Pushing on a String, or, The End of the Rope

One of the biggest stories in recent weeks and months has been the crisis facing the banking and the financial systems. The first rumblings in the mainstream press began last summer, when news of the housing bubble appeared. Yes, news of the rise in housing prices was well known long before that; but only after many areas of the country had flat sales did it occur to most people that the prices were the result of a bubble, and not of their own financial genius. With the peak in housing prices, and the slowdown in house sales, it was interesting to watch the progression of people’s reactions over time.

First, people began to wonder what had happened;
then they decided that the problem was with speculators trying to “flip” houses for a rapid profit, but that other houses were safe;
then, it was discovered that the banks had been repackaging and selling the loans, and that the problem was only limited to subprime mortgages;
next, it came out that the banks had decided to sell the repackaged loans by cleverly mixing the good with the bad;
the next shoe to drop was the additional factor that the pricing models had assumed that housing prices would go up forever, so that there would never be any risk of default;
following this, it came out that the banks forgot to allow for the amount of risk created by mixing in the subprime loans;
then it came out that the banks had to start taking these bad loans back onto their books, as the toxic sludge of debt was so bad that nobody else wanted it;
after this was the discovery that the banks had changed their business models so that they made a disproportionate share of their money by packaging and reselling these loans – so when the loans came back on the books it really hurt the banks;
You see, banks are required by law to hold so and so much cash in reserve in proportion to the total amount of loans they hold. So when the banks had to take back these toxic mortgage loans, that means they had to come up with more money real quick so they wouldn’t be breaking the law;
furthermore, all of the banks were so nervous over their own status, that they became very suspicious of other banks, and began charging each other a lot more for loans, and were much more reluctant to lend money to other people as well.

And this affects other businesses, many of whom need to borrow money to fund day-to-day operations (“cash flow”) as well as for buying new supplies, inventory, and expansion. Now they have to pay higher costs for what they’ve been doing all along anyway.

And if that weren’t enough, this caution on the part of the banks means that the spigot of home refinancing and home equity loans is drying up—lines of credit being arbitrarily cut, standards (and mortgage rates!) rising for new homes, credit card fees and interest rates rising. Not to mention, with house prices falling, many people are trapped in homes which they cannot sell.

Which means that consumers have less to spend. With less to spend, people don’t buy as much. So what do retailers, homebuilders, and producers do? Well, we need to sell, let’s lower the price! If that goes on long enough, soon companies are having a hard time paying the bills, since they don’t make as much of a profit; so they produce less, or move to a cheaper country, or lay people off. This, in turn, reduces demand. Which lowers prices, and so on. This process is known as “deflation”. It is a contraction in the amount of money and credit; but to laypeople it looks like “prices falling off of a cliff.” It has begun with housing; and the worry is that it will spread to other areas of the economy.

The Federal Reserve has seen all of this playing out, like a slow-motion train wreck. One of the tools they have at hand in order to stimulate the economy, and to make banks more willing to take risks, is to lower the interest rate which the Fed charges banks when they borrow money from it. If a bank doesn’t have to pay as much in interest when it borrows money, then it can charge a lower interest rate for people borrowing from it. And, if a bank doesn’t have to pay as much interest to get its money, then it doesn’t have to insist on so much of a sure investment when it is loaning money, either.

The problem is, banks aren’t the only thing influenced by the interest rates. You also have to look at the interest rates paid on government bonds. Who owns those? All kinds of people, but especially foreign investors. The US government funds its deficit (remember that?) by selling government securities. And the lower the interest rate, the less attractive the securities are to people. (Why would you buy a US-government bond which pays, say, 2.5% interest when you can get bonds from individual municipalities, or states, or other countries, or even corporate bonds at a higher interest rate?)(*)

There is another tool which the Federal Reserve has, too. The money supply. Chairman Bernanke has even been given the nickname “Helicopter Ben” from a speech where he spoke of dropping money from a Helicopter to prevent deflation if necessary. How does this work? Think of the cliché of “turn on the printing presses”. If the government decides to make more money, yes, everyone will have more money to lend. But if there are more dollars floating around, and everything else is equal, then that leads to inflation. The definition of inflation is “too many dollars chasing too few goods”. Remember the wonderful days of Jimmy Carter? But – for a time, printing money can help to stave off deflation. So not only has the Fed been lowering the interest rate, it has been printing money.

The problem which seems to be happening lately is this. If you look at the number of housing starts (down), the willingness of banks to loan (down), and the like, things look really deflationary. Scary deflationary. But if you look at the results of the money printing and of the lowered interest rates, things look scary the other way: the price of gasoline, for instance. Or groceries. Or most imported goods – if we have inflation, and the dollar is worth less, it costs more dollars to buy the same item from overseas. So the Fed is trying to supply all this stimulus to keep the housing market from eating up the rest of the economy, but it is not helping – until the last couple of days, the mortgage rate charged by banks has gone UP at the same time the interest rate charged by the Fed has gone DOWN. And ordinary people, who are busy paying higher fuel bills and more at the grocery store, and who are concerned about losing their jobs in a recession, and who have maxed out their home equity loans, and their credit cards, aren’t about to go on a new spending spree. They want to pay things down first. So all the extra money being pumped into the system is having the same effect as ‘pushing on a string’: the end of the string next to the hand pushing it is moving it, but the rest of the string isn’t cooperating.

The question to be added in the coming months is, will the banks and the housing market start to chug to life again, so Bernanke can stop the helicopter dump? Because, if not, then we run the risk of stagflation – no growth, high inflation. And with that, we run the risk that President Bush does to the Republican Party what Jimmy Carter did for the Dems: ruin their reputation for a generation.

(*) I hate to say this, but it gets even more complicated than this. Try reading this for more details.

Everyone always says the Fed is pushing on a string at the bottom. It isn't pushing and money isn't string. Markets respond to opportunities. There are just lags.

The asset classes that are attractive right now are not the rear view mirror bear market and inflation bets, commodities etc. There are a few of those still attractive (some industrial metals, India steel e.g.) but mostly that is just the latest bubble asset being blown far beyond fundamentals.

Instead, the right asset classes are (1) US financials, a generational sale; use dollar cost averaging, don't try to time it just call the level (2) US preferreds, especially of financials and the more soundly capitalized commercial real estate plays; these can be bought today for 7-12% yields, with 8-9 readily achieveable with a mix of credits (3) some foreign banks, notably Barclays and Deutsche bank, and (4) borderline investment grade debt in the US; add a few very long A rateds for interest rate convexity, and (5) soundly capitalized (leverage 4 times or less) commercial real estate, since rents will hold and funding costs are falling like a stone.

All of them unloved because they are asset classes held in the past at high levels of leverage by many of the players currently in trouble.

You can hedge the dollar risk with a few Euro futures if you like. The Yuan is also sure to appreciate and there are Yuan futures available.

Baron Rothschild was asked the secret of his trading success in the 19th century. He replied, "when the streets of Paris are running with blood, I buy". They were in the revolutionary period, the Napoleonic period, in the revolutions of 1830 and 1848, in the coups of Louis Napoleon, in the 1870 war with Germany and commune. All were panics, and all were buys not sells.

So much FReeping, so little time.

One idea that intrigues me with the "pushing on a string" is the idea that the increase in the money supply, coupled with the lowering of the interest rates, is helping with the financial firms and the sub-prime stuff, as well as buying time for homeowners (i.e. adjustable mortgages won't go up quite as much quite as quickly) -- and this helps the financial companies too.

But this comes at a cost, as those who have lots of money are seeking safe havens after Mr. Housing Bubble are piling into commodities (thereby driving the prices up) at the same time that the secular growth of India and China is driving the commodities up; and of course the increase of the money supply helps too.

So in the short term, what Joe six-pack sees is a lot of talk of "the sky is falling" and all of the policies designed to help "the big banks and Wall Street", while he is faced with skyrocketing gas and grocery bills, and rumors of layoffs coming, just after he thought he had escaped the outsourcing wave. And he has too much credit card debt, SUV loans, and home equity loans for the banks to give a damn...so the feds are providing backstopping to the banks, but they are not passing it on to the beleaguered consumer. (*)

So there is a "Hobson's choice" in the near term: save us from deflation, or screw the dollar and invite inflation?

...and all this, in an election year when the Republicans have no heir apparent to the one President who cannot sound smooth, or sell a political or fiscal policy, to save his life.

Moving on to your post.

What do you mean by "a generational sale"? As in, "once in a generation, so buy now?"

I'd like too, but I don't have enough spare investment money to pick the DEC Computers over Microsoft. Recall the CEO of Bear Stearns was denying any problems just 72 hours before the collapse: how am I to know which investments are "safe"? You know, "don't try to catch a falling knife" and all that.

For the nonce, I took a gander for several hundred bucks in TMA ; I bought at $2.40 a share, and I've lost money, but not interest. Can you suggest a way to figure out what the dilution would do to the share price once the company recovers (i.e., if the company hadn't plummeted from $11 or $12 /share, and suddenly all the convertible bonds bought today were converted to shares at 75 cents, what would the share price get diluted to?)

As far as soundly capitalized real estate, I am worried that there has been a glut of commercial real estate (in general) lately, so I am not sure that rents will hold. However, if a company holds long-term leases, (say of medical office plazas), and the tenant has to pay the upkeep (I forget the technical term for that kind of lease), that would be a good deal.

Cheers!

(*) So therefore, the average person will see less employment opportunity, a withdrawal of credit necessary to buy luxury items, and the cost of staples skyrocketing. Otherwise known as "a falling standard of living".

How much is due to the hangover from easy credit, how much from globalization, how much to govt. debt...?

People who borrow what they cannot afford see their standard of living fall by a law of nature, not financial developments or government policy anything.

Americans as a whole have reduced their net savings rate to zero, and the trade deficit moved to negative 5% of GDP to replace those missing savings with imported capital. That zero net savings rate is composed of a modest class of savers, maybe a quarter, and a larger class of borrowers, maybe half, with a quarter or so not in either group.

No policy conceivable could possibly have prevented the currency of a nation acting in that manner and on that scale for half a dozen years, from falling, against both other currencies and commodity prices. The boom allowed temporary trading gains to outweigh the debts being contracted for it, as long as prices were moving rapidly in one predictable direction. But that was temporary, and as soon as those price increases drove long interest rates high enough, had to reverse.

Present commodity prices are a bubble, just like real estate 4 years ago and stock 8 years ago. Money doesn't literally "pile in" to an asset class, however. The amount of money is unaffected by people's trading actions and asset preferences - there is a seller for every buyer - and the commodities in existence likewise. Higher prices do call forth additional supply, at the expense of less urgent branches of production. But that is precisely a restoring force (eventually any high enough demand will create new supply that swamps it) and not a continuation of the herding preference that causes the price spike.

By generational sale I mean yes, that your sons and daughters might again see US financials this cheap in their lifetimes, but you will not. As for the knife adage, it is simply momentum traders looking in the rear view mirror. No one can call the turns in prices for this or that asset. But you do not need to call bottoms to profit from wild price movements. Momentum players using borrowed money think they need to, that any movement against them ever is ruinous. That is why they are condemned by mathematical law to lose in the end, as a group.

The solution is to call levels and not turns. If you know prices are in the bottom half of their cyclical range, you needn't care when they turn or whether their present direction is down or up. You just invest gradually, not all at once, and thereby achieve an *average* price for all you buy.

In fact, by mathematical law, if you invest the same amount per unit time in an asset bouncing around in price, you are certain to achieve a better than average price, and a better one, the more violently it bounces around. You are buying fewer shares when the price is high and more when the price is low, if you invest the same amount continually. If in addition you only turn this "on" in the lower half of price oscillations, you are essentially guaranteed far better than average prices.

The only real requirement is that the asset continue to exist later, or have a positive long term expected return, and that you can hold it as long as necessary without ever being forced to sell against your will, but a margin call or whatever. If you can't be forced to sell and got a better than average price, what do you care if the price is better still the day after tomorrow? You just buy some more.

Calling levels is consistently more profitable than calling timing, and it is much easier to do, in the sense of the level of skill required. It takes discipline, and an apparently rare contrarian mindset, and a longer time horizon than frantic day traders (or year traders - the average, pro or amateur, only holds a stock for 1-2 years, and over those periods they might as well go to Vegas and bet on a wheel).

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