at the biggest-ticket items on people's budgets. Housing, health insurance, transportation, and child care are the top expenses for American families, according to Elizabeth Warren, a bankruptcy law specialist at Harvard Law School; along with taxes, these take up two-thirds of income, on average. And when those are squeezed, that could mean everything from more crowded subways to a proliferation of cheap, unlicensed day-care centers. [[Check out how today's poor live.: normxxx]]
Health insurance premiums have risen to onerous levels in recent years, and in a long period of unemployment— or underemployment— they would quickly become unmanageable for many people. Dropping health insurance would be an immediate way for families to save hundreds of dollars per month. People without health insurance tend to skip routine dental and medical checkups, and instead deal with health problems only when they become acute— meaning they get their healthcare through hospital emergency rooms.
That means even longer waits at ERs, which are even now overtaxed in many places, and a growing financial drain on hospitals that already struggle to pay for the care they give uninsured people. And if, as is likely, this coincided with cuts in money for hospitals coming from cash-strapped state and local governments, there's a very real possibility that many hospitals would have to close, only further increasing the burden on those that remain open. In their place people would rely more on federally-funded health centers, or the growing number of 'drugstore' clinics, like the MinuteClinics in CVS branches, for vaccines, strep throat tests, and other basic medical care. And as the costs of traditional medicine climbed out reach for families, the appeal of alternative medicine would in all likelihood grow.
Higher education, another big expense, would probably take a hit as well. Students unable to afford private universities would opt for public universities, students unable to afford four-year colleges would opt for community colleges, and students unable to afford community college wouldn't go at all. With fewer applicants, admissions standards would drop, with spots that once would have been filled by more qualified, poorer students going instead to wealthier applicants who before would not have made the cut. Some universities would simply shrink. In Boston, a city almost uniquely dependent on higher education, the results— fewer students renting apartments, going to restaurants and bars, opening bank accounts, buying books, taking taxis— would be particularly acute.
A depression would last too long for unemployed college graduates to ride out the downturn in business or law school, so people would have to change career plans entirely. One place that could see an uptick in applications and interest is government work: Its relative stability, combined with a growing suspicion of 'free-market' ideology that would accompany a truly disastrous downturn, could attract more and better people, and even help the public sector shake off its image as a redoubt for the mediocre and the unambitious.
. . .
In many ways, though, today's depression would not look like the last one because it would not look like much at all. As Warren wrote in an e-mail, "The New Depression would be largely invisible because people would experience loss privately, not publicly." In the public imagination, the Depression was a galvanizing time, the crucible in which the Greatest Generation came of age and came together.
That is, at best, only partly true. Harvard political scientist Robert Putnam has found that, for many, the Depression was isolating: Kiwanis clubs, PTAs, and other social groups lost around half their members from 1930 to 1935. [[And broke up families, as the "man of the house" went off to look for work and sometimes never returned, and "welfare" paid out more to families without a man in the house.: normxxx]] And other studies on economic hardship suggest that it tends to sap people's civic engagement, often permanently.
"When people became unemployed in the Great Depression, they hunkered down, they pulled in from everybody." Putnam says. That effect, Putnam believes, would only be more pronounced today. The Depression was, famously, a boom time for movies— people flocked to cheap double features to escape the dreariness of their everyday poverty. Today, however, neither a day at the ballpark nor movies are particularly cheap. [[But "cheap" movies would quickly spring up again; it was not only a way to escape boredom, it also provided a means to escape overcrowded living spaces and a little privacy for dating teens.: normxxx]]
Much of a modern depression would unfold in the domestic sphere: people driving less, shopping less, and eating in their houses more. They would watch television at home; unemployed parents would watch over their own kids instead of taking them to day care. With online banking, it would even be possible to have a bank run in which no one leaves the comfort of their home.
There would be darker effects, as well. Mental depression, unsurprisingly, is higher in economically distressed households; so is domestic violence. Suicide rates go up in tough times, marriage rates and birthrates go down. And while divorce rates usually rise in recessions, they dropped during the Great Depression, in part because unhappy couples found they simply couldn't afford separation.
In precarious times, hunkering down can become not simply a defense mechanism, but a worldview. Grant McCracken, an anthropologist affiliated with MIT who studies consumer behavior, calls this distinction "surging" vs. "dwelling"— the difference, as he wrote recently on his blog, between believing that the world "teems with new features, new things, new opportunities, new excitement" and thinking that life's pleasures come from counting one's blessings and appreciating and holding onto what one already has. Economic uncertainty, he argues, drives us toward the latter.
As a nation, we have grown very accustomed to the momentum that "surging" imparts. And while a depression remains far from inevitable, it's as close as it has been in a lifetime. We might want to get a sense for what "dwelling" feels like.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Long Lines At The ER, A Television Boom, Emptying Suburbs. A New Catastrophic Economic Downturn Would Feel Nothing Like The Last One.
By Drake Bennett | 16 November 2008
Over the past few months, Americans have been hearing the word "depression" with unfamiliar and alarming regularity. The financial crisis tearing through Wall Street is routinely described as the worst since the Great Depression, and the recession into which we are sinking looks deep enough, financial commentators warn, that a few poor policy decisions could put us in a depression of our own.
It's a frightening possibility, but also in many ways an abstraction. The country has gone so long without a depression that it's hard to know what it would be like to live through one. Most of us, of course, think we know what a depression looks like. Open a history book and the images will be familiar.
Mobs lined up at the banks and lines at soup kitchens; stockbrokers in suits selling apples on the street; families piled with all their belongings into jalopies. Families scrimping on coffee and flour and sugar, rinsing off tinfoil to reuse it and mending and re-mending their pants and dresses. A desperate government mobilizes legions of the unemployed to build bridges, roads, and airports, to blaze trails in national forests, to put on traveling plays and paint social-realist murals.
Today, however, whatever a depression would look like, that's not it. We are separated from the 1930s by decades of profound economic, technological, and political change, and a modern landscape of scarcity would reflect that. What, then, would we see instead? And how would we even know a depression had started?
It's not a topic that professional observers of the economy study much. And there's no single answer, because there's no one way a depression might unfold. But it's nonetheless an important question to consider— there's no way to make informed decisions about the present without understanding, in some detail, the worst-case scenario about the future.
By looking at what we know about how society and commerce would slow down, and how people respond, it's possible to envision what we might face. Unlike the 1930s, when food and clothing were far more expensive, today we spend much of our remaining money on healthcare, child care, and education— and we'd see uncomfortable changes in those parts of our lives. The lines wouldn't be outside soup kitchens, but at emergency rooms; and rather than itinerant farmers, we could see waves of laid-off office workers leaving homes to foreclosure and heading for areas of the country where there's more work— or just a relative with a free room over the garage. Already hollowed-out manufacturing cities could be all but deserted, and suburban neighborhoods would be left checkerboarded, with abandoned houses next to overcrowded ones.
And above all, a depression circa 2009 might be a less visible and altogether more isolating experience. With the diminishing price of televisions and the proliferation of channels, it's getting easier and easier to kill time alone— isolated from the rest of the community— and free time is one thing a 21st-century depression would create in abundance. Instead of dusty farm families, the icon of a modern-day depression might be something as subtle as the flickering glow of millions of televisions glimpsed through living room windows, as the nation's unemployed sit at home filling their days with the cheapest form of distraction available.
The odds are, most economists say, we will yet avoid a full-blown depression— the world's policy makers, they argue, have learned enough not to repeat the mistakes of the 1930s. Still, in a country that has known little but economic growth for 50 years, it matters to think about what life would look like without it.
. . .
There is, in fact, no agreed-upon definition of what a depression is. Economists are unanimous that the Great Depression was the worst economic downturn the industrial world has ever seen, and that we haven't had a 'depression' since, but beyond that there is not a consensus. Recessions have an official definition from the National Bureau of Economic Research, but the bureau pointedly declines to define a depression.
What sets a depression apart, most economists would agree, are duration and the scale of joblessness. To be worthy of the name, a depression needs to be more than a few years long— far longer than the eight-month average of our recent recessions— and it needs to put a lot of people out of work. The Great Depression lasted a decade by some measures, and at its worst, one in four American workers was out of a job. (By comparison, unemployment now is at a 14-year high of 'merely' 6.5 percent— or possibly twice that by the old accounting.)
In a modern depression, the swelling ranks of the unemployed would likely change the landscape of the country, uprooting people who would rather stay where they are and trapping people who want to move. In the 1930s, this took the visible form of waves of displaced tenant farmers washing into California, but it also had another, subtler effect: it froze the movement of the middle class. The suburbanization that was to define the post-World-War-II years had in fact started in the 1920s, only to be brought sharply to a halt when the economy collapsed.
Today, a depression could reverse that process altogether. In a deep and sustained downturn, home prices would likely sink further and not rise, dimming the appeal of homeownership, a large part of suburbia's draw. Renting an apartment— perhaps in a city, where commuting costs are lower— might be more tempting. And although city crime might increase, the sense of safety that attracted city-dwellers to the suburbs might suffer, too, in a downturn.
Many suburban areas have already seen upticks in crime in recent years, which would only get worse as tax-poor towns spent less money on policing and public services. "You could have a sort of desuburbanization phenomenon," suggests Michael Bernstein, a historian of the Depression and the provost of Tulane University.
The migrations kicked off by a depression wouldn't be in just one direction, but a tangle of demographic crosscurrents: young families moving back to their hometowns to live with the grandparents when they can no longer afford to live on their own, parents moving in with their adult children when their postretirement fixed incomes can no longer support them.
Some parts of the country, especially the Rust Belt, could see a wholesale depopulation as the last remnants of the American heavy-manufacturing base die out. "There will be some cities like Detroit that in a real depression could just become ghost towns," says Jeffrey Frankel, a Harvard economist and member of the National Bureau of Economic Research committee that declares recessions. (Frankel does not, he emphasizes, think we are headed for a depression.)
. . .
At the household level, the look of want is different today than during the last prolonged downturn. The government helps the unemployed and the poor with programs that didn't exist when the Great Depression hit— unemployment insurance, Medicaid, food stamps, Social Security for seniors. Beyond that, two of the basics of existence— food and clothing— are a lot cheaper today, thanks to industrial agriculture and overseas labor. The average middle-class man in the late 1920s, according to the writer and cultural critic Virginia Postrel, could afford just six outfits, and his wife nine— by comparison, the average woman today has seven pairs of jeans alone. So we're less likely to see one of the iconic images of the Great Depression: Formerly middle-class workers in threadbare clothes lining up for free food. [[Although our private charity soup kitchens have already reported sizable upticks in the numbers visiting their facilities.: normxxx]]
If we look closely, however, we might see more former lawyers wearing knockoffs, doing their back-to-school shopping at Target or Wal-Mart rather than Banana Republic and Abercrombie & Fitch. Lean times might kill off much of the taboo of visiting thrift shops and buying used items, and with modern distribution networks— and a push from the reduce-reuse-recycle mind-set of environmentalism— we might see the development of nationwide used-clothing chains. "Seconds" and "irregular" shops would flourish again; as would "thrifts" of every variety.
In general, novelty would lose some of its luster. It's not simply that we'd buy less, we'd look for different qualities in what we buy. New technology would grow less seductive, basic reliability more important. "Throw-away" items would disappear (or undergo a face-lift). We'd see more products like Nextel phones and the Panasonic Toughbook laptop, which trade on their sturdiness, and fewer like the iPhone— beautiful, cleverly designed, but not noted for durability. The neighborhood appliance shop could reappear in a new form— unlicensed, with hacked cellphones and rebuilt computers.
And while very few would starve, a depression would change how we eat. Food costs remain far below what they were for a family in the 1920s and 1930s, but they have been rising in recent years, and many people already on the edge of poverty would be unable to feed themselves on their own in a harsh economic climate— soup kitchens are already seeing an uptick in attendance. At the high end of the market, specialty and organic foods— which drove the success of chains like Whole Foods— would seem pointlessly and needlessly expensive; the booming organic food movement could suffer as people start to see specially grown produce as more of a luxury than a moral choice. New England's surviving farmers would be particularly hard-hit, as demand for their seasonal, relatively high-cost products dried up.
According to Marion Nestle, a food and public health professor at New York University, people low on cash and with more time on their hands will cook more rather than go out. They may also, Nestle suggests, try their hands at growing and even raising more of their own food, if they have any way of doing so. Among the green lawns of suburbia, kitchen gardens would spring up. And it might go well beyond just growing your own tomatoes: early last month, the English bookstore chain Waterstone's reported a 200 percent increase in the sales of books on keeping chickens.
At the same time, the cheapest option for many is decidedly less rustic: meals like packaged macaroni and cheese, and drive-through fast food. And we're likely to see a move, as well, toward cheaper, easier calories. If so, lean times could have the odd effect of making the population fatter, as more Americans eat like today's poor.
. . .
To understand where a depression would hit hardest, however, look at the biggest-ticket items on people's budgets. Housing, health insurance, transportation, and child care are the top expenses for American families, according to Elizabeth Warren, a bankruptcy law specialist at Harvard Law School; along with taxes, these take up two-thirds of income, on average. And when those are squeezed, that could mean everything from more crowded subways to a proliferation of cheap, unlicensed day-care centers. [[Check out how today's poor live.: normxxx]]
Health insurance premiums have risen to onerous levels in recent years, and in a long period of unemployment— or underemployment— they would quickly become unmanageable for many people. Dropping health insurance would be an immediate way for families to save hundreds of dollars per month. People without health insurance tend to skip routine dental and medical checkups, and instead deal with health problems only when they become acute— meaning they get their healthcare through hospital emergency rooms.
That means even longer waits at ERs, which are even now overtaxed in many places, and a growing financial drain on hospitals that already struggle to pay for the care they give uninsured people. And if, as is likely, this coincided with cuts in money for hospitals coming from cash-strapped state and local governments, there's a very real possibility that many hospitals would have to close, only further increasing the burden on those that remain open. In their place people would rely more on federally-funded health centers, or the growing number of 'drugstore' clinics, like the MinuteClinics in CVS branches, for vaccines, strep throat tests, and other basic medical care. And as the costs of traditional medicine climbed out reach for families, the appeal of alternative medicine would in all likelihood grow.
Higher education, another big expense, would probably take a hit as well. Students unable to afford private universities would opt for public universities, students unable to afford four-year colleges would opt for community colleges, and students unable to afford community college wouldn't go at all. With fewer applicants, admissions standards would drop, with spots that once would have been filled by more qualified, poorer students going instead to wealthier applicants who before would not have made the cut. Some universities would simply shrink. In Boston, a city almost uniquely dependent on higher education, the results— fewer students renting apartments, going to restaurants and bars, opening bank accounts, buying books, taking taxis— would be particularly acute.
A depression would last too long for unemployed college graduates to ride out the downturn in business or law school, so people would have to change career plans entirely. One place that could see an uptick in applications and interest is government work: Its relative stability, combined with a growing suspicion of 'free-market' ideology that would accompany a truly disastrous downturn, could attract more and better people, and even help the public sector shake off its image as a redoubt for the mediocre and the unambitious.
. . .
In many ways, though, today's depression would not look like the last one because it would not look like much at all. As Warren wrote in an e-mail, "The New Depression would be largely invisible because people would experience loss privately, not publicly." In the public imagination, the Depression was a galvanizing time, the crucible in which the Greatest Generation came of age and came together.
That is, at best, only partly true. Harvard political scientist Robert Putnam has found that, for many, the Depression was isolating: Kiwanis clubs, PTAs, and other social groups lost around half their members from 1930 to 1935. [[And broke up families, as the "man of the house" went off to look for work and sometimes never returned, and "welfare" paid out more to families without a man in the house.: normxxx]] And other studies on economic hardship suggest that it tends to sap people's civic engagement, often permanently.
"When people became unemployed in the Great Depression, they hunkered down, they pulled in from everybody." Putnam says. That effect, Putnam believes, would only be more pronounced today. The Depression was, famously, a boom time for movies— people flocked to cheap double features to escape the dreariness of their everyday poverty. Today, however, neither a day at the ballpark nor movies are particularly cheap. [[But "cheap" movies would quickly spring up again; it was not only a way to escape boredom, it also provided a means to escape overcrowded living spaces and a little privacy for dating teens.: normxxx]]
Much of a modern depression would unfold in the domestic sphere: people driving less, shopping less, and eating in their houses more. They would watch television at home; unemployed parents would watch over their own kids instead of taking them to day care. With online banking, it would even be possible to have a bank run in which no one leaves the comfort of their home.
There would be darker effects, as well. Mental depression, unsurprisingly, is higher in economically distressed households; so is domestic violence. Suicide rates go up in tough times, marriage rates and birthrates go down. And while divorce rates usually rise in recessions, they dropped during the Great Depression, in part because unhappy couples found they simply couldn't afford separation.
In precarious times, hunkering down can become not simply a defense mechanism, but a worldview. Grant McCracken, an anthropologist affiliated with MIT who studies consumer behavior, calls this distinction "surging" vs. "dwelling"— the difference, as he wrote recently on his blog, between believing that the world "teems with new features, new things, new opportunities, new excitement" and thinking that life's pleasures come from counting one's blessings and appreciating and holding onto what one already has. Economic uncertainty, he argues, drives us toward the latter.
As a nation, we have grown very accustomed to the momentum that "surging" imparts. And while a depression remains far from inevitable, it's as close as it has been in a lifetime. We might want to get a sense for what "dwelling" feels like.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Wednesday, November 19, 2008
30 Reasons For Great Depression 2
30 Reasons For Great Depression 2 By 2011
New-New Deal, Bailouts, Trillions In Debt, Antitax Mindset Spell Disaster
By Paul B. Farrell, Marketwatch | 17 November 2008
ARROYO GRANDE, Calif. (MarketWatch)— By 2011? No recovery? No new bull? "Hey Paul, why do you keep talking about a bigger crash coming by 2011?" Readers ask that often. So here's a sequel to my predictions of 2000 and 2004, with a look three years ahead:
First. Dot-Com Crash
We pinpointed the dot-com crash at its peak, in a March 20, 2000 column: "Next crash? Sorry, you won't see it coming." Bulls-eye: The dot-com bubble popped. The economy went into a 30-month recession. The stock market lost $8 trillion. And today, over eight years later, the market is still roughly 40% below its 2000 peak. See previous Paul B. Farrell.
Factor in inflation and the average stock has lost well over 50% of its value. Stocks have proven to be a very big loser, a bad investment for Americans, thanks to Wall Street's selfish greed, plus the complicity and naiveté of politicians, press and public.
Second. Subprime Meltdown
We reported on warnings of another crash coming as early as 2004, wrote a sequel, also titled "Next crash? Sorry, you won't see it coming." Yes, we were early, but in good company. We wrote many more warning columns. Few listened.
Subsequent events, notably former Fed Chairman Alan Greenspan's admission of his failures in congressional testimony, prove that if he and other Reaganomic ideologues weren't so myopic and intransigent about proving their free-market deregulation theories, they could have acted earlier and prevented today's colossal mess. Instead, their ideology kept the bubble bloating, delayed the pop, making matters worse.
So once again, as history proves over and over, ideology trumps common sense, reality and the facts. Greed drives ideologues to blow bubbles. They pop. Crashes happen. The public is 'collateral damage'.
Third. Megabubble Cycles
We also detailed the broader, accelerating macroeconomic sweep of cycles last summer in columns like "20 reasons new megabubble pops in 2011." We summarized a long list of major warnings from financial periodicals— Forbes, Fortune, the Wall Street Journal, Economist— and from the voices of Warren Buffett, Bill Gross, a sitting Fed governor and a former Commerce secretary. Multiple warnings "hiding in plain sight," beginning with a Fed governor warning Greenspan in 2000 about subprime risk.
But the big shocker came from the new Treasury secretary two years before the meltdown: Bloomberg News reports that shortly after leaving Wall Street as Goldman Sachs' CEO, Henry Paulson was at Camp David warning the president and his staff of "over-the-counter derivatives as an example of financial innovation that could, under certain circumstances, blow up in Wall Street's face and affect the whole economy."
Yes, they knew. And still both Paulson, a Wall Street insider, and Greenspan's successor, Ben Bernanke, a Princeton scholar of the Great Depression, stayed trapped in denial and kept happy-talking the public for months after the meltdown began in mid-2007. Get it? While they could have put the brakes on this meltdown years ago, our leaders were prisoners of their distorted, inflexible views of conservative Reaganomics ideology.
As a result, once again the "best and the brightest" failed America and now they and their buddies in Washington and Corporate America are setting up for The Crash of 2011.
Now it's time for my 2008 update, a look into the future where things will get far worse during the next presidential term. And given human behavior, especially in the deep recesses of Wall Street's "greed is good" DNA, it seems inevitable that no matter how well-intentioned the new president may be, Wall Street and Washington's 41,000 special-interest lobbyists will drive America into The Great Depression 2.
30 'Leading Edge' Indicators Of The Coming Great Depression 2
Every day there is more breaking news, proof Wall Street's greed is already back to "business as usual" and in denial, grabbing more and more from the new "Bailouts-R-Us" bonanza of free taxpayer cash and credits, like two-year-olds in a toy store at Christmas— anything to boost earnings, profits and stock prices, and keep those bonuses and salaries flowing, anything to blow up a new bubble.
Scan these 30 "leading indicators." Each problem has one or more possible solutions, but lacks unified political support. Time's running out. We're already at the edge. Add up the trillions in debt: Any collective solution will only compound our problems, because the cumulative debt will overwhelm us, making matters worse:
Will the next meltdown, the third of the 21st Century, trigger a second Great Depression? Or will the 2007-08 crisis simply morph into a painful extension of today's mess to 2011 and beyond, with no new bull market, no economic recovery as our new president's best hope? Perhaps some of the first 29 problems may be solved separately, but collectively, after building on a failed ideology, they spell disaster. So listen closely to "leading indicator" No. 30:
We see the Great Depression 2. Why? Wall Street's self-interested greed. They are their own worst enemy… and America's too.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
New-New Deal, Bailouts, Trillions In Debt, Antitax Mindset Spell Disaster
By Paul B. Farrell, Marketwatch | 17 November 2008
ARROYO GRANDE, Calif. (MarketWatch)— By 2011? No recovery? No new bull? "Hey Paul, why do you keep talking about a bigger crash coming by 2011?" Readers ask that often. So here's a sequel to my predictions of 2000 and 2004, with a look three years ahead:
First. Dot-Com Crash
We pinpointed the dot-com crash at its peak, in a March 20, 2000 column: "Next crash? Sorry, you won't see it coming." Bulls-eye: The dot-com bubble popped. The economy went into a 30-month recession. The stock market lost $8 trillion. And today, over eight years later, the market is still roughly 40% below its 2000 peak. See previous Paul B. Farrell.
Factor in inflation and the average stock has lost well over 50% of its value. Stocks have proven to be a very big loser, a bad investment for Americans, thanks to Wall Street's selfish greed, plus the complicity and naiveté of politicians, press and public.
Second. Subprime Meltdown
We reported on warnings of another crash coming as early as 2004, wrote a sequel, also titled "Next crash? Sorry, you won't see it coming." Yes, we were early, but in good company. We wrote many more warning columns. Few listened.
Subsequent events, notably former Fed Chairman Alan Greenspan's admission of his failures in congressional testimony, prove that if he and other Reaganomic ideologues weren't so myopic and intransigent about proving their free-market deregulation theories, they could have acted earlier and prevented today's colossal mess. Instead, their ideology kept the bubble bloating, delayed the pop, making matters worse.
So once again, as history proves over and over, ideology trumps common sense, reality and the facts. Greed drives ideologues to blow bubbles. They pop. Crashes happen. The public is 'collateral damage'.
Third. Megabubble Cycles
We also detailed the broader, accelerating macroeconomic sweep of cycles last summer in columns like "20 reasons new megabubble pops in 2011." We summarized a long list of major warnings from financial periodicals— Forbes, Fortune, the Wall Street Journal, Economist— and from the voices of Warren Buffett, Bill Gross, a sitting Fed governor and a former Commerce secretary. Multiple warnings "hiding in plain sight," beginning with a Fed governor warning Greenspan in 2000 about subprime risk.
But the big shocker came from the new Treasury secretary two years before the meltdown: Bloomberg News reports that shortly after leaving Wall Street as Goldman Sachs' CEO, Henry Paulson was at Camp David warning the president and his staff of "over-the-counter derivatives as an example of financial innovation that could, under certain circumstances, blow up in Wall Street's face and affect the whole economy."
Yes, they knew. And still both Paulson, a Wall Street insider, and Greenspan's successor, Ben Bernanke, a Princeton scholar of the Great Depression, stayed trapped in denial and kept happy-talking the public for months after the meltdown began in mid-2007. Get it? While they could have put the brakes on this meltdown years ago, our leaders were prisoners of their distorted, inflexible views of conservative Reaganomics ideology.
As a result, once again the "best and the brightest" failed America and now they and their buddies in Washington and Corporate America are setting up for The Crash of 2011.
Now it's time for my 2008 update, a look into the future where things will get far worse during the next presidential term. And given human behavior, especially in the deep recesses of Wall Street's "greed is good" DNA, it seems inevitable that no matter how well-intentioned the new president may be, Wall Street and Washington's 41,000 special-interest lobbyists will drive America into The Great Depression 2.
30 'Leading Edge' Indicators Of The Coming Great Depression 2
Every day there is more breaking news, proof Wall Street's greed is already back to "business as usual" and in denial, grabbing more and more from the new "Bailouts-R-Us" bonanza of free taxpayer cash and credits, like two-year-olds in a toy store at Christmas— anything to boost earnings, profits and stock prices, and keep those bonuses and salaries flowing, anything to blow up a new bubble.
Scan these 30 "leading indicators." Each problem has one or more possible solutions, but lacks unified political support. Time's running out. We're already at the edge. Add up the trillions in debt: Any collective solution will only compound our problems, because the cumulative debt will overwhelm us, making matters worse:
- America's credit rating may soon be downgraded below AAA
- Fed refusal to disclose $2 trillion loans, now the new "shadow banking system"
- Congress has no oversight of $700 billion, and Paulson's Wall Street Trojan Horse
- King Henry Paulson flip-flops on plan to buy toxic bank assets, confusing markets
- Goldman, Morgan lost tens of billions, but planning over $13 billion in bonuses this year
- AIG bails big banks out of $150 billion in credit swaps, protects shareholders before taxpayers
- American Express joins Goldman, Morgan as bank holding firms, looking for Fed money
- Treasury sneaks $172 billion of corporate tax credits into bailout giveaway, shifts costs to states
- State revenues down, taxes and debt up; hiring, spending, borrowing add even more debt
- State, municipal, corporate pensions lost hundreds of billions on derivative swaps
- Hedge funds: 610 in 1990, almost 10,000 now. Returns down 15%, liquidations up
- Consumer debt way up, now at $2.5 trillion; next area for credit meltdowns
- Fed also plans to provide billions to $3.6 trillion money-market fund industry
- Freddie Mac and Fannie Mae are bleeding cash, want to tap taxpayer dollars
- Washington manipulating data: War not $600 billion but estimates actually $3 trillion
- Hidden costs of $700 billion bailout are likely $5 trillion; plus $1 trillion Street write-offs
- Commodities down, resource exporters and currencies dropping, triggering a global meltdown
- Big three automakers near bankruptcy; unions, workers, retirees will suffer
- Corporate bond market, both junk and top-rated, slumps more than 25%
- Retailers bankrupt: Circuit City, Sharper Image, Mervyns; mall sales in free fall
- Unemployment heading toward 8% plus; more 1930's photos of soup lines
- Government policy is dictated by 42,000 myopic, highly paid, greedy lobbyists
- China's sees GDP growth drop, crates $586 billion stimulus; deflation is now global, hitting even Dubai
- Despite global recession, U.S. trade deficit continues, now at $650 billion
- The 800-pound gorillas: Social Security, Medicare with $60 trillion in unfunded liabilities
- Now 46 million uninsured as medical, drug costs explode
- New-New Deal: U.S. planning billions for infrastructure, adding to unsustainable debt
- Outgoing leaders handicapping new administration with huge liabilities
- The "antitaxes" message is a new bubble, a new version of the American dream offering a free lunch, no sacrifices, exposing us to more false promises
Will the next meltdown, the third of the 21st Century, trigger a second Great Depression? Or will the 2007-08 crisis simply morph into a painful extension of today's mess to 2011 and beyond, with no new bull market, no economic recovery as our new president's best hope? Perhaps some of the first 29 problems may be solved separately, but collectively, after building on a failed ideology, they spell disaster. So listen closely to "leading indicator" No. 30:
|
We see the Great Depression 2. Why? Wall Street's self-interested greed. They are their own worst enemy… and America's too.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Buy When There Is Blood In The Streets!
Buy When There Is Blood In The Streets!
Anatomy Of Some 20th Century "Panics".
By David Chapman | 17 November 2008
We are not sure who coined the above phrase. Some say it was Baron Rothschild, the scion of the Rothschild banking family. What it means is that when fear is at its highest, one must toss aside the bearish feeling and turn bullish. Of course the $64 million question is, "Are we there yet?" As the market sank this past week one could be forgiven if even the most optimistic amongst us turned out to be wrong as well.
The original quote is believed to be "Buy when there is blood in the streets, even if the blood is your own". Well, we have suffered some bleeding. We guess the question now is, have we bled enough or is there more to come?
In last week's Scoop we premised that the financial panic of 2008 was more akin to the financial panics of 1907, 1937-38 and 1973-74 than the seemingly endless liquidation of 1929-32. We also premised that the equivalent of that famous 1930-32 collapse in the Dow Jones Industrials (DJI) was the NASDAQ in 2000-02. The DJI was the cutting edge index in its time, and it fell 89 per cent. The NASDAQ fell 78 per cent.
If we are in the throes of a monumental collapse á la 1929-32, we have a long way to go before we see the bottom. That collapse was a series of endless liquidations. The bottom did not come in until after the swearing-in of a new president— Franklin Roosevelt, in March 1933. We don't have quite as long to wait for the next new president; only until January 20, 2009.
We held off showing that horrible chart of 1929-32 but it is a lesson. From the highs of September 1929 there were seven declines and six rebounds— a 13-wave decline. The declines varied from 30 per cent to 50 per cent. The first decline, which included the 1929 stock market crash, was the worst: 50 per cent. The six rebounds varied from 19 per cent to 52 per cent. If the first decline was the steepest, the first rebound was also the best one.
Click Here, or on the image, to see a larger, undistorted image.
The 1937-38 financial panic was quite different. In total the market lost 50 per cent. It fell in a mere five wave decline. The first collapse was only 17 per cent. The ensuing rebound was also 17 per cent. The second collapse was for 41 per cent, with the final plunge coming in two parts, with a short-term rebound and then the final drop. What followed was a three-month choppy rebound that added about 21 per cent. The final wave collapse was for 28 per cent.
Click Here, or on the image, to see a larger, undistorted image.
The 1973-74 financial panic was different yet again. The market lost a total of 47 per cent. Again we see what appears to be a five wave decline. The first drop was a very choppy one but ultimately lost 21 per cent. The swift rebound regained 18 per cent. The next drop was short and swift as well, losing 22 per cent. What followed was a choppy rebound that lasted six months but at the top had regained only 15 per cent. The final drop also lasted six months and made the double bottom low in October and December 1974, for a loss of 37 per cent.
Click Here, or on the image, to see a larger, undistorted image.
Flash forward to today's market, where we made our final top in October 2007. Our first decline lasted into January (setting aside the mini-rebound in November and December) and lost 19 per cent. The rebound, which tested the lows in March 2008 (and many others made new lows) lasted until May and gained 15 per cent. The second decline was into July 2008, losing 19 per cent again, and the subsequent rebound into August gained back 11 per cent. The final collapse into what thus far has been the low in October lost 35 per cent. The final plunges in these three markets were 28, 37 and 35 per cent respectively. In total we lost 46 per cent— very comparable to the two aforementioned panics.
Click Here, or on the image, to see a larger, undistorted image.
In structure, this decline has thus far also looked more like the two aforementioned panics. The 1907 financial panic declined in three stages and not the five-stage declines of 1937-38, 1973-74 and (assuming we are at the lows) 2007-08. Even in time there are some similarities. The 1937-38 decline lasted 386 days while the 1973-74 decline lasted 698 days— nearly twice as long. For the current decline, October 10, 2008 was Day 365 and the October 27 low was Day 382. The Great Depression of 1929-32 lasted almost three years, or about 1,000 days.
The background news has been relentlessly gloomy, yet it has now been over a month since the markets generally made their lows. The DJI's was on October 10. The S&P 500 did see small new lows this past week on November 13 coinciding with a huge reversal up day. The NASDAQ also made small new lows on November 13 coinciding with a huge reversal up day. The TSX Composite made its low with a double bottom on October 27-28. Despite attempts to take out these lows, we have successfully rebounded each time.
Volatility as measured by the VIX Indicator peaked on October 24. While it has eased since then, it has remained high. The collapse has been spectacular and has taken a serious bite out of retirement funds, mutual funds and pension funds.
Yet the market can rebound quite quickly as well. A year after the lows in 1907 the markets had recouped 66 per cent; a year after the lows of 1974 they were up 40 per cent. The market was tougher in 1938 because a year later the world went to war [[and 1938 was filled with forebodings and preludes to war: normxxx]], but still [it went] up 23 per cent. Naturally it still took a while to regain the old highs.
The highs of 1907 were not surpassed for good until 1915; the highs of 1973 were not surpassed for good until 1983 and those of 1937 were not surpassed for good until 1949-50. We will certainly not be surprised if it took us a decade or more to see the highs of 2007 again. But then markets can sometimes certainly surprise.
The financial panics of 1907, 1937-38 and 1973-74 were the worst market collapses of the past century, with the one exception of 1929-32. Only that last market went into endless liquidation. One has to take into account some conditions that existed then that do not exist today. They are as follows:
Today we are getting nothing but gloomy news. Volatility and negative sentiment have never been worse. But these are the conditions that often give us bottoms. We are not saying we are out of the woods; at some point, lower lows may occur. But we are saying that we may be in the early stages of creating a more substantial bottom that may still have months to play out, with many twists and turns.
Certainly we would be foolish to assume at this stage that we have seen the absolute bottom. One can only determine that in hindsight. This is a bottom, not necessarily the bottom. It may be the latter but we need to work our way through a lot more. Risks continue to abound.
There is no magic elixir for the cure of the market. While we believe we are at a low it will still take many months of work and no new lows before we can determine whether we have put in the lows for this cycle. We have often remarked on the similarities between the markets of the 1930's and this decade. We can only hope that continues. We compare the two below and show the chart of the 1930's and early 1940's.
Click Here, or on the image, to see a larger, undistorted image.
If we continue to follow the earlier decade's road map we should see a feeble recovery in 2009 followed by another collapse in 2010. Another feeble rise could get underway in 2011 and then we plunge to our final lows in 2012. The scary alternative is that a feeble recovery into 2009 is followed by a further collapse to new lows and while we follow that road map the final lows of 2012 are made some 40 to 50 per cent below today's lows. We certainly hope not, but it is possible if things do not go well in attempting to restructure the world. But right now the scenario still calls for a rebound into 2009.
Click Here, or on the image, to see a larger, undistorted image.
There is another market we would like to look at that is also seeing blood in the streets. That is the oil market. The collapse of oil prices, while not completely unexpected, has caught many unprepared because of its steepness and velocity. The collapse also spread to the energy stocks, many of which were not trading at overvalued levels in the first place and which are now even more undervalued.
In looking at the market we have noted that there appears to be a four-year cycle (Merriman— MMA Market Analyst) in oil prices. Merriman has raised the possibility of a 12/13-year cycle as well. Trouble is, oil prices have been trading on a futures exchange only since 1983. Prior to that, prices were controlled by a cartel of oil companies until the Arab oil embargo that initially occurred following the 1967 Arab-Israeli Six-Day War. That embargo lasted only three months. The second and more serious one got underway in October 1973 and was a factor behind the 1973-74 financial panic. It coincided with the 1973 Yom Kippur-Ramadan War.
In 1979 the Iranian crisis broke out with the fall of the Shah and the Iranian Revolution that culminated in the seizing of the American Embassy hostages. Oil prices soared to $40 (equivalent to over $110 today). After the hostage crisis ended oil prices began a slow descent and then crashed in 1985. Our first good low was made then. In total, oil prices fell some 75 per cent but took five years to do so.
The next crash took place following Gulf War I in 1991. Oil prices peaked at $41 in 1990, prior to the start of the war. But it wasn't until 1998 that they made their final bottom, once again losing some 75 per cent from the highs of 1990.
Our chart labels what Merriman believes are examples of a four-year cycle in oil prices. The lows occurred in 1986 (April), 1990 (June), 1993 (December), 1998 (December), 2001 (December) and 2007 (January). While the average is roughly four years, it has ranged from 36 to 61 months. Those actually occurred with the series from 1998 to 2007 and the average worked out to four years.
Click Here, or on the image, to see a larger, undistorted image.
Merriman has alluded to the possibilities of 12/13-year cycle with the two huge lows made in 1986 and 1998. Both lost roughly 75 per cent from top to bottom but the time between the two was measured in years, not a few months. If it exists then the next one is due between 2009 and 2011.
The collapse that has taken place this year from the highs of $147 has been steep: 62 per cent so far. If the 75 per cent figure holds, then the low could be made as early as sometime next year near $35/$40. If that were to occur it would be a huge buying opportunity for oil and gas stocks.
The reality is that the current malaise in oil is unsustainable. Demand has fallen due to recessionary fears, but the reality is that the world's global production is also declining rapidly and new sources are incresingly difficult and expensive to find. We reiterate that no major discoveries have been made in 30 years.
Much of the world's reserves are in the war-torn Middle East; in Canada's oil sands— a huge reserve, but increasingly expensive to extract and extremely polluting; and in difficult areas such as deep beneath the ocean, or in the Arctic regions. Finally, the current price of oil is far too low below the cost of newer sources of energy production. With OPEC cutting back and the unlikelihood of new sources coming on stream at these prices, the longer term outlook for oil remains very bullish.
While we may be temporarily at a low in oil prices and due for a rebound, resistance will now be seen in the $90/$110 range but due to weak demand it may be difficult regaining much ground above $80. After an attempt to go to higher prices we could easily see another decline and possible targets down to $35/$40 for our final bottom of this much larger cycle. Investors should be aware of that possibility.
But in the interim the gloom out there is pervasive. There is blood in the streets and that is the time to buy, not to be shy. But the forming of any significant final bottom could still be several months away.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Anatomy Of Some 20th Century "Panics".
By David Chapman | 17 November 2008
We are not sure who coined the above phrase. Some say it was Baron Rothschild, the scion of the Rothschild banking family. What it means is that when fear is at its highest, one must toss aside the bearish feeling and turn bullish. Of course the $64 million question is, "Are we there yet?" As the market sank this past week one could be forgiven if even the most optimistic amongst us turned out to be wrong as well.
The original quote is believed to be "Buy when there is blood in the streets, even if the blood is your own". Well, we have suffered some bleeding. We guess the question now is, have we bled enough or is there more to come?
In last week's Scoop we premised that the financial panic of 2008 was more akin to the financial panics of 1907, 1937-38 and 1973-74 than the seemingly endless liquidation of 1929-32. We also premised that the equivalent of that famous 1930-32 collapse in the Dow Jones Industrials (DJI) was the NASDAQ in 2000-02. The DJI was the cutting edge index in its time, and it fell 89 per cent. The NASDAQ fell 78 per cent.
If we are in the throes of a monumental collapse á la 1929-32, we have a long way to go before we see the bottom. That collapse was a series of endless liquidations. The bottom did not come in until after the swearing-in of a new president— Franklin Roosevelt, in March 1933. We don't have quite as long to wait for the next new president; only until January 20, 2009.
We held off showing that horrible chart of 1929-32 but it is a lesson. From the highs of September 1929 there were seven declines and six rebounds— a 13-wave decline. The declines varied from 30 per cent to 50 per cent. The first decline, which included the 1929 stock market crash, was the worst: 50 per cent. The six rebounds varied from 19 per cent to 52 per cent. If the first decline was the steepest, the first rebound was also the best one.
Click Here, or on the image, to see a larger, undistorted image.
The 1937-38 financial panic was quite different. In total the market lost 50 per cent. It fell in a mere five wave decline. The first collapse was only 17 per cent. The ensuing rebound was also 17 per cent. The second collapse was for 41 per cent, with the final plunge coming in two parts, with a short-term rebound and then the final drop. What followed was a three-month choppy rebound that added about 21 per cent. The final wave collapse was for 28 per cent.
Click Here, or on the image, to see a larger, undistorted image.
The 1973-74 financial panic was different yet again. The market lost a total of 47 per cent. Again we see what appears to be a five wave decline. The first drop was a very choppy one but ultimately lost 21 per cent. The swift rebound regained 18 per cent. The next drop was short and swift as well, losing 22 per cent. What followed was a choppy rebound that lasted six months but at the top had regained only 15 per cent. The final drop also lasted six months and made the double bottom low in October and December 1974, for a loss of 37 per cent.
Click Here, or on the image, to see a larger, undistorted image.
Flash forward to today's market, where we made our final top in October 2007. Our first decline lasted into January (setting aside the mini-rebound in November and December) and lost 19 per cent. The rebound, which tested the lows in March 2008 (and many others made new lows) lasted until May and gained 15 per cent. The second decline was into July 2008, losing 19 per cent again, and the subsequent rebound into August gained back 11 per cent. The final collapse into what thus far has been the low in October lost 35 per cent. The final plunges in these three markets were 28, 37 and 35 per cent respectively. In total we lost 46 per cent— very comparable to the two aforementioned panics.
Click Here, or on the image, to see a larger, undistorted image.
In structure, this decline has thus far also looked more like the two aforementioned panics. The 1907 financial panic declined in three stages and not the five-stage declines of 1937-38, 1973-74 and (assuming we are at the lows) 2007-08. Even in time there are some similarities. The 1937-38 decline lasted 386 days while the 1973-74 decline lasted 698 days— nearly twice as long. For the current decline, October 10, 2008 was Day 365 and the October 27 low was Day 382. The Great Depression of 1929-32 lasted almost three years, or about 1,000 days.
The background news has been relentlessly gloomy, yet it has now been over a month since the markets generally made their lows. The DJI's was on October 10. The S&P 500 did see small new lows this past week on November 13 coinciding with a huge reversal up day. The NASDAQ also made small new lows on November 13 coinciding with a huge reversal up day. The TSX Composite made its low with a double bottom on October 27-28. Despite attempts to take out these lows, we have successfully rebounded each time.
Volatility as measured by the VIX Indicator peaked on October 24. While it has eased since then, it has remained high. The collapse has been spectacular and has taken a serious bite out of retirement funds, mutual funds and pension funds.
Yet the market can rebound quite quickly as well. A year after the lows in 1907 the markets had recouped 66 per cent; a year after the lows of 1974 they were up 40 per cent. The market was tougher in 1938 because a year later the world went to war [[and 1938 was filled with forebodings and preludes to war: normxxx]], but still [it went] up 23 per cent. Naturally it still took a while to regain the old highs.
The highs of 1907 were not surpassed for good until 1915; the highs of 1973 were not surpassed for good until 1983 and those of 1937 were not surpassed for good until 1949-50. We will certainly not be surprised if it took us a decade or more to see the highs of 2007 again. But then markets can sometimes certainly surprise.
The financial panics of 1907, 1937-38 and 1973-74 were the worst market collapses of the past century, with the one exception of 1929-32. Only that last market went into endless liquidation. One has to take into account some conditions that existed then that do not exist today. They are as follows:
- During 1929-32 the Fed (sometimes) hiked interest rates. This time they are cutting them.
- The Smoot-Hawley law of June 1930 raised US tariffs on host of imported goods and set in motion trade wars. We don't believe that will happen this time around and avoiding protectionism was a key note from this weekend's G20 meeting.
- The Fed tightened the money supply. [[Actually, they had little control over money supply as a consequence of being on the gold standard; they initially did tighten in 1929 and early 1930 to keep gold from leaving the US; but had lowered rates by 2%— about a third— by the end of 1930.: normxxx]] Rather than providing backup to the banking system, the Fed let it fail. [[That was true; possibly partly because of antisemitism: the NY Bank of the US was not saved from a run on it because "it was owned and run by a bunch of [speculating Jews]…" That started a general panic among banks in the US and overseas (not unlike what happened after Lehman Brothers failed).: normxxx]] This caused a huge contraction in money supply. This time they are expanding money supply and bailing out the banking system.
- Society at that time was primarily rural/agrarian and manufacturing. This time we are an urban society dominated by service jobs in high technology, finance and sales (setting aside the massive number of McJobs). [[Indeed, it is China and the little Tigers who have so far taken the brunt of the sharp drop in manufacturing associated with the sharp drop in retail sales.: normxxx]]
- The common factors were market euphoria, and bubbles created prior to the collapse because of easy credit.
- The Great Depression was made worse because social safety nets such as unemployment insurance, social security, Medicare and welfare programs did not exist then. [[In fact, even 'relief' was strictly a local (city and private charities) affair— no federal involvement in any way.: normxxx]]
- It wasn't until Roosevelt took office and instituted the New Deal which included massive infrastructure spending that the stock market and the economy began to turn around. In the end it also took a war [[with its orders of magnitude greater spending and reduction in the civilian labor force: normxxx]] to raise employment levels back to pre-Depression levels.
Today we are getting nothing but gloomy news. Volatility and negative sentiment have never been worse. But these are the conditions that often give us bottoms. We are not saying we are out of the woods; at some point, lower lows may occur. But we are saying that we may be in the early stages of creating a more substantial bottom that may still have months to play out, with many twists and turns.
Certainly we would be foolish to assume at this stage that we have seen the absolute bottom. One can only determine that in hindsight. This is a bottom, not necessarily the bottom. It may be the latter but we need to work our way through a lot more. Risks continue to abound.
- The G20 meetings this weekend accomplished very little. Not that much was expected. In June 1933 a similar global conference also accomplished very little. However, we do note the market after rallying from March 1933 paused in June before taking off again.
- Like Obama though, Roosevelt did not attend the 1933 meeting as Roosevelt had already decided to turn inward and go it alone for America. Obama does not have that luxury when you are indebted to the rest of the world even if he missed the meeting because officially he is not yet President. But unlike that conference of yesteryears the world is not in the throes of dying imperialism (Britain), dogmatic communism (Russia), rising fascism (Germany) and of course Roosevelt was burdened with collapsing capitalism. Today we have only the latter although there is no doubt that America may also be in the throes of dying imperialism even if it has never been called that.
- The Federal Reserve is not in the same position to bail out the world the way it used to. [Today, i]t needs the co-operation of all central banks. With a grossly weakened USA there is no one country or countries that can adequately replace the USA. Europe is equally if not worse battered by this crisis, Japan is in no position either and China is too new to the game to run the show. We hardly think of China as a bastion of world capitalism.
- The US is bogged down in debt that is rapidly approaching $11 trillion. There is a real risk of $1 trillion deficits. More than 40 per cent of US debt is held by foreigners primarily China, Japan and Saudi Arabia. The US is no position to dictate terms to its creditors. [Moreover, t]he US has [the] huge unfunded debts of Social Security, Medicare and Medicaid. That problem as well plays itself out over numerous companies whose pension funds are now grossly underfunded and have very little in their arsenal to ever catch up.
- The crisis continues. Credit card debt is on the verge of toppling (and along with it probably car loan debt). Losses in these two areas have been rising but any final numbers are unknown.
- The housing crisis continues with numerous [[pay option ARM: normxxx]] mortgages due for renewal in 2009. Lenders are charging high interest rates due to both the tightness of credit and fear of not collecting. This just makes the situation worse. While plans are being made for upcoming mortgages in order to try to prevent another huge wave of defaults, it does nothing for the thousands that have already been foreclosed and lost their homes [[or are already in process of foreclosure: normxxx]].
- With retail sales plunging and the upcoming Christmas season promising to be bleak there are probably more large retailers teetering on the brink of bankruptcy.
- The major big three automobile companies are all teetering on the brink of bankruptcy with hundreds of thousands [[millions?: normxxx]] of jobs in the balance.
- The unemployment rate has not peaked. While the consensus appears to be upwards of 10 per cent at least, the rate could go substantially higher [[but unlikely to be anywheres near the 25% of the GD: normxxx]].
- Inflation could once again rear its ugly head given the huge monetary stimuli being provided by the monetary and fiscal authorities.
- Global business conditions continue to deteriorate and will probably get far worse before it gets better.
- America's ideological rift is real and could become more pronounced under Obama preventing anything of any substance being accomplished. That would probably exacerbate the current malaise.
- America remains embroiled in two [[and a half: normxxx]] wars that have accomplished little at huge cost. Failure to end these wars will soon give back the elation over the election of Obama and continue to add to the cost which is being primarily funded by foreigners.
- Despite the recent rise in the value of the US$ it has gone up primarily due to technical reasons as hedge funds and others repatriate foreign assets. A US$ crisis would exacerbate the situation for the US and probably cause interest rates to rise. On the other hand a US$ crisis would be positive for gold.
There is no magic elixir for the cure of the market. While we believe we are at a low it will still take many months of work and no new lows before we can determine whether we have put in the lows for this cycle. We have often remarked on the similarities between the markets of the 1930's and this decade. We can only hope that continues. We compare the two below and show the chart of the 1930's and early 1940's.
Click Here, or on the image, to see a larger, undistorted image.
If we continue to follow the earlier decade's road map we should see a feeble recovery in 2009 followed by another collapse in 2010. Another feeble rise could get underway in 2011 and then we plunge to our final lows in 2012. The scary alternative is that a feeble recovery into 2009 is followed by a further collapse to new lows and while we follow that road map the final lows of 2012 are made some 40 to 50 per cent below today's lows. We certainly hope not, but it is possible if things do not go well in attempting to restructure the world. But right now the scenario still calls for a rebound into 2009.
Click Here, or on the image, to see a larger, undistorted image.
There is another market we would like to look at that is also seeing blood in the streets. That is the oil market. The collapse of oil prices, while not completely unexpected, has caught many unprepared because of its steepness and velocity. The collapse also spread to the energy stocks, many of which were not trading at overvalued levels in the first place and which are now even more undervalued.
In looking at the market we have noted that there appears to be a four-year cycle (Merriman— MMA Market Analyst) in oil prices. Merriman has raised the possibility of a 12/13-year cycle as well. Trouble is, oil prices have been trading on a futures exchange only since 1983. Prior to that, prices were controlled by a cartel of oil companies until the Arab oil embargo that initially occurred following the 1967 Arab-Israeli Six-Day War. That embargo lasted only three months. The second and more serious one got underway in October 1973 and was a factor behind the 1973-74 financial panic. It coincided with the 1973 Yom Kippur-Ramadan War.
In 1979 the Iranian crisis broke out with the fall of the Shah and the Iranian Revolution that culminated in the seizing of the American Embassy hostages. Oil prices soared to $40 (equivalent to over $110 today). After the hostage crisis ended oil prices began a slow descent and then crashed in 1985. Our first good low was made then. In total, oil prices fell some 75 per cent but took five years to do so.
The next crash took place following Gulf War I in 1991. Oil prices peaked at $41 in 1990, prior to the start of the war. But it wasn't until 1998 that they made their final bottom, once again losing some 75 per cent from the highs of 1990.
Our chart labels what Merriman believes are examples of a four-year cycle in oil prices. The lows occurred in 1986 (April), 1990 (June), 1993 (December), 1998 (December), 2001 (December) and 2007 (January). While the average is roughly four years, it has ranged from 36 to 61 months. Those actually occurred with the series from 1998 to 2007 and the average worked out to four years.
Click Here, or on the image, to see a larger, undistorted image.
Merriman has alluded to the possibilities of 12/13-year cycle with the two huge lows made in 1986 and 1998. Both lost roughly 75 per cent from top to bottom but the time between the two was measured in years, not a few months. If it exists then the next one is due between 2009 and 2011.
The collapse that has taken place this year from the highs of $147 has been steep: 62 per cent so far. If the 75 per cent figure holds, then the low could be made as early as sometime next year near $35/$40. If that were to occur it would be a huge buying opportunity for oil and gas stocks.
The reality is that the current malaise in oil is unsustainable. Demand has fallen due to recessionary fears, but the reality is that the world's global production is also declining rapidly and new sources are incresingly difficult and expensive to find. We reiterate that no major discoveries have been made in 30 years.
Much of the world's reserves are in the war-torn Middle East; in Canada's oil sands— a huge reserve, but increasingly expensive to extract and extremely polluting; and in difficult areas such as deep beneath the ocean, or in the Arctic regions. Finally, the current price of oil is far too low below the cost of newer sources of energy production. With OPEC cutting back and the unlikelihood of new sources coming on stream at these prices, the longer term outlook for oil remains very bullish.
While we may be temporarily at a low in oil prices and due for a rebound, resistance will now be seen in the $90/$110 range but due to weak demand it may be difficult regaining much ground above $80. After an attempt to go to higher prices we could easily see another decline and possible targets down to $35/$40 for our final bottom of this much larger cycle. Investors should be aware of that possibility.
But in the interim the gloom out there is pervasive. There is blood in the streets and that is the time to buy, not to be shy. But the forming of any significant final bottom could still be several months away.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Tuesday, November 18, 2008
The Worst Is NOT Behind Us
Doctor Doom: The Worst Is NOT Behind Us
Beware Of Those Who Say We've Hit The Bottom.
By Nouriel Roubini | 18 November 2008
The U.S. will experience its most severe recession since World War II, much worse and longer and deeper than even the 1974-1975 and 1980-1982 recessions. The recession will continue until at least the end of 2009 for a cumulative gross domestic product drop of over 4%; the unemployment rate will likely reach 9%. The U.S. consumer is shopped-out, saving less and debt-burdened: This will be the worst consumer recession in decades.
The prospect of a short and shallow six— to eight-month V-shaped recession is out of the window; a U-shaped 18— to 24-month recession is now a certainty, and the probability of a worse, multi-year L-shaped recession (as in Japan in the 1990s) is still small but rising. Even if the economy were to exit a recession by the end of 2009, the recovery could be so weak because of the impairment of the financial system and the credit mechanism that it may feel like a recession even if the economy is technically out of the recession.
Obama will inherit an economic and financial mess worse than anything the U.S. has faced in decades: the most severe recession in 50 years; the worst financial and banking crisis since the Great Depression; a ballooning fiscal deficit that may be as high as a trillion dollars in 2009 and 2010; a huge current account deficit; a financial system that is in a severe crisis and where deleveraging is still occurring at a very rapid pace, thus causing a worsening of the credit crunch; a household sector where millions of households are insolvent, into negative equity territory and on the verge of losing their homes; a serious risk of deflation as the slack in goods, labor and commodity markets becomes deeper; the risk that we will end in a deflationary liquidity trap as the Fed is fast approaching the zero-bound constraint for the Fed funds rate; the risk of a severe debt deflation as the real value of nominal liabilities will rise, given price deflation, while the value of financial assets is still plunging.
The world economy will experience a severe recession: Output will sharply contract in the Eurozone, the U.K. and the rest of Europe, as well as in Canada, Japan and Australia/New Zealand. There is also a risk of a hard landing in emerging market economies. Expect global growth— at market prices— to be close to zero in Q3 and negative by Q4. Leaving aside the effects of the fiscal stimulus, China could face a hard landing growth rate of 6% in 2009. The global recession will continue through most of 2009.
The advanced economies will face stag-deflation (stagnation/recession and deflation) rather than stagflation, as the slack in goods, labor and commodity markets will lead advanced economies' inflation rates to drop below 1% by 2009.
Expect a few advanced economies (certainly the U.S. and Japan and possibly others) to reach the zero-bound constraint for policy rates by early 2009. With deflation on the horizon, zero-bound on interest rates implies the risk of a liquidity trap where money and bonds become perfectly substitutable, where real interest rates become high and rising, thus further pushing down aggregate demand, and where money market fund returns cannot even cover their management costs.
Deflation also implies a debt deflation where the real value of nominal debts is rising, thus increasing the real burden of such debts. Monetary policy easing will become more aggressive in other advanced economies even if the European Central Bank cuts too little too late. But monetary policy easing will be scarcely effective, as it will be pushing on a string, given the glut of global aggregate supply relative to demand— and given a very severe credit crunch.
For 2009, the consensus estimates for earnings are delusional: Current consensus estimates are that S&P 500 earnings per share (EPS) will be $90 in 2009, up 15% from 2008. Such estimates are outright silly. If EPS falls— as is most likely— to a level of $60, then with a price-to-earnings (P/E) ratio of 12, the S&P 500 index could fall to 720 (i.e. about 20% below current levels).
If the P/E falls to 10— as is possible in a severe recession— the S&P could be down to 600, or 35% below current levels.
And in a very severe recession, one cannot exclude the possibility that the EPS could fall as low as $50 in 2009, dragging the S&P 500 index down as low as 500. So, even based on fundamentals and valuations, there are significant downside risks to U.S. equities (20% to 40%).
Similar arguments can be made for global equities: A severe global recession implies further downside risks to global equities in the order of 20% to 30%. Thus, the recent rally in U.S. and global equities was only a bear-market rally that is already fizzling out— buried under a mountain of worse-than-expected macro, earnings and financial news.
Credit losses will be well above $1 trillion and closer to $2 trillion, as such losses will spread from subprime to near-prime and prime mortgages and home equity loans (and the related securitized products); to commercial real estate, to credit cards, auto loans and student loans; to leveraged loans and LBOs, to muni bonds, corporate bonds, industrial and commercial loans and credit default swaps. These credit losses will lead to a severe credit crunch, absent a rapid and aggressive recapitalization of financial institutions.
Almost all of the $700 billion in the TARP program will be used to recapitalize U.S. financial institutions (banks, broker dealers, insurance companies, finance companies) as rising credit losses (close to $2 trillion) will imply that the initial $250 billion allocated to recap these institutions will not be enough. Sooner rather than later, a TARP-2 will become necessary, as the recapitalization needs of U.S. financial institutions will likely be well above $1 trillion.
Current spreads on speculative-grade bonds may widen further as a tsunami of defaults will hit the corporate sector; investment-grade bond spreads have widened excessively relative to financial fundamentals, but further spread-widening is possible, driven by market dynamics, deleveraging and the fact that many AAA-rated firms (say, GE) are [no longer] really AAA, and should be downgraded by the rating agencies.
Expect a U.S. fiscal deficit of almost $1 trillion in 2009 and 2010. The outlook for the U.S. current account deficit is mixed: The recession, a rise in private savings and a fall in investment, and a further fall in commodity prices will tend to shrink it, but a stronger dollar, global demand weakness and a larger U.S. fiscal deficit will tend to worsen it. On net, we will observe still-large U.S. twin fiscal and current account deficits— and less willingness and ability in the rest of the world to finance it unless the interest rate on such debt rises. [[Perhaps substantially so.: normxxx]]
In this economic and financial environment, it is wise to stay away from most risky assets for the next 12 months: There are downside risks to U.S. and global equities; credit spreads— especially for the speculative grade— may widen further; commodity prices will fall another 20% from current levels; gold will also fall as deflation sets in; the U.S. dollar may weaken further in the next six to 12 months as the factors behind the recent rally weather off, while medium-term bearish fundamentals for the dollar set in again; government bond yields in the U.S. and advanced economies may fall further as recession and deflation emerge but, over time, the surge in fiscal deficits in the U.S. and globally will reduce the supply of global savings and lead to higher long-term interest rates unless the fall in global real investment outpaces the fall in global savings.
Expect further downside risks to emerging-markets assets (in particular, equities and local and foreign currency debt), especially in economies with significant macro, policy and financial vulnerabilities. Cash and cash-like instruments (short-term dated government bonds and inflation-indexed bonds that do well both in inflation and deflation times) will dominate most risky assets.
So, serious risks and vulnerabilities remain, and the downside risks to financial markets (worse than expected macro news, earnings news and developments in systemically important parts of the global financial system) will, over the next few months, overshadow the positive news (G-7 policies to avoid a systemic meltdown, and other policies that— in due time— may reduce interbank spreads and credit spreads).
Beware, therefore, of those who tell you that we have reached a bottom for risky financial assets. The same optimists told you that we reached a bottom and the worst was behind us after the rescue of the creditors of Bear Stearns in March; after the announcement of the possible bailout of Fannie and Freddie in July; after the actual bailout of Fannie and Freddie in September; after the bailout of AIG (nyse: AIG— news— people ) in mid-September; after the TARP legislation was presented; and after the latest G-7 and E.U. action.
In each case, the optimists argued that the latest crisis and rescue policy response was the cathartic event that signaled the bottom of the crisis and the recovery of markets. They were wrong at least six times in a row as the crisis— as I have consistently predicted over the last year— became worse and worse. So excessive optimism has been proved consistently wrong in the last eight months alone.
A reality check is needed to assess risks— and to take appropriate action. And reality tells us that we barely avoided, only a week ago, a total systemic financial meltdown; that the policy actions are now finally more aggressive and systematic, and more appropriate; that it will take a long while for interbank and credit markets to mend; that further important policy actions are needed to avoid the meltdown and an even more severe recession; that central banks, instead of being the lenders of last resort, will be, for now, the lenders of first and only resort; that even if we avoid a meltdown, we will experience a severe U.S., advanced economy and, most likely, global recession, the worst in decades; that we are in the middle of a severe global financial and banking crisis, the worst since the Great Depression; and that the flow of macro, earnings and financial news will significantly surprise (as during the last few weeks) on the downside with significant further risks to financial markets.
I'll stop now.
Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.
Beware Of Those Who Say We've Hit The Bottom.
By Nouriel Roubini | 18 November 2008
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The U.S. will experience its most severe recession since World War II, much worse and longer and deeper than even the 1974-1975 and 1980-1982 recessions. The recession will continue until at least the end of 2009 for a cumulative gross domestic product drop of over 4%; the unemployment rate will likely reach 9%. The U.S. consumer is shopped-out, saving less and debt-burdened: This will be the worst consumer recession in decades. The prospect of a short and shallow six— to eight-month V-shaped recession is out of the window; a U-shaped 18— to 24-month recession is now a certainty, and the probability of a worse, multi-year L-shaped recession (as in Japan in the 1990s) is still small but rising. Even if the economy were to exit a recession by the end of 2009, the recovery could be so weak because of the impairment of the financial system and the credit mechanism that it may feel like a recession even if the economy is technically out of the recession. Obama will inherit an economic and financial mess worse than anything the U.S. has faced in decades: the most severe recession in 50 years; the worst financial and banking crisis since the Great Depression; a ballooning fiscal deficit that may be as high as a trillion dollars in 2009 and 2010; a huge current account deficit; a financial system that is in a severe crisis and where deleveraging is still occurring at a very rapid pace, thus causing a worsening of the credit crunch; a household sector where millions of households are insolvent, into negative equity territory and on the verge of losing their homes; a serious risk of deflation as the slack in goods, labor and commodity markets becomes deeper; the risk that we will end in a deflationary liquidity trap as the Fed is fast approaching the zero-bound constraint for the Fed funds rate; the risk of a severe debt deflation as the real value of nominal liabilities will rise, given price deflation, while the value of financial assets is still plunging. The world economy will experience a severe recession: Output will sharply contract in the Eurozone, the U.K. and the rest of Europe, as well as in Canada, Japan and Australia/New Zealand. There is also a risk of a hard landing in emerging market economies. Expect global growth— at market prices— to be close to zero in Q3 and negative by Q4. Leaving aside the effects of the fiscal stimulus, China could face a hard landing growth rate of 6% in 2009. The global recession will continue through most of 2009. The advanced economies will face stag-deflation (stagnation/recession and deflation) rather than stagflation, as the slack in goods, labor and commodity markets will lead advanced economies' inflation rates to drop below 1% by 2009. Expect a few advanced economies (certainly the U.S. and Japan and possibly others) to reach the zero-bound constraint for policy rates by early 2009. With deflation on the horizon, zero-bound on interest rates implies the risk of a liquidity trap where money and bonds become perfectly substitutable, where real interest rates become high and rising, thus further pushing down aggregate demand, and where money market fund returns cannot even cover their management costs.Deflation also implies a debt deflation where the real value of nominal debts is rising, thus increasing the real burden of such debts. Monetary policy easing will become more aggressive in other advanced economies even if the European Central Bank cuts too little too late. But monetary policy easing will be scarcely effective, as it will be pushing on a string, given the glut of global aggregate supply relative to demand— and given a very severe credit crunch.
For 2009, the consensus estimates for earnings are delusional: Current consensus estimates are that S&P 500 earnings per share (EPS) will be $90 in 2009, up 15% from 2008. Such estimates are outright silly. If EPS falls— as is most likely— to a level of $60, then with a price-to-earnings (P/E) ratio of 12, the S&P 500 index could fall to 720 (i.e. about 20% below current levels).If the P/E falls to 10— as is possible in a severe recession— the S&P could be down to 600, or 35% below current levels.
And in a very severe recession, one cannot exclude the possibility that the EPS could fall as low as $50 in 2009, dragging the S&P 500 index down as low as 500. So, even based on fundamentals and valuations, there are significant downside risks to U.S. equities (20% to 40%).
Similar arguments can be made for global equities: A severe global recession implies further downside risks to global equities in the order of 20% to 30%. Thus, the recent rally in U.S. and global equities was only a bear-market rally that is already fizzling out— buried under a mountain of worse-than-expected macro, earnings and financial news.
Credit losses will be well above $1 trillion and closer to $2 trillion, as such losses will spread from subprime to near-prime and prime mortgages and home equity loans (and the related securitized products); to commercial real estate, to credit cards, auto loans and student loans; to leveraged loans and LBOs, to muni bonds, corporate bonds, industrial and commercial loans and credit default swaps. These credit losses will lead to a severe credit crunch, absent a rapid and aggressive recapitalization of financial institutions. Almost all of the $700 billion in the TARP program will be used to recapitalize U.S. financial institutions (banks, broker dealers, insurance companies, finance companies) as rising credit losses (close to $2 trillion) will imply that the initial $250 billion allocated to recap these institutions will not be enough. Sooner rather than later, a TARP-2 will become necessary, as the recapitalization needs of U.S. financial institutions will likely be well above $1 trillion. Current spreads on speculative-grade bonds may widen further as a tsunami of defaults will hit the corporate sector; investment-grade bond spreads have widened excessively relative to financial fundamentals, but further spread-widening is possible, driven by market dynamics, deleveraging and the fact that many AAA-rated firms (say, GE) are [no longer] really AAA, and should be downgraded by the rating agencies. Expect a U.S. fiscal deficit of almost $1 trillion in 2009 and 2010. The outlook for the U.S. current account deficit is mixed: The recession, a rise in private savings and a fall in investment, and a further fall in commodity prices will tend to shrink it, but a stronger dollar, global demand weakness and a larger U.S. fiscal deficit will tend to worsen it. On net, we will observe still-large U.S. twin fiscal and current account deficits— and less willingness and ability in the rest of the world to finance it unless the interest rate on such debt rises. [[Perhaps substantially so.: normxxx]] In this economic and financial environment, it is wise to stay away from most risky assets for the next 12 months: There are downside risks to U.S. and global equities; credit spreads— especially for the speculative grade— may widen further; commodity prices will fall another 20% from current levels; gold will also fall as deflation sets in; the U.S. dollar may weaken further in the next six to 12 months as the factors behind the recent rally weather off, while medium-term bearish fundamentals for the dollar set in again; government bond yields in the U.S. and advanced economies may fall further as recession and deflation emerge but, over time, the surge in fiscal deficits in the U.S. and globally will reduce the supply of global savings and lead to higher long-term interest rates unless the fall in global real investment outpaces the fall in global savings. Expect further downside risks to emerging-markets assets (in particular, equities and local and foreign currency debt), especially in economies with significant macro, policy and financial vulnerabilities. Cash and cash-like instruments (short-term dated government bonds and inflation-indexed bonds that do well both in inflation and deflation times) will dominate most risky assets. So, serious risks and vulnerabilities remain, and the downside risks to financial markets (worse than expected macro news, earnings news and developments in systemically important parts of the global financial system) will, over the next few months, overshadow the positive news (G-7 policies to avoid a systemic meltdown, and other policies that— in due time— may reduce interbank spreads and credit spreads). Beware, therefore, of those who tell you that we have reached a bottom for risky financial assets. The same optimists told you that we reached a bottom and the worst was behind us after the rescue of the creditors of Bear Stearns in March; after the announcement of the possible bailout of Fannie and Freddie in July; after the actual bailout of Fannie and Freddie in September; after the bailout of AIG (nyse: AIG— news— people ) in mid-September; after the TARP legislation was presented; and after the latest G-7 and E.U. action.In each case, the optimists argued that the latest crisis and rescue policy response was the cathartic event that signaled the bottom of the crisis and the recovery of markets. They were wrong at least six times in a row as the crisis— as I have consistently predicted over the last year— became worse and worse. So excessive optimism has been proved consistently wrong in the last eight months alone.
A reality check is needed to assess risks— and to take appropriate action. And reality tells us that we barely avoided, only a week ago, a total systemic financial meltdown; that the policy actions are now finally more aggressive and systematic, and more appropriate; that it will take a long while for interbank and credit markets to mend; that further important policy actions are needed to avoid the meltdown and an even more severe recession; that central banks, instead of being the lenders of last resort, will be, for now, the lenders of first and only resort; that even if we avoid a meltdown, we will experience a severe U.S., advanced economy and, most likely, global recession, the worst in decades; that we are in the middle of a severe global financial and banking crisis, the worst since the Great Depression; and that the flow of macro, earnings and financial news will significantly surprise (as during the last few weeks) on the downside with significant further risks to financial markets.I'll stop now.
Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.
Monday, November 17, 2008
Giant Mines Scramble To Cut Output
Giant Mines Scramble To Cut Output
By Patrick Barta, Robert Guy Matthews and Andrew Batson | 17 November 2008
Mining companies— which couldn't dig minerals out of the earth fast enough just a few months ago— now are struggling to climb out of a very deep hole. On Friday, the world's biggest miner, BHP Billiton, said major Chinese customers are trying to delay purchases of iron ore as China's building boom slows sharply. The scale of the December delays could cut BHP's iron-ore deliveries by at least 5% for the full year. The mining giants that feed the world's appetite for iron, copper and other industry staples earned piles of money as commodities prices soared the past few years. But those days are over for now.
Metals prices fell 35% in just four weeks last month— the steepest decline ever recorded, according to Barclays Capital. Prices for palladium, a key ingredient in automobile catalytic converters, are down 70% since midyear as car buyers make themselves scarce. Half or more of the world's aluminum production is now unprofitable.
Mining companies, a significant barometer of global economic health, are shuttering operations and firing thousands of workers across South Africa, Australia, Canada and Russia. Rio Tinto cut 10% of its iron-ore production last week, matching a similar move by the world's largest iron-ore producer, Brazil-based Companhia Vale do Rio Doce. On Thursday, Xstrata PLC announced plans to close two nickel mines in Northern Ontario. Alcoa Inc. has so far cut about 15% of its annual capacity.
Big steelmakers world-wide have been cutting production as much as 35%. U.S. Steel Corp., the largest steelmaker in the U.S, last week said it was laying off 2% of its work force due the the slowing economy. Nearly every mineral is affected. Molybendum, which gives steel its strength, fell 60% to $12 a pound in the past year. Copper— recently so expensive that burglars would break into houses not to steal jewelry, but to steal the plumbing— is off more than 50% since April. Tin smelters across Indonesia, where nearly 25% of the world's tin is made, are halting production.
Mining ranked among the fastest-growing sectors of the world economy in recent years. That money flowed to the four corners of the globe. China's voracious appetite for commodities helped spur waves of investment in poor but resource-rich Africa, a rare economic bright spot there. That's all changing now, as Chinese demand slows at the same time that consumers world-wide start penny-pinching. In the past few days, the world's largest producer of steel ingredient ferrochrome, Merafe Resources Lindiwe Montshiwagae, said it would shut down six of its South African furnaces. In Kenya, a $25 million titanium project was also put on hold.
The question is whether these cutbacks, while sizeable, will be enough to stabilize prices and the industry. Markets got a brief boost on Monday when China announced a nearly $600 billion spending spree to perk up its economy by building new roads and railways, among other things. By Tuesday, however, prices for many commodities resumed their decline as the reality set in that even China's plan might not be enough to prop up demand in the short term.
The mining business has been through cycles before, and is exceedingly volatile. But analysts say they can't recall a more sudden, sharp decline in prices. And, of course, this slump is still in its early days. Prices could bounce back if China's housing market regains its vigor. After all, China, India and other developing nations still need massive helpings of copper, zinc and other metals as they strive to catch up to rich countries' living standards.
China currently consumes only about one-fourth as much copper per capita as Germany. Still, at current market prices, it's hard to make money running many mines, which have high labor, equipment and energy costs. About 30% of nickel mines and more than 15% of zinc mines have turned unprofitable due to falling prices.
Two weeks ago, North American Palladium Ltd. said it would lay off 350 workers and shut down production at its Lac des Illes mine near Thunder Bay in Canada because it couldn't turn a profit once prices fell to about $180 an ounce currently from a high of $582 as recently as March. The pain from shutdowns like these is particularly acute in places that rely almost exclusively on mining for their well-being. Because of their odd locations— mines are often in hard-to-reach places where they are the only major employers in town— closures can decimate local economies.
Two weeks ago, Blue Note Mining closed its zinc and lead mine in Bathurst, a Canadian town of 12,000 or so perched on the edge of New Brunswick. Younger workers will probably leave town, says Mayor Stephen Brunet. But the closing is particularly tough for older workers, many of whom were laid off a few years ago. "They have paid for their houses and aren't likely to move," he said.
Across Africa, many new projects that were to begin this year and next, including uranium, iron ore and titanium, are being put on hold. This is bad news for the continent, which had been enjoying a rare economic boom. In recent years, mining activity had helped propel growth rates to their highest levels in decades, offering new hope of an end to the continent's cycles of poverty.
But when commodities prices fall, investing in Africa becomes a hard sell again. While countries like Congo are sitting on lucrative mineral deposits, it and other large chunks of Africa lack the roads or ports needed to process and export those minerals. Many regions are also politically unstable or dangerous, further dissuading investors.
The economic spasms aren't limited to poor countries. Some economists fear the mining slump will help drag Australia into recession. Australia, one of the world's biggest producers of iron ore and nickel, has seen its currency weaken more than 30% since July against the U.S. dollar as the mining industry stumbles there.
Melbourne-based OZ Minerals Ltd. recently said it is contemplating some shutdowns, including possibly at its operation in the vicinity of Mount Isa, Australia, currently the second-largest open-pit zinc mine in the world. Big cutbacks could leave scores of towns across the dusty, forbidding Australian Outback with little or no other reason to exist. The swift reversal is remarkable in an industry that saw its profits increase 20-fold in five years, climbing to $80 billion in 2007 from just $4 billion in 2002. Just a few months ago, miners were struggling to hire enough workers to keep up with unprecedented global demand.
Some companies were so desperate for equipment that they were forced to dig up old, discarded tires from garbage dumps to outfit their giant trucks because new tires were in such short supply. In South Africa, power companies were no longer able to provide enough electricity to keep the country's burgeoning mines running. In the last major commodities downturn, in the late 1990s and early part of this decade, mining companies got clobbered. Prices for copper fell some 50% in the wake of the 1997 Asian financial crisis followed by the U.S. recession in 2001.
In 1998 and 1999, BHP (a predecessor of today's BHP Billiton) posted cumulative losses of nearly $3 billion and required a major restructuring before it could be revived. It mothballed major mines in Arizona and Nevada, while Rio Tinto laid off staff at its copper operations in Utah. Other companies went out of business.
The mining business didn't perk up again until demand in China began to take off around 2002 and 2003.
This time around, the biggest mining companies— including BHP Billiton, Companhia Vale do Rio Doce, Anglo-American and Barrick Gold— are likely to use this downturn to try to grab market share from smaller rivals, known as "junior" minors, that sprang up like mushrooms in recent years when it was easier to raise capital. While junior miners often carry heavy debt, the giant firms have built up formidable war chests over the past few years. Many are keeping an eye peeled to buy struggling smaller companies on the cheap.
The current pricing volatility has been intensified by the global financial crisis. Many hedge funds, pension funds and other investors desperate to raise cash as their stock— and bond-related holdings tumbled, quickly sold their commodities holdings in recent months. That pushed down prices of copper, zinc and nickel more rapidly than in previous downturns.
Five years ago, nickel was selling for about $9,000 a metric ton. A year ago, that price had swollen to more than $40,000, in part because of demand, but also because so many hedge funds and other investors were piling in. In recent months, demand for nickel has declined somewhat— but cash-strapped investors like these have rapidly bailed out of their holdings. As a result, the price declines have far outstripped the rate of decline in actual demand for the metal. Nickel is now selling for about $11,600 a metric ton.
Ultimately though, the industry's problems are rooted in weakening demand, particularly in China, rather than the financial crisis. China's soaring economy gobbled up unprecedented amounts of raw materials in recent years, as the country built skyscrapers and roads, cellphones and autos at an historic pace. With the urban migration of tens of millions of people spurring an epic construction spree, many analysts still believe the China metals boom could have a decade or more to run.
Now, however, China is suffering a one-two economic punch. The world is buying fewer of the goods cranked out by its factories, and China's own spooked consumers are retreating from the housing market. As a result, China's economic growth is slowing sharply, to 9% in the third quarter from nearly 12% last year. Some analysts worry it could easily drop below 8% next year.
That's weak by China's recent standards [[and domestic needs: normxxx]], and many consumers are worried about the future. On a recent weekend in Beijing, hundreds of young families piled onto buses to tour new housing developments on the city's edge. But many have no plans to put money down just yet. "I prefer to wait for a bit… until, say, the end of this year or early next year— in case the housing prices in Beijing continue to fall," said Xiao Yalin, a kindergarten teacher.
With so many people taking the same wait-and-see attitude, housing sales in China have collapsed: The volume of transactions has been dropping 40% to 60% nationwide in recent months, according to Macquarie Securities. In September, the volume of China's of new-construction fell 13%, its sharpest decline in a decade. That decline hits mining companies right where it counts. A large chunk of China's metals demand is directly tied to construction, from the steel rebar that supports buildings to the aluminum that goes into new appliances.
China's steel output plunged 17% in October alone. That has led to an equally rapid reversal in the demand for iron ore. As of last month, the country had nearly three months worth of imports, or 89 million metric tons of ore, sitting unused at its ports, according to the China Iron & Steel Association. Getting that ore off the docks depends in large part on getting China's reluctant home-buyers back into a buying mood. But people on the front lines, like Nie Xin, a director at real-estate agents E-House China in Beijing, aren't particularly optimistic. "We feel that the rebound won't come until 2010," he says. This market "is very cold right now."
By Patrick Barta, Robert Guy Matthews and Andrew Batson | 17 November 2008
Mining companies— which couldn't dig minerals out of the earth fast enough just a few months ago— now are struggling to climb out of a very deep hole. On Friday, the world's biggest miner, BHP Billiton, said major Chinese customers are trying to delay purchases of iron ore as China's building boom slows sharply. The scale of the December delays could cut BHP's iron-ore deliveries by at least 5% for the full year. The mining giants that feed the world's appetite for iron, copper and other industry staples earned piles of money as commodities prices soared the past few years. But those days are over for now.
Metals prices fell 35% in just four weeks last month— the steepest decline ever recorded, according to Barclays Capital. Prices for palladium, a key ingredient in automobile catalytic converters, are down 70% since midyear as car buyers make themselves scarce. Half or more of the world's aluminum production is now unprofitable.Mining companies, a significant barometer of global economic health, are shuttering operations and firing thousands of workers across South Africa, Australia, Canada and Russia. Rio Tinto cut 10% of its iron-ore production last week, matching a similar move by the world's largest iron-ore producer, Brazil-based Companhia Vale do Rio Doce. On Thursday, Xstrata PLC announced plans to close two nickel mines in Northern Ontario. Alcoa Inc. has so far cut about 15% of its annual capacity.
Big steelmakers world-wide have been cutting production as much as 35%. U.S. Steel Corp., the largest steelmaker in the U.S, last week said it was laying off 2% of its work force due the the slowing economy. Nearly every mineral is affected. Molybendum, which gives steel its strength, fell 60% to $12 a pound in the past year. Copper— recently so expensive that burglars would break into houses not to steal jewelry, but to steal the plumbing— is off more than 50% since April. Tin smelters across Indonesia, where nearly 25% of the world's tin is made, are halting production.
Mining ranked among the fastest-growing sectors of the world economy in recent years. That money flowed to the four corners of the globe. China's voracious appetite for commodities helped spur waves of investment in poor but resource-rich Africa, a rare economic bright spot there. That's all changing now, as Chinese demand slows at the same time that consumers world-wide start penny-pinching. In the past few days, the world's largest producer of steel ingredient ferrochrome, Merafe Resources Lindiwe Montshiwagae, said it would shut down six of its South African furnaces. In Kenya, a $25 million titanium project was also put on hold.The question is whether these cutbacks, while sizeable, will be enough to stabilize prices and the industry. Markets got a brief boost on Monday when China announced a nearly $600 billion spending spree to perk up its economy by building new roads and railways, among other things. By Tuesday, however, prices for many commodities resumed their decline as the reality set in that even China's plan might not be enough to prop up demand in the short term.
The mining business has been through cycles before, and is exceedingly volatile. But analysts say they can't recall a more sudden, sharp decline in prices. And, of course, this slump is still in its early days. Prices could bounce back if China's housing market regains its vigor. After all, China, India and other developing nations still need massive helpings of copper, zinc and other metals as they strive to catch up to rich countries' living standards.
China currently consumes only about one-fourth as much copper per capita as Germany. Still, at current market prices, it's hard to make money running many mines, which have high labor, equipment and energy costs. About 30% of nickel mines and more than 15% of zinc mines have turned unprofitable due to falling prices.
Two weeks ago, North American Palladium Ltd. said it would lay off 350 workers and shut down production at its Lac des Illes mine near Thunder Bay in Canada because it couldn't turn a profit once prices fell to about $180 an ounce currently from a high of $582 as recently as March. The pain from shutdowns like these is particularly acute in places that rely almost exclusively on mining for their well-being. Because of their odd locations— mines are often in hard-to-reach places where they are the only major employers in town— closures can decimate local economies.Two weeks ago, Blue Note Mining closed its zinc and lead mine in Bathurst, a Canadian town of 12,000 or so perched on the edge of New Brunswick. Younger workers will probably leave town, says Mayor Stephen Brunet. But the closing is particularly tough for older workers, many of whom were laid off a few years ago. "They have paid for their houses and aren't likely to move," he said.
Across Africa, many new projects that were to begin this year and next, including uranium, iron ore and titanium, are being put on hold. This is bad news for the continent, which had been enjoying a rare economic boom. In recent years, mining activity had helped propel growth rates to their highest levels in decades, offering new hope of an end to the continent's cycles of poverty.
But when commodities prices fall, investing in Africa becomes a hard sell again. While countries like Congo are sitting on lucrative mineral deposits, it and other large chunks of Africa lack the roads or ports needed to process and export those minerals. Many regions are also politically unstable or dangerous, further dissuading investors.
The economic spasms aren't limited to poor countries. Some economists fear the mining slump will help drag Australia into recession. Australia, one of the world's biggest producers of iron ore and nickel, has seen its currency weaken more than 30% since July against the U.S. dollar as the mining industry stumbles there.
Melbourne-based OZ Minerals Ltd. recently said it is contemplating some shutdowns, including possibly at its operation in the vicinity of Mount Isa, Australia, currently the second-largest open-pit zinc mine in the world. Big cutbacks could leave scores of towns across the dusty, forbidding Australian Outback with little or no other reason to exist. The swift reversal is remarkable in an industry that saw its profits increase 20-fold in five years, climbing to $80 billion in 2007 from just $4 billion in 2002. Just a few months ago, miners were struggling to hire enough workers to keep up with unprecedented global demand.
Some companies were so desperate for equipment that they were forced to dig up old, discarded tires from garbage dumps to outfit their giant trucks because new tires were in such short supply. In South Africa, power companies were no longer able to provide enough electricity to keep the country's burgeoning mines running. In the last major commodities downturn, in the late 1990s and early part of this decade, mining companies got clobbered. Prices for copper fell some 50% in the wake of the 1997 Asian financial crisis followed by the U.S. recession in 2001.
In 1998 and 1999, BHP (a predecessor of today's BHP Billiton) posted cumulative losses of nearly $3 billion and required a major restructuring before it could be revived. It mothballed major mines in Arizona and Nevada, while Rio Tinto laid off staff at its copper operations in Utah. Other companies went out of business.
The mining business didn't perk up again until demand in China began to take off around 2002 and 2003.
This time around, the biggest mining companies— including BHP Billiton, Companhia Vale do Rio Doce, Anglo-American and Barrick Gold— are likely to use this downturn to try to grab market share from smaller rivals, known as "junior" minors, that sprang up like mushrooms in recent years when it was easier to raise capital. While junior miners often carry heavy debt, the giant firms have built up formidable war chests over the past few years. Many are keeping an eye peeled to buy struggling smaller companies on the cheap.
The current pricing volatility has been intensified by the global financial crisis. Many hedge funds, pension funds and other investors desperate to raise cash as their stock— and bond-related holdings tumbled, quickly sold their commodities holdings in recent months. That pushed down prices of copper, zinc and nickel more rapidly than in previous downturns.
Five years ago, nickel was selling for about $9,000 a metric ton. A year ago, that price had swollen to more than $40,000, in part because of demand, but also because so many hedge funds and other investors were piling in. In recent months, demand for nickel has declined somewhat— but cash-strapped investors like these have rapidly bailed out of their holdings. As a result, the price declines have far outstripped the rate of decline in actual demand for the metal. Nickel is now selling for about $11,600 a metric ton.
Ultimately though, the industry's problems are rooted in weakening demand, particularly in China, rather than the financial crisis. China's soaring economy gobbled up unprecedented amounts of raw materials in recent years, as the country built skyscrapers and roads, cellphones and autos at an historic pace. With the urban migration of tens of millions of people spurring an epic construction spree, many analysts still believe the China metals boom could have a decade or more to run.
Now, however, China is suffering a one-two economic punch. The world is buying fewer of the goods cranked out by its factories, and China's own spooked consumers are retreating from the housing market. As a result, China's economic growth is slowing sharply, to 9% in the third quarter from nearly 12% last year. Some analysts worry it could easily drop below 8% next year.
That's weak by China's recent standards [[and domestic needs: normxxx]], and many consumers are worried about the future. On a recent weekend in Beijing, hundreds of young families piled onto buses to tour new housing developments on the city's edge. But many have no plans to put money down just yet. "I prefer to wait for a bit… until, say, the end of this year or early next year— in case the housing prices in Beijing continue to fall," said Xiao Yalin, a kindergarten teacher.
With so many people taking the same wait-and-see attitude, housing sales in China have collapsed: The volume of transactions has been dropping 40% to 60% nationwide in recent months, according to Macquarie Securities. In September, the volume of China's of new-construction fell 13%, its sharpest decline in a decade. That decline hits mining companies right where it counts. A large chunk of China's metals demand is directly tied to construction, from the steel rebar that supports buildings to the aluminum that goes into new appliances.
China's steel output plunged 17% in October alone. That has led to an equally rapid reversal in the demand for iron ore. As of last month, the country had nearly three months worth of imports, or 89 million metric tons of ore, sitting unused at its ports, according to the China Iron & Steel Association. Getting that ore off the docks depends in large part on getting China's reluctant home-buyers back into a buying mood. But people on the front lines, like Nie Xin, a director at real-estate agents E-House China in Beijing, aren't particularly optimistic. "We feel that the rebound won't come until 2010," he says. This market "is very cold right now."
Sunday, November 16, 2008
Market Bottom; or, Close Enough?
Market Bottom? For Some Investors, It’s Close Enough
By Paul J. Lim | 16 November 2008
Jeremy Grantham, left, of the investment firm GMO, and Warren Buffett, of Berkshire Hathaway. Both are buying stocks, but not for short-term gains. "Seven years out, these will be good purchases for us," Mr. Grantham said.
Every time the market suffers another steep drop, it’s tempting to think that stock prices may have come down so much that the elusive market bottom is finally in sight. Prices have certainly come down. On Friday, the Standard & Poor’s 500-stock index was 44 percent below its peak of a little more than a year ago. Since then, the price/earnings ratio on the S&P has dropped from 16.8 all the way down to 12. With numbers this low, is the sell-off nearing an end?
It’s certainly possible, and some canny investors have begun nibbling at stocks. But don’t count on being able to time the market. While cheap stock prices are always a welcome development for bargain-seeking investors, low P/E ratios haven’t always been an accurate gauge of predicting turnarounds in the market. If they were, stocks would have surged sharply in the mid to late ’70s, when the market’s P/E ratio sank into single digits. Instead, the S&P was pretty much flat throughout that time.
"Cheap valuations are simply a symptom of what’s wrong, not the catalyst to get the market out," said Richard Bernstein, chief investment strategist at Merrill Lynch. After all, just because stocks are trading at extremely low levels today, it doesn’t mean they can’t become even cheaper tomorrow. [[Old WS adage: A stock is never so low that it can't go all the way to zero; and a 100% loss for a $1 stock leaves you in the same place as a 100% loss for a $1000 dollar stock.: normxxx]]
To be sure, investors may be hopeful now that some respected investors— including Warren E. Buffett, chief executive of Berkshire Hathaway, and Jeremy Grantham, a chairman of the investment management firm GMO— say they’ve begun to selectively buy stocks. But both have gone to painstaking lengths to stress that they weren’t predicting that the worst of the sell-off was over. In an Op-Ed article in The New York Times, Mr. Buffett wrote: "I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month— or a year— from now."
Similarly, Mr. Grantham said in an interview that even though his firm began buying stocks in early October, after prices fell to attractive levels, the market had a tendency to "overshoot" during sell-offs. "Market bottoms have this Murphy’s Law style of being much lower than you ever expected in your worst nightmare," he said. Mr. Grantham adds that he thinks the odds are roughly two to one that stock prices will sink to new lows next year. If the economy is in a modest recession, Mr. Grantham thinks the S&P could fall from its current level of around 870 down to 800. But if the recession turns out to be a severe one, "the S&P could fall to a range that’s closer to 600 than 800," he said.
If that’s the case, why did GMO begin to buy stocks in this market? Because Mr. Grantham doesn’t believe in trying to time short-term market moves.
Mr. Grantham noted that GMO began buying only after its portfolios had fallen below some key thresholds. For example, in GMO’s global balanced portfolio of stocks and bonds, the firm’s minimum allocation to equities is usually 45 percent. But after the market sell-off, that equity allocation dipped to around 38 percent. So once stock prices began to look attractive, GMO started rebalancing back into what it regards as the most undervalued types of equities: emerging markets stocks and high-quality domestic blue chip shares. After a few rounds of purchases, stocks now make up around 55 percent of GMO’s global balanced portfolio.
Mr. Grantham says that although he doesn’t know how well he timed his purchases, "we do know that seven years out, these will be good purchases for us." But what if you are determined to be opportunistic? How can you tell if the market is poised to rebound anytime soon— or at least sooner than seven years?
There is no sure-fire answer. But one way is to pay close attention to the asset allocation recommendations of Wall Street strategists. "It turns out to be a tremendous contrarian signal" for spotting market trends, said Mr. Bernstein.
For more than two decades, Mr. Bernstein has tracked recommended equity allocations in balanced portfolios managed by Wall Street firms. He found that when the consensus recommendation for stocks exceeds 60 to 65 percent of a balanced portfolio— as was the case between 2000 and 2004— it tends to be a bearish indicator for future stock performance. On the other hand, when market strategists recommend keeping only around half of your portfolio in stocks, as was the case in 1997, it tends to be a bullish sign.
The most recent survey taken by Mr. Bernstein, about two weeks ago, shows an allocation of around 58 percent stocks. While that’s down from the mid-60s percentages of the start of last year, it’s still far from real pessimism. "We’re still hovering right around the long-term average," he said. His own assessment is more bearish. He recommends allocating 50 percent in stocks, with the rest in bonds and cash.
In addition to investor sentiment, it’s also worth keeping tabs on the sentiment of another group of Wall Street pros: the analysts who follow individual companies. In recent weeks, these analysts have begun to lower their forecasts for 2009 earnings. Mr. Bernstein notes that for the first time in seven years, the ratio of upward earnings revisions to downward revisions has fallen to 0.5— meaning that for every corporate earnings forecast that has grown more positive, two have become more pessimistic. "Analysts may be finally appreciating that the financial crisis has turned into a full-blown economic crisis," he said.
Still, analysts are far from throwing in the towel on their earnings forecasts, which may be needed for the market to start to rally. While profit projections have declined, they may still be way too bullish. According to a survey of analysts by Thomson Financial, earnings growth estimates for S&P 500 companies in 2009 have fallen well below the rosy 22 percent forecast at the start of October. But, they’re still expecting corporate profits to grow more than 12 percent next year. Since many are predicting a difficult first half of the year, thanks to the weakening economy, this would assume a tremendous profit surge in the latter half of 2009[!?!]
Christopher N. Orndorff, head of equity strategy at Payden & Rygel, an asset manager based in Los Angeles, predicts that "the earnings releases in January are going to be poor." That should drive down earnings forecasts for 2009 even lower, he said. If earnings forecasts begin to fall substantially, he said, "it will be very difficult for stocks to rally."
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By Paul J. Lim | 16 November 2008
Jeremy Grantham, left, of the investment firm GMO, and Warren Buffett, of Berkshire Hathaway. Both are buying stocks, but not for short-term gains. "Seven years out, these will be good purchases for us," Mr. Grantham said.
Every time the market suffers another steep drop, it’s tempting to think that stock prices may have come down so much that the elusive market bottom is finally in sight. Prices have certainly come down. On Friday, the Standard & Poor’s 500-stock index was 44 percent below its peak of a little more than a year ago. Since then, the price/earnings ratio on the S&P has dropped from 16.8 all the way down to 12. With numbers this low, is the sell-off nearing an end?
|
It’s certainly possible, and some canny investors have begun nibbling at stocks. But don’t count on being able to time the market. While cheap stock prices are always a welcome development for bargain-seeking investors, low P/E ratios haven’t always been an accurate gauge of predicting turnarounds in the market. If they were, stocks would have surged sharply in the mid to late ’70s, when the market’s P/E ratio sank into single digits. Instead, the S&P was pretty much flat throughout that time.
"Cheap valuations are simply a symptom of what’s wrong, not the catalyst to get the market out," said Richard Bernstein, chief investment strategist at Merrill Lynch. After all, just because stocks are trading at extremely low levels today, it doesn’t mean they can’t become even cheaper tomorrow. [[Old WS adage: A stock is never so low that it can't go all the way to zero; and a 100% loss for a $1 stock leaves you in the same place as a 100% loss for a $1000 dollar stock.: normxxx]]
To be sure, investors may be hopeful now that some respected investors— including Warren E. Buffett, chief executive of Berkshire Hathaway, and Jeremy Grantham, a chairman of the investment management firm GMO— say they’ve begun to selectively buy stocks. But both have gone to painstaking lengths to stress that they weren’t predicting that the worst of the sell-off was over. In an Op-Ed article in The New York Times, Mr. Buffett wrote: "I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month— or a year— from now."
Similarly, Mr. Grantham said in an interview that even though his firm began buying stocks in early October, after prices fell to attractive levels, the market had a tendency to "overshoot" during sell-offs. "Market bottoms have this Murphy’s Law style of being much lower than you ever expected in your worst nightmare," he said. Mr. Grantham adds that he thinks the odds are roughly two to one that stock prices will sink to new lows next year. If the economy is in a modest recession, Mr. Grantham thinks the S&P could fall from its current level of around 870 down to 800. But if the recession turns out to be a severe one, "the S&P could fall to a range that’s closer to 600 than 800," he said.
If that’s the case, why did GMO begin to buy stocks in this market? Because Mr. Grantham doesn’t believe in trying to time short-term market moves.
Mr. Grantham noted that GMO began buying only after its portfolios had fallen below some key thresholds. For example, in GMO’s global balanced portfolio of stocks and bonds, the firm’s minimum allocation to equities is usually 45 percent. But after the market sell-off, that equity allocation dipped to around 38 percent. So once stock prices began to look attractive, GMO started rebalancing back into what it regards as the most undervalued types of equities: emerging markets stocks and high-quality domestic blue chip shares. After a few rounds of purchases, stocks now make up around 55 percent of GMO’s global balanced portfolio.
Mr. Grantham says that although he doesn’t know how well he timed his purchases, "we do know that seven years out, these will be good purchases for us." But what if you are determined to be opportunistic? How can you tell if the market is poised to rebound anytime soon— or at least sooner than seven years?
There is no sure-fire answer. But one way is to pay close attention to the asset allocation recommendations of Wall Street strategists. "It turns out to be a tremendous contrarian signal" for spotting market trends, said Mr. Bernstein.
For more than two decades, Mr. Bernstein has tracked recommended equity allocations in balanced portfolios managed by Wall Street firms. He found that when the consensus recommendation for stocks exceeds 60 to 65 percent of a balanced portfolio— as was the case between 2000 and 2004— it tends to be a bearish indicator for future stock performance. On the other hand, when market strategists recommend keeping only around half of your portfolio in stocks, as was the case in 1997, it tends to be a bullish sign.
The most recent survey taken by Mr. Bernstein, about two weeks ago, shows an allocation of around 58 percent stocks. While that’s down from the mid-60s percentages of the start of last year, it’s still far from real pessimism. "We’re still hovering right around the long-term average," he said. His own assessment is more bearish. He recommends allocating 50 percent in stocks, with the rest in bonds and cash.
In addition to investor sentiment, it’s also worth keeping tabs on the sentiment of another group of Wall Street pros: the analysts who follow individual companies. In recent weeks, these analysts have begun to lower their forecasts for 2009 earnings. Mr. Bernstein notes that for the first time in seven years, the ratio of upward earnings revisions to downward revisions has fallen to 0.5— meaning that for every corporate earnings forecast that has grown more positive, two have become more pessimistic. "Analysts may be finally appreciating that the financial crisis has turned into a full-blown economic crisis," he said.
Still, analysts are far from throwing in the towel on their earnings forecasts, which may be needed for the market to start to rally. While profit projections have declined, they may still be way too bullish. According to a survey of analysts by Thomson Financial, earnings growth estimates for S&P 500 companies in 2009 have fallen well below the rosy 22 percent forecast at the start of October. But, they’re still expecting corporate profits to grow more than 12 percent next year. Since many are predicting a difficult first half of the year, thanks to the weakening economy, this would assume a tremendous profit surge in the latter half of 2009[!?!]
Christopher N. Orndorff, head of equity strategy at Payden & Rygel, an asset manager based in Los Angeles, predicts that "the earnings releases in January are going to be poor." That should drive down earnings forecasts for 2009 even lower, he said. If earnings forecasts begin to fall substantially, he said, "it will be very difficult for stocks to rally."
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
Saturday, November 15, 2008
The 40 Year Cycle
The 40 Year Cycle
By The Prudent Trader | 9 November 2008
Cycle theories in stocks and commodities have been around for at least a couple of centuries. While intriguing they are also quite controversial. Cyclists vehemently disagree on what constitutes a cycle and which cycles are most important; but most agree that it's a good idea to use cycles only as rough guidelines (or road maps if you will), and not as a means of day to day trading. Cycle theory should always be combined with other analytical methods such as fundamental, technical, and/or market psychology.
The following 3 paragraphs of interest are from Cliff Drake.com. For a more detailed description and analysis visit his site.
Of all the long term cycles I've played with, perhaps the most prominent is the 40 year cycle. Again according to Cliff Drake at Kitco.com the 40-year cycle bottomed in the following years: 1894, 1934, 1974. Its next bottom is scheduled for 2014. In each of those years when the 40-year cycle bottomed it produced a dramatic decline in the stock market as well as being preceded in each case by a severe economic recession (or outright depression in the case of 1894 and 1934).
The most damaging part of any cycle is the final 10% of the cycle's phase, i.e. the last 4 years. Let's look at what happens when the 40-year cycle enters its final "hard down" phase.
The four years prior to the 1934 expected cycle low was of course 1930 to 1934. The great crash of course, most believe, was in September/October of 1929. Actually the worst part of the decline occurred after a rally into April 1930, the decline occurred from April 1930 through July 1932; a whopping decline of 86.5% from the April 1930 high.
Click Here, or on the image, to see a larger, undistorted image.
Moving on to the 1970's, the 'bottoming process', or the last 10% of the cycle, would be 1970 thru 1974. The beginning of this four year period was marked by a recession in the U.S. economy, yet the Dow Jones advanced after the 1969 dip to about 1,000— up from about 700.
It wasn't until January of 1973 that the market topped out at 1,067. In fact I remember watching Louis Rukeyser's show on PBS (Wall Street Week) on the eve of the New Year, when he always asked his panelists for their high/low predictions for the coming year. In this particular show, one panelist stated that the low was already in. Rukeyser challenged this projection— "You mean we will not go any lower than last close of last year at any time?"— the panelist answered "yes". Being the contrary opinion person I like to consider myself, all I could think of was uh-oh. And that was the beginning of the hard down phase of that 40 year cycle, taking the Dow from 1,067 to 570 in 23 months. A decline of almost 50% in two years.
Click Here, or on the image, to see a larger, undistorted image.
The following chart is courtesy of StockCharts.com from 1900 to present. Perhaps the big picture look will make this 40 year cycle more apparent.
Click Here, or on the image, to see a larger, undistorted image.
Now the big "IF" questions; If the 40 year cycle has credence and if we will soon be staring into the last 10% of a 40 year cycle due to bottom in 2014, what shape will it take? 1930's or 1970's? The only answer of course is "no one knows"— although it seems everyone has an opinion. So far at least, the chart does look similar to the 1970's and if that turns out to be the case then we should essentially trade sideways, with perhaps one more hard down move in 2014, as in 1974. [[But watch out for 2010! As you can see from the decade chart below, starting in the last quarter of the '9 year and continuing through the first three quarters of the '0 year, the market takes a noticeable dip.: normxxx]] That of course is not a prediction; it's merely a guess— an observation.
The following chart presents the Dow Jones Industrial Average's 4 year presidential cycle from 1897 to the present.
Point of Interest— Notice how the upward trend falters starting in the later part of the post election year. It is argued that any major economic policies that may cause hardship are implemented early in the presidential cycle with hopes that the economy will recover in time for the next election and hence improve the chance of re-election for the party in power.
The following chart presents the Dow Jones Industrial Average's average decade cycle from 1896 to the present.
Point of Interest— One shouldn't put too much emphasis on this popular cycle as there isn't any particular underlying reason why the stock market's performance should be tied to any given year within a decade except, perhaps, as it relates to the 'presidential' cycle.
Large 100+ Year Dow.
Click Here, or on the image, to see a larger, undistorted image.
The following Dow chart compares the Dow (1900 - Present) to an inflation-adjusted Dow (1925 - Present).
Point of Interest— To better demonstrate the true magnitude of the great bull and bear markets of the last century, it is necessary to adjust the Dow Jones Industrial Average for inflation. What the CPI (Consumer Price Index) adjusted Dow chart shows is that the 1966 to 1982 bear market was almost as severe as that of the early 1930s. And since 1982, a true and great bull market has ensued (even when adjusted for inflation).
For some long-term, inflation perspective, this chart also illustrates the Dow adjusted for inflation since 1925.
Click Here, or on the image, to see a larger, undistorted image.
Click Here, or on the image, to see a larger, undistorted image.
There are several points of interest. For one, when adjusted for inflation, the bear market that concluded in the early 1980s was almost as severe as the one that concluded in the early 1930s. Also, the inflation-adjusted Dow is now less than double where it was in 1929 and trades a mere 29% above its 1966 peak. Not that spectacular a performance considering the time frames involved. However, the magnitude of the bull market of 1982 to 1999 (even when adjusted for inflation) was truly of historic proportions. It is also interesting to note that the magnitude of the current bear market (when adjusted for inflation) is greater than that which occurred during the dot-com bust of 1999 to 2003. As a result, the Dow currently trades at 12-year lows! Finally, Market Price Volatility first defines a best-fit, +1.64%/yr compounded annually, trend curve for these Real Dow data. The average Real Dow volatility (“+ or – difference of Real Dow from the trend curve”) is equivalent to 20 years of the 1.64%/yr trend growth! A range of Real Dow market price of a factor of 2.0 is equivalent to this average volatility.
*Note: Specifically, points are monthly Dow averages starting with January 1924; each 'market datum' = the monthly average of daily closing Dow values, divided by the CPI-U for that month, multiplied by 1.49629 (in order to adjust the all-time high in January 2000 to be equal to 100). These data are designated the “Real Dow”. Note: CPI-U is the broadest, most comprehensive consumer price index published by the U.S. government.
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
By The Prudent Trader | 9 November 2008
Cycle theories in stocks and commodities have been around for at least a couple of centuries. While intriguing they are also quite controversial. Cyclists vehemently disagree on what constitutes a cycle and which cycles are most important; but most agree that it's a good idea to use cycles only as rough guidelines (or road maps if you will), and not as a means of day to day trading. Cycle theory should always be combined with other analytical methods such as fundamental, technical, and/or market psychology.
The following 3 paragraphs of interest are from Cliff Drake.com. For a more detailed description and analysis visit his site.
|
Of all the long term cycles I've played with, perhaps the most prominent is the 40 year cycle. Again according to Cliff Drake at Kitco.com the 40-year cycle bottomed in the following years: 1894, 1934, 1974. Its next bottom is scheduled for 2014. In each of those years when the 40-year cycle bottomed it produced a dramatic decline in the stock market as well as being preceded in each case by a severe economic recession (or outright depression in the case of 1894 and 1934).
The most damaging part of any cycle is the final 10% of the cycle's phase, i.e. the last 4 years. Let's look at what happens when the 40-year cycle enters its final "hard down" phase.
The four years prior to the 1934 expected cycle low was of course 1930 to 1934. The great crash of course, most believe, was in September/October of 1929. Actually the worst part of the decline occurred after a rally into April 1930, the decline occurred from April 1930 through July 1932; a whopping decline of 86.5% from the April 1930 high.
Click Here, or on the image, to see a larger, undistorted image.
Moving on to the 1970's, the 'bottoming process', or the last 10% of the cycle, would be 1970 thru 1974. The beginning of this four year period was marked by a recession in the U.S. economy, yet the Dow Jones advanced after the 1969 dip to about 1,000— up from about 700.
It wasn't until January of 1973 that the market topped out at 1,067. In fact I remember watching Louis Rukeyser's show on PBS (Wall Street Week) on the eve of the New Year, when he always asked his panelists for their high/low predictions for the coming year. In this particular show, one panelist stated that the low was already in. Rukeyser challenged this projection— "You mean we will not go any lower than last close of last year at any time?"— the panelist answered "yes". Being the contrary opinion person I like to consider myself, all I could think of was uh-oh. And that was the beginning of the hard down phase of that 40 year cycle, taking the Dow from 1,067 to 570 in 23 months. A decline of almost 50% in two years.
Click Here, or on the image, to see a larger, undistorted image.
The following chart is courtesy of StockCharts.com from 1900 to present. Perhaps the big picture look will make this 40 year cycle more apparent.
Click Here, or on the image, to see a larger, undistorted image.
Now the big "IF" questions; If the 40 year cycle has credence and if we will soon be staring into the last 10% of a 40 year cycle due to bottom in 2014, what shape will it take? 1930's or 1970's? The only answer of course is "no one knows"— although it seems everyone has an opinion. So far at least, the chart does look similar to the 1970's and if that turns out to be the case then we should essentially trade sideways, with perhaps one more hard down move in 2014, as in 1974. [[But watch out for 2010! As you can see from the decade chart below, starting in the last quarter of the '9 year and continuing through the first three quarters of the '0 year, the market takes a noticeable dip.: normxxx]] That of course is not a prediction; it's merely a guess— an observation.
|
The following chart presents the Dow Jones Industrial Average's 4 year presidential cycle from 1897 to the present.
Point of Interest— Notice how the upward trend falters starting in the later part of the post election year. It is argued that any major economic policies that may cause hardship are implemented early in the presidential cycle with hopes that the economy will recover in time for the next election and hence improve the chance of re-election for the party in power.
The following chart presents the Dow Jones Industrial Average's average decade cycle from 1896 to the present.
Point of Interest— One shouldn't put too much emphasis on this popular cycle as there isn't any particular underlying reason why the stock market's performance should be tied to any given year within a decade except, perhaps, as it relates to the 'presidential' cycle.
Large 100+ Year Dow.
Click Here, or on the image, to see a larger, undistorted image.
The following Dow chart compares the Dow (1900 - Present) to an inflation-adjusted Dow (1925 - Present).
Point of Interest— To better demonstrate the true magnitude of the great bull and bear markets of the last century, it is necessary to adjust the Dow Jones Industrial Average for inflation. What the CPI (Consumer Price Index) adjusted Dow chart shows is that the 1966 to 1982 bear market was almost as severe as that of the early 1930s. And since 1982, a true and great bull market has ensued (even when adjusted for inflation).
For some long-term, inflation perspective, this chart also illustrates the Dow adjusted for inflation since 1925.
Click Here, or on the image, to see a larger, undistorted image.
Click Here, or on the image, to see a larger, undistorted image.
There are several points of interest. For one, when adjusted for inflation, the bear market that concluded in the early 1980s was almost as severe as the one that concluded in the early 1930s. Also, the inflation-adjusted Dow is now less than double where it was in 1929 and trades a mere 29% above its 1966 peak. Not that spectacular a performance considering the time frames involved. However, the magnitude of the bull market of 1982 to 1999 (even when adjusted for inflation) was truly of historic proportions. It is also interesting to note that the magnitude of the current bear market (when adjusted for inflation) is greater than that which occurred during the dot-com bust of 1999 to 2003. As a result, the Dow currently trades at 12-year lows! Finally, Market Price Volatility first defines a best-fit, +1.64%/yr compounded annually, trend curve for these Real Dow data. The average Real Dow volatility (“+ or – difference of Real Dow from the trend curve”) is equivalent to 20 years of the 1.64%/yr trend growth! A range of Real Dow market price of a factor of 2.0 is equivalent to this average volatility.
|
*Note: Specifically, points are monthly Dow averages starting with January 1924; each 'market datum' = the monthly average of daily closing Dow values, divided by the CPI-U for that month, multiplied by 1.49629 (in order to adjust the all-time high in January 2000 to be equal to 100). These data are designated the “Real Dow”. Note: CPI-U is the broadest, most comprehensive consumer price index published by the U.S. government.
ߧ
Normxxx
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Friday, November 14, 2008
The End
The End
By Michael Lewis Nov 11 2008 | 11 November 2008
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Photoillustration by: Ji Lee
To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital— to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue.
I’d never taken an accounting course, never run a business, never even had savings of my own to manage. I stumbled into a job at Salomon Brothers in 1985 and stumbled out much richer three years later, and even though I wrote a book about the experience, the whole thing still strikes me as preposterous— which is one of the reasons the money was so easy to walk away from.
I figured the situation was unsustainable. Sooner rather than later, someone was going to identify me, along with a lot of people more or less like me, as a fraud. Sooner rather than later, there would come a Great Reckoning when Wall Street would wake up and hundreds if not thousands of young people like me, who had no business making huge bets with other people’s money, would be expelled from finance.
When I sat down to write my account of the experience in 1989— Liar’s Poker, it was called— it was in the spirit of a young man who thought he was getting out while the getting was good. I was merely scribbling down a message on my way out and stuffing it into a bottle for those who would pass through these parts in the far distant future. Unless some insider got all of this down on paper, I figured, no future human would believe that it happened.
I thought I was writing a period piece about the 1980s in America. Not for a moment did I suspect that the financial 1980s would last two full decades longer or that the difference in degree between Wall Street and ordinary life would swell into a difference in kind. I expected readers of the future to be outraged that back in 1986, the C.E.O. of Salomon Brothers, John Gutfreund, was paid $3.1 million; I expected them to gape in horror when I reported that one of our traders, Howie Rubin, had moved to Merrill Lynch, where he lost $250 million; I assumed they’d be shocked to learn that a Wall Street C.E.O. had only the vaguest idea of the risks his traders were running. What I didn’t expect was that any future reader would look on my experience and say, "How quaint."
I had no great agenda, apart from telling what I took to be a remarkable tale, but if you got a few drinks in me and then asked what effect I thought my book would have on the world, I might have said something like, "I hope that college students trying to figure out what to do with their lives will read it and decide that it’s silly to phony it up and abandon their passions to become financiers." I hoped that some bright kid at, say, Ohio State University who really wanted to be an oceanographer would read my book, spurn the offer from Morgan Stanley, and set out to sea.
Somehow that message failed to come across. Six months after Liar’s Poker was published, I was knee-deep in letters from students at Ohio State who wanted to know if I had any other secrets to share about Wall Street. They’d read my book as a how-to manual.
In the two decades since then, I had been waiting for the end of Wall Street. The outrageous bonuses, the slender returns to shareholders, the never-ending scandals, the bursting of the internet bubble, the crisis following the collapse of Long-Term Capital Management: Over and over again, the big Wall Street investment banks would be, in some narrow way, discredited. Yet they just kept on growing, along with the sums of money that they doled out to 26-year-olds to perform tasks of no obvious social utility. The rebellion by American youth against the money culture never happened. Why bother to overturn your parents’ world when you can buy it, slice it up into tranches, and sell off the pieces?
At some point, I gave up waiting for the end. There was no scandal or reversal, I assumed, that could sink the system.
Then came Meredith Whitney with news. Whitney was an obscure analyst of financial firms for Oppenheimer Securities who, on October 31, 2007, ceased to be obscure. On that day, she predicted that Citigroup had so mismanaged its affairs that it would need to slash its dividend or go bust.
It’s never entirely clear on any given day what causes what in the stock market, but it was pretty obvious that on 31 October 2007 Meredith Whitney caused the market in financial stocks to crash. By the end of the trading day, a woman whom basically no one had ever heard of had shaved $369 billion off the value of financial firms in the market. Four days later, Citigroup’s C.E.O., Chuck Prince, resigned. In January, Citigroup slashed its dividend.
From that moment, Whitney became E.F. Hutton: When she spoke, people listened. Her message was clear. If you want to know what these Wall Street firms are really worth, take a hard look at the crappy assets they bought with huge sums of borrowed money, and imagine what they’d fetch in a fire sale. The vast assemblages of highly paid people inside the firms were essentially worth nothing. For better than a year now, Whitney has responded to the claims by bankers and brokers that they had put their problems behind them with this write-down or that capital raise with a claim of her own: You’re wrong. You’re still not facing up to how badly you have mismanaged your business.
Rivals accused Whitney of being overrated; bloggers accused her of being lucky. What she was, mainly, was right. But it’s true that she was, in part, guessing. There was no way she could have known what was going to happen to these Wall Street firms. The C.E.O.’s themselves didn’t know.
Now, obviously, Meredith Whitney didn’t sink Wall Street. She just expressed most clearly and loudly a view that was, in retrospect, far more seditious to the financial order than, say, Eliot Spitzer’s campaign against Wall Street corruption. If mere scandal could have destroyed the big Wall Street investment banks, they’d have vanished long ago. This woman wasn’t saying that Wall Street bankers were corrupt. She was saying they were stupid. These people whose job it was to allocate capital apparently didn’t even know how to manage their own.
At some point, I could no longer contain myself: I called Whitney. This was back in March, when Wall Street’s fate still hung in the balance. I thought, If she’s right, then this really could be the end of Wall Street as we’ve known it. I was curious to see if she made sense but also to know where this young woman who was crashing the stock market with her every utterance had come from.
It turned out that she made a great deal of sense and that she’d arrived on Wall Street in 1993, from the Brown University history department. "I got to New York, and I didn’t even know research existed," she says. She’d wound up at Oppenheimer and had the most incredible piece of luck: to be trained by a man who helped her establish not merely a career but a worldview. His name, she says, was Steve Eisman.
Eisman had moved on, but they kept in touch. "After I made the Citi call," she says, "one of the best things that happened was when Steve called and told me how proud he was of me."
Having never heard of Eisman, I didn’t think anything of this. But a few months later, I called Whitney again and asked her, as I was asking others, whom she knew who had anticipated the cataclysm and set themselves up to make a fortune from it. There’s a long list of people who now say they saw it coming all along but a far shorter one of people who actually did.
Of those, even fewer had the nerve to bet on their vision. It’s not easy to stand apart from mass hysteria— to believe that most of what’s in the financial news is wrong or distorted, to believe that most important financial people are either lying or deluded— without actually being insane. A handful of people had been inside the black box, understood how it worked, and bet on it blowing up. Whitney rattled off a list with a half-dozen names on it. At the top was Steve Eisman.
Steve Eisman entered finance about the time I exited it. He’d grown up in New York City and gone to a Jewish day school, the University of Pennsylvania, and Harvard Law School. In 1991, he was a 30-year-old corporate lawyer. "I hated it," he says. "I hated being a lawyer. My parents worked as brokers at Oppenheimer. They managed to finagle me a job. It’s not pretty, but that’s what happened."
He was hired as a junior equity analyst, a helpmate who didn’t actually offer his opinions. That changed in December 1991, less than a year into his new job, when a subprime mortgage lender called Ames Financial went public and no one at Oppenheimer particularly cared to express an opinion about it. One of Oppenheimer’s investment bankers stomped around the research department looking for anyone who knew anything about the mortgage business.
Recalls Eisman: "I’m a junior analyst and just trying to figure out which end is up, but I told him that as a lawyer I’d worked on a deal for the Money Store." He was promptly appointed the lead analyst for Ames Financial. "What I didn’t tell him was that my job had been to proofread the documents and that I hadn’t understood a word of the fucking things."
Ames Financial belonged to a category of firms known as nonbank financial institutions. The category didn’t include J.P. Morgan, but it did encompass many little-known companies that one way or another were involved in the early-1990s boom in subprime mortgage lending— the lower class of American finance.
The second company for which Eisman was given sole responsibility was Lomas Financial, which had just emerged from bankruptcy. "I put a sell rating on the thing because it was a piece of shit," Eisman says. "I didn’t know that you weren’t supposed to put a sell rating on companies. I thought there were three boxes— buy, hold, sell— and you could pick the one you thought you should." He was pressured generally to be a bit more upbeat, but upbeat wasn’t Steve Eisman’s style.
Upbeat and Eisman didn’t occupy the same planet. A hedge fund manager who counts Eisman as a friend set out to explain him to me but quit a minute into it. After describing how Eisman exposed various important people as either liars or idiots, the hedge fund manager started to laugh. "He’s sort of a prick in a way, but he’s smart and honest and fearless."
"A lot of people don’t get Steve," Whitney says. "But the people who get him love him." Eisman stuck to his sell rating on Lomas Financial, even after the company announced that investors needn’t worry about its financial condition, as it had hedged its market risk. "The single greatest line I ever wrote as an analyst," says Eisman, "was after Lomas said they were hedged." He recited the line from memory: " ‘The Lomas Financial Corp. is a perfectly hedged financial institution: It loses money in every conceivable interest-rate environment.’ I enjoyed writing that sentence more than any sentence I ever wrote." A few months after he’d delivered that line in his report, Lomas Financial returned to bankruptcy.
Eisman wasn’t, in short, an analyst with a sunny disposition who expected the best of his fellow financial man and the companies he created. "You have to understand," Eisman says in his defense, "I did subprime first. I lived with the worst first. These guys lied to infinity. What I learned from that experience was that Wall Street didn’t give a shit what it sold."
Harboring suspicions about people’s morals and telling investors that companies don’t deserve their capital wasn’t, in the 1990s or at any other time, the fast track to success on Wall Street. Eisman quit Oppenheimer in 2001 to work as an analyst at a hedge fund, but what he really wanted to do was run money. FrontPoint Partners, another hedge fund, hired him in 2004 to invest in financial stocks.
Eisman’s brief was to evaluate Wall Street banks, homebuilders, mortgage originators, and any company (General Electric or General Motors, for instance) with a big financial-services division— anyone who touched American finance. An insurance company backed him with $50 million, a paltry sum. "Basically, we tried to raise money and didn't really do it," Eisman says. Instead of money, he attracted people whose worldviews were as shaded as his own— Vincent Daniel, for instance, who became a partner and an analyst in charge of the mortgage sector.
Now 36, Daniel grew up a lower-middle-class kid in Queens. One of his first jobs, as a junior accountant at Arthur Andersen, was to audit Salomon Brothers’ books. "It was shocking," he says. "No one could explain to me what they were doing." He left accounting in the middle of the internet boom to become a research analyst, looking at companies that made subprime loans. "I was the only guy I knew covering companies that were all going to go bust," he says. "I saw how the sausage was made in the economy, and it was really freaky."
Danny Moses, who became Eisman’s head trader, was another who shared his perspective. Raised in Georgia, Moses, the son of a finance professor, was a bit less fatalistic than Daniel or Eisman, but he nevertheless shared a general sense that bad things can and do happen. When a Wall Street firm helped him get into a trade that seemed perfect in every way, he said to the salesman, "I appreciate this, but I just want to know one thing: How are you going to screw me?"
Heh heh heh, c’mon. We’d never do that, the trader started to say, but Moses was politely insistent: We both know that unadulterated good things like this trade don’t just happen between little hedge funds and big Wall Street firms. I’ll do it, but only after you explain to me how you are going to screw me. And the salesman explained how he was going to screw him. And Moses did the trade.
Both Daniel and Moses enjoyed, immensely, working with Steve Eisman. He put a fine point on the absurdity they saw everywhere around them. "Steve’s fun to take to any Wall Street meeting," Daniel says. "Because he’ll say ‘Explain that to me’ 30 different times. Or ‘Could you explain that more, in English?’ Because once you do that, there’s a few things you learn. For a start, you figure out if they even know what they’re talking about. And a lot of times, they don’t!"
At the end of 2004, Eisman, Moses, and Daniel shared a sense that unhealthy things were going on in the U.S. housing market: Lots of firms were lending money to people who shouldn’t have been borrowing it. They thought Alan Greenspan’s decision after the internet bust to lower interest rates to 1 percent was a travesty that would lead to some terrible day of reckoning. Neither of these insights was entirely original.
Ivy Zelman, at the time the housing-market analyst at Credit Suisse, had seen the bubble forming very early on. There’s a simple measure of sanity in housing prices: the ratio of median home price to income. Historically, it runs around 3 to 1; by late 2004, it had risen nationally to 4 to 1. "All these people were saying it was nearly as high in some other countries," Zelman says. "But the problem wasn’t just that it was 4 to 1. In Los Angeles, it was 10 to 1, and in Miami, 8.5 to 1. And then you coupled that with the buyers. They weren’t real buyers. They were speculators."
Zelman alienated clients with her pessimism, but she couldn’t pretend everything was good. "It wasn’t that hard in hindsight to see it," she says. "It was very hard to know when it would stop." Zelman spoke occasionally with Eisman and always left these conversations feeling better about her views and worse about the world. "You needed the occasional assurance that you weren’t nuts," she says. She wasn’t nuts. The world was.
By the spring of 2005, FrontPoint was fairly convinced that something was very screwed up not merely in a handful of companies but in the financial underpinnings of the entire U.S. mortgage market. In 2000, there had been $130 billion in subprime mortgage lending, with $55 billion of that repackaged as mortgage bonds. But in 2005, there was $625 billion in subprime mortgage loans, $507 billion of which found its way into mortgage bonds.
Eisman couldn’t understand who was making all these loans or why. He had a from-the-ground-up understanding of both the U.S. housing market and Wall Street. But he’d spent his life in the stock market, and it was clear that the stock market was, in this story, largely irrelevant. "What most people don’t realize is that the fixed-income world dwarfs the equity world," he says. "The equity world is like a fucking zit compared with the bond market."
He shorted companies that originated subprime loans, like New Century and Indy Mac, and companies that built the houses bought with the loans, such as Toll Brothers. Smart as these trades proved to be, they weren’t entirely satisfying. These companies paid high dividends, and their shares were often expensive to borrow; selling them short was a costly proposition.
Enter Greg Lippman, a mortgage-bond trader at Deutsche Bank. He arrived at FrontPoint bearing a 66-page presentation that described a better way for the fund to put its view of both Wall Street and the U.S. housing market into action. The smart trade, Lippman argued, was to sell short not New Century’s stock but its bonds that were backed by the subprime loans it had made. Eisman hadn’t known this was even possible— because until recently, it hadn’t been. But Lippman, along with traders at other Wall Street investment banks, had created a way to short the subprime bond market with precision.
Here’s where financial technology became suddenly, urgently relevant. The typical mortgage bond was still structured in much the same way it had been when I worked at Salomon Brothers. The loans went into a trust that was designed to pay off its investors not all at once but according to their rankings. The investors in the top tranche, rated AAA, received the first payment from the trust and, because their investment was the least risky, received the lowest interest rate on their money.
The investors who held the trusts’ BBB tranche got the last payments— and bore the brunt of the first defaults. Because they were taking the most risk, they received the highest return. Eisman wanted to bet that some subprime borrowers would default, causing the trust to suffer losses. The way to express this view was to short the BBB tranche. The trouble was that the BBB tranche was only a tiny slice of the deal.
But the scarcity of truly crappy subprime-mortgage bonds no longer mattered. The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.
The arrangement bore the same relation to actual finance as fantasy football bears to the N.F.L. Eisman was perplexed in particular about why Wall Street firms would be coming to him and asking him to sell short. "What Lippman did, to his credit, was he came around several times to me and said, ‘Short this market,’ " Eisman says. "In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’ "
And short Eisman did— then he tried to get his mind around what he’d just done so he could do it better. He’d call over to a big firm and ask for a list of mortgage bonds from all over the country. The juiciest shorts— the bonds ultimately backed by the mortgages most likely to default— had several characteristics. They’d be in what Wall Street people were now calling the sand states: Arizona, California, Florida, Nevada.
The loans would have been made by one of the more dubious mortgage lenders; Long Beach Financial, wholly owned by Washington Mutual, was a great example. Long Beach Financial was moving money out the door as fast as it could, few questions asked, in loans built to self-destruct. It specialized in asking homeowners with bad credit and no proof of income to put no money down and defer interest payments for as long as possible. In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $720,000.
More generally, the subprime market tapped a tranche of the American public that did not typically have anything to do with Wall Street. Lenders were making loans to people who, based on their credit ratings, were less creditworthy than 71 percent of the population. Eisman knew some of these people. One day, his housekeeper, a South American woman, told him that she was planning to buy a townhouse in Queens.
In retrospect, pretty much all of the riskiest subprime-backed bonds were worth betting against; they would all one day be worth zero. But at the time Eisman began to do it, in the fall of 2006, that wasn’t clear. He and his team set out to find the smelliest pile of loans they could so that they could make side bets against them with Goldman Sachs or Deutsche Bank.
What they were doing, oddly enough, was the analysis of subprime lending that should have been done before the loans were made: Which poor Americans were likely to jump which way with their finances? How much did home prices need to fall for these loans to blow up? (It turned out they didn’t have to fall; they merely needed to stay flat.) The default rate in Georgia was five times higher than that in Florida even though the two states had the same unemployment rate. Why? Indiana had a 25 percent default rate; California’s was only 5 percent. Why?
Moses actually flew down to Miami and wandered around neighborhoods built with subprime loans to see how bad things were. "He’d call me and say, ‘Oh my God, this is a calamity here,’ " recalls Eisman. All that was required for the BBB bonds to go to zero was for the default rate on the underlying loans to reach 14 percent. Eisman thought that, in certain sections of the country, it would go far, far higher.
The funny thing, looking back on it, is how long it took for even someone who predicted the disaster to grasp its root causes. They were learning about this on the fly, shorting the bonds and then trying to figure out what they had done. Eisman knew subprime lenders could be scumbags. What he underestimated was the total unabashed complicity of the upper class of American capitalism. For instance, he knew that the big Wall Street investment banks took huge piles of loans that in and of themselves might be rated BBB, threw them into a trust, carved the trust into tranches, and wound up with 60 percent of the new total being rated AAA.
But he couldn’t figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. "I didn’t understand how they were turning all this garbage into gold," he says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. "We always asked the same question," says Eisman. "Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk."
He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. "They were assuming home prices would just keep going up," Eisman says.
As an investor, Eisman was allowed on the quarterly conference calls held by Moody’s but not allowed to ask questions. The people at Moody’s were polite about their brush-off, however. The C.E.O. even invited Eisman and his team to his office for a visit in June 2007. By then, Eisman was so certain that the world had been turned upside down that he just assumed this guy must know it too.
"But we’re sitting there," Daniel recalls, "and he says to us, like he actually means it, ‘I truly believe that our rating will prove accurate.’ And Steve shoots up in his chair and asks, ‘What did you just say?’ as if the guy had just uttered the most preposterous statement in the history of finance. He repeated it. And Eisman just laughed at him."
"With all due respect, sir," Daniel told the C.E.O. deferentially as they left the meeting, "you’re delusional." This wasn’t Fitch or even S&P. This was Moody’s, the aristocrats of the rating business, 20 percent owned by Warren Buffett. And the company’s C.E.O. was being told he was either a fool or a crook by one Vincent Daniel, from Queens.
A full nine months earlier, Daniel and Moses had flown to Orlando for an industry conference. It had a grand title— the American Securitization Forum— but it was essentially a trade show for the subprime-mortgage business: the people who originated subprime mortgages, the Wall Street firms that packaged and sold subprime mortgages, the fund managers who invested in nothing but subprime-mortgage-backed bonds, the agencies that rated subprime-mortgage bonds, the lawyers who did whatever the lawyers did. Daniel and Moses thought they were paying a courtesy call on a cottage industry, but the cottage had become a castle.
"There were like 6,000 people there," Daniel says. "There were so many people being fed by this industry. The entire fixed-income department of each brokerage firm is built on this. Everyone there was the long side of the trade. The wrong side of the trade. And then there was us. That’s when the picture really started to become clearer, and we started to get more cynical, if that was possible. We went back home and said to Steve, ‘You gotta see this.’ "
Eisman, Daniel, and Moses then flew out to Las Vegas for an even bigger subprime conference. By now, Eisman knew everything he needed to know about the quality of the loans being made. He still didn’t fully understand how the apparatus worked, but he knew that Wall Street had built a doomsday machine. He was at once opportunistic and outraged.
Their first stop was a speech given by the C.E.O. of Option One, the mortgage originator owned by H&R Block. When the guy got to the part of his speech about Option One’s subprime-loan portfolio, he claimed to be expecting a modest default rate of 5 percent. Eisman raised his hand. Moses and Daniel sank into their chairs. "It wasn’t a Q&A," says Moses. "The guy was giving a speech. He sees Steve’s hand and says, ‘Yes?’"
"Would you say that 5 percent is a probability or a possibility?" Eisman asked. A probability, said the C.E.O., and he continued his speech.
Eisman had his hand up in the air again, waving it around. Oh, no, Moses thought. "The one thing Steve always says," Daniel explains, "is you must assume they are lying to you. They will always lie to you." Moses and Daniel both knew what Eisman thought of these subprime lenders but didn’t see the need for him to express it here in this manner. For Eisman wasn’t raising his hand to ask a question. He had his thumb and index finger in a big circle. He was using his fingers to speak on his behalf. Zero! they said.
"Yes?" the C.E.O. said, obviously irritated. "Is that another question?" "No," said Eisman. "It’s a zero. There is zero probability that your default rate will be 5 percent." The losses on subprime loans would be much, much greater.
Before the guy could reply, Eisman’s cell phone rang. Instead of shutting it off, Eisman reached into his pocket and answered it. "Excuse me," he said, standing up. "But I need to take this call." And with that, he walked out.
Eisman’s willingness to be abrasive in order to get to the heart of the matter was obvious to all; what was harder to see was his credulity: He actually wanted to believe in the system. As quick as he was to cry bullshit when he saw it, he was still shocked by bad behavior. That night in Vegas, he was seated at dinner beside a really nice guy who invested in mortgage C.D.O.’s— collateralized debt obligations. By then, Eisman thought he knew what he needed to know about C.D.O.’s. He didn’t, it turned out.
Later, when I sit down with Eisman, the very first thing he wants to explain is the importance of the mezzanine C.D.O. What you notice first about Eisman is his lips. He holds them pursed, waiting to speak. The second thing you notice is his short, light hair, cropped in a manner that suggests he cut it himself while thinking about something else.
"You have to understand this," he says. "This was the engine of doom." Then he draws a picture of several towers of debt. The first tower is made of the original subprime loans that had been piled together. At the top of this tower is the AAA tranche, just below it the AA tranche, and so on down to the riskiest, the BBB tranche— the bonds Eisman had shorted. But Wall Street had used these BBB tranches— the worst of the worst— to build yet another tower of bonds: a "particularly egregious" C.D.O.
The reason they did this was that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce most of them AAA. These bonds could then be sold to investors— pension funds, insurance companies— who were allowed to invest only in highly rated securities. "I cannot fucking believe this is allowed— I must have said that a thousand times in the past two years," Eisman says.
His dinner companion in Las Vegas ran a fund of about $15 billion and managed C.D.O.’s backed by the BBB tranche of a mortgage bond, or as Eisman puts it, "the equivalent of three levels of dog shit lower than the original bonds." FrontPoint had spent a lot of time digging around in the dog shit and knew that the default rates were already sufficient to wipe out this guy’s entire portfolio. "God, you must be having a hard time," Eisman told his dinner companion. "No," the guy said, "I’ve sold everything out."
After taking a fee, he passed them on to other investors. His job was to be the C.D.O. "expert," but he actually didn’t spend any time at all thinking about what was in the C.D.O.’s. "He managed the C.D.O.’s," says Eisman, "but managed what? I was just appalled. People would pay up to have someone manage their C.D.O.’s— as if this moron was helping you. I thought, You prick, you don’t give a fuck about the investors in this thing."
Whatever rising anger Eisman felt was offset by the man’s genial disposition. Not only did he not mind that Eisman took a dim view of his C.D.O.’s; he saw it as a basis for friendship. "Then he said something that blew my mind," Eisman tells me. "He says, ‘I love guys like you who short my market. Without you, I don’t have anything to buy.’ "
That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms were using Eisman’s bets to synthesize more of them.
Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs.
Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. "They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford," Eisman says. "They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?"
This particular dinner was hosted by Deutsche Bank, whose head trader, Greg Lippman, was the fellow who had introduced Eisman to the subprime bond market. Eisman went and found Lippman, pointed back to his own dinner companion, and said, "I want to short him." Lippman thought he was joking; he wasn’t. "Greg, I want to short his paper," Eisman repeated. "Sight unseen."
Eisman started out running a $60 million equity fund but was now short around $600 million of various subprime-related securities. In the spring of 2007, the market strengthened. But, says Eisman, "credit quality always gets better in March and April. And the reason it always gets better in March and April is that people get their tax refunds. You would think people in the securitization world would know this. We just thought that was moronic."
He was already short the stocks of mortgage originators and the homebuilders. Now he took short positions in the rating agencies— "they were making 10 times more rating C.D.O.’s than they were rating G.M. bonds, and it was all going to end"— and, finally, the biggest Wall Street firms because of their exposure to C.D.O.’s.
He wasn’t allowed to short Morgan Stanley because it owned a stake in his fund. But he shorted UBS, Lehman Brothers, and a few others. Not long after that, FrontPoint had a visit from Sanford C. Bernstein’s Brad Hintz, a prominent analyst who covered Wall Street firms. Hintz wanted to know what Eisman was up to. "We just shorted Merrill Lynch," Eisman told him. "Why?" asked Hintz.
"We have a simple thesis," Eisman explained. "There is going to be a calamity, and whenever there is a calamity, Merrill is there." When it came time to bankrupt Orange County with bad advice, Merrill was there. When the internet went bust, Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit.
That was Eisman’s logic— the logic of Wall Street’s pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things. The game, as Eisman saw it, was Crack the Whip. He assumed Merrill Lynch had taken its assigned place at the end of the chain.
There was only one thing that bothered Eisman, and it continued to trouble him as late as May 2007. "The thing we couldn’t figure out is: It’s so obvious. Why hasn’t everyone else figured out that the machine is done?" Eisman had long subscribed to Grant’s Interest Rate Observer, a newsletter famous in Wall Street circles and obscure outside them. Jim Grant, its editor, had been prophesying doom ever since the great debt cycle began, in the mid-1980s.
In late 2006, he decided to investigate these things called C.D.O.’s. Or rather, he had asked his young assistant, Dan Gertner, a chemical engineer with an M.B.A., to see if he could understand them. Gertner went off with the documents that purported to explain C.D.O.’s to potential investors and for several days sweated and groaned and heaved and suffered. "Then he came back," says Grant, "and said, ‘I can’t figure this thing out.’ And I said, ‘I think we have our story.’ "
Eisman read Grant’s piece as independent confirmation of what he knew in his bones about the C.D.O.’s he had shorted. "When I read it, I thought, Oh my God. This is like owning a gold mine. When I read that, I was the only guy in the equity world who almost had an orgasm."
On July 19, 2007, the same day that Federal Reserve Chairman Ben Bernanke told the U.S. Senate that he anticipated as much as $100 billion in losses in the subprime-mortgage market, FrontPoint did something unusual: It hosted its own conference call. It had had calls with its tiny population of investors, but this time FrontPoint opened it up. Steve Eisman had become a poorly kept secret.
Five hundred people called in to hear what he had to say, and another 500 logged on afterward to listen to a recording of it. He explained the strange alchemy of the C.D.O. and said that he expected losses of up to $300 billion from this sliver of the market alone. To evaluate the situation, he urged his audience to:
On September 18, 2008, Danny Moses came to work as usual at 6:30 a.m. Earlier that week, Lehman Brothers had filed for bankruptcy. The day before, the Dow had fallen 449 points to its lowest level in four years. Overnight, European governments announced a ban on short-selling, but that served as faint warning for what happened next.
At the market opening in the U.S., everything— every financial asset— went into free fall. "All hell was breaking loose in a way I had never seen in my career," Moses says. FrontPoint was net short the market, so this total collapse should have given Moses pleasure. He might have been forgiven if he stood up and cheered. After all, he’d been betting for two years that this sort of thing could happen, and now it was, more dramatically than he had ever imagined.
Instead, he felt this terrifying shudder run through him. He had maybe 100 trades on, and he worked hard to keep a handle on them all. "I spent my morning trying to control all this energy and all this information," he says, "and I lost control. I looked at the screens. I was staring into the abyss. The end. I felt this shooting pain in my head. I don’t get headaches. At first, I thought I was having an aneurysm."
Moses stood up, wobbled, then turned to Daniel and said, "I gotta leave. Get out of here. Now." Daniel thought about calling an ambulance but instead took Moses out for a walk. Outside it was gorgeous, the blue sky reaching down through the tall buildings and warming the soul. Eisman was at a Goldman Sachs conference for hedge fund managers, raising capital. Moses and Daniel got him on the phone, and he left the conference and met them on the steps of St. Patrick’s Cathedral. "We just sat there," Moses says. "Watching the people pass."
This was what they had been waiting for: total collapse. "The investment-banking industry is fucked," Eisman had told me a few weeks earlier. "These guys are only beginning to understand how fucked they are. It’s like being a Scholastic, prior to Newton. Newton comes along, and one morning you wake up: ‘Holy shit, I’m wrong!’ " Now Lehman Brothers had vanished, Merrill had surrendered, and Goldman Sachs and Morgan Stanley were just a week away from ceasing to be investment banks. The investment banks were not just fucked; they were extinct.
Not so for hedge fund managers who had seen it coming. "As we sat there, we were weirdly calm," Moses says. "We felt insulated from the whole market reality. It was an out-of-body experience. We just sat and watched the people pass and talked about what might happen next. How many of these people were going to lose their jobs. Who was going to rent these buildings after all the Wall Street firms collapsed."
Eisman was appalled. "Look," he said. "I’m short. I don’t want the country to go into a depression. I just want it to fucking deleverage." He had tried a thousand times in a thousand ways to explain how screwed up the business was, and no one wanted to hear it. "That Wall Street has gone down because of this is justice," he says. "They fucked people. They built a castle to rip people off. Not once in all these years have I come across a person inside a big Wall Street firm who was having a crisis of conscience."
Truth to tell, there wasn’t a whole lot of hand-wringing inside FrontPoint either. The only one among them who wrestled a bit with his conscience was Daniel. "Vinny, being from Queens, needs to see the dark side of everything," Eisman says. To which Daniel replies, "The way we thought about it was, ‘By shorting this market we’re creating the liquidity to keep the market going.’ "
"It was like feeding the monster," Eisman says of the market for subprime bonds. "We fed the monster until it blew up." About the time they were sitting on the steps of the midtown cathedral, I sat in a booth in a restaurant on the East Side, waiting for John Gutfreund to arrive for lunch, and wondered, among other things, why any restaurant would seat side by side two men who had not the slightest interest in touching each other.
There was an umbilical cord running from the belly of the exploded beast back to the financial 1980s. A friend of mine created the first mortgage derivative in 1986, a year after we left the Salomon Brothers trading program. ("The problem isn’t the tools," he likes to say. "It’s who is using the tools. Derivatives are like guns.")
When I published my book, the 1980s were supposed to be ending. I received a lot of undeserved credit for my timing. The social disruption caused by the collapse of the savings-and-loan industry and the rise of hostile takeovers and leveraged buyouts had given way to a brief period of recriminations.
Just as most students at Ohio State read Liar’s Poker as a manual, most TV and radio interviewers regarded me as a whistleblower. (The big exception was Geraldo Rivera. He put me on a show called "People Who Succeed Too Early in Life" along with some child actors who’d gone on to become drug addicts.)
Anti-Wall Street feeling ran high— high enough for Rudy Giuliani to float a political career on it— but the result felt more like a witch hunt than an honest reappraisal of the financial order. The public lynchings of Gutfreund and junk-bond king Michael Milken were excuses not to deal with the disturbing forces underpinning their rise. Ditto the cleaning up of Wall Street’s trading culture.
The surface rippled, but down below, in the depths, the bonus pool remained undisturbed. Wall Street firms would soon be frowning upon profanity, firing traders for so much as glancing at a stripper, and forcing male employees to treat women almost as equals. Lehman Brothers circa 2008 more closely resembled a normal corporation with solid American values than did any Wall Street firm circa 1985.
The changes were camouflage. They helped distract outsiders from the truly profane event: the growing misalignment of interests between the people who trafficked in financial risk and the wider culture. I’d not seen Gutfreund since I quit Wall Street. I’d met him, nervously, a couple of times on the trading floor. A few months before I left, my bosses asked me to explain to Gutfreund what at the time seemed like exotic trades in derivatives I’d done with a European hedge fund.
I tried. He claimed not to be smart enough to understand any of it, and I assumed that was how a Wall Street C.E.O. showed he was the boss, by rising above the details. There was no reason for him to remember any of these encounters, and he didn’t: When my book came out and became a public-relations nuisance to him, he told reporters we’d never met.
Over the years, I’d heard bits and pieces about Gutfreund. I knew that after he’d been forced to resign from Salomon Brothers he’d fallen on harder times. I heard later that a few years ago he’d sat on a panel about Wall Street at Columbia Business School. When his turn came to speak, he advised students to find something more meaningful to do with their lives. As he began to describe his career, he broke down and wept.
When I emailed him to invite him to lunch, he could not have been more polite or more gracious. That attitude persisted as he was escorted to the table, made chitchat with the owner, and ordered his food. He’d lost a half-step and was more deliberate in his movements, but otherwise he was completely recognizable. The same veneer of denatured courtliness masked the same animal need to see the world as it was, rather than as it should be.
We spent 20 minutes or so determining that our presence at the same lunch table was not going to cause the earth to explode. We discovered we had a mutual acquaintance in New Orleans. We agreed that the Wall Street C.E.O. had no real ability to keep track of the frantic innovation occurring inside his firm. ("I didn’t understand all the product lines, and they don’t either," he said.)
We agreed, further, that the chief of the Wall Street investment bank had little control over his subordinates. ("They’re buttering you up and then doing whatever the fuck they want to do.") He thought the cause of the financial crisis was "simple. Greed on both sides— greed of investors and the greed of the bankers." I thought it was more complicated. Greed on Wall Street was a given— almost an obligation. The problem was the system of incentives that channeled the greed.
But I didn’t argue with him. For just as you revert to being about nine years old when you visit your parents, you revert to total subordination when you are in the presence of your former C.E.O. John Gutfreund was still the King of Wall Street, and I was still a geek. He spoke in declarative statements; I spoke in questions.
But as he spoke, my eyes kept drifting to his hands. His alarmingly thick and meaty hands. They weren’t the hands of a soft Wall Street banker but of a boxer. I looked up. The boxer was smiling— though it was less a smile than a placeholder expression. And he was saying, very deliberately, "Your…fucking…book."
I smiled back, though it wasn’t quite a smile. "Your fucking book destroyed my career, and it made yours," he said. I didn’t think of it that way and said so, sort of. "Why did you ask me to lunch?" he asked, though pleasantly. He was genuinely curious.
You can’t really tell someone that you asked him to lunch to let him know that you don’t think of him as evil. Nor can you tell him that you asked him to lunch because you thought that you could trace the biggest financial crisis in the history of the world back to a decision he had made. John Gutfreund did violence to the Wall Street social order— and got himself dubbed the King of Wall Street— when he turned Salomon Brothers from a private partnership into Wall Street’s first public corporation.
He ignored the outrage of Salomon’s retired partners. ( "I was disgusted by his materialism," William Salomon, the son of the firm’s founder, who had made Gutfreund C.E.O. only after he’d promised never to sell the firm, had told me.) He lifted a giant middle finger at the moral disapproval of his fellow Wall Street C.E.O.’s. And he seized the day. He and the other partners not only made a quick killing; they transferred the ultimate financial risk from themselves to their shareholders.
It didn’t, in the end, make a great deal of sense for the shareholders. (A share of Salomon Brothers purchased when I arrived on the trading floor, in 1986, at a then market price of $42, would be worth 2.26 shares of Citigroup today— market value: $27.) But it made fantastic sense for the investment bankers.
From that moment, though, the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith.
No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.
No partnership, for that matter, would have hired me or anyone remotely like me. Was there ever any correlation between the ability to get in and out of Princeton and a talent for taking financial risk?
Now I asked Gutfreund about his biggest decision. "Yes," he said. "They— the heads of the other Wall Street firms— all said what an awful thing it was to go public and how could you do such a thing. But when the temptation arose, they all gave in to it." He agreed that the main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders.
"When things go wrong, it’s their problem," he said— and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government. "It’s laissez-faire until you get in deep shit," he said, with a half chuckle. He was out of the game.
It was now all someone else’s fault. He watched me curiously as I scribbled down his words. "What’s this for?" he asked. I told him I thought it might be worth revisiting the world I’d described in Liar’s Poker, now that it was finally dying. Maybe bring out a 20th-anniversary edition. "That’s nauseating," he said.
Hard as it was for him to enjoy my company, it was harder for me not to enjoy his. He was still tough, as straight and blunt as a butcher. He’d helped create a monster, but he still had in him a lot of the old Wall Street, where people said things like "A man’s word is his bond." On that Wall Street, people didn’t walk out of their firms and cause trouble for their former bosses by writing books about them.
"No," he said, "I think we can agree about this: Your fucking book destroyed my career, and it made yours." With that, the former king of a former Wall Street lifted the plate that held his appetizer and asked sweetly, "Would you like a deviled egg?"
Until that moment, I hadn’t paid much attention to what he’d been eating. Now I saw he’d ordered the best thing in the house, this gorgeous frothy confection of an earlier age. Who ever dreamed up the deviled egg? Who knew that a simple egg could be made so complicated and yet so appealing? I reached over and took one. Something for nothing. It never loses its charm.
ߧ
Normxxx
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By Michael Lewis Nov 11 2008 | 11 November 2008
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Photoillustration by: Ji Lee
To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital— to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue.
I’d never taken an accounting course, never run a business, never even had savings of my own to manage. I stumbled into a job at Salomon Brothers in 1985 and stumbled out much richer three years later, and even though I wrote a book about the experience, the whole thing still strikes me as preposterous— which is one of the reasons the money was so easy to walk away from.
I figured the situation was unsustainable. Sooner rather than later, someone was going to identify me, along with a lot of people more or less like me, as a fraud. Sooner rather than later, there would come a Great Reckoning when Wall Street would wake up and hundreds if not thousands of young people like me, who had no business making huge bets with other people’s money, would be expelled from finance.
When I sat down to write my account of the experience in 1989— Liar’s Poker, it was called— it was in the spirit of a young man who thought he was getting out while the getting was good. I was merely scribbling down a message on my way out and stuffing it into a bottle for those who would pass through these parts in the far distant future. Unless some insider got all of this down on paper, I figured, no future human would believe that it happened.
I thought I was writing a period piece about the 1980s in America. Not for a moment did I suspect that the financial 1980s would last two full decades longer or that the difference in degree between Wall Street and ordinary life would swell into a difference in kind. I expected readers of the future to be outraged that back in 1986, the C.E.O. of Salomon Brothers, John Gutfreund, was paid $3.1 million; I expected them to gape in horror when I reported that one of our traders, Howie Rubin, had moved to Merrill Lynch, where he lost $250 million; I assumed they’d be shocked to learn that a Wall Street C.E.O. had only the vaguest idea of the risks his traders were running. What I didn’t expect was that any future reader would look on my experience and say, "How quaint."
I had no great agenda, apart from telling what I took to be a remarkable tale, but if you got a few drinks in me and then asked what effect I thought my book would have on the world, I might have said something like, "I hope that college students trying to figure out what to do with their lives will read it and decide that it’s silly to phony it up and abandon their passions to become financiers." I hoped that some bright kid at, say, Ohio State University who really wanted to be an oceanographer would read my book, spurn the offer from Morgan Stanley, and set out to sea.
Somehow that message failed to come across. Six months after Liar’s Poker was published, I was knee-deep in letters from students at Ohio State who wanted to know if I had any other secrets to share about Wall Street. They’d read my book as a how-to manual.
In the two decades since then, I had been waiting for the end of Wall Street. The outrageous bonuses, the slender returns to shareholders, the never-ending scandals, the bursting of the internet bubble, the crisis following the collapse of Long-Term Capital Management: Over and over again, the big Wall Street investment banks would be, in some narrow way, discredited. Yet they just kept on growing, along with the sums of money that they doled out to 26-year-olds to perform tasks of no obvious social utility. The rebellion by American youth against the money culture never happened. Why bother to overturn your parents’ world when you can buy it, slice it up into tranches, and sell off the pieces?
At some point, I gave up waiting for the end. There was no scandal or reversal, I assumed, that could sink the system.
Then came Meredith Whitney with news. Whitney was an obscure analyst of financial firms for Oppenheimer Securities who, on October 31, 2007, ceased to be obscure. On that day, she predicted that Citigroup had so mismanaged its affairs that it would need to slash its dividend or go bust.
It’s never entirely clear on any given day what causes what in the stock market, but it was pretty obvious that on 31 October 2007 Meredith Whitney caused the market in financial stocks to crash. By the end of the trading day, a woman whom basically no one had ever heard of had shaved $369 billion off the value of financial firms in the market. Four days later, Citigroup’s C.E.O., Chuck Prince, resigned. In January, Citigroup slashed its dividend.
From that moment, Whitney became E.F. Hutton: When she spoke, people listened. Her message was clear. If you want to know what these Wall Street firms are really worth, take a hard look at the crappy assets they bought with huge sums of borrowed money, and imagine what they’d fetch in a fire sale. The vast assemblages of highly paid people inside the firms were essentially worth nothing. For better than a year now, Whitney has responded to the claims by bankers and brokers that they had put their problems behind them with this write-down or that capital raise with a claim of her own: You’re wrong. You’re still not facing up to how badly you have mismanaged your business.
Rivals accused Whitney of being overrated; bloggers accused her of being lucky. What she was, mainly, was right. But it’s true that she was, in part, guessing. There was no way she could have known what was going to happen to these Wall Street firms. The C.E.O.’s themselves didn’t know.
Now, obviously, Meredith Whitney didn’t sink Wall Street. She just expressed most clearly and loudly a view that was, in retrospect, far more seditious to the financial order than, say, Eliot Spitzer’s campaign against Wall Street corruption. If mere scandal could have destroyed the big Wall Street investment banks, they’d have vanished long ago. This woman wasn’t saying that Wall Street bankers were corrupt. She was saying they were stupid. These people whose job it was to allocate capital apparently didn’t even know how to manage their own.
At some point, I could no longer contain myself: I called Whitney. This was back in March, when Wall Street’s fate still hung in the balance. I thought, If she’s right, then this really could be the end of Wall Street as we’ve known it. I was curious to see if she made sense but also to know where this young woman who was crashing the stock market with her every utterance had come from.
It turned out that she made a great deal of sense and that she’d arrived on Wall Street in 1993, from the Brown University history department. "I got to New York, and I didn’t even know research existed," she says. She’d wound up at Oppenheimer and had the most incredible piece of luck: to be trained by a man who helped her establish not merely a career but a worldview. His name, she says, was Steve Eisman.
Eisman had moved on, but they kept in touch. "After I made the Citi call," she says, "one of the best things that happened was when Steve called and told me how proud he was of me."
Having never heard of Eisman, I didn’t think anything of this. But a few months later, I called Whitney again and asked her, as I was asking others, whom she knew who had anticipated the cataclysm and set themselves up to make a fortune from it. There’s a long list of people who now say they saw it coming all along but a far shorter one of people who actually did.
Of those, even fewer had the nerve to bet on their vision. It’s not easy to stand apart from mass hysteria— to believe that most of what’s in the financial news is wrong or distorted, to believe that most important financial people are either lying or deluded— without actually being insane. A handful of people had been inside the black box, understood how it worked, and bet on it blowing up. Whitney rattled off a list with a half-dozen names on it. At the top was Steve Eisman.
Steve Eisman entered finance about the time I exited it. He’d grown up in New York City and gone to a Jewish day school, the University of Pennsylvania, and Harvard Law School. In 1991, he was a 30-year-old corporate lawyer. "I hated it," he says. "I hated being a lawyer. My parents worked as brokers at Oppenheimer. They managed to finagle me a job. It’s not pretty, but that’s what happened."
He was hired as a junior equity analyst, a helpmate who didn’t actually offer his opinions. That changed in December 1991, less than a year into his new job, when a subprime mortgage lender called Ames Financial went public and no one at Oppenheimer particularly cared to express an opinion about it. One of Oppenheimer’s investment bankers stomped around the research department looking for anyone who knew anything about the mortgage business.
Recalls Eisman: "I’m a junior analyst and just trying to figure out which end is up, but I told him that as a lawyer I’d worked on a deal for the Money Store." He was promptly appointed the lead analyst for Ames Financial. "What I didn’t tell him was that my job had been to proofread the documents and that I hadn’t understood a word of the fucking things."
Ames Financial belonged to a category of firms known as nonbank financial institutions. The category didn’t include J.P. Morgan, but it did encompass many little-known companies that one way or another were involved in the early-1990s boom in subprime mortgage lending— the lower class of American finance.
The second company for which Eisman was given sole responsibility was Lomas Financial, which had just emerged from bankruptcy. "I put a sell rating on the thing because it was a piece of shit," Eisman says. "I didn’t know that you weren’t supposed to put a sell rating on companies. I thought there were three boxes— buy, hold, sell— and you could pick the one you thought you should." He was pressured generally to be a bit more upbeat, but upbeat wasn’t Steve Eisman’s style.
Upbeat and Eisman didn’t occupy the same planet. A hedge fund manager who counts Eisman as a friend set out to explain him to me but quit a minute into it. After describing how Eisman exposed various important people as either liars or idiots, the hedge fund manager started to laugh. "He’s sort of a prick in a way, but he’s smart and honest and fearless."
"A lot of people don’t get Steve," Whitney says. "But the people who get him love him." Eisman stuck to his sell rating on Lomas Financial, even after the company announced that investors needn’t worry about its financial condition, as it had hedged its market risk. "The single greatest line I ever wrote as an analyst," says Eisman, "was after Lomas said they were hedged." He recited the line from memory: " ‘The Lomas Financial Corp. is a perfectly hedged financial institution: It loses money in every conceivable interest-rate environment.’ I enjoyed writing that sentence more than any sentence I ever wrote." A few months after he’d delivered that line in his report, Lomas Financial returned to bankruptcy.
Eisman wasn’t, in short, an analyst with a sunny disposition who expected the best of his fellow financial man and the companies he created. "You have to understand," Eisman says in his defense, "I did subprime first. I lived with the worst first. These guys lied to infinity. What I learned from that experience was that Wall Street didn’t give a shit what it sold."
Harboring suspicions about people’s morals and telling investors that companies don’t deserve their capital wasn’t, in the 1990s or at any other time, the fast track to success on Wall Street. Eisman quit Oppenheimer in 2001 to work as an analyst at a hedge fund, but what he really wanted to do was run money. FrontPoint Partners, another hedge fund, hired him in 2004 to invest in financial stocks.
Eisman’s brief was to evaluate Wall Street banks, homebuilders, mortgage originators, and any company (General Electric or General Motors, for instance) with a big financial-services division— anyone who touched American finance. An insurance company backed him with $50 million, a paltry sum. "Basically, we tried to raise money and didn't really do it," Eisman says. Instead of money, he attracted people whose worldviews were as shaded as his own— Vincent Daniel, for instance, who became a partner and an analyst in charge of the mortgage sector.
Now 36, Daniel grew up a lower-middle-class kid in Queens. One of his first jobs, as a junior accountant at Arthur Andersen, was to audit Salomon Brothers’ books. "It was shocking," he says. "No one could explain to me what they were doing." He left accounting in the middle of the internet boom to become a research analyst, looking at companies that made subprime loans. "I was the only guy I knew covering companies that were all going to go bust," he says. "I saw how the sausage was made in the economy, and it was really freaky."
Danny Moses, who became Eisman’s head trader, was another who shared his perspective. Raised in Georgia, Moses, the son of a finance professor, was a bit less fatalistic than Daniel or Eisman, but he nevertheless shared a general sense that bad things can and do happen. When a Wall Street firm helped him get into a trade that seemed perfect in every way, he said to the salesman, "I appreciate this, but I just want to know one thing: How are you going to screw me?"
Heh heh heh, c’mon. We’d never do that, the trader started to say, but Moses was politely insistent: We both know that unadulterated good things like this trade don’t just happen between little hedge funds and big Wall Street firms. I’ll do it, but only after you explain to me how you are going to screw me. And the salesman explained how he was going to screw him. And Moses did the trade.
Both Daniel and Moses enjoyed, immensely, working with Steve Eisman. He put a fine point on the absurdity they saw everywhere around them. "Steve’s fun to take to any Wall Street meeting," Daniel says. "Because he’ll say ‘Explain that to me’ 30 different times. Or ‘Could you explain that more, in English?’ Because once you do that, there’s a few things you learn. For a start, you figure out if they even know what they’re talking about. And a lot of times, they don’t!"
At the end of 2004, Eisman, Moses, and Daniel shared a sense that unhealthy things were going on in the U.S. housing market: Lots of firms were lending money to people who shouldn’t have been borrowing it. They thought Alan Greenspan’s decision after the internet bust to lower interest rates to 1 percent was a travesty that would lead to some terrible day of reckoning. Neither of these insights was entirely original.
Ivy Zelman, at the time the housing-market analyst at Credit Suisse, had seen the bubble forming very early on. There’s a simple measure of sanity in housing prices: the ratio of median home price to income. Historically, it runs around 3 to 1; by late 2004, it had risen nationally to 4 to 1. "All these people were saying it was nearly as high in some other countries," Zelman says. "But the problem wasn’t just that it was 4 to 1. In Los Angeles, it was 10 to 1, and in Miami, 8.5 to 1. And then you coupled that with the buyers. They weren’t real buyers. They were speculators."
Zelman alienated clients with her pessimism, but she couldn’t pretend everything was good. "It wasn’t that hard in hindsight to see it," she says. "It was very hard to know when it would stop." Zelman spoke occasionally with Eisman and always left these conversations feeling better about her views and worse about the world. "You needed the occasional assurance that you weren’t nuts," she says. She wasn’t nuts. The world was.
By the spring of 2005, FrontPoint was fairly convinced that something was very screwed up not merely in a handful of companies but in the financial underpinnings of the entire U.S. mortgage market. In 2000, there had been $130 billion in subprime mortgage lending, with $55 billion of that repackaged as mortgage bonds. But in 2005, there was $625 billion in subprime mortgage loans, $507 billion of which found its way into mortgage bonds.
Eisman couldn’t understand who was making all these loans or why. He had a from-the-ground-up understanding of both the U.S. housing market and Wall Street. But he’d spent his life in the stock market, and it was clear that the stock market was, in this story, largely irrelevant. "What most people don’t realize is that the fixed-income world dwarfs the equity world," he says. "The equity world is like a fucking zit compared with the bond market."
He shorted companies that originated subprime loans, like New Century and Indy Mac, and companies that built the houses bought with the loans, such as Toll Brothers. Smart as these trades proved to be, they weren’t entirely satisfying. These companies paid high dividends, and their shares were often expensive to borrow; selling them short was a costly proposition.
Enter Greg Lippman, a mortgage-bond trader at Deutsche Bank. He arrived at FrontPoint bearing a 66-page presentation that described a better way for the fund to put its view of both Wall Street and the U.S. housing market into action. The smart trade, Lippman argued, was to sell short not New Century’s stock but its bonds that were backed by the subprime loans it had made. Eisman hadn’t known this was even possible— because until recently, it hadn’t been. But Lippman, along with traders at other Wall Street investment banks, had created a way to short the subprime bond market with precision.
Here’s where financial technology became suddenly, urgently relevant. The typical mortgage bond was still structured in much the same way it had been when I worked at Salomon Brothers. The loans went into a trust that was designed to pay off its investors not all at once but according to their rankings. The investors in the top tranche, rated AAA, received the first payment from the trust and, because their investment was the least risky, received the lowest interest rate on their money.
The investors who held the trusts’ BBB tranche got the last payments— and bore the brunt of the first defaults. Because they were taking the most risk, they received the highest return. Eisman wanted to bet that some subprime borrowers would default, causing the trust to suffer losses. The way to express this view was to short the BBB tranche. The trouble was that the BBB tranche was only a tiny slice of the deal.
But the scarcity of truly crappy subprime-mortgage bonds no longer mattered. The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.
The arrangement bore the same relation to actual finance as fantasy football bears to the N.F.L. Eisman was perplexed in particular about why Wall Street firms would be coming to him and asking him to sell short. "What Lippman did, to his credit, was he came around several times to me and said, ‘Short this market,’ " Eisman says. "In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’ "
And short Eisman did— then he tried to get his mind around what he’d just done so he could do it better. He’d call over to a big firm and ask for a list of mortgage bonds from all over the country. The juiciest shorts— the bonds ultimately backed by the mortgages most likely to default— had several characteristics. They’d be in what Wall Street people were now calling the sand states: Arizona, California, Florida, Nevada.
The loans would have been made by one of the more dubious mortgage lenders; Long Beach Financial, wholly owned by Washington Mutual, was a great example. Long Beach Financial was moving money out the door as fast as it could, few questions asked, in loans built to self-destruct. It specialized in asking homeowners with bad credit and no proof of income to put no money down and defer interest payments for as long as possible. In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $720,000.
More generally, the subprime market tapped a tranche of the American public that did not typically have anything to do with Wall Street. Lenders were making loans to people who, based on their credit ratings, were less creditworthy than 71 percent of the population. Eisman knew some of these people. One day, his housekeeper, a South American woman, told him that she was planning to buy a townhouse in Queens.
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In retrospect, pretty much all of the riskiest subprime-backed bonds were worth betting against; they would all one day be worth zero. But at the time Eisman began to do it, in the fall of 2006, that wasn’t clear. He and his team set out to find the smelliest pile of loans they could so that they could make side bets against them with Goldman Sachs or Deutsche Bank.
What they were doing, oddly enough, was the analysis of subprime lending that should have been done before the loans were made: Which poor Americans were likely to jump which way with their finances? How much did home prices need to fall for these loans to blow up? (It turned out they didn’t have to fall; they merely needed to stay flat.) The default rate in Georgia was five times higher than that in Florida even though the two states had the same unemployment rate. Why? Indiana had a 25 percent default rate; California’s was only 5 percent. Why?
Moses actually flew down to Miami and wandered around neighborhoods built with subprime loans to see how bad things were. "He’d call me and say, ‘Oh my God, this is a calamity here,’ " recalls Eisman. All that was required for the BBB bonds to go to zero was for the default rate on the underlying loans to reach 14 percent. Eisman thought that, in certain sections of the country, it would go far, far higher.
The funny thing, looking back on it, is how long it took for even someone who predicted the disaster to grasp its root causes. They were learning about this on the fly, shorting the bonds and then trying to figure out what they had done. Eisman knew subprime lenders could be scumbags. What he underestimated was the total unabashed complicity of the upper class of American capitalism. For instance, he knew that the big Wall Street investment banks took huge piles of loans that in and of themselves might be rated BBB, threw them into a trust, carved the trust into tranches, and wound up with 60 percent of the new total being rated AAA.
But he couldn’t figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. "I didn’t understand how they were turning all this garbage into gold," he says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. "We always asked the same question," says Eisman. "Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk."
He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. "They were assuming home prices would just keep going up," Eisman says.
As an investor, Eisman was allowed on the quarterly conference calls held by Moody’s but not allowed to ask questions. The people at Moody’s were polite about their brush-off, however. The C.E.O. even invited Eisman and his team to his office for a visit in June 2007. By then, Eisman was so certain that the world had been turned upside down that he just assumed this guy must know it too.
"But we’re sitting there," Daniel recalls, "and he says to us, like he actually means it, ‘I truly believe that our rating will prove accurate.’ And Steve shoots up in his chair and asks, ‘What did you just say?’ as if the guy had just uttered the most preposterous statement in the history of finance. He repeated it. And Eisman just laughed at him."
"With all due respect, sir," Daniel told the C.E.O. deferentially as they left the meeting, "you’re delusional." This wasn’t Fitch or even S&P. This was Moody’s, the aristocrats of the rating business, 20 percent owned by Warren Buffett. And the company’s C.E.O. was being told he was either a fool or a crook by one Vincent Daniel, from Queens.
A full nine months earlier, Daniel and Moses had flown to Orlando for an industry conference. It had a grand title— the American Securitization Forum— but it was essentially a trade show for the subprime-mortgage business: the people who originated subprime mortgages, the Wall Street firms that packaged and sold subprime mortgages, the fund managers who invested in nothing but subprime-mortgage-backed bonds, the agencies that rated subprime-mortgage bonds, the lawyers who did whatever the lawyers did. Daniel and Moses thought they were paying a courtesy call on a cottage industry, but the cottage had become a castle.
"There were like 6,000 people there," Daniel says. "There were so many people being fed by this industry. The entire fixed-income department of each brokerage firm is built on this. Everyone there was the long side of the trade. The wrong side of the trade. And then there was us. That’s when the picture really started to become clearer, and we started to get more cynical, if that was possible. We went back home and said to Steve, ‘You gotta see this.’ "
Eisman, Daniel, and Moses then flew out to Las Vegas for an even bigger subprime conference. By now, Eisman knew everything he needed to know about the quality of the loans being made. He still didn’t fully understand how the apparatus worked, but he knew that Wall Street had built a doomsday machine. He was at once opportunistic and outraged.
Their first stop was a speech given by the C.E.O. of Option One, the mortgage originator owned by H&R Block. When the guy got to the part of his speech about Option One’s subprime-loan portfolio, he claimed to be expecting a modest default rate of 5 percent. Eisman raised his hand. Moses and Daniel sank into their chairs. "It wasn’t a Q&A," says Moses. "The guy was giving a speech. He sees Steve’s hand and says, ‘Yes?’"
"Would you say that 5 percent is a probability or a possibility?" Eisman asked. A probability, said the C.E.O., and he continued his speech.
Eisman had his hand up in the air again, waving it around. Oh, no, Moses thought. "The one thing Steve always says," Daniel explains, "is you must assume they are lying to you. They will always lie to you." Moses and Daniel both knew what Eisman thought of these subprime lenders but didn’t see the need for him to express it here in this manner. For Eisman wasn’t raising his hand to ask a question. He had his thumb and index finger in a big circle. He was using his fingers to speak on his behalf. Zero! they said.
"Yes?" the C.E.O. said, obviously irritated. "Is that another question?" "No," said Eisman. "It’s a zero. There is zero probability that your default rate will be 5 percent." The losses on subprime loans would be much, much greater.
Before the guy could reply, Eisman’s cell phone rang. Instead of shutting it off, Eisman reached into his pocket and answered it. "Excuse me," he said, standing up. "But I need to take this call." And with that, he walked out.
Eisman’s willingness to be abrasive in order to get to the heart of the matter was obvious to all; what was harder to see was his credulity: He actually wanted to believe in the system. As quick as he was to cry bullshit when he saw it, he was still shocked by bad behavior. That night in Vegas, he was seated at dinner beside a really nice guy who invested in mortgage C.D.O.’s— collateralized debt obligations. By then, Eisman thought he knew what he needed to know about C.D.O.’s. He didn’t, it turned out.
Later, when I sit down with Eisman, the very first thing he wants to explain is the importance of the mezzanine C.D.O. What you notice first about Eisman is his lips. He holds them pursed, waiting to speak. The second thing you notice is his short, light hair, cropped in a manner that suggests he cut it himself while thinking about something else.
"You have to understand this," he says. "This was the engine of doom." Then he draws a picture of several towers of debt. The first tower is made of the original subprime loans that had been piled together. At the top of this tower is the AAA tranche, just below it the AA tranche, and so on down to the riskiest, the BBB tranche— the bonds Eisman had shorted. But Wall Street had used these BBB tranches— the worst of the worst— to build yet another tower of bonds: a "particularly egregious" C.D.O.
The reason they did this was that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce most of them AAA. These bonds could then be sold to investors— pension funds, insurance companies— who were allowed to invest only in highly rated securities. "I cannot fucking believe this is allowed— I must have said that a thousand times in the past two years," Eisman says.
His dinner companion in Las Vegas ran a fund of about $15 billion and managed C.D.O.’s backed by the BBB tranche of a mortgage bond, or as Eisman puts it, "the equivalent of three levels of dog shit lower than the original bonds." FrontPoint had spent a lot of time digging around in the dog shit and knew that the default rates were already sufficient to wipe out this guy’s entire portfolio. "God, you must be having a hard time," Eisman told his dinner companion. "No," the guy said, "I’ve sold everything out."
After taking a fee, he passed them on to other investors. His job was to be the C.D.O. "expert," but he actually didn’t spend any time at all thinking about what was in the C.D.O.’s. "He managed the C.D.O.’s," says Eisman, "but managed what? I was just appalled. People would pay up to have someone manage their C.D.O.’s— as if this moron was helping you. I thought, You prick, you don’t give a fuck about the investors in this thing."
Whatever rising anger Eisman felt was offset by the man’s genial disposition. Not only did he not mind that Eisman took a dim view of his C.D.O.’s; he saw it as a basis for friendship. "Then he said something that blew my mind," Eisman tells me. "He says, ‘I love guys like you who short my market. Without you, I don’t have anything to buy.’ "
That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms were using Eisman’s bets to synthesize more of them.
Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs.
Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. "They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford," Eisman says. "They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?"
This particular dinner was hosted by Deutsche Bank, whose head trader, Greg Lippman, was the fellow who had introduced Eisman to the subprime bond market. Eisman went and found Lippman, pointed back to his own dinner companion, and said, "I want to short him." Lippman thought he was joking; he wasn’t. "Greg, I want to short his paper," Eisman repeated. "Sight unseen."
Eisman started out running a $60 million equity fund but was now short around $600 million of various subprime-related securities. In the spring of 2007, the market strengthened. But, says Eisman, "credit quality always gets better in March and April. And the reason it always gets better in March and April is that people get their tax refunds. You would think people in the securitization world would know this. We just thought that was moronic."
He was already short the stocks of mortgage originators and the homebuilders. Now he took short positions in the rating agencies— "they were making 10 times more rating C.D.O.’s than they were rating G.M. bonds, and it was all going to end"— and, finally, the biggest Wall Street firms because of their exposure to C.D.O.’s.
He wasn’t allowed to short Morgan Stanley because it owned a stake in his fund. But he shorted UBS, Lehman Brothers, and a few others. Not long after that, FrontPoint had a visit from Sanford C. Bernstein’s Brad Hintz, a prominent analyst who covered Wall Street firms. Hintz wanted to know what Eisman was up to. "We just shorted Merrill Lynch," Eisman told him. "Why?" asked Hintz.
"We have a simple thesis," Eisman explained. "There is going to be a calamity, and whenever there is a calamity, Merrill is there." When it came time to bankrupt Orange County with bad advice, Merrill was there. When the internet went bust, Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit.
That was Eisman’s logic— the logic of Wall Street’s pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things. The game, as Eisman saw it, was Crack the Whip. He assumed Merrill Lynch had taken its assigned place at the end of the chain.
There was only one thing that bothered Eisman, and it continued to trouble him as late as May 2007. "The thing we couldn’t figure out is: It’s so obvious. Why hasn’t everyone else figured out that the machine is done?" Eisman had long subscribed to Grant’s Interest Rate Observer, a newsletter famous in Wall Street circles and obscure outside them. Jim Grant, its editor, had been prophesying doom ever since the great debt cycle began, in the mid-1980s.
In late 2006, he decided to investigate these things called C.D.O.’s. Or rather, he had asked his young assistant, Dan Gertner, a chemical engineer with an M.B.A., to see if he could understand them. Gertner went off with the documents that purported to explain C.D.O.’s to potential investors and for several days sweated and groaned and heaved and suffered. "Then he came back," says Grant, "and said, ‘I can’t figure this thing out.’ And I said, ‘I think we have our story.’ "
Eisman read Grant’s piece as independent confirmation of what he knew in his bones about the C.D.O.’s he had shorted. "When I read it, I thought, Oh my God. This is like owning a gold mine. When I read that, I was the only guy in the equity world who almost had an orgasm."
On July 19, 2007, the same day that Federal Reserve Chairman Ben Bernanke told the U.S. Senate that he anticipated as much as $100 billion in losses in the subprime-mortgage market, FrontPoint did something unusual: It hosted its own conference call. It had had calls with its tiny population of investors, but this time FrontPoint opened it up. Steve Eisman had become a poorly kept secret.
Five hundred people called in to hear what he had to say, and another 500 logged on afterward to listen to a recording of it. He explained the strange alchemy of the C.D.O. and said that he expected losses of up to $300 billion from this sliver of the market alone. To evaluate the situation, he urged his audience to:
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On September 18, 2008, Danny Moses came to work as usual at 6:30 a.m. Earlier that week, Lehman Brothers had filed for bankruptcy. The day before, the Dow had fallen 449 points to its lowest level in four years. Overnight, European governments announced a ban on short-selling, but that served as faint warning for what happened next.
At the market opening in the U.S., everything— every financial asset— went into free fall. "All hell was breaking loose in a way I had never seen in my career," Moses says. FrontPoint was net short the market, so this total collapse should have given Moses pleasure. He might have been forgiven if he stood up and cheered. After all, he’d been betting for two years that this sort of thing could happen, and now it was, more dramatically than he had ever imagined.
Instead, he felt this terrifying shudder run through him. He had maybe 100 trades on, and he worked hard to keep a handle on them all. "I spent my morning trying to control all this energy and all this information," he says, "and I lost control. I looked at the screens. I was staring into the abyss. The end. I felt this shooting pain in my head. I don’t get headaches. At first, I thought I was having an aneurysm."
Moses stood up, wobbled, then turned to Daniel and said, "I gotta leave. Get out of here. Now." Daniel thought about calling an ambulance but instead took Moses out for a walk. Outside it was gorgeous, the blue sky reaching down through the tall buildings and warming the soul. Eisman was at a Goldman Sachs conference for hedge fund managers, raising capital. Moses and Daniel got him on the phone, and he left the conference and met them on the steps of St. Patrick’s Cathedral. "We just sat there," Moses says. "Watching the people pass."
This was what they had been waiting for: total collapse. "The investment-banking industry is fucked," Eisman had told me a few weeks earlier. "These guys are only beginning to understand how fucked they are. It’s like being a Scholastic, prior to Newton. Newton comes along, and one morning you wake up: ‘Holy shit, I’m wrong!’ " Now Lehman Brothers had vanished, Merrill had surrendered, and Goldman Sachs and Morgan Stanley were just a week away from ceasing to be investment banks. The investment banks were not just fucked; they were extinct.
Not so for hedge fund managers who had seen it coming. "As we sat there, we were weirdly calm," Moses says. "We felt insulated from the whole market reality. It was an out-of-body experience. We just sat and watched the people pass and talked about what might happen next. How many of these people were going to lose their jobs. Who was going to rent these buildings after all the Wall Street firms collapsed."
Eisman was appalled. "Look," he said. "I’m short. I don’t want the country to go into a depression. I just want it to fucking deleverage." He had tried a thousand times in a thousand ways to explain how screwed up the business was, and no one wanted to hear it. "That Wall Street has gone down because of this is justice," he says. "They fucked people. They built a castle to rip people off. Not once in all these years have I come across a person inside a big Wall Street firm who was having a crisis of conscience."
Truth to tell, there wasn’t a whole lot of hand-wringing inside FrontPoint either. The only one among them who wrestled a bit with his conscience was Daniel. "Vinny, being from Queens, needs to see the dark side of everything," Eisman says. To which Daniel replies, "The way we thought about it was, ‘By shorting this market we’re creating the liquidity to keep the market going.’ "
"It was like feeding the monster," Eisman says of the market for subprime bonds. "We fed the monster until it blew up." About the time they were sitting on the steps of the midtown cathedral, I sat in a booth in a restaurant on the East Side, waiting for John Gutfreund to arrive for lunch, and wondered, among other things, why any restaurant would seat side by side two men who had not the slightest interest in touching each other.
There was an umbilical cord running from the belly of the exploded beast back to the financial 1980s. A friend of mine created the first mortgage derivative in 1986, a year after we left the Salomon Brothers trading program. ("The problem isn’t the tools," he likes to say. "It’s who is using the tools. Derivatives are like guns.")
When I published my book, the 1980s were supposed to be ending. I received a lot of undeserved credit for my timing. The social disruption caused by the collapse of the savings-and-loan industry and the rise of hostile takeovers and leveraged buyouts had given way to a brief period of recriminations.
Just as most students at Ohio State read Liar’s Poker as a manual, most TV and radio interviewers regarded me as a whistleblower. (The big exception was Geraldo Rivera. He put me on a show called "People Who Succeed Too Early in Life" along with some child actors who’d gone on to become drug addicts.)
Anti-Wall Street feeling ran high— high enough for Rudy Giuliani to float a political career on it— but the result felt more like a witch hunt than an honest reappraisal of the financial order. The public lynchings of Gutfreund and junk-bond king Michael Milken were excuses not to deal with the disturbing forces underpinning their rise. Ditto the cleaning up of Wall Street’s trading culture.
The surface rippled, but down below, in the depths, the bonus pool remained undisturbed. Wall Street firms would soon be frowning upon profanity, firing traders for so much as glancing at a stripper, and forcing male employees to treat women almost as equals. Lehman Brothers circa 2008 more closely resembled a normal corporation with solid American values than did any Wall Street firm circa 1985.
The changes were camouflage. They helped distract outsiders from the truly profane event: the growing misalignment of interests between the people who trafficked in financial risk and the wider culture. I’d not seen Gutfreund since I quit Wall Street. I’d met him, nervously, a couple of times on the trading floor. A few months before I left, my bosses asked me to explain to Gutfreund what at the time seemed like exotic trades in derivatives I’d done with a European hedge fund.
I tried. He claimed not to be smart enough to understand any of it, and I assumed that was how a Wall Street C.E.O. showed he was the boss, by rising above the details. There was no reason for him to remember any of these encounters, and he didn’t: When my book came out and became a public-relations nuisance to him, he told reporters we’d never met.
Over the years, I’d heard bits and pieces about Gutfreund. I knew that after he’d been forced to resign from Salomon Brothers he’d fallen on harder times. I heard later that a few years ago he’d sat on a panel about Wall Street at Columbia Business School. When his turn came to speak, he advised students to find something more meaningful to do with their lives. As he began to describe his career, he broke down and wept.
When I emailed him to invite him to lunch, he could not have been more polite or more gracious. That attitude persisted as he was escorted to the table, made chitchat with the owner, and ordered his food. He’d lost a half-step and was more deliberate in his movements, but otherwise he was completely recognizable. The same veneer of denatured courtliness masked the same animal need to see the world as it was, rather than as it should be.
We spent 20 minutes or so determining that our presence at the same lunch table was not going to cause the earth to explode. We discovered we had a mutual acquaintance in New Orleans. We agreed that the Wall Street C.E.O. had no real ability to keep track of the frantic innovation occurring inside his firm. ("I didn’t understand all the product lines, and they don’t either," he said.)
We agreed, further, that the chief of the Wall Street investment bank had little control over his subordinates. ("They’re buttering you up and then doing whatever the fuck they want to do.") He thought the cause of the financial crisis was "simple. Greed on both sides— greed of investors and the greed of the bankers." I thought it was more complicated. Greed on Wall Street was a given— almost an obligation. The problem was the system of incentives that channeled the greed.
But I didn’t argue with him. For just as you revert to being about nine years old when you visit your parents, you revert to total subordination when you are in the presence of your former C.E.O. John Gutfreund was still the King of Wall Street, and I was still a geek. He spoke in declarative statements; I spoke in questions.
But as he spoke, my eyes kept drifting to his hands. His alarmingly thick and meaty hands. They weren’t the hands of a soft Wall Street banker but of a boxer. I looked up. The boxer was smiling— though it was less a smile than a placeholder expression. And he was saying, very deliberately, "Your…fucking…book."
I smiled back, though it wasn’t quite a smile. "Your fucking book destroyed my career, and it made yours," he said. I didn’t think of it that way and said so, sort of. "Why did you ask me to lunch?" he asked, though pleasantly. He was genuinely curious.
You can’t really tell someone that you asked him to lunch to let him know that you don’t think of him as evil. Nor can you tell him that you asked him to lunch because you thought that you could trace the biggest financial crisis in the history of the world back to a decision he had made. John Gutfreund did violence to the Wall Street social order— and got himself dubbed the King of Wall Street— when he turned Salomon Brothers from a private partnership into Wall Street’s first public corporation.
He ignored the outrage of Salomon’s retired partners. ( "I was disgusted by his materialism," William Salomon, the son of the firm’s founder, who had made Gutfreund C.E.O. only after he’d promised never to sell the firm, had told me.) He lifted a giant middle finger at the moral disapproval of his fellow Wall Street C.E.O.’s. And he seized the day. He and the other partners not only made a quick killing; they transferred the ultimate financial risk from themselves to their shareholders.
It didn’t, in the end, make a great deal of sense for the shareholders. (A share of Salomon Brothers purchased when I arrived on the trading floor, in 1986, at a then market price of $42, would be worth 2.26 shares of Citigroup today— market value: $27.) But it made fantastic sense for the investment bankers.
From that moment, though, the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith.
No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.
No partnership, for that matter, would have hired me or anyone remotely like me. Was there ever any correlation between the ability to get in and out of Princeton and a talent for taking financial risk?
Now I asked Gutfreund about his biggest decision. "Yes," he said. "They— the heads of the other Wall Street firms— all said what an awful thing it was to go public and how could you do such a thing. But when the temptation arose, they all gave in to it." He agreed that the main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders.
"When things go wrong, it’s their problem," he said— and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government. "It’s laissez-faire until you get in deep shit," he said, with a half chuckle. He was out of the game.
It was now all someone else’s fault. He watched me curiously as I scribbled down his words. "What’s this for?" he asked. I told him I thought it might be worth revisiting the world I’d described in Liar’s Poker, now that it was finally dying. Maybe bring out a 20th-anniversary edition. "That’s nauseating," he said.
Hard as it was for him to enjoy my company, it was harder for me not to enjoy his. He was still tough, as straight and blunt as a butcher. He’d helped create a monster, but he still had in him a lot of the old Wall Street, where people said things like "A man’s word is his bond." On that Wall Street, people didn’t walk out of their firms and cause trouble for their former bosses by writing books about them.
"No," he said, "I think we can agree about this: Your fucking book destroyed my career, and it made yours." With that, the former king of a former Wall Street lifted the plate that held his appetizer and asked sweetly, "Would you like a deviled egg?"
Until that moment, I hadn’t paid much attention to what he’d been eating. Now I saw he’d ordered the best thing in the house, this gorgeous frothy confection of an earlier age. Who ever dreamed up the deviled egg? Who knew that a simple egg could be made so complicated and yet so appealing? I reached over and took one. Something for nothing. It never loses its charm.
ߧ
Normxxx
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October Meltdown: After Shocks
After Shocks From The October Meltdown
By Gary Dorsch | 6 November 2008
October is famous for stock markets crashes,— the Crash of 1929, "Black Monday" 1987, the Asian Contagion crash in October 1997, and the Sub-Prime crash of October 2008. US Treasury chief Henry Paulson's ill-fated decision on Sept 14th, to pull the plug on the 158-year old brokerage firm of Lehman Brothers, set in motion a horrific chain of events that unleashed a torrent of panic selling on commodity and global stock markets, froze the European and US banking systems, and changed the direction of American politics for years to come. [[Speaking of unintended consequences: right in the footsteps of the 1929 Fed and Treasury.: normxxx]]
At its lowest point in October 2008, the meltdown in equities around the world erased $12 trillion of market value for the month and $31 trillion from a year earlier. Lehman's bankruptcy left sellers of credit default swaps with liabilities of $270 billion, and hedge-funds scrambled to raise cash by selling anything they could get their hands on, including commodities/PMs and stocks. The Reuters/Jefferies Commodity Index plunged -23% in October, its steepest monthly decline since 1956. Investment grade corporate bonds lost -7.4% in October, their worst month since 1976.
At the same time, US-home prices continued their unrelenting slide for a 20th straight month, to stand -222% below their peak in July 2006. Falling US-home prices have reduced homeowner wealth by about $3 trillion, and stock market losses add-up to an additional $8-trillion. This reduced household wealth could force US-households to cut aggregate spending by $300-billion a year or more.
Historically, September is the cruelest month for the US-stock market, but residual selling often spills over into October. The Dow's loss of -18% in October, 2008 was the biggest since the crash of October, 1987. Paper losses totaled $2.5 trillion. But for Republican nominee John "Maverick" McCain, a late October to Nov 4th rally, boosting the market by 15%, was too-little, too-late. The tide of opinion among the investor class whose 401k's and IRA's had plummeted, tilted against the Republicans, and was made worse by the unrelenting slide in home prices.
In mid-September, Republican nominee John "Maverick" McCain understood the fatal impact of a stock market meltdown on his presidential bid. He frantically suspended his campaign in order to persuade rebellious House Republicans to quickly agree to a $700-billion rescue plan for US-banks, and prevent a meltdown in the market. But House Republicans decried it as a "bailout" and helped to kill its first version, sending the Dow into a tailspin of 777 points. Obama stayed quiet and above the fray.
The Treasury's bail-out,— purchasing toxic mortgage-backed securities from banks was badly flawed and utterly rejected by the marketplace. Even after the House finally passed the bill on October 3rd, the Dow Jones Industrials plunged another 3,000 points, free-falling to a five-year low. It was not until the British and Euro-zone governments moved aggressively to inject capital directly into their banks, and the US Treasury followed suit, did some measure of calm and stability return to the global stock markets. But for "Maverick" McCain, the collateral damage from the October market meltdown torpedoed his long-shot bid for the presidency.
The Dow Jones Industrials rallied 15% in the week prior to Nov 4th election results, a move that has surprised many traders. Barack Obama's higher tax policies combined with far-left Democratic control of Congress defied the conventional wisdom that markets like lower taxes and at least some gridlock on Capitol Hill. However, soon after Obama's victory speech in Chicago, the stock market rally fizzled out, and the Dow began melting down 800 points over the next 36-hours of trading.
McCain had a steep uphill climb, tied to an expensive war in Iraq, linked to an deeply unpopular Republican president, 760,000-jobs lost this year before the stock market crash began in mid-September, roughly 90% of Americans saying the economy is on the wrong track, and his selection of Sarah Palin as his running mate, turned off 60% of independent voters. The Arizona senator was also handicapped by his confessions that economics wasn't his strongest suit, which showed during the debates, while the Main Stream Media elite gave its blessings to Barack Obama.
Americans are naturally eager for fresh start,— a "New Deal," as is typical during periods of economic hardship. And a majority of voters turned to Obama in a giant leap-of-faith,— a man whom many Americans know little about, with no executive experience, less than four-years out of the Illinois Senate. McCain tried to paint Obama as a tax-raising Socialist, who will "spread the wealth around," a fear that resonates with the biggest and most powerful traders in the financial markets. [[But absolutely the wrong message for the vast majority of taxpayers, with hundreds of billions already on the way to those 'plutocrat' vandals who got us into this mess. : normxxx]]
Uncertainty over how Obama and the far-left Social Democrats in Congress would alter tax policies for US-multinationals listed on the NYSE, and capital gains taxes on wealthy investors, intensified the stock market's meltdown in October. On corporate taxes, Obama proposes to tax world-wide income earned by American multi-nationals at the 35% US-corporate rate, the world's second highest. Obama is also promising a windfall profits tax on oil companies, and in his stump speeches, talked about lifting the capital gains tax on wealthy investors to 20% next year.
The volatility on Wall Street was unprecedented in October, with gut-wrenching swings of 500 points or more per day. The CBoE's Volatility Index (VIX), which measures how much traders are willing to pay for stock options, typically at-the-money S&P-500 index put-options, soared to a high of 89.5 on October 24th. Even in the biggest panics this decade, the VIX did not move above 48. The VIX tends to go up during sharp market declines, and falls during sideways or rising markets.
Most importantly, the VIX is regarded as a contrarian indicator. Historically super-high VIX readings signal extreme fear and panic, and have coincided with significant bottoms in the stock market. On October 25th, contrarians lifted the Dow nearly 900 points higher, betting the fourth worst bear-market in history had run its course. The 2000-2002 bear market fell -49% before finding a bottom and the 1973-1974 bear market lost -48%. After the 2007-2008 bear-market tumbled -46% from the October 2007 high, contrarians figured that the trading patterns of the past would once again, serve as a reliable guide for the future.
The "Group of Seven" cartel of central bankers and the Bank of Japan played a key role in engineering the late October stock market surge, by capping the rise of the Japanese yen against other major foreign currencies. On Oct 26th, the G-7 central bankers issued a veiled threat to intervene in the marketplace if necessary, to block the yen's advance, "We are concerned about the recent excessive volatility in the exchange rate of the yen and its possible adverse implications for economic and financial stability," the G-7 finance officials said.
The next day, Japanese Finance chief Shoichi Nakagawa warned that Tokyo financial warlords were "watching the foreign exchange market with great interest," secret code words for intervention to weaken the yen. Within 48-hours, the Euro had surged 10-yen to 125-yen, and the US-dollar rebounded from a 13-year low of 91-yen to as high as 99.70-yen. The unwinding of "yen carry" trades, that has been terrorizing the global stock markets since the Lehman bankruptcy, was successfully brought under control by the G-7 central bankers.
However, threats of intervention can't suppress the yen forever, in a market where roughly $550-billion changes hands each day. Tokyo backed-up its verbal intervention threat by pressuring the Bank of Japan to cut its overnight loan rate to 0.30-percent. Currency traders hadn't been expecting a BoJ rate-cut and quickly scrambled to cover short dollar positions towards 100-yen.
The Brazilian real also rebounded against the yen, a key catalyst that ignited a +30% rebound in the Sao Paulo's Bovespa Index. Emerging stock markets in Asia and Latin America soared after the Federal Reserve swapped $30 billion with Brazil, Mexico, South Korea and Singapore to bolster their foreign currency reserves. Brazil's government is struggling to prop up its currency, which has already lost a third of its value against the Japanese yen.
Brazil said it would put a quarter of its $210 billion of foreign exchange reserves on the line to defend the real. Brazil's central bank has spent $40 billion in foreign exchange interventions so far, Brazil's central banker President Henrique Meirelles said on Nov 6th, adding that the worst of the crisis has already passed.
Preventing unwinding of "yen carry" trades was only one juggling-act performed by the US Treasury's "Plunge Protection Team" in late-October. There was also the job of snuffing-out the surge in US$ LIBOR interest rates, to which $360-billion of adjustable rate home loans, ARM's, and many business loans are pegged. After adopting the more sensible European approach, the US Treasury began injecting $250-billion directly into US-banks, and over the next 20-days, the 3-month US-dollar LIBOR rate quickly fell by 242-basis points to 2.40% today.
The flood of US dollar liquidity pumped into the global banking system by the Fed, together with aggressive interest rate cuts around the world, have calmed the panic and eased the worst of the credit crisis. LIBOR rates in England and the Euro-zone have declined by 70-basis points respectively, signaling that the $3.2-trillion of emergency funds approved by governments may be thawing out credit markets.
Still, until US-home prices stop falling, the S&P-500 Index is skating on very thin ice. The average US-home price might fall another 10% in the year ahead to get back to pre-bubble levels. Worse yet, home price declines can overshoot on the downside, which would increase the number of [marginal] homeowners with negative equity, creating a strong incentive to default on their mortgages. And in a vicious cycle, more foreclosures put more homes on the market, driving prices yet lower, increasing bank losses. That's why powerful stock market rallies, engineered by bargain hunters and central bankers, have typically ended-up as bull-traps.
The stunning collapse of the US-industrial sector in the past two months was a bombshell that shook the ground beneath the Republican Party. The ISM's factory activity index plunged -20% over the past two months alone, to a reading of 38.9 in October, it's lowest since September 1982. The purchasing managers' gauge of new factory orders plunged to 32.2, the lowest since 1980, from 38.8 the prior month, and exports, the one bright spot for the US-economy this year, also collapsed, with the ISM's export gauge dropping to 41, the lowest reading since 1988.
US auto sales plummeted -32% in October to the lowest since January 1991, led by General Motors' 45% slide, as reduced access to car loans and a weaker economy kept consumers off dealer lots. With credit drying up and new-vehicle sales slumping, 700 car dealerships will close this year, and taking with them an estimated 37,100 jobs. That's a heavy blow to the US economy. The country's 20,700 dealerships accounted for $693 billion in sales last year, or 18% of all retail sales. Dealership wages and salaries make up 13% of the nation's retail payroll.
However, bargain hunters in badly battered blue-chip stocks, are betting the ISM Factory Index has hit rock-bottom, will recover in the months ahead, perhaps with a V-shaped pattern. The risk for bottom pickers however, is the possibility that the chart pattern for the ISM factory indexes, will evolve into an L-shape pattern, or a prolonged period of stagnation at deeply depressed levels in the months ahead. Worse yet, the ultimate bottom might be located at lower levels.
Synchronized Slide In Global Economies And Markets
Despite all the adverse problems in the housing and banking sectors, that froze credit markets, toppled banks and brokers, and wreaked havoc with stock markets, the Republican ticket was still within the margin of error in mid-September. However, during the presidential debates, McCain failed to point-out that foreign stock markets in Asia, Europe, and Latin America were also melting down by 50% or more, and factory indexes overseas had fallen-off a cliff to multi-year lows. Highlighting the synchronization of global economies and markets, might have helped McCain deflect some of the blame for the economic downturn.
In Japan, the Nikkei-225 index plunged to its lowest in 26-years in late-October, shedding 60% from a year earlier, and handing investors' $2.5-trillion of losses. Japan's factory activity index plunged to the 42.2-level in October, far below the 50-mark dividing growth from contraction for the eighth straight month, suggesting the worsening global slowdown has pushed Japan deeper into recession.
New export orders, a key engine of growth for Japan, fell to 37.5 from 45.4 in September, the lowest on record, after contracting for the ninth straight month. Japanese exporters are also getting battered by the stronger yen, which reduces the value of overseas profits earned in Euros or US-dollars when repatriated back into local currency. To make matters worse, Toyota, the largest Asian automaker, reported US-auto sales plunged 23% in October, from a year earlier. Honda, Japan's second-largest automaker, said car and light truck sales fell -26% from a year ago.
If traders are looking for China to miraculously to save the world economy, the latest signs of an economic slowdown in the Asian juggernaut are not promising. The CLSA China Manufacturers Index (PMI) showed that factory activity contracted sharply in October, falling to 45.2, its lowest level since the surveys began in June 2004. Manufacturing is a key engine of growth for China's juggernaut economy, and accounts for about 42% of China's gross domestic product.
Companies from Hong Kong, Taiwan, America and Europe flooded into the Guangdong province to set up low-cost factories that made everything from sneakers to laptops and iPods. China's vast manufacturing hub along the Pearl River Delta, has long been regarded as the world's factory floor. However, Chinese manufacturers are now seeing their order books cut, both at home and abroad, as the world economy falls deeper into recession. For the first time in three years, the growth rate for Chinese exports in the third quarter of 2008 declined.
Government statistics show that 67,000 Chinese factories have been shut-down in the first half of this year, and another 33,000 plants will close by year's end. Factory owners in China were straining under soaring labor and raw-materials costs, and an appreciating Chinese currency. When the credit crunch took hold, Western importers slashed orders for Chinese goods and bankers curtailed loans to factories, so many operations were pushed over the edge.
China has been the biggest driver of global demand for commodities this decade, including agriculture, base metals, and energy. For instance, from 2000 through 2007, China's energy demand grew by 65%, and accounted for a third of the total increase in oil consumption around the world. One big question is what will happen to Chinese oil demand if the global economy goes into a tailspin? Given that there are 2.2 billion people in China and India, there should be plenty of demand for commodities, even if their economies slow to an average growth rate of around 7% in real dollar terms. Yet signs of "demand destruction" from China's factories in recent months have sliced the Reuter's Commodity Index in half.
Bank Of England Pushes The Panic Button
The British pound has suddenly collapsed from a 26-year high in the summer of 2007 to a five-year low against the dollar in October, the most brutal devaluation sterling has suffered, since it was ejected from the European Exchange Rate Mechanism in 1992. Major players in London are dumping the British ounce, on expectations the Bank of England will slash its base rate to 2% next year— which would be the lowest rate in the Bank of England's 314-year history.
Bank of England chief Mervyn King warned on October 23rd, that "the pound could face a larger and faster adjustment in the coming months as the UK economy is forced to adapt to the new post-financial crisis landscape." He warned that the UK was facing a similar economic downturn to the Asian economies in the late 1990's when foreign investors pull out their capital from their countries. "The drama of the banking crisis, which is unprecedented in the lifetime of almost all of us, will damage business and consumer confidence," he warned.
Much like the bursting of the US-housing bubble, British home prices are spiraling lower. Britain's biggest mortgage lender, Halifax, said UK house prices fell 2.2% in October, the ninth successive decline, and are -15.75% lower compared with a year ago, the steepest fall since records began in 1983. A report by Standard & Poor's revealed that 335,000 households in Britain now find themselves in negative equity, an increase of 250,000 in only four months. By 2010, S&P predicts that as many as 2 million UK households could be threatened with falling into negative equity.
Recognizing the extreme danger to the British economy from a double barreled slide in housing and stock markets, the Bank of England delivered a shocking 1.50% cut in interest rates on Nov 6th, lowering its base rate to 3%, it's lowest in more than half a century. The BoE judged "the economic outlook had worsened markedly because of the global financial crisis and that drastic action was needed." However, British banks are reluctant to pass along lower mortgage rates in line with official BoE lending rates because of historically high sterling LIBOR rates.
British factory output also contracted for a sixth consecutive month in October as falling demand both at home and abroad tipped the sector into recession. In response, the BoE engineered the biggest devaluation of the British pound since sterling's ejection from the EU's Exchange Rate Mechanism in 1992, to help UK exporters compete in foreign markets, and artificially inflate the income of UK multinationals earned abroad. Despite the pound's 24% devaluation however, the UK's index for new export orders fell to 43.5, its lowest since September 2001.
Commodity markets have been on their wildest roller-coaster ride this year, soaring amid an inflationary boom in the first half, and then plummeting in a deflationary bust in the second half. At its peak in early July, the Dow Jones Commodity Index stood +40% higher than a year earlier, led by spectacular gains in energy, grains, and precious metals. But signs of a serious worldwide recession have meant the end of the commodities boom. Gold, tracking trends in the broad commodity indexes, has tumbled 28% since a record high of $1,030/ ounce on March 17th.
Mitigating some of gold's vulnerability to sliding commodities is its traditional role as a hedge against global security risks. US Vice-president elect Joe Biden might be right. There could be an international crisis to test the new American President in 2009. Perhaps North Korea will refuse to honor its disarmament promises, and fire up its plutonium reprocessing plant. Perhaps Iran's Revolutionary Guard units located in Lebanon, the Gaza Strip, southern Iraq, and its "special groups" in the Persian Gulf, will become more active, once the US-military withdraws from Iraq.
Tension in Russian-American relations has been driven to a post-Cold War high by Moscow's invasion of South Ossetia. Russian President Dmitry Medvedev wasted no time on Nov 5th, and in his first state of the nation speech, said Moscow will deploy Iskander missiles near Poland, and equipment to electronically hamper the operation of US missile defense facilities in Poland and the Czech Republic. "From what we have seen, the creation of a missile defense system, the encirclement of Russia with military bases, the relentless expansion of NATO, we have gotten the clear impression that NATO is testing our strength," Medvedev warned.
On the financial crisis, Medvedev said overconfidence in American dominance after the collapse of the Soviet Union "led the US authorities to major mistakes in the economic sphere. The American administration ignored warnings and harmed itself and others by blowing up a money bubble to stimulate its own growth," he said. Of course, the Kremlin has also been guilty of inflating the the Russian stock market bubble, by expanding its M2 money supply an average 50% per year.
Soaring oil prices also fueled a boom in Russian stocks over the past few years, and bloated Russia's foreign exchange reserves to a peak of $597 billion, the third-largest in the world, from just $10 billion in 1998. Four years of high oil prices have left the country with no foreign debt. But since July, sliding oil prices, concerns about the Russian banking sector, and a mass exodus of foreign investors from Russia's stock market, has wiped-out three-quarters of the Russian Trading System Index's value, led by Gazprom and Rosneft, the country's biggest energy companies.
Moscow has been forced to draw-down $113-billion from its reserves to $484 billion, in order to support state-run banks with subordinated loans, to buy equities on the stock exchange, and to defend the Russian rouble in the foreign exchange market. Russian kingpin Vladimir Putin argues there is no alternative to his prescription of greater state-control over the economy and stock markets, and that the turmoil in Western capitalist economies only proves it.
Since August, the Bush-Paulson team has seized America's largest insurance company, AIG, nationalized mortgage giants Fannie and Freddie, pumped $250 billion into US-banks, paid the $29 billion dowry for Bear Stearns to enter its shotgun marriage with JP Morgan Chase, and will soon bail-out GM, Ford and Chrysler. Is America sliding on the slippery slope towards Europe's "Enlightened Socialism?"
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By Gary Dorsch | 6 November 2008
October is famous for stock markets crashes,— the Crash of 1929, "Black Monday" 1987, the Asian Contagion crash in October 1997, and the Sub-Prime crash of October 2008. US Treasury chief Henry Paulson's ill-fated decision on Sept 14th, to pull the plug on the 158-year old brokerage firm of Lehman Brothers, set in motion a horrific chain of events that unleashed a torrent of panic selling on commodity and global stock markets, froze the European and US banking systems, and changed the direction of American politics for years to come. [[Speaking of unintended consequences: right in the footsteps of the 1929 Fed and Treasury.: normxxx]]
At its lowest point in October 2008, the meltdown in equities around the world erased $12 trillion of market value for the month and $31 trillion from a year earlier. Lehman's bankruptcy left sellers of credit default swaps with liabilities of $270 billion, and hedge-funds scrambled to raise cash by selling anything they could get their hands on, including commodities/PMs and stocks. The Reuters/Jefferies Commodity Index plunged -23% in October, its steepest monthly decline since 1956. Investment grade corporate bonds lost -7.4% in October, their worst month since 1976.
At the same time, US-home prices continued their unrelenting slide for a 20th straight month, to stand -222% below their peak in July 2006. Falling US-home prices have reduced homeowner wealth by about $3 trillion, and stock market losses add-up to an additional $8-trillion. This reduced household wealth could force US-households to cut aggregate spending by $300-billion a year or more.
Historically, September is the cruelest month for the US-stock market, but residual selling often spills over into October. The Dow's loss of -18% in October, 2008 was the biggest since the crash of October, 1987. Paper losses totaled $2.5 trillion. But for Republican nominee John "Maverick" McCain, a late October to Nov 4th rally, boosting the market by 15%, was too-little, too-late. The tide of opinion among the investor class whose 401k's and IRA's had plummeted, tilted against the Republicans, and was made worse by the unrelenting slide in home prices.
In mid-September, Republican nominee John "Maverick" McCain understood the fatal impact of a stock market meltdown on his presidential bid. He frantically suspended his campaign in order to persuade rebellious House Republicans to quickly agree to a $700-billion rescue plan for US-banks, and prevent a meltdown in the market. But House Republicans decried it as a "bailout" and helped to kill its first version, sending the Dow into a tailspin of 777 points. Obama stayed quiet and above the fray.
The Treasury's bail-out,— purchasing toxic mortgage-backed securities from banks was badly flawed and utterly rejected by the marketplace. Even after the House finally passed the bill on October 3rd, the Dow Jones Industrials plunged another 3,000 points, free-falling to a five-year low. It was not until the British and Euro-zone governments moved aggressively to inject capital directly into their banks, and the US Treasury followed suit, did some measure of calm and stability return to the global stock markets. But for "Maverick" McCain, the collateral damage from the October market meltdown torpedoed his long-shot bid for the presidency.
The Dow Jones Industrials rallied 15% in the week prior to Nov 4th election results, a move that has surprised many traders. Barack Obama's higher tax policies combined with far-left Democratic control of Congress defied the conventional wisdom that markets like lower taxes and at least some gridlock on Capitol Hill. However, soon after Obama's victory speech in Chicago, the stock market rally fizzled out, and the Dow began melting down 800 points over the next 36-hours of trading.
McCain had a steep uphill climb, tied to an expensive war in Iraq, linked to an deeply unpopular Republican president, 760,000-jobs lost this year before the stock market crash began in mid-September, roughly 90% of Americans saying the economy is on the wrong track, and his selection of Sarah Palin as his running mate, turned off 60% of independent voters. The Arizona senator was also handicapped by his confessions that economics wasn't his strongest suit, which showed during the debates, while the Main Stream Media elite gave its blessings to Barack Obama.
Americans are naturally eager for fresh start,— a "New Deal," as is typical during periods of economic hardship. And a majority of voters turned to Obama in a giant leap-of-faith,— a man whom many Americans know little about, with no executive experience, less than four-years out of the Illinois Senate. McCain tried to paint Obama as a tax-raising Socialist, who will "spread the wealth around," a fear that resonates with the biggest and most powerful traders in the financial markets. [[But absolutely the wrong message for the vast majority of taxpayers, with hundreds of billions already on the way to those 'plutocrat' vandals who got us into this mess. : normxxx]]
Uncertainty over how Obama and the far-left Social Democrats in Congress would alter tax policies for US-multinationals listed on the NYSE, and capital gains taxes on wealthy investors, intensified the stock market's meltdown in October. On corporate taxes, Obama proposes to tax world-wide income earned by American multi-nationals at the 35% US-corporate rate, the world's second highest. Obama is also promising a windfall profits tax on oil companies, and in his stump speeches, talked about lifting the capital gains tax on wealthy investors to 20% next year.
The volatility on Wall Street was unprecedented in October, with gut-wrenching swings of 500 points or more per day. The CBoE's Volatility Index (VIX), which measures how much traders are willing to pay for stock options, typically at-the-money S&P-500 index put-options, soared to a high of 89.5 on October 24th. Even in the biggest panics this decade, the VIX did not move above 48. The VIX tends to go up during sharp market declines, and falls during sideways or rising markets.
Most importantly, the VIX is regarded as a contrarian indicator. Historically super-high VIX readings signal extreme fear and panic, and have coincided with significant bottoms in the stock market. On October 25th, contrarians lifted the Dow nearly 900 points higher, betting the fourth worst bear-market in history had run its course. The 2000-2002 bear market fell -49% before finding a bottom and the 1973-1974 bear market lost -48%. After the 2007-2008 bear-market tumbled -46% from the October 2007 high, contrarians figured that the trading patterns of the past would once again, serve as a reliable guide for the future.
The "Group of Seven" cartel of central bankers and the Bank of Japan played a key role in engineering the late October stock market surge, by capping the rise of the Japanese yen against other major foreign currencies. On Oct 26th, the G-7 central bankers issued a veiled threat to intervene in the marketplace if necessary, to block the yen's advance, "We are concerned about the recent excessive volatility in the exchange rate of the yen and its possible adverse implications for economic and financial stability," the G-7 finance officials said.
The next day, Japanese Finance chief Shoichi Nakagawa warned that Tokyo financial warlords were "watching the foreign exchange market with great interest," secret code words for intervention to weaken the yen. Within 48-hours, the Euro had surged 10-yen to 125-yen, and the US-dollar rebounded from a 13-year low of 91-yen to as high as 99.70-yen. The unwinding of "yen carry" trades, that has been terrorizing the global stock markets since the Lehman bankruptcy, was successfully brought under control by the G-7 central bankers.
However, threats of intervention can't suppress the yen forever, in a market where roughly $550-billion changes hands each day. Tokyo backed-up its verbal intervention threat by pressuring the Bank of Japan to cut its overnight loan rate to 0.30-percent. Currency traders hadn't been expecting a BoJ rate-cut and quickly scrambled to cover short dollar positions towards 100-yen.
The Brazilian real also rebounded against the yen, a key catalyst that ignited a +30% rebound in the Sao Paulo's Bovespa Index. Emerging stock markets in Asia and Latin America soared after the Federal Reserve swapped $30 billion with Brazil, Mexico, South Korea and Singapore to bolster their foreign currency reserves. Brazil's government is struggling to prop up its currency, which has already lost a third of its value against the Japanese yen.
Brazil said it would put a quarter of its $210 billion of foreign exchange reserves on the line to defend the real. Brazil's central bank has spent $40 billion in foreign exchange interventions so far, Brazil's central banker President Henrique Meirelles said on Nov 6th, adding that the worst of the crisis has already passed.
Preventing unwinding of "yen carry" trades was only one juggling-act performed by the US Treasury's "Plunge Protection Team" in late-October. There was also the job of snuffing-out the surge in US$ LIBOR interest rates, to which $360-billion of adjustable rate home loans, ARM's, and many business loans are pegged. After adopting the more sensible European approach, the US Treasury began injecting $250-billion directly into US-banks, and over the next 20-days, the 3-month US-dollar LIBOR rate quickly fell by 242-basis points to 2.40% today.
The flood of US dollar liquidity pumped into the global banking system by the Fed, together with aggressive interest rate cuts around the world, have calmed the panic and eased the worst of the credit crisis. LIBOR rates in England and the Euro-zone have declined by 70-basis points respectively, signaling that the $3.2-trillion of emergency funds approved by governments may be thawing out credit markets.
Still, until US-home prices stop falling, the S&P-500 Index is skating on very thin ice. The average US-home price might fall another 10% in the year ahead to get back to pre-bubble levels. Worse yet, home price declines can overshoot on the downside, which would increase the number of [marginal] homeowners with negative equity, creating a strong incentive to default on their mortgages. And in a vicious cycle, more foreclosures put more homes on the market, driving prices yet lower, increasing bank losses. That's why powerful stock market rallies, engineered by bargain hunters and central bankers, have typically ended-up as bull-traps.
The stunning collapse of the US-industrial sector in the past two months was a bombshell that shook the ground beneath the Republican Party. The ISM's factory activity index plunged -20% over the past two months alone, to a reading of 38.9 in October, it's lowest since September 1982. The purchasing managers' gauge of new factory orders plunged to 32.2, the lowest since 1980, from 38.8 the prior month, and exports, the one bright spot for the US-economy this year, also collapsed, with the ISM's export gauge dropping to 41, the lowest reading since 1988.
US auto sales plummeted -32% in October to the lowest since January 1991, led by General Motors' 45% slide, as reduced access to car loans and a weaker economy kept consumers off dealer lots. With credit drying up and new-vehicle sales slumping, 700 car dealerships will close this year, and taking with them an estimated 37,100 jobs. That's a heavy blow to the US economy. The country's 20,700 dealerships accounted for $693 billion in sales last year, or 18% of all retail sales. Dealership wages and salaries make up 13% of the nation's retail payroll.
However, bargain hunters in badly battered blue-chip stocks, are betting the ISM Factory Index has hit rock-bottom, will recover in the months ahead, perhaps with a V-shaped pattern. The risk for bottom pickers however, is the possibility that the chart pattern for the ISM factory indexes, will evolve into an L-shape pattern, or a prolonged period of stagnation at deeply depressed levels in the months ahead. Worse yet, the ultimate bottom might be located at lower levels.
Synchronized Slide In Global Economies And Markets
Despite all the adverse problems in the housing and banking sectors, that froze credit markets, toppled banks and brokers, and wreaked havoc with stock markets, the Republican ticket was still within the margin of error in mid-September. However, during the presidential debates, McCain failed to point-out that foreign stock markets in Asia, Europe, and Latin America were also melting down by 50% or more, and factory indexes overseas had fallen-off a cliff to multi-year lows. Highlighting the synchronization of global economies and markets, might have helped McCain deflect some of the blame for the economic downturn.
In Japan, the Nikkei-225 index plunged to its lowest in 26-years in late-October, shedding 60% from a year earlier, and handing investors' $2.5-trillion of losses. Japan's factory activity index plunged to the 42.2-level in October, far below the 50-mark dividing growth from contraction for the eighth straight month, suggesting the worsening global slowdown has pushed Japan deeper into recession.
New export orders, a key engine of growth for Japan, fell to 37.5 from 45.4 in September, the lowest on record, after contracting for the ninth straight month. Japanese exporters are also getting battered by the stronger yen, which reduces the value of overseas profits earned in Euros or US-dollars when repatriated back into local currency. To make matters worse, Toyota, the largest Asian automaker, reported US-auto sales plunged 23% in October, from a year earlier. Honda, Japan's second-largest automaker, said car and light truck sales fell -26% from a year ago.
If traders are looking for China to miraculously to save the world economy, the latest signs of an economic slowdown in the Asian juggernaut are not promising. The CLSA China Manufacturers Index (PMI) showed that factory activity contracted sharply in October, falling to 45.2, its lowest level since the surveys began in June 2004. Manufacturing is a key engine of growth for China's juggernaut economy, and accounts for about 42% of China's gross domestic product.
Companies from Hong Kong, Taiwan, America and Europe flooded into the Guangdong province to set up low-cost factories that made everything from sneakers to laptops and iPods. China's vast manufacturing hub along the Pearl River Delta, has long been regarded as the world's factory floor. However, Chinese manufacturers are now seeing their order books cut, both at home and abroad, as the world economy falls deeper into recession. For the first time in three years, the growth rate for Chinese exports in the third quarter of 2008 declined.
Government statistics show that 67,000 Chinese factories have been shut-down in the first half of this year, and another 33,000 plants will close by year's end. Factory owners in China were straining under soaring labor and raw-materials costs, and an appreciating Chinese currency. When the credit crunch took hold, Western importers slashed orders for Chinese goods and bankers curtailed loans to factories, so many operations were pushed over the edge.
China has been the biggest driver of global demand for commodities this decade, including agriculture, base metals, and energy. For instance, from 2000 through 2007, China's energy demand grew by 65%, and accounted for a third of the total increase in oil consumption around the world. One big question is what will happen to Chinese oil demand if the global economy goes into a tailspin? Given that there are 2.2 billion people in China and India, there should be plenty of demand for commodities, even if their economies slow to an average growth rate of around 7% in real dollar terms. Yet signs of "demand destruction" from China's factories in recent months have sliced the Reuter's Commodity Index in half.
Bank Of England Pushes The Panic Button
The British pound has suddenly collapsed from a 26-year high in the summer of 2007 to a five-year low against the dollar in October, the most brutal devaluation sterling has suffered, since it was ejected from the European Exchange Rate Mechanism in 1992. Major players in London are dumping the British ounce, on expectations the Bank of England will slash its base rate to 2% next year— which would be the lowest rate in the Bank of England's 314-year history.
Bank of England chief Mervyn King warned on October 23rd, that "the pound could face a larger and faster adjustment in the coming months as the UK economy is forced to adapt to the new post-financial crisis landscape." He warned that the UK was facing a similar economic downturn to the Asian economies in the late 1990's when foreign investors pull out their capital from their countries. "The drama of the banking crisis, which is unprecedented in the lifetime of almost all of us, will damage business and consumer confidence," he warned.
Much like the bursting of the US-housing bubble, British home prices are spiraling lower. Britain's biggest mortgage lender, Halifax, said UK house prices fell 2.2% in October, the ninth successive decline, and are -15.75% lower compared with a year ago, the steepest fall since records began in 1983. A report by Standard & Poor's revealed that 335,000 households in Britain now find themselves in negative equity, an increase of 250,000 in only four months. By 2010, S&P predicts that as many as 2 million UK households could be threatened with falling into negative equity.
Recognizing the extreme danger to the British economy from a double barreled slide in housing and stock markets, the Bank of England delivered a shocking 1.50% cut in interest rates on Nov 6th, lowering its base rate to 3%, it's lowest in more than half a century. The BoE judged "the economic outlook had worsened markedly because of the global financial crisis and that drastic action was needed." However, British banks are reluctant to pass along lower mortgage rates in line with official BoE lending rates because of historically high sterling LIBOR rates.
British factory output also contracted for a sixth consecutive month in October as falling demand both at home and abroad tipped the sector into recession. In response, the BoE engineered the biggest devaluation of the British pound since sterling's ejection from the EU's Exchange Rate Mechanism in 1992, to help UK exporters compete in foreign markets, and artificially inflate the income of UK multinationals earned abroad. Despite the pound's 24% devaluation however, the UK's index for new export orders fell to 43.5, its lowest since September 2001.
Commodity markets have been on their wildest roller-coaster ride this year, soaring amid an inflationary boom in the first half, and then plummeting in a deflationary bust in the second half. At its peak in early July, the Dow Jones Commodity Index stood +40% higher than a year earlier, led by spectacular gains in energy, grains, and precious metals. But signs of a serious worldwide recession have meant the end of the commodities boom. Gold, tracking trends in the broad commodity indexes, has tumbled 28% since a record high of $1,030/ ounce on March 17th.
Mitigating some of gold's vulnerability to sliding commodities is its traditional role as a hedge against global security risks. US Vice-president elect Joe Biden might be right. There could be an international crisis to test the new American President in 2009. Perhaps North Korea will refuse to honor its disarmament promises, and fire up its plutonium reprocessing plant. Perhaps Iran's Revolutionary Guard units located in Lebanon, the Gaza Strip, southern Iraq, and its "special groups" in the Persian Gulf, will become more active, once the US-military withdraws from Iraq.
Tension in Russian-American relations has been driven to a post-Cold War high by Moscow's invasion of South Ossetia. Russian President Dmitry Medvedev wasted no time on Nov 5th, and in his first state of the nation speech, said Moscow will deploy Iskander missiles near Poland, and equipment to electronically hamper the operation of US missile defense facilities in Poland and the Czech Republic. "From what we have seen, the creation of a missile defense system, the encirclement of Russia with military bases, the relentless expansion of NATO, we have gotten the clear impression that NATO is testing our strength," Medvedev warned.
On the financial crisis, Medvedev said overconfidence in American dominance after the collapse of the Soviet Union "led the US authorities to major mistakes in the economic sphere. The American administration ignored warnings and harmed itself and others by blowing up a money bubble to stimulate its own growth," he said. Of course, the Kremlin has also been guilty of inflating the the Russian stock market bubble, by expanding its M2 money supply an average 50% per year.
Soaring oil prices also fueled a boom in Russian stocks over the past few years, and bloated Russia's foreign exchange reserves to a peak of $597 billion, the third-largest in the world, from just $10 billion in 1998. Four years of high oil prices have left the country with no foreign debt. But since July, sliding oil prices, concerns about the Russian banking sector, and a mass exodus of foreign investors from Russia's stock market, has wiped-out three-quarters of the Russian Trading System Index's value, led by Gazprom and Rosneft, the country's biggest energy companies.
Moscow has been forced to draw-down $113-billion from its reserves to $484 billion, in order to support state-run banks with subordinated loans, to buy equities on the stock exchange, and to defend the Russian rouble in the foreign exchange market. Russian kingpin Vladimir Putin argues there is no alternative to his prescription of greater state-control over the economy and stock markets, and that the turmoil in Western capitalist economies only proves it.
Since August, the Bush-Paulson team has seized America's largest insurance company, AIG, nationalized mortgage giants Fannie and Freddie, pumped $250 billion into US-banks, paid the $29 billion dowry for Bear Stearns to enter its shotgun marriage with JP Morgan Chase, and will soon bail-out GM, Ford and Chrysler. Is America sliding on the slippery slope towards Europe's "Enlightened Socialism?"
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