Posted on 09/27/2003 5:56:52 AM PDT by Psalm118
This following was written in late June and early July. Since the early summer, the direction of financial flows has not changed. The exception is the bond market sell off, particularly in the U.S. and Japan. Given the authorities’ (U.S., Japan, Swiss, euro, others) perpetual paper printing, the recent buying climax may be tested again in a Sisyphean charge.
The chatter of June 25 inspired this diatribe, when all the talk was of whether Greenspan would cut the Fed funds rate to 1.00% or 0.75%. The debate surrounding the question is pointless, the normal jabber of the mob. But, the question has merits – though, they don’t happen to be the ones raised. The curse of lower rates is to turn the nation into a bankruptcy court.
First, the sophistry of it all. Greenspan’s rationale was mangled, as one would expect. He said something about boosting the economy with a little extra dose of money. This was in the same week that General Motors, a very sick company, completed the largest corporate bond offering ever. It expected to issue $13 billion in bonds but was overwhelmed with $30 billion in bids. In a mannerly desire to please its customers, GM sold $17 billion of debt instead. The Financial Times’ reporters, apparently (and appropriately) agape, wrote: “GM’s is just the latest in a slew of new bond issues to run into what the bankers are referring to as a ‘wall of money,’ as cash-rich investors seek to put their money to work…Investors are increasingly willing to buy lower-rated credit, because bonds with lower credit ratings pay higher yields….” Global bond issuance for the first half of 2003 achieved the greatest volume ever, running at about a 20% faster pace than a year ago.
The Fed funds cut was in the same week that May new home sales figures were announced; they increased 13% in May (17% greater than May 2002), to a record 1.117 million annual pace. The average price was $242,500, $11,400 greater than in March and a 42% price jump from 1997. The State of California can still borrow even though its finance director admitted, “California is broke. We are operating as of today completely on borrowed money, and we have no collateral left for additional borrowing capacity.”
There is no shortage of money (“credit” to the purists).
The greatest impoverishment seems of no interest: the old people. Many rely, or, did rely, on interest earned on money market funds, CDs, savings accounts, and U.S. savings bonds. Since January of 2001, the Federal Reserve has cut the funds rate from 6.5% to 1.0%. All other short-term rates (U.S. Treasury bills, commercial paper, short-term loans) are priced off the funds rate. As the funds yield dwindled, so have money market returns. Assuming a constant level of money market assets, retail investors are earning around $45 billion less in money market assets than in 2000. It doesn’t seem that anybody cares, including their watchdog, the American Association for Retired People (AARP). As a guess, the AARP weighs the political battles to fight and they have steered clear of this malnutrition problem. The AARP probably cannot accomplish much, but should advertise its constituencies’ plight.
What are the retired people to do? They can, and many probably have, started to spend their principal. They have, and we know they have, been buying other assets, with higher possible yields, but much higher risks. The primary risk to retirees is principal. Once it’s gone, it’s very hard to make it back especially for those who won’t earn a paycheck. They don’t have future income to accumulate and cover their losses.
The rest of the population faces some grim choices. Although the previous paragraph can be interpreted more liberally for younger workers, they, too, are heading for big trouble. How do we know? We can see the money flows and asset prices. Higher yielding securities are the first choice, which accounts for the enormous flows into high-yield bond funds. Already this year, more money has flowed into high-yield mutual funds than in any entire year in the past. (Echoes of March 2000?)
High-yield bond investors have done well; lower-yield (investment grade) bond investors have also profited. But how much lower can interest rates go, or, can corporate spreads tighten? Well, they can go to zero, and it should be noted that over the past year the 30-year, 5.4%-yielding Treasury bond now yields 4.4% - a 25% return. The profit of this trade does not change this appraisal one bit – there is great risk in the bond market, with every chance of big losses.
Most people do not understand bonds, and – let’s use retirees again as an example; it’s easier to get sentimental about them – do not know how quickly such a bond could produce a 25% loss by roughly retracing last year’s yield path. The inadequate education was quantified by a recent poll in which 54% of investors think interest rates will be higher next year and 74% think the value of a bond rises when interest rates go up. The most basic mathematical certainty that bond prices go down when yields go up is not widely known.
The bond bulls have one explanation that has served them well – Alan Greenspan. The man is determined to keep this economy from collapsing, but he will fail. The reasons are obvious so not worth discussing here, but it is worth looking at the additional damage that cascades from the Most Valuable Machine of the Productivity Miracle: the currency printer. The Fed has pumped more money into the economy since 2000 than had been created in the history of the country up to 1980.
Grant’s Interest Rate Observer dissected the flows for the week ending May 28, 2003. The Federal Reserve “increased its earning assets – repurchase agreements, Treasury securities, etc. – by $8.7 billion, in the process creating exactly $8.7 billion of new liabilities, i.e., dollar bills.” That’s only the half of it. Globalization produces winners and losers. The U.S. dollar remains the big winner since “Central Banks the world over buy [the dollar] by the 18-wheelerful, their purchases….in the May 28 banking week [were $10.9 billion].” That is a total of $19.6 billion “called into existence by the world’s central banks in only five business days.”
This is money pumped into an economy that does not need a monetary boost; it needs to be liquidated. During the boom, companies overspent in the most redundant ways (the factory capacity utilization rate is 74%; among technology companies, it’s 50-something percent). It needs to be liquidated now. Well, the liquidation should have started 30 months ago, when the Fed first cut the funds rate. Unemployment would have soared, the stock market would have crashed but we probably would be headed towards recovery now. As it stands, the corpses sell products at bargain basement levels and make it impossible for anyone to profit. This has been a reason Japan is still in such tough shape. The Japanese government lacks the fortitude to let the market decide who should survive.
The inevitable – and, the liquidation is inevitable – is still to come, but will be much worse, due to the Fed’s recklessness. Since the $20 billion a week has no productive purpose, it speculates. Examples abound. Please keep in mind that the speculations I write about started their ascent in the past nine months, so those who get wiped out are chasing a fantasy that would never have existed without the hyperactive Fed. Now, to what Alan Greenspan hath wrought:
First, the dot.com bubble is back. Today, the fad is Chinese dot.coms that trade on the Nasdaq. Netease, Sina, and Sohu hover around a $1 billion market price and have price: earnings ratios, respectively, of 562 times earnings, 746 times earnings, and no earnings. Ah, feel that hornet sting of nostalgia!
Second, the speculative industries of 1999 are in fine shape. Let’s leave China alone and look at U.S. dot.coms: the Street.com Internet index is up over 100% from its 52-week low. Profits are few, but it’s fun to hope. Another motivation: the casino mentality of finding some gambler who will buy at a higher price. The Philadelphia Semiconductor index is up by 80%, despite the fact that May sales lagged April’s, were 30% lower than a year ago, and the annual sales rate (in dollars) is about 10% greater than 1995. According to the High-Tech Strategist, semiconductor stocks are trading at 62 times earnings; when those losing money are not included. If this speculative money was not flooding the economy, fewer companies would exist; ergo, semiconductor chip capacity would decline. (Chip prices keep falling, but the industry relentlessly expands. In the July 1, 2003 Financial Times, we read that Texas Instruments will build a $3 billion semiconductor manufacturing plant in Dallas. “The project will be the largest ever private-sector development in Texas history.”) The Nasdaq average is up over 50% since October 2002 and the Nasdaq 100 (trailing 12-months) price: earnings ratio is 226:1.
I pause now and refer to an opinion written by Brian Wesbury in the June 23rd Wall Street Journal. He listed several reasons why the Fed should not lower the funds rate. All of them are worthy of attention, but I won’t get back to some of them. Wesbury’s warnings: 1- Fees may exceed the yield on money market funds; 2 – insurance companies’ miniscule returns on investments will hike premiums; 3- pension fund contributions will rise, [I will add: “and pension benefits will vanish”]; 4- mortgages are pre-paying so fast that bankers may be reluctant to make loans; 5 – no matter how much the Fed cuts rates on the downside, this will, “lead to more drastic rate hikes, and all the damage they do, at some point in the future.”
As long as I’m at it, here’s my little list. First, is Greenspan’s constant ranting about productivity. The only productivity gains in this economy are from job cuts. Often, those jobs go to India or China. We may see a productivity-led job drain for the next decade. Second: the government numbers are bogus. Inflation is much higher than the government figures. What is inflation in your life? It’s about 10% a year in mine. I ask this question to people, not one of whom has said it is below 5%. The unemployment numbers and the productivity figures are also fudged. (If those who have stopped looking for a job (for at least four weeks) and those working part-time who would like to work full-time are added, the unemployment rate is over 11 %.) The extent and willingness of corporate employees willing to participate in corruption certainly finds its counterpart in government. Third: federal, state and municipal finance. Governments spent money that was a product of the boom. Now we pay for this profligacy. California’s annual spending rose 44% between 1990 and 2002. The state just announced that the fee to operate a car will triple. The tax is a percentage of the car’s value, a mid-range fee hike that rises from $160 to $480 a year. That’s a thousand dollars for most families – just to drive their cars. The state budget cuts should cut to the source of greatest inflation – jobs. This capital gains bonanza has paid for a lot of political favors and bought rock solid constituencies. Government payrolls need amputations - then hike the fee to $480 if necessary. (This highlight another distortion: Government C.P.I. inflation figures do not include taxes, inflationary as higher fees, permits, and taxes might be.)
Fourth: the federal government’s impoverishment plan construed patriotism as throwing money into the stock market. This was candidly stated in the fall of 2001. Any administration with a sense of historical knowledge would recall that when you fight a war, it is best to preserve one’s capital because it becomes rare and precious. Through some screwy logic the Bush team thought it more important to prop the stock market. By mid-2002, that was a couple of trillion patriotic dollars down the drain. (Was this the New Era interpretation of how to run a war bonds campaign?) One source of confusion is to blend patriotism with nationalism; these spring from two very different impulses.
Fifth: patriots were also urged to spend money like drunken sailors. Bob McTeer, the adolescent Federal Reserve governor, urged all Americans to “join hands and buy a new SUV.” (Which is more revolting: dragooned into buying an SUV or this holding hands business?) The legacy, in addition to the money lost in the stock market, is car loans spent on a possession that sucks dry our most valuable and needed commodity - oil. This seems particularly inept given the location of our foreign engagements. Now, it looks like car sales are falling off, with the patriotic consumer much deeper in debt. In 1993, consumer debt ran at 65% of annual income. Now, that’s 85%.
Sixth: the lunatic housing market. The government is leveraging the housing boom because it’s the only thing left. Companies aren’t making profits, and, on the larger scale, they will spend the next couple (if we’re lucky) of years paying off debt, not growing their businesses. This is a leading reason the free-flowing credit does not make its way into productive enterprises.
In these discussions, the government is accused of “forcing” people to take on bigger mortgages (to live off the home equity) or forcing them into the stock market. The government is doing no such thing. The government never forced anyone to invest money in the Janus 20 or the Munder NetNet funds. It is forcing many people, whether complicit in the bubble or not, to live either an impoverished or speculative life. (A more upbeat consequence is the self-discipline enforced by straightened conditions.) One may lead to the other, which turns these poor souls into supplicants of the state. The housing mania has been largely leveraged off lower interest rates, aided by all those who have poured money into bonds recently. (These bond fund flows have pushed prices up; therefore, yields have gone down. Again, most retail bond investors do not understand this dynamic.) House prices have rocketed. From the fall of 1997 to the fall of 2002, the average house price rose in the U.S. rose 42%. In New York City, they rose 67%; in Jersey City, 75%; in Boston, 69%, and in San Francisco, 88%. Many a bewildered and nearly bankrupt household has turned itself into a very poorly managed hedge fund. Like the more reckless hedge fund managers, as interest rates drop, homeowners re-finance their houses, and increase their leverage by sucking the extra equity out of an asset that is rising in price. (In the early 1980s, homeowners’ average equity equaled 70% of the house market values; today, it is only 55%.)
The housing madness is abetted by the government agencies, Fannie and Freddie and Sallie and Dopey and Goofy and…oh, that’s enough. They fall under the acronym of “GSE”. If you don’t know what that stands for, you don’t need to know. The GSEs hold an advantage over banks because the implicit government backing subsidizes their loan portfolios. And what portfolios they are! Fannie and Freddie hold a trillion dollars of mortgage exposure on their balance sheets. That’s separately, not combined.
Since 1992, Fannie’s balance sheet has grown five-fold, Freddie’s: twenty-fold. How could any financial institution possibly grow at those rates without taking big risks? The numbers are staggering. Fannie projects mortgage originations of $3.7 trillion this year - in an economy with a G.D.P. of $10 trillion dollars. The total volume of mortgage originations (not just by the GSEs) between 1990 and 1996 was $1 trillion. In this context, consider that Fannie’s mortgage purchases grew $139 billion in April 2003. It must be noted that housing is only one part, albeit the largest part, of the larger credit bubble. Total U.S. outstanding debt rose from $13 trillion in 1990 to $16 trillion in 1998 to $32 trillion by the end of 2002. The GSEs are doing their part to ensure that our indebtedness not only rises, but also accelerates. If we were discussing supermarket prices instead of credit growth, we would call this hyperinflation. It is only a matter of time before these growth figures occur in a category of prices that we recognize as such.
The GSEs also hold an advantage over non-government lenders in their ability to raise capital more cheaply. Their reserve requirements are so low in comparison to their portfolios that they may as well spend the money on a magnificent office party. When Fannie or Freddie blows up, we – the taxpayers – pay for these follies, follies that may reach into the trillions. This is another avenue by which those whose lives never participated in the boom will become impoverished.
I should say that the GSEs object to being called government agencies. Ignore them. If they were forced to post a real financial statement, maybe they would have an argument. As it is, nobody can tell what they are holding. But, they do have some characteristics more in keeping with a corporate structure: their stock option motivations are asymmetric fortune-hunting schemes. Management can gamble and leverage the company to the highest degree possible. If they are successful, their options will pay tens of millions of dollars. If they are wrong, they might get fired, but, in any case will walk away whole.
As Holman Jenkins wrote in the Wall Street Journal: “No matter how well they are run, Fannie and Freddie can’t be run well enough. [No other bank] represents such a colossal concentration of a narrow kind of risk in a single gigantic institution….
“Investors and portfolio managers happily fund their risk by buying Fannie and Freddie bonds. They don’t worry themselves about what goes on inside Fannie and Freddie’s “black box” derivative portfolios. Big holders of their debt, including many foreign governments, assume the U.S. government will always be available to bail them out.
“[Fannie and Freddie’s] executives were among the most highly paid in the land, are loaded up with stock options, though managing the risks of their trillion-dollar portfolios is a detail handed off to minions. Top management’s job is politicking….”
Other participants may also think their risks are asymmetric. The refinanced mortgage that squeezes an extra $30,000 of money is not a risk, because everyone knows that house prices always go up. If one were to point out that real estate prices have fallen 70% in Hong Kong since 1997 and by an equal percentage in Japan since 1991, the reply would be: “But, this is America.”
Yes, and America can’t pay its bills. (The rest of the world has its fill of unpaid claims. According to the Daily Reckoning, “In 1970, the entire global bond market had a value of only $776 billion. [For perspective, Cisco and Microsoft were valued at well over $1 trillion at the peak.] Today there are $40 trillion worth of bonds.” Again, this is inflation and quite ominous. Every loan gets repaid: sometimes by the borrower, sometimes by the lender, sometimes by the taxpayer and, in our derivative culture, sometimes by a security holder who doesn’t even know the borrower exists.)
The madness of manias always produces clever and shady dealings as the bubble rises. That’s one reason they grow out of control. People lose perspective. Interest rates that are too low corrupt markets. A favorite of mine was a Time magazine article with this up-to-the-minute advice: “Borrow against your house to buy stocks now.” (To give Time due credit, this was published last November, so would have produced some profitable though nerve-rattling opportunities.)
What follows is a snapshot, a look at real estate developments that happened in the week of June 16. E-loan expects a 25% - 30% earnings growth rate from hiking sales of, “purchase and non-prime loans, home equity and auto loans.” As if the poor don’t have enough trouble. CBS MarketWatch reports that, “…125 percent loans are still widely available through many lenders. All borrowers need to do is ask.” That’s a nice way to saddle borrowers with an asset that might climb back to their mortgage commitment two generations from now. Then there is E*Trade, which is selling portable mortgages. These are mortgages a homeowner can carry from one house to another. Not to miss a beat, Fannie and Freddie are talking to E*Trade in the hope of creating a secondary market. In other words, these mortgages would trade like stocks; they could be churned and burned. The creation of a liquid market may instantly boost the value of portable mortgages, which would cause a new, mad rush into this market by lenders. With this increment of profitability and since the riskier loans can be sold into a market, all kinds of desperadoes will chase down the financially and mentally feeble.
Where are the government regulators in all this? I acknowledge that society would benefit if government regulators spent their afternoons in the pool hall rather than work, but their absence is conspicuous. Even if bank examiners don’t examine, don’t they at least read? The “125% loans” article stood center court on the CBS MarketWatch home page. Likewise, it takes no great effort to read about “charitable organizations” that lend home buyers the 5% or 10% down payment. The bank doesn’t know this and, in fact, these charities are fronts for the developers whose 30% profits are reduced by 5% or 10%, which is worth the price to keep the bubble rising. The builders don’t expect this loan to be repaid, an insight into creditworthiness the bank would lack. Another topic regulators should have read about is the homebuilders’ access to Wall Street. Something like telecom companies in 2000, the investment banks will underwrite anything. If they are lucky, they will get the builders’ reorganization assignment after bankruptcy. Synergy, at last.
I think, in all of this, the normal procedures and norms have been tossed aside by a government afraid of an economic collapse. There is no capital spending, so it’s the housing market that keeps the U.S. economy above water. Many people will be ruined by rising interest rates, along with the Nasdaq at 800, and will inevitably suffer when home loans consume so much of a families’ income that its diet consists of Ramen Pride. These consequences are of little interest to the government.
In a word: dependency
Just a side note though, on your comment...........I remember Rush talking about the "next President" having to deal with an incredible problem with the economy back in 1999 on his show. He was basing his comments, if I remember correctly, just on the commonsense observation of economic boom-and-bust cycles. He further opined at that time (again.......if I remember correctly) that maybe the Republican Party would/should (?) field a 'weak candidate' so that Gore would be saddled with the repurcussions of The 90's.
I don't think it is either. Big companies that have managed to survive many recessions or corrections are now going under or leaving the country. Small businesses that have been around for decades are now shutting their doors ---- a good example are the tool & die shops --- we're losing even our means of production ---- and that we could not suddenly get back if we later decided we should.
As manufacturing jobs are offshored at an increasing rate and the currency is debased by the administration even as they are on a borrow and spend binge, the inertia is all to the downside.
Richard W.
Dealing with reality is not necessarily doom and gloom. Due to the exaggerated size of the late 90's bubble, we are not facing "garden variety" corrections to the excesses. Could and probably will be extemely painful for many citizens. The government and the administration has yet to stop digging us into an even deeper hole. That is not encouraging.
Richard W.
You have it nailed to the wall. Excellent! I would like to add also that the present fiat currency system (backed by nothing more than government debt and promises) allows the ruling class to buy votes with nothing other than more and more debt. It's like giving bank robbers the keys to the bank. How do you think that situation is going to end?
Richard W.
I don't think the gov't wants to impoverish us, just the opposite. The problem is that their policies are a zero sum game. Business owners, investors, homeowners, and the rest of the world are gaining at the expense of everyone else. This system will collapse when the people with the short stick figure out what is going on.
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