Monday, December 10, 2007 (reprinted Saturday, March 15, 2008)

Executive Summary

• The credit bubble collapse is just getting started.
• Odds of a major systemic financial crisis now higher than ever.
• Dollar collapse is underway.
• Your opportunities to protect your assets are dwindling fast.

(Originally printed on 12-10-2007. Uncannily good predictions and recommendations, all of which I still stand by.)

The Great Credit Bubble, for which you can thank Alan Greenspan, is now in the process of bursting. While the US media implacably attempts to assure everyone that it is well contained or almost over, nothing could be further from the truth. As one financial commentator recently put it, "the good news is that the subprime crisis has been contained…to the planet earth."

The odds of a major systemic financial collapse are now higher than ever.

If you’ve seen the Crash Course (formerly the End of Money seminar), you know I’ve been concerned for a number of years about the toxic witch’s brew of poor-quality loans and unfathomably risky derivatives that are poisoning our financial body. Part of my concern stems from the fact that no matter how hard I try, I cannot understand how the derivatives markets work.

I’ve been unable to discover the most basic answers to the most basic questions, such as “how much capital is actually backing these things?” and “who’s holding the bag?” Wall Street and its ever-compliant financial propaganda services organizations (CNBC, WSJ, et al.) have maintained all along that these new products have completely eliminated risk by spreading it so thin that it has literally disappeared. I do not believe in financial alchemy, and I do not believe this version of ‘reality,’ because it makes no sense at all. Just as it made no sense to finance 19 houses to a part-time hairdresser in Las Vegas with subprime, negative amortization loans (true story), it makes no sense that this level of malinvestment could simply ‘disappear’.

The rest of my concern centers on the fact that 3,800 paper currencies in the past have all gone to money heaven due to the exact same formula of mismanagement that our fiscal and monetary authorities are applying to the US dollar. A few key warning signs would be, (1) bailing out the poor decisions of big banks by flooding the markets with hundreds of billions of dollars of public money/credit, and (2) conducting a pair of very expensive wars “off budget,” while (3) expanding your total monetary base at an astounding, banana-republic double digit percentage rate (as we discussed last time).

I won’t be disappointed if you tend to believe proclamations from the titans of Wall Street more than you would from some random guy named Chris. However, before you place too much faith on the possibility that those guys on Wall Street “must know what they are doing,” I would ask you to consider these facts:

Exhibit A:

Out of all the toxic subprime mortgages ever issued, the subprime loans with highest rates of default were made in the first 6 months of 2007 .

While you and I and everybody else had figured out that the subprime jig was up in 2005 or 2006, the Wall Street machinery couldn’t figure out how to stop what it was doing even as late as July of 2007. Titans or nitwits? You be the judge.

Exhibit B:

Rather than admit they made a bunch of really stupid loans, Wall Street banks first went straight to the US Treasury to mediate a bailout, and, when that proved to be too slow a course of action, simply hid the extent of their losses by massively abusing an obscure accounting gimmick .

Nov. 7 (Bloomberg) Banks may be forced to write down as much as $64 billion on collateralized debt obligations of securities backed by subprime assets, from about $15 billion so far, Citigroup analysts led by Matt King in London wrote in a report e-mailed today. The data exclude Citigroup’s own projected writedowns.

Under FASB terminology, Level 1 means mark-to-market, where an asset’s worth is based on a real price. Level 2 is mark-to-model, an estimate based on observable inputs which is used when no quoted prices are available. Level 3 values are based on “unobservable” inputs reflecting companies’ “own assumptions” about the way assets would be priced.

In other words, these so-called “Level 3” assets are balance-sheet entries that company management value at whatever they say they’re worth. This is like your drunk uncle claiming to be a millionaire because he said he found a lottery ticket in the gutter on the way home last night, but he won’t let anybody see it. The value of these so-called assets is entirely in the eye of the beholder, or bank management in this case, who has decided that they are ‘worth’ every penny that they paid for them and that’s how much they are going to continue insisting they are worth, thank you very much.

Exhibit C:

As the subprime derivative debacle was unfolding, what do you suppose was the response of Wall Street? If you guessed “doubling down,” you are a winner!

Nov. 22 (Bloomberg) — The market for derivatives grew at the fastest pace in at least nine years to $516 trillion in the first half of 2007, the Bank for International Settlements said.

Credit-default swaps, contracts designed to protect investors against default and used to speculate on credit quality, led the increase, expanding 49 percent to cover a notional $43 trillion of debt in the six months ended June 30, the BIS said in a report published late yesterday.

Wow. Wowowowowow. This is shocking. First, because of how hard it is to set new records for the “fastest pace” at the same time that you are setting records for the total amount. This would be like a weightlifter setting a new world record by adding 700 pounds to the old record. Second, because the specific types of derivatives that expanded the fastest were those designed to speculate on credit quality – the very area that is most at risk right now. So we now know that even as the credit debacle was so completely obvious that people returning from year-long wilderness solos knew something was wrong, Wall Street and Hedge Funds were busy accelerating the pace at which they continued to pursue these broken bets on shaky mortgages. Rather than sound fiscal prudence, this appears to be a last desperate grab for what few chips remained on the table.

It is possible that each individual transaction made a lot of sense to the hedge fund managers, but to outsiders like us they look foolish collectively. Why? Because when everybody is hedged, nobody is. Hedging is a zero-sum game. For somebody to win, somebody has to lose. So while all these smarty-pants were busy ‘hedging their risk away,’ nobody seems to have taken stock of the fact that the assets they were hedging were themselves seriously impaired and were going to result in massive losses for somebody. In short, it is impossible to hedge a failed system.

So, there are three perfectly good reasons to suspect that the captains of Wall Street are rather mortal after all and possibly even less competent than the average soul. I could give you forty more, but in the interest of time, I won’t, except to offer the best explanation I’ve ever read on how the derivative market works (PDF) and the human mechanisms at play that allowed all this to get so out of hand. This article will be well worth your time.

Systemic Banking Crisis?

If you own a house, odds are you carry fire insurance. Not because the chance of a house fire is particularly large, but because the cost of a house fire is catastrophic. You carry fire insurance because you have rightly calculated that (small chance) x (a big cost) = unacceptable risk. So you offset that risk with insurance.

Now I want you to seriously consider what the cost to you would be if there were the equivalent of a house fire in the banking system. I’m talking about a major system ‘freeze’ where banks close, huge losses spread throughout the system, electronic interbank transfers become impossible (ATMs, credit cards, electronic funds transfers, wires, and all the rest simply stop), and many banks and brokerages simultaneously go out of business. I’d imagine the impact to you would be quite large. So the next question is, what can/should mature, responsible adults do to insure themselves against such an outcome? How much time, energy and money should one dedicate to insuring one’s financial house?

When I started giving The End of Money seminar three years ago, I had put the possibility of this sort of event at about 15% to 20% over the next 5-10 years. It turns out that I was a raging optimist compared to some financial professionals such as this guy:

Nov. 13 (Bloomberg) — There’s a greater than 50 percent probability that the financial system "will come to a grinding halt" because of losses from mortgages, Gregory Peters, head of credit strategy at Morgan Stanley, said.

This is serious business especially now that the head of credit strategy at a major Wall Street bank is openly writing about it to their main clients. In fact, there are now many respected economists and financial professionals who are calling for a generalized systemic financial meltdown or a severe stock market decline. Even if you have no assets in the larger speculative financial markets (stocks and bonds), or have already taken steps to protect them by getting them out, you are still at risk if your assets are sitting in a risky bank. The possibility of massive bank failures is now a stark reality and it is my opinion that several are already insolvent, just not publicly (yet).

These sorts of crises always start at the edges and work in. First it was the shakier mortgage broker ‘bucket shops’ that began going under in late 2006. Then larger and seemingly firmer mortgage outfits began going under. Now more than 190 mortgage brokers, including most of the ‘top ten’, have gone bankrupt. And today not only is the very largest of them all (Countrywide Financial Corp) rumored to be a strong candidate for bankruptcy, the unthinkable seems to be unfolding before our very eyes. Both Fannie Mae and Freddie Mac, collectively holding several trillions of dollars worth of US mortgages and an even larger portfolio of associated interest rate derivatives, appear to be in some serious trouble . If either, or both, of these companies goes bust, it is highly unlikely (to me) that both the US banking system and the dollar could survive the event.

I am now putting out my strongest warning ever.

If you do not already own gold and/or silver, your time is running out. My best guess would be that once the world’s paper markets implode, the price of gold and silver will skyrocket to unimaginable and unreachable heights, if you can even locate any to buy. Get some.

By the time it is completely obvious that this is the right thing to do, you will find it difficult either due to price, availability, or both. Luckily, the world’s central banks are still capping the price of gold and silver, offering you a wonderful subsidy, which is really quite nice of them. Why do I advocate gold and silver? Simple. Because they are among the very few money-like assets that you can own (hold) that are not simultaneously somebody else’s liability. Consider that a bond (your asset) is the liability of a corporation or government. Even your checking account is your bank’s liability. A house owned free and clear would certainly qualify as a valuable asset, but a house is not very “money like.” When you go through the list (stocks, bonds, annuities, money-market accounts, etc), there is virtually no paper asset that you can identify that is not somebody else’s liability. Even a cash dollar is the liability of the Federal Reserve. But when you own physical precious metals (not mining shares or other paper claims), that’s the long and the short of it. It’s yours. Period.

Next, in order to protect from the possibility of a general banking ‘holiday’ (freeze), every family should have somewhere between one and six months worth of living expenses on hand in the form of cold, hard cash. You know, the bits of paper that work even if the ATMs and credit card readers do not. To be clear, I am not talking about cash in your checking account, I am talking about cash out of the bank and in your hands. Katrina, a natural storm, taught this lesson and we now need to apply that learning to the potential arrival of an economic storm.

Unfortunately, not very many people will be able to do this because the total cash available is a very small percentage of total deposits (~5%). Your bank will look at you funny when you take cash out, mainly because they do not have very much on hand at any given moment. If you plan to cash out more than a few thousand dollars, I highly recommend that you give your bank advance warning and thereby avoid the awkward social moment that will result when they have to tell you that they don’t actually have that much on hand. One thing to remember is that if you take out $10,000.00 or more of cash your bank is required to report you to the federal government via a SAR (Suspicious Activity Report). So the banks appreciate amounts smaller than that as it cuts down on the paperwork.

I would maintain a cash balance until we see clear signs that the evolving credit crisis is getting better, not worse. Given the latest data, which all point to a serious erosion of the credit markets, this could be awhile.

All that’s really happening here is that the long-awaited credit bust is finally upon us. It is important to remember that historically, bubbles have always deflated over approximately the same amount of time as they took to inflate. This means we are looking at a potential end to this crisis somewhere in the range of 2012 to 2020, depending on where you mark the beginning. In the meantime, there will be plenty of false dawns and countertrend rallies that will siphon even more wealth from the unwary.

Don’t be among them.

Monday, March 10, 2008

The greatest shortcoming of the human race is our inability to understand the exponential function.

~ Dr. Albert Bartlett

While it was operating well, our monetary system was a great system, one that fostered incredible technological innovation and advances in standards of living. But every system has its pros and its cons, and our monetary system has a doozy of a flaw.

It is run by humans.

Oh, wait, that’s a valid complaint, but not the one I was looking for.  Here it is:

Our monetary system must continually expand, forever.

What’s going on here? Could it be that the US economy is so robust that it requires monetary and credit growth to double every 6 to 7 years? Are US households expecting a huge surge in wages, to be able to pay off all that debt? Are wealthy people really that much more productive than the rest of us? If not, then what’s going on?

The key to understanding this situation was snuck in a few paragraphs ago: Every single dollar in circulation is loaned into existence by a bank, with interest.

That little statement contains the entire mystery. If all money in circulation is loaned into existence, it means that if every loan were paid back, all our money would disappear. As improbable as that may sound to you, it is precisely correct, although some of you are going to consider this proof that I could have saved a lot in tuition costs if I had simply drunk all that beer at home. But with a little investigation, you would readily discover that literally every single dollar in every single bank account can be traced back to a bank loan somewhere. For one person to have money in a bank account requires someone else to owe a similar-sized debt to a bank somewhere else.

But if all money is loaned into existence with interest, how does the interest get paid? Where does the money for that come from?

If you guessed "from additional loans," you are a winner! Said another way: For interest to be paid, the money supply must expand. Which means that next year there’s going to be more money in circulation, requiring a larger set of loans to pay off a larger set of interest charges, and so on, etc., etc., etc. With every passing year, the money supply must expand by an amount at least equal to the interest charges due on all the past money that was borrowed (into existence), or else severe stress will show up within our banking system. In other words, our monetary system is a textbook example of a compounding, or exponential, function.

Yeast in a vat of sugar water, lemming populations, and algal blooms are natural examples of exponential functions. Plotted on graph paper, they start out slowly, begin to rise more quickly, and then, suddenly, the line on the paper goes almost straight up, threatening to shoot off the paper and ruin your new desk surface. Fortunately, before this happens, the line always reverses somewhat violently back to the downside. Unfortunately, this means that our monetary system has no natural analog upon which we can model a happy ending.

When comparing the two graphs above, you are probably immediately struck by the fact that one refers to a nearly mythical creation especially revered at Christmas time, while the other is a graph of reindeer populations. You may have also noticed that our money supply looks suspiciously like any other exponential graph, except it hasn’t yet transitioned into the sharply falling stage.

To get the best possible understanding of the issues involved in exponential growth while spending only 10 minutes doing so, please read this supremely excellent transcript of a speech given by Dr. Albert Bartlett. If, like me, your lips move when you read, it may take 15 minutes, but I’d still recommend it. In this snippet he explains all:

Bacteria grow by doubling. One bacterium divides to become two, the two divide to become 4, become 8, 16 and so on. Suppose we had bacteria that doubled in number this way every minute. Suppose we put one of these bacterium into an empty bottle at eleven in the morning, and then observe that the bottle is full at twelve noon. There’s our case of just ordinary steady growth, it has a doubling time of one minute, and it’s in the finite environment of one bottle.

I want to ask you three questions:

First, at which time was the bottle half full? Well, would you believe 11:59, one minute before 12, because they double in number every minute?

Second, if you were an average bacterium in that bottle at what time would you first realize that you were running out of space? Well let’s just look at the last minute in the bottle. At 12 noon its full, one minute before its half full, 2 minutes before its 1/4 full, then 1/8th, then a 1/16th.

And inally, at 5 minutes before 12 when the bottle is only 3% full and is 97% open space just yearning for development, how many of you would realize there’s a problem?

And that’s it in a nutshell, right there. Exponential functions are sneaky buggers. One minute everything seems fine; the next minute your flask is full and there’s nowhere left to grow.

So, who cares, right? Perhaps you’re thinking that it’s possible, just this one time in the entire known universe of experience, for something to expand infinitely forever. But what happens if that’s not the case? What happens if a monetary system that must expand, can’t? Then what? How might that end come about? And when? For an excellent description of this process, read this article by Steven Lachance (emphasis mine):

A debt-based monetary system has a lifespan-limiting Achilles heel: as debt is created through loan origination, an obligation above and beyond this sum is also created in the form of interest. As a result, there can never be enough money to repay principal and pay interest unless debt is continually expanded. Debt-based monetary systems do not work in reverse, nor can they stand still without a liquidity buffer in the form of savings or a current account surplus.

When interest charges exceed debt growth, debtors at the margin are unable to service their debt. They must begin liquidating.

Mr. Lachance reveals the mathematical limit as being the moment that new debt creation falls short of existing interest charges. When that day comes, a wave of defaults will sweep through the system. Which is why our fiscal and monetary authorities are doing everything they can to keep money/debt creation robust.

But it’s a losing game, and they are only buying time. How do I know? Because nothing can expand infinitely forever. The evidence clearly points to exponentially rising levels of money and credit creation. As the bacterium example shows, once an exponential function gets rolling along, its self-reinforcing nature quickly takes over, requiring larger and larger aggregate amounts, even as the percentage remains seemingly tame.

Similarly, our supremely wealthy suffer only from an inability to spend what they ‘earn’ on their capital (interest & dividend income), which means their principal is compounding. But, because each dollar is loaned into existence, it means that when Bill Gates ‘earns’ $2 billion on his holdings, a whole lot of people somewhere else had to borrow that $2 billion. Taken to its logical extreme, and without enforced redistribution, this system would ultimately conclude with one person owning all of the world’s wealth. Game over, time for a Jubilee, hit the reset button, and start again.

When we started our monetary system, nobody ever thought that we would fill up our empty bacterium bottle. Nobody really thought through what it would mean to society once wealthy people earned more in interest & dividends than they could possibly spend. Nobody considered whether it was wise to place 100% of our economic chips into a monolithic banking system that requires perpetual, endless growth in order to merely function.

So, we must ask ourselves: Does it seem possible that our money supply can continue to double every 6 years forever? How about another 100 years? How about another six? What will it feel like when we are adding another $1 trillion every month, week, day, and then, finally, every hour?

Just remember, money is supposed to be a store of value; or, said another way, a store of human effort. Currently it seems to be failing at meeting that characteristic and therefore is failing at being money.

Who ever thought that oil production would hit a limit? Who knew that every acre of arable land, and then some, would someday be put into production? How could we possibly fish the seas empty?

We have parabolic money on a spherical planet. The former demands perpetual growth while the latter has definitive boundaries. Which will win?

What will happen when a system that must grow, can’t? How will an economic paradigm, so steeped in the necessity of growth that economists unflinchingly use the term ‘negative growth,’ suddenly evolve into an entirely new system? If compound interest based monetary systems have a fatal math problem, what will banks do if they can’t charge interest? And what shall we replace them with?

Since I’ve never read a single word on the subject, I suspect there’s even less interest in exploring this subject by our leaders than there is in being honest about our collective $53 trillion federal shortfall.

I am convinced that our monetary system’s encounter with natural and/or mathematical limits will be anything but smooth (possibly fatal), and I have placed my bets accordingly. It seems that our money system is thoroughly incompatible with natural laws and limits, and therefore is destined to fail.

Now you know why I have entitled my initial economic seminar series "The End of Money." [Although I later renamed it The Crash Course.]

But the end of something is always the beginning of something else. Where’s our modern day Adam Smith? We need a new economic model.

The greatest shortcoming of the human race is our inability to understand the exponential function. ~ Dr. Albert Bartlett

 

Monday, December 17, 2007

Executive Summary

• A series of government bailouts attack the symptoms, utterly failing to address the root cause.
• The bailouts were for the big banks, not you.
• House prices need to decline in price by 30% to 50%, and they will.
• Trillions of dollars of losses lurk in ultra-safe pension bond funds and small Norwegian towns, as well as in some unlikely places.
• Current crisis is one of solvency, not liquidity.

Q: “Has the housing market bottomed, is it soon to bottom, or is it in the process of bottoming?”

A:  No, nope, and no.

There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.

~ Ludwig Von Mises

In order to get at the question of ‘Just how bad is the current housing crisis?’ we need to understand the dimensions of the problem. It is a complicated mess if one considers all the scenery in detail, but it’s startlingly simple when viewed from a distance.

The threat to our banking system is described by the extent of the mortgage losses, and those will depend on how far (and how fast) house prices fall, together with the impact of outright fraud. Below we shall explore the (very) simple reasons that explain why house prices must fall by 30% to 50%. Each one can be lumped into a category of fraud, reducing demand, or boosting supply.

• House prices rose far above income gains. Too far. They became unaffordable, and now they are in the process of correcting back to affordable levels. What goes up must come down. Simple as that.

• Mortgage lending standards are tightening up, leading to fewer people qualifying for loans. Fewer qualified buyers means demand will drop and prices will fall. Simple as that.

• From 2000 to 2007, regulatory oversight of lending practices was so lax that there was effectively none. This means that lots of fraud was committed (a fantastic summary of types of real estate fraud can be found here), and an even larger pile of bad loans were made to people who will never be able to pay them back. That money is gone, gone, gone, and somebody is going to have to eat those losses. Simple as that.

• More than one out of every four homes sold in 2005 and 2006 were sold to speculators, and now house prices are at or below 2005 levels. This means that the speculators’ investments are wiped out (and then some, considering transaction costs). Speculator demand is gone, and will not return for many years. Less demand equals lower prices. Simple as that.

• Developers overbuilt the national housing stock by a very large amount, in part to meet the false speculator demand; I calculate somewhere in the vicinity of two to three million excess units. We have too much housing stock, and it will be a minimum of three years before population gains naturally work it off. All things housing-related will be in recession until that oversupply is worked off. Simple as that.

• Even though the subprime foreclosure crisis is much closer to the beginning than the end, already hundreds of billions of dollars of losses have been recorded by small towns in Norway, in state and municipal investment funds, and by institutional money market funds. While big banks have managed to stuff all these investment channels with dodgy mortgage paper, they themselves remain as exposed to real estate loans as they’ve ever been. Truly, there is no historical precedent to inform us to how bad this could get. I estimate somewhere between $1 trillion and $2 trillion in losses, which means that the entire capital of the entire US banking system could be wiped out. This is an issue of solvency, not liquidity, and therefore this is a major crisis that goes far beyond the official actions and statements to date. Simple as that.

• In summary, real estate supply, demand, and price are severely out of whack and can only be fixed by a significant decline in prices, which means that a whole lot of individuals and financial institutions are in trouble as a consequence. It all adds up to one simple conclusion: Banks, pensions, hedge funds, and money market funds will all have to dispose of a whole lot of bad paper. Possibly up to $2 trillion dollars worth, if my calculations are correct, meaning that the potential exists for the entire capital of the US banking system to be wiped out.

Now you have all the information you need to understand why there really are no policy fixes to this mess (e.g. ‘freezing interest rates’), only an inevitable date with lower house prices. If you care to continue, below I provide my supporting data for the above statements.

From a purely logical standpoint, house prices need to fall to match those at the start of the bubble in 2000. Why? Because otherwise we have to believe in The Free Lunch. For The Free Lunch to be true, it must be possible for a person to buy a house, do nothing except sit on a couch drinking beer for the next 5 years, and get rich in the process. Examining 70 past examples of asset bubbles, we find that The Free Lunch has never worked before. It’s not going to work out this time, either.

To illustrate, I put together the chart below by combining data from two government sources, the Census Bureau for income and the OFHEO for housing price gains.

What is immediately obvious is that house prices and income gains have historically tracked each other very, very closely through the entire data series until about 2000, where house prices pull significantly away from income gains. I have marked two historical housing bubbles (1979 and 1989) with arrows, noteworthy because they were well supported by income gains and therefore seem insignificant when viewed on this graph. But that in itself is noteworthy, because, as both homebuilders and house sellers during those periods can attest, it means that even a very slight departure between the blue and the red lines can be quite painful. It also means that we have no historical precedent for the territory in which we currently find ourselves.

So, onto the primary question: “What would be required to bring house prices and income gains back in line?”

The answer to that is either:

• An income gain of 51%
• A decline in house prices of 34%

Of the two, income gains or house price declines, which seems more likely? Before you answer that, you should know that the average income gain over the past 6 years has been 2.3% per year (not inflation-adjusted). At that rate it would take 21 years, or until 2028, to close the gap. In the meantime, house prices would have to remain frozen at today’s prices. In a normal world, we would see a bit of both, with house prices falling and incomes rising to meet somewhere down the road.

However, I expect house prices to do most of the heavy lifting, and I am expecting a decline of even more than 34%, possibly as much as 50%, because of the correlated job losses that will result from the housing wipeout. An outsized proportion of the meager job gains recorded since the recession of 2001 were in some way linked to housing. The ripple effect of job losses will extend far beyond realtors and mortgage brokers, and into window manufacturing, lumber, plumbing fixtures, nail salons, BMW detailing services, and so forth.

My calculations are therefore in rough alignment with those at economy.com:

NEW YORK (Reuters) – Housing markets from Punta Gorda, Florida, to Stockton, California, will crash and suffer price drops of more than 30 percent before the housing crisis is over, a report from Moody’s Economy.com said on Thursday.

On a national level, the housing market recession will continue through early 2009, said the report, co-authored by Mark Zandi, chief economist, and Celia Chen, director of housing economics.

At this particular moment in time, banks are about as heavily exposed to mortgages (as a total percent of assets) as they have ever been. Further, banks are holding an enormous quantity of commercial real estate loans, especially in the rah-rah areas such as Florida, the Southwest, and in California. The FDIC reported last year that more than 50% of all the banks in the southeast and west regions had exposure to commercial real estate loans that exceeded their total capital by 300% or more. Holy smokes!

Here’s how it happens. As the housing bubble takes off, people get into a buying frenzy, while builders get into a building frenzy. Soon enough, the commercial builders get excited and say to themselves “Saaaaay, would you lookit all these houses going up? We better build a few more malls and condos out this way!” They then go to a local or regional bank, who agrees that there’s no possible downside to building more shopping areas and condos, and so they loan huge amounts of money to these developers. When the inevitable bust comes, everybody acts surprised, and the banks go to the FDIC for a bailout. At least, that’s how it usually works. This time, because the amount of excessive building was so over the top and the banks were so unfavorably leveraged, I fully expect the FDIC to be inadequate for the job, which means Congress will have to get involved.

To put it in the simplest of terms, the total amount of bank capital in the entire country is a little over $1.1 trillion, while more than $11 trillion in real estate loans exist, meaning that a 10% to 15% loss on those loans would translate into the complete bankruptcy of the US banking system. What this all means is that we have a crisis of solvency, not liquidity. Currently the Federal Reserve has teamed up with European central banks to provide vast new sources of liquidity (unlimited, really) to the banking system. That is, banks can trade in their piles of dodgy loans for cash for a specified period of time. This gives banks access to cash. However, as currently structured, they have to buy those dodgy loans back at par, at some point in the future. If those loans are bad (which they are), then this maneuver by the Fed simply won’t work. Instead, we need wipe those bad loans out, which means we will lose a financial intuition or two (or thirty) along the way.

It is against this relatively simple backdrop of overly expensive, overbuilt housing that the government recently launched an awful, poorly conceived and named subprime bailout plan named the New Hope Alliance. “Hope?” Well, I suppose since ‘hope’ is what got us into this mess, it makes sense that the government might choose to use ‘hope’ to get us back out of it. “Hope” is not a sound strategy, which makes it a natural fit for the current housing crisis.

Since this new plan of Hope will not prevent house prices from falling, it is pretty much dead on arrival, at least as far as actually helping to solve the primary problem. The primary problem is how a lack of housing affordability will lead to a decline in prices, as brilliantly captured by this industry insider:

One final thought. How can any of this get repaired unless home values stabilize? And how will that happen? In Northern California, a household income of $90,000 per year could legitimately pay the minimum monthly payment on an Option ARM on a million home for the past several years. Most Option ARMs allowed zero to 5% down. Therefore, given the average income of the Bay Area, most families could buy that million dollar home. A home seller had a vast pool of available buyers.

Now, with all the exotic programs gone, a household income of $175,000 is needed to buy that same home, which is about 10% of the Bay Area households. And inventories are up 500%. So, in a nutshell, we have 90% fewer qualified buyers for five times the number of homes. To get housing moving again in Northern California, either all the exotic programs must come back, everyone must get a 100% raise, or home prices have to fall 50%. None, except the last, sound remotely possible.

Wow. A tenfold reduction in buyers and a fivefold increase in house supply. There is only one way for that to resolve, and that is through reduced prices.

As presented, the purpose of the program of Hope was to help prevent or delay foreclosures – as if they were the problem. Unfortunately, foreclosures are merely the symptom. The cause is the fact that people bought overpriced houses they couldn’t afford, while hoping that rising house prices would provide a ready source of cashout mortgage money. House prices are no longer rising, they are falling. That is the root of the current crisis, and this most recent government fix does absolutely nothing about it. So we can score the plan a zero on that front. Where the New Hope Alliance really breaks down and becomes a solid negative, though, is in how it undermines confidence in the sanctity of US contract law.

Dec. 7 (Bloomberg) — President George W. Bush’s plan to freeze interest rates on some subprime mortgages may prove to be a cure that breeds another disease.

“If the government goes in and changes contracts it will definitely have a chilling effect on the securitization of mortgages,” said Milton Ezrati, senior economist and market strategist at Lord Abbett & Co. in Jersey City, New Jersey, which oversees $120 billion in assets.

“When the government comes in and says you have contracted to have this arrangement and you can no longer have it, I think it opens the door for lawsuits.”

What’s being said here is that enforceable contracts are a vital component of the US financial industry. Heck, of the entire US way of life, since it is the trust foreigners place in our ‘system’ that gives them the confidence to loan us back the money we spent on their products. Without the trust that a given contract will be collectible, then those contracts either get written at a much higher price to compensate for the risk of not being paid, or they do not get written at all. So if part of the subprime crisis is reduced house prices resulting from reduced demand, would we expect a serious disturbance in mortgage contract enforceability to result in more or fewer mortgages written? Who will be able to afford significantly higher mortgage payments? Who will issue them? Who would buy them and hold them?

This is an important concept, because a huge prop to our economy over the past decade has been the flood of foreign funds that allowed us to enjoy low interest rates even as our trade deficit plumbed new depths. Part of the reason foreigners felt comfortable, if not confident, investing in the US, is that our contract laws and supporting legal infrastructure are exceptionally strong in protecting investors’ claims. Foreign investors bought many packaged mortgage products from Wall Street banks at a price based on expected returns that included future rate adjustments. That’s now at risk. This would be no different than your boss telling you that next year’s 5% raise, which you are counting on and have in writing, is actually going to be 0% – but could you please loan him another few hundred bucks?

So what was the purpose of the New Hope deal? Simple. It’s meant to bail out big banks and mortgage companies who simply do not wish to recognize the actual value of the mortgages they hold at current market prices. When houses enter foreclosure and then get sold, a price discovery event happens that ‘hits the books’ of the financial institution involved.

Here’s the best explanation of the week, courtesy of the San Francisco Gate:

Now, just unveiled Thursday, comes the “freeze,” the brainchild of Treasury Secretary Henry Paulson. It sounds good: For five years, mortgage lenders will freeze interest rates on a limited number of “teaser” subprime loans. Other homeowners facing foreclosure will be offered assistance from the Federal Housing Administration.

But unfortunately, the “freeze” is just another fraud – and like the other bailout proposals, it has nothing to do with U.S. house prices, with “working families,” keeping people in their homes or any of that nonsense.

The sole goal of the freeze is to prevent owners of mortgage-backed securities, many of them foreigners, from suing U.S. banks and forcing them to buy back worthless mortgage securities at face value – right now almost 10 times their market worth.

The ticking time bomb in the U.S. banking system is not resetting subprime mortgage rates. The real problem is the contractual ability of investors in mortgage bonds to require banks to buy back the loans at face value if there was fraud in the origination process.

And, to be sure, fraud is everywhere. It’s in the loan application documents, and it’s in the appraisals. There are e-mails and memos floating around showing that many people in banks, investment banks and appraisal companies – all the way up to senior management – knew about it.

However, this was actually the third bailout/remedy by the government. There were already two past bailouts that were simply not well publicized, and those are the ones to which you should be paying attention, because they involve vast gobs of public money.

The first was this eye-popping advance by the Federal Home Loan Bank system (FHLB) to the overall mortgage market in October:

NEW YORK (Fortune) — As the credit crunch hit hard in the third quarter, most banks were forced to cut back their lending. But one group of banks increased lending by an incredible $182 billion. Who were these deep-pocketed lenders — and are they capable of handling such a large rise in loans, especially at a time when credit markets are unsettled and mortgage defaults on the rise?

The lenders in question were the 12 Federal Home Loan Banks, set up under a government charter during the Great Depression to provide support to the housing market by advancing funds to over 8000 member banks that make mortgages. In the third quarter, loans to member banks, also called ‘advances,’ totaled $822 billion, a 28% leap from $640 billion at the end of June.

This is a staggering amount of mortgage-buying activity. Where did this $182 billion come from? Did the FHLB just happen to have nearly $200 billion lying around? If not, how was it that the FHLB was able to find buyers for mortgage paper at a time when the mortgage markets were more or less frozen? What sorts of mortgages were purchased? Were they high grade or the subbiest of the subprime? In point of fact, it is a bailout, plain and simple. It is an egregious use of public monies that was not voted on, but is guaranteed, by the public. But the FHLB fiduciary stewards did not stop there. They went further, by advancing a stunning $51 billion to Countrywide Financial Corp, recently voted as most likely to fail by its classmates. How bad does this move smell? Bad enough for a US Senator to notice.

In a letter to the regulator of the Federal Home Loan Bank system, Sen. Charles Schumer said Countrywide, the largest U.S. mortgage lender, may be abusing the program.

At the end of September, Countrywide had borrowed $51.1 billion from the Federal Home Loan Bank system — a government-sponsored program.

“Countrywide is treating the Federal Home Loan Bank system like its personal ATM,” Schumer, a New York Democrat who heads the housing panel of the Senate Banking Committee, said in the letter. “At a time when Countrywide’s mortgage portfolio is deteriorating drastically, FHLB’s exposure to Countrywide poses an unreasonable risk.”

So what we have here is a case where the fiscal and monetary authorities are desperately shoving enormous amounts of money (and new policy) into a very stressed and ultimately unsavable situation. On a personal level, this bothers me a great deal. Partly because I have been prudent and saved and rented while waiting for the silliness to end, yet the very first response of my government is to punish me and reward the imprudent. But mainly because big bailouts doubly punish us all; first, by the inevitable inflation that results, and second, because our future options will be diminished by debt.

What needs to happen is very clear. The bad debts need to be wiped out. The mal-investments need to be written off.

So now that we know this thing is going to implode, the only relevant part left is to ask the questions, ‘How am I exposed, and how can I avoid having the bag passed to me?’

Here I will revert to my past recommendations:

• Get out of debt.
• Be very careful about where you keep your money. Already several high profile money market funds have suffered losses and closed down, returning less than the deposit amount to their clients. Expect this to get worse.
• The dollar is in a precarious situation, especially if the Fed begins buying up bad debt for paper money in a big way. Gold. Silver. Top off your oil tank at home.
• Be aware that pensions, municipal investment accounts, and even your bank are all highly likely to be exposed to the leveraged losses that are now upon us. If you are exposed here, figure out how not to be.
• If you are a citizen of a country whose central bank insists on bailing out the monied elite (big banks) with your current and/or future tax dollars, use every possible avenue available to legally apply pressure upon your political representatives to prevent this from happening.

Now, go back to the top and re-read the quote by Ludwig Von Mises. It neatly describes everything you need to know. The preceding 20 paragraphs were my way of illustrating that there will be no voluntary abandonment of credit expansion. In fact, the data shows that our fiscal and monetary authorities are fighting that possible outcome tooth and nail. That leaves the dollar exposed to the risk of losing its reserve currency status as it heads towards international pariah status. Not that there’s anything wrong with that…unless you think we might, someday, need to import oil, or something made out of plastic, or electronics, or underwear, or …

Friday, October 19, 2007

Executive Summary

• It’s not over; the trouble has only just begun
• Look out – inflation is coming!
• The Fed cuts rates, bails out big banks
• Inflation set to rip
• Oil
• Oh, the dollar!
• August TIC data and the dollar
• Bank runs in the US and England, and a failure in Germany
• Uh oh – derivatives

Last time I wrote that the game is afoot. Boy, is it ever. This past month, while the stock market bizarrely hovered near all-time highs (more on that later), the credit markets slipped into even deeper disarray (an understatement) and commodities became pricier (a severe understatement). As always, my primary goal here is to help you understand what’s going on, and that it’s all a matter of policy, not accident. Bad policy, perhaps, but policy nonetheless. My secondary goal is to connect the dots and provide you with a source of news aggregation you can trust.

To begin, let’s review my most recent recommendations from my August 30th newsletter:

• Get out of debt, especially variable rate debt such as credit cards and any adjustable rate loans. If I’m right about the dollar, vastly higher interest rates are on the way.
• Get some exposure to assets that tend to vary inversely with the dollar. Gold, silver, oil, natural gas, and foreign currencies are my favorites.
• Build up some cash reserves (savings) to get you through a potentially severe recession.
• Be prepared for a serious decline in equity and bond values.

I stand by all of these and will try to make the case below that now is a time calling for additional fiscal prudence and caution.

Unfortunately, there’s so much juicy stuff going on right now that I am forced to limit this missive to a few of the tastier bits.

For starters, one of the central economic/investing conundrums seems to have been settled. Since I started giving The End of Money talks in November of 2004, I have been on the fence as to whether deflation (brought on by loan destruction first centered on residential real estate, next on commercial real estate, and finally on corporate bond defaults) or inflation would dominate our economic future (never underestimate what a determined government with a printing press can do, says Bernanke). Okay, I admit that I was not literally fifty-fifty ‘on the fence,’ but more like seventy-thirty, tipped in favor of inflation. So that’s central theme #1 of this article: Inflation now seems to have the upper hand.

Further, to those who’ve come to my seminars over the past three years, you know that I have been consistently harping on the dangers posed by a housing bubble, which bred with recklessly reduced lending standards to produce a toxic offspring of derivative products, which are now running about like feral children on a Halloween night. These past few weeks we’ve seen the first warning signs that the big banks are seriously exposed to these derivative bombs and already lobbying for a taxpayer bailout. So that’s theme #2: A housing-decline-fueled derivative crisis is approaching.

So, let’s get started with the rate cuts by the Fed.

On August 16th, when the stock market was taking a small tumble, the Fed overreacted and cut one of their two key interest rates by a half a point, or 0.50%. This cut was in the so-called “discount window” rate, but insiders call it the “penalty window,” because only dead-beat banks that can’t otherwise borrow from other banks use it. While this may seem like an innocuous move to you (I can see you shrugging and yawning), it was rightly read by insiders as a sign that the Fed was deeply worried about the credit markets in general (probably about a specific mortgage related bank in particular), and that it was going to continue Al Greenspan’s policy of bailing out poorly-run banks. The second rate cut on September 18th (actually a pair to both the Fed funds and discount window rates) just confirmed this view and added more fuel to the fire.

Once we strip away all the gobbledy-gook, what does a ‘bailout’ mean? It means that the Fed is determined to supply whatever liquidity is necessary to prevent any market declines from taking hold. And what does this mean? It means inflation. Lots of it.

Don’t believe me? Then take a look at this chart (below) of commodity prices, and take a nice close look at what happened there on August 16th (blue arrow) following the rate cut.

Holy smokes! That’s a 14% gain in commodity prices in only 2 months! Oil is making the headlines, but literally everything is exploding in price – corn, wheat, zinc, gold, you name it. At this same rate, we can expect a 119% increase in commodities over the next year.

Or, as a Bloomberg article put it, September saw the biggest monthly gain in commodity prices in 32 years, leading one investment advisor to sum it all up thus:

[quote]”The Fed has signaled pretty clearly that they will answer the problem of a slowing economy with greater liquidity,” said Chip Hanlon, who manages $1 billion at Delta Global Advisors Inc. in Huntington Beach, California. “We’re in a bullish phase for commodities.” [/quote]

That’s euphemistic trader-speak meaning, “Commodities are gonna rip! Everybody who lives on a fixed income is in real, deep trouble.”

Speaking of which, the just-announced Social Security COLA adjustment for this year is a measly 2.3%, the smallest since 2003. (Hey! that’s $24 a month, on average!) As you know, I am highly critical of government inflation reporting (I still can’t decide, is it merely negligent, or is it overtly fraudulent?), but this 2.3% number just takes the cake. I guess I’m leaning towards fraud now, because there isn’t a single sentient person alive who can argue that inflation over the past 12 months was 2.3%. Why does the government do this? So it can redirect money that would go towards Social Security beneficiaries to other endeavors.

Hopefully, nobody on a fixed income needs to heat their house with oil, because oil is up 29% in the past 2 months (see chart below – can you spot August 16th???). Ouch.

Of course, everybody from the middle class on down already knows that inflation is much, much higher than what our government admits. Here’s an AP article that came out this morning (10-19-07):

What used to last four days might last half that long now. Pay the gas bill, but skip breakfast. Eat less for lunch so the kids can have a healthy dinner.

“It even costs more to get the basics like soap and laundry detergent,” said Michelle Grassia, who lives with her husband and three teenage children in the Bedford-Stuyvesant section of Brooklyn, New York.

Her husband’s check from his job at a grocery store used to last four days. “Now, it lasts only two,” she said.

A paycheck that used to last four days now only lasts two? Does that sound like “2.3%” to you? No, obviously not, and the economic disconnect has never been more profound between the distorted version of reality that is being peddled by Washington DC and our daily shopping reality. Heck, even Newsweek is saying “There’s No Inflation (If you Ignore Facts).” The charade is pretty far gone by the time Newsweek is calling shenanigans on the government.

How sure am I that the Fed & US government have charted a course of dollar abandonment and reckless inflation? Very.

Take a look at this table showing the percentage gains in our money supply. Note that this is a table of something called “MZM” (Money of Zero Maturity), and it’s the best remaining measure, ever since the Fed scrapped reporting of the much more inclusive M3 measure, the most complete indicator of how much money was being created out of thin air. However, MZM is not a terrible measure, and it’s all we’ve officially got, so we’ll use it even though it misses about 35% of the total amount of money created.

Holy exponential expansion, Batman! Twenty five point three percent??? You might have expected that all the credit market woes would have stalled money creation, but instead, the Fed and its crony banks have somehow engineered a remarkable expansion of our money supply that is running at a better than 25% annualized rate over the last four weeks. If that rate continues, the Rule of 70 tells us that the total money supply will double in about three years. Let’s see here….if I compare that against economic growth…it means that there is 10 times more money being created than economic growth.

As you may remember from our seminar series, money created in surplus of economic growth leads to inflation. It always does, and it always will. If you are still uncertain, go back and take another look at the commodity chart above and re-read the anecdotes from the linked article.

Not to be outdone by the Fed, the US government, having burned through the last $800 billion debt expansion in record time, recently raised the debt ceiling by another by $850 billion (to $9.815 trillion, with a “t”). For those keeping score at home, US government debt has expanded by 50% in only ten years. All of this debt represents hot new money that can only lead to even more inflation.

At any rate, to make a long story endless, the Fed has tipped its hand and has set us all on a course that favors inflation, but risks hyperinflation and the possible destruction of the dollar as an accepted international monetary unit. They did this because they fear the alternative even more.

The recommendations I have been giving out for the past three years stand – every one of ’em. While it may seem like I really hit a few out of the park in my prognostications, all I did was observe that 3,800 paper currencies have been destroyed by virtually identical mechanisms. So I simply applied those histories to the situation in the US and predicted that our own leaders would suffer from the same weaknesses as other humans throughout history.

If you are not extremely rich, I sympathize, because these next few years are going to be difficult. You see, inflation is an unequal-opportunity destroyer. In the short term, inflation dramatically favors the already rich but is devastating to everyone else. In the long term, severe inflation is bad for everyone, because it erodes the entire social and economic framework of a country. However, “short-term-itis” rules the roost down in the halls of power, so I do not expect to see a sudden outbreak of fiscal or monetary sanity anytime soon. For those in power, the path of least resistance is one that attempts to preserve the status quo and provides maximum short-term benefits to those already in power. So, best get ready for some rip-roaring inflation.

Dollar Daze

The dollar is hitting 30-year lows against the currencies of our trading partners. Why has the dollar been so weak lately? Besides the fact that we’re printing massive, reckless quantities of them, you mean? Well, the actual mechanism by which the dollar rises or falls is really simple. It all depends on how many dollars are being bought vs. being sold, across, and outside of, our borders. One important report, the Treasury International Capital Flows report, which measures net foreign purchases of US paper assets, had a positively dreadful showing in August, indicating a net decline of $163 billion in US capital flows. This meant that foreigners sold a whopping $163 billion of US assets in a single month! And when foreigners sell US assets that are denominated in dollars, they then need to sell those US dollars for their native currency so they can bring their cash home. In short, a sell-off of US assets by foreigners typically means a decline in the dollar.

Which foreigners? Of particular note, Japan and China both cut their holdings of US Treasuries at the fastest pace in the last five years. Whoops.

At any rate, this report tells us that foreigners are not tip-toeing away from our markets, they are stampeding. Oh, to be a fly on the wall at the Fed, to know what’s really going on behind the scenes. Of course, August could have been anomalous, so we’ll be keeping a very close eye on the September figures due to be released November 16th. If that is also bad…look out below. And be sure to be holding some of your assets in foreign currencies, gold, and/or oil to protect against further dollar declines.

Bank Runs

You’ve probably heard about the bank runs that happened in the US and the UK. What? You didn’t? This means you don’t receive any foreign newspapers, because this was huge news and has been on the front page of the Financial Times (UK) for the past several weeks. For some reason, this news was minimized over here in the US.

Here’s a breakdown of the past month: First, there was a run on Countrywide Bank in Los Angeles. Then, a major run on Northern Rock in the UK, complete with large queues of people desperately waiting to retrieve their money from the bank. Next, a major German bank completely failed and had to be taken over. Then the FDIC seized and shut down Netbank in the US.

What was the common element for all these banks? They were all in trouble because of excessive exposure to mortgage defaults.

I raise the issue of bank runs because I see a very strong possibility of the emerging mortgage derivative disaster crippling quite a few US banks – possibly more than can be serviced by a completely inadequate FDIC reserve of ~$50 billion. It is my suggestion that you spend a bit of time to be sure your bank is highly rated and somewhat insulated from this whole mess. You can start by following this link to thestreet.com, selecting the Banks & Thrifts tab, entering your bank(s), and then checking out how it/they stand. I personally would not have anything to do with a bank with less than a “B” rating. A surprising number of banks are rated B- or lower. And, of course, do not keep more than $100,000 in any one bank account, ever.

If you have the time, this is an excellent article by Jon Markham at MSN that details just how large and exceptional the risks are to the entire financial system. After reading this, I became even more convinced of the possibility of a major financial catastrophe that may completely shutter whole portions of our banking and insurance industries. To be clear, I am not saying it is going to happen, I am saying the risk is there and has been growing larger, not smaller, over the past several months. Like a prudent person who carries fire insurance on their physical dwelling, you need to consider taking out insurance on your financial dwelling. The recommendations above would be a good set of first steps.

---

Oh, woe is me. I planned to keep this short, and I failed. Worse, I didn’t even get to the most recent housing data, which is both breathtaking and important. And there is more in the news in support of the notion that Peak Oil is already upon us. I will reserve both of these topics for special reports that will be coming out shortly.

Wednesday, August 8, 2007

First, a warning about the dollar. As you know, I’ve been keeping a close eye on the US dollar and have been very concerned over the years that the dollar would someday steeply decline against foreign currencies. In fact, the dollar has been steadily eroding in value for since 2002, and it is now poised at a critical spot where there are really only two choices: a sustained rally or a serious drop.

The dollar chart below shows the monthly ‘value’ of the dollar as measured against a basket of foreign currencies. The red line shows that the dollar is now perched at a level last seen in 2005 and (off the chart) in 1992.

If the dollar breaks through this level of ~ 80 on this chart, then it’s anybody’s guess as to how much farther it would fall after that.

In truth, the dollar should be a lot lower than even this dismal level right now, but foreign central banks, notably Japan and China, have been working very hard to keep the dollar propped up over the past few years. If this foreign propping should ever end, we’d immediately experience two things, a rapidly falling dollar (leading to rapidly rising import prices, notably for crude oil) and sharply higher interest rates (because the Chinese hold their dollars in US bonds, which, when sold, cause interest rates to rise).

Higher oil and steeper interest rates? Crikey!

That’s a certain recipe for unpleasantness in the US economy. So it is of critical importance that dollar support be maintained. However, China is now making threatening noises in this regard, warning the US that our insistence on a higher Chinese yuan is unwelcome:

The Chinese government has begun a concerted campaign of economic threats against the United States, hinting that it may liquidate its vast holding of US treasuries if Washington imposes trade sanctions to force a yuan revaluation.

Two officials at leading Communist Party bodies have given interviews in recent days warning – for the first time – that Beijing may use its $1.33 trillion (£658bn) of foreign reserves as a political weapon to counter pressure from the US Congress.

There may be a lot of compelling reasons why China would not want to follow up on this threat, but it’s worth your time to consider what you’d do if it did. While there’s no "one size fits all" solution, a few basic steps to consider would be:

• Get out of debt, especially variable rate debt such as credit cards and any adjustable rate loans.
• Get some exposure to assets that tend to vary inversely with the dollar. Gold, silver, oil, natural gas, and foreign currencies are my favorites.
• Build up some cash reserves (savings) to get you through a potentially severe recession that could be brought about by high(er) interest rates.
• Be prepared for a serious decline in equity and bond values.

On that last point (#4), there are some other reasons to be concerned right now. It turns out that the US credit markets, principally for mortgage debt, are undergoing some pretty dramatic convulsions, and while I can’t say for sure how bad it will all be, I can tell you that fear has finally returned to our capital markets after a particularly long absence.

However, should the dollar start to break down in a serious way, I don’t know what else to counsel besides "Stay alert!" It is entirely unknowable to me how our highly leveraged house-of-cards economy would actually behave in a dollar crisis, but I think it’s prudent to question whether all of our financial institutions would remain solvent.

As you know, I’ve always been deeply suspicious of the modern financial alchemy that has allowed Wall Street to skim record profits off of dodgy pools of repackaged mortgage loans while simultaneously claiming to have reduced the risk of those instruments. Huh? How does one start with a pool of bad credit risk loans (many of them fraudulent ‘liar loans’), strip out a whole bunch of money, and end up with a safer product? I don’t believe it’s any more complicated than that, and I’ve been saying so for several years.

And, in truth, this is now pretty much obvious to everyone in the financial industry as well. Paul Muolo, executive editor and associate publisher of National Mortgage News, had this to say:

"I’ll put it bluntly: if you operate a non-depository mortgage firm (lender or servicer) and don’t have a deep-pocketed parent or hedge fund as a sugar daddy you’re likely to be out of business by year-end, probably sooner.

In the 20-plus years that I’ve been covering residential finance I haven’t seen a financial meltdown this swift since the S&L crisis of the mid-to-late 1980s. One subprime executive who closed his shop a few months ago told me, "This is a liquidity crunch the likes I have never seen."

So industry insiders are publicly saying that this is the worst financial crisis to hit since the S&L crisis. Of course, that is the perfect analogy, because the S&L crisis was precipitated by the easing of lending standards that morphed into the usual mélange of bad investments and outright fraud. Same as our current crisis.

Because of this similarity, what should you, the beleaguered taxpayer, be on the lookout for? A bailout, of course.

Looks like we won’t have to wait very long for the government officials to begin to look for ways to "help people keep their houses," which is DC code-speak for "help my uber-rich banking buddies avoid paying for their mistakes."

Here’s an email from the CEO of IndyMac, the second largest independent mortgage lender, that came out last week:

Unfortunately, the private secondary markets (excluding the GSEs and Ginnie Mae) continue to remain very panicked and illiquid. By way of example, it is currently difficult, at present, to trade even the AAA bond on any private MBS transaction.

In addition, to give you an idea as to how unprecedented this market has become…I received a call from U.S. Senator Dodd this morning who seeking an understanding of "what is really going on and how can I and Congress help?"

I also have talked to the Chairman of Fannie Mae this morning and have traded calls with the Chairman of Freddie Mac (Fannie Mae’s Chairman telling me that they are "prepared to step up and help the industry").

The interesting part is to hear this kind of talk already before the crisis has even really begun. Over the next 12-145 months, more than $1.5 trillion of additional subprime mortgages will be resetting to higher rates, and that’s when I expect the crisis to really get underway. Still, I have to wonder how many more US tax dollars are going to be wasted trying to help people keep houses they can’t afford (which many lied to get into) and thereby bail out a mortgage and banking industry that would prefer not to have to give back any of the obscene profits they made off of this racket.

I mean, what, with bridges crumbling, a waste-water infrastructure that scores a D-minus, two tragically expensive wars, and a looming pension crisis of biblical proportions, it’s not like we really can afford to bail out the rich, the greedy, and the stupid. I say, let them live with the consequences of their decisions. Call it tuition or something.

Besides, a bailout will not help at all. The main problem is that house prices rose too far away from median incomes and no amount of mortgage assistance is going to remedy that problem. Median house prices need to fall anywhere from 10% to 60%, depending on the market.

My prediction is that this will happen over the next 3-4 years, no matter what sort of government intervention schemes are hatched.

In the meantime, I’m going to sit tight, stay alert, and ponder my options.

Thursday, March 15, 2007

Prepare to be shocked.

The US is insolvent. There is simply no way for our national bills to be paid under current levels of taxation and promised benefits. Our combined federal deficits now total more than 400% of GDP.

That is the conclusion of a recent Treasury/OMB report entitled Financial Report of the United States Government that was quietly slipped out on a Friday (12/15/06), deep in the holiday season, with little fanfare.

Sometimes I wonder why the Treasury Department doesn’t just pay somebody to come in at 4:30 am on Christmas morning to release the report. Additionally, I’ve yet to read a single account of this report in any of the major news media outlets, but that is another matter.

But, hey, I understand. A report this bad requires all the muffling it can get.

In his accompanying statement to the report, David Walker, Comptroller of the US, warmed up his audience by stating that the GAO had found so many significant material deficiencies in the government’s accounting systems that the GAO was "unable to express an opinion" on the financial statements. Ha ha! He really knows how to play an audience!

In accounting parlance, that’s the same as telling your spouse, "Our checkbook is such an out-of-control mess, I can’t tell if we’re broke or rich!" The next time you have an unexplained rash of checking withdrawals from that fishing trip with your buddies, just tell her that you are "unable to express an opinion" and see how that flies. Let us know how it goes!

Then Walker went on to deliver the really bad news:

Despite improvement in both the fiscal year 2006 reported net operating cost and the cash-based budget deficit, the U.S. government’s total reported liabilities, net social insurance commitments, and other fiscal exposures continue to grow and now total approximately $50 trillion, representing approximately four times the Nation’s total output (GDP) in fiscal year 2006, up from about $20 trillion, or two times GDP in fiscal year 2000.

As this long-term fiscal imbalance continues to grow, the retirement of the "baby boom" generation is closer to becoming a reality with the first wave of boomers eligible for early retirement under Social Security in 2008.

Given these and other factors, it seems clear that the nation’s current fiscal path is unsustainable and that tough choices by the President and the Congress are necessary in order to address the nation’s large and growing long-term fiscal imbalance.

Wow! I know David Walker has been vocal lately about his concern over our economic future, but it seems almost impossible to ignore the implications of his statements above. From $20 trillion in fiscal exposures in 2000 to over $50 trillion in only six years? What shall we do for an encore, shoot for $100 trillion?

And how about the fact that boomers begin retiring in 2008…that always seemed to be waaaay out in the future. However, beginning January 1st we can start referring to 2008 as ‘next year’ instead of ‘some point in the future too distant to get concerned about now.’ Our economic problems need to be classified as growing, imminent, and unsustainable.

And let me clarify something. The $53 trillion shortfall is expressed as a ‘net present value.’ That means that in order to make the shortfall disappear, we would have to have that amount of cash in the bank – today – earning interest (the GAO uses 5.7% & 5.8% as the assumed long-term rate of return). I’ll say it again – $53 trillion, in the bank, today. Heck, I don’t even know how much a trillion is, let alone fifty-three of ’em.

And next year we’d have to put even more into this mythical interest-bearing account, simply because we didn’t collect any interest on money we didn’t put in the bank account this year. For the record, 5.7% on $53 trillion is a bit more than $3 trillion dollars, so you can see how the math is working against us here. This means the deficit will swell by at least another $3 trillion, plus whatever other shortfalls the government can rack up in the meantime. So call it another $4 trillion as an early guess for next year.

Given how studiously our nation is avoiding this topic, both in the major media outlets and during our last election cycle, I sometimes feel as if I live in a small mountain town that has decided to ignore an avalanche, which has already let loose above, in favor of holding the annual kindergarten ski sale.

The Treasury Department soft-pedaled the whole unsustainable gigantic deficit thingy in last year’s report, but they have taken a quite different approach this year. From page 10 of the report:

The net social insurance responsibilities scheduled benefits in excess of estimated revenues) indicate that those programs are on an unsustainable fiscal path and difficult choices will be necessary in order to address their large and growing long-term fiscal imbalance.

Delay is costly and choices will be more difficult as the retirement of the ‘baby boom’ gets closer to becoming a reality with the first wave of boomers eligible for retirement under Social Security in 2008.

I don’t know how that could be any clearer. The US Treasury Department has issued a public report warning that we are on an unsustainable path, and that we face difficult choices that will only become more costly the longer we delay.

Perhaps the reason US bonds and the dollar have held up so well is that we are far from alone in our predicament. In a recent article detailing why the UK Pound Sterling may fall, we read this horrifying evidence:

Officially, [UK] public sector net debt stands at £486.7bn. That’s equal to US$953.9bn and represents a little under 38% of annual GDP. Add the state’s "off balance sheet" debt, however – including its pension promises to state-paid employees – and the total shoots nearly three times higher. Research by the Centre for Policy Studies in London says it would put UK government deficits at a staggering 103% of GDP.

If we perform the same calculations for the US, however, we find that the official debt stands at $8.507 trillion or 65% of (nominal) GDP, but when we add in our "off balance sheet" items, the national debt stands at $53 trillion or 403% of GDP.

Now that’s horrifying. Staggering. Whatever you wish to call it. More than four hundred percent of GDP(!). And that’s just at the federal level. We could easily make this story a bit more ominous by including state, municipal, and corporate shortfalls. But let’s not do that.

Here’s what the federal shortfall means in the simplest terms:

There is no way to ‘grow out of this problem.’

What really jumps out is that the US financial position has deteriorated by over $22 trillion in only 4 years and $4.5 trillion in the last 12 months (see table below, from page 10 of the report).

The problem did not ‘get better’ as a result of the excellent economic growth over the past 3 years, but, rather, got worse, and is apparently accelerating to the downside. Any economic weakness will only exacerbate the problem. You should be aware that the budgetary assumptions of the US government are for greater than 5% nominal GDP growth through at least 2011. In other words, because no economic weakness is included in the deficit projections below, $53 trillion could be on the low side. Further, none of the long-term costs associated with the Iraq and Afghanistan wars are factored in any of the numbers presented (thought to be upwards of $2 trillion more).

 

 

The future will be defined by lowered standards of living.

As Lawrence Kotlikoff pointed out in his paper titled "Is the US Bankrupt?" posted to the St. Louis Federal Reserve website, the insolvency of the US will minimally require some combination of lowered entitlement payouts and higher taxes. Both of those represent less money in the taxpayer’s pockets, and the last time I checked, less money meant a lower standard of living.

Every government facing this position has opted to "print its way out of trouble."

That’s a historical fac,tand our country shows no indications, unfortunately, of possessing the unique brand of political courage required to take a different route. In the simplest terms, this means you and I will face a future of uncomfortably high inflation, possibly hyperinflation, if the US dollar loses its reserve currency status somewhere along the way.

Of course, it is impossible to print our way out of this particular pickle, because printing money is inflationary and is therefore a ‘hidden tax’ on everyone. What is the difference between having half of your money directly taken (taxed) by the government and having half of its value disappear due to inflation?

Nothing.

Except that raising taxes is political suicide, while the overprinting of money as the cause of inflation is, conveniently, never discussed by the US financial mainstream press (for some reason) and therefore goes undetected by a majority of people as a deliberate matter of policy. Ergo, we will get all manner of government monetary and fiscal excess, but carefully disguised as bailouts and deficit spending.

Unfortunately, all that printing can ever realistically accomplish is the preservation of a few DC jobs and the decimation of the middle and lower classes.

In summary, I am wondering how long we can pretend this problem does not exist? How long can we continue to buy stocks, flip houses, forget to save, pile up debt, import Chinese made goods, and export debt? Are these useful activities to perform while there’s an economic avalanche bearing down upon us?

Unfortunately, I only know that hoping a significant and mounting problem will go away is not a winning strategy.

I know that we, as a nation, owe it to ourselves to have the hard conversation about our financial future sooner rather than later. And I suspect that conversation will have to begin right here, between you and me, because I cannot detect even the faintest glimmer that our current crop of leaders can distinguish between urgent and expedient.

What we need is a good, old-fashioned grassroots campaign.

In the meantime, I simply do not know of any way to fully protect oneself against the economic ravages resulting from poorly managed monetary and fiscal institutions. For what it’s worth, I am heavily invested in gold and silver and will remain that way until the aforementioned institutions choose to confront "what is" rather than "what’s expedient." This could be a very long-term investment.

Are you shocked?