Looking around at the economic and financial situation, I am drawn into making further analysis and comment based on the all the reading I have done on the topic as of late. So kind of wrapping up all this into a general piece of scribe, I decided that it would be more coherent if I broke things up into categories.
What I know (a.k.a. things I am pretty certain about):
What I know (a.k.a. things I am pretty certain about):
- We are just into the beginning of the credit crunch and the looming credit crisis. The sub prime mortgage market may only be the tip of the iceberg. There are major issues around the corner involving the solvency of monoline bond insurers, a potential cascade of muni-bond defaults, counterparty risk with credit default swaps, and other bad loans on the balance sheets of banks that have not been marked to market.
- The bond insurers and rating agencies made fundamental errors in judging the risk of these mortgages. Credit standards in the past few years have been so lax that there was in the sub prime arena, no real effort to have collateral or prove ability to pay. When these crappy mortgages (which coincidently, had high degrees of fraud embedded in them, whether it be on the applicant or the mortgage brokers who initiated them) were securitized, the bond insurers took the money to guarantee them and the rating agencies gave those tranches a AAA rating.
- The rating agencies and insurers made, in my opinion a fundamental error in behavior: they believed that homeowners would do what they traditionally do and pay the mortgage before anything else. However, the psychology of the home buyers in this bubble behaved differently (albeit rationally) than homeowners in the past. Traditionally, homeowners had put in a significant amount of money down in a purchase of a home (15-20%); with that amount of equity in a home, there was downside cushion for the lender, and the incentive for the borrower to continue to make payments, less they lose what equity they have in their home. Plus, there was a moral incentive to pay the mortgage, as there has been traditionally a shame factor in losing one's home in foreclosure. However, that sense of shame in society is well gone, and beyond the scope of this piece. The key point is, though, that a borrower has little economic incentive to continue to throw money into a mortgage when there is negative equity in the house. Add the fact that for most states, mortgages are non-recourse loans, which means in the event of default, the lender cannot sue the borrower for any deficiency. Thus the increase of jingle mail homes, where borrowers are just mailing in the keys to the house and walking away. Outside of their credit rating taking a bath, there is no real cost for borrowers to do this.
- The bubble of easy credit fueled housing is starting to cascade through the entire financial system. The municipal bond market is now looking at a spate of defaults. First, the bond insurers are teetering on the brink of collapse from the CDOs they guaranteed, and now the muni bonds they have insured have problems. Many local governments, whose coffers were flush with cash from inflated property taxes and developer fees, now are in a cash bind with regards to all the bonds they issued during the fat times. Some localities will cut spending on services and other items and ensure that they make their loan payments on time. However, some localities will rather default on their debts than make the cuts in services necessary. Bloomberg reported that Vallejo, California is looking at defaulting on its debts. This is just the tip of the iceberg, as more and more localities will be hit with declining property tax bases.
- Defaults in auto loans and credit cards are increasing sharply as well, but nobody really knows how much bad credit card debt there is out there.
- This is not just an American problem. Britain, Australia, Western and Eastern Europe have similar issues with their housing markets and the debt that is financing it. The credit crunch is much more global than it has been in prior time.
- So, who can we blame? Predatory lenders? Greedy real estate speculators? Well, yes, and yes. But if one person, overall, had to have this simmering crisis pinned on their chest, it is none other than Alan Greenspan. The Fed has implemented a massive monetary expansion since the mid 1990s. It has manifested itself in many ways during this time. It first fueled a capex (capital expenditure) bubble in the mid-1990's, which then gravitated to financial assets (i.e. technology stocks) later on. This excess money in the capex bubble led to deflationary pressures as companies kept high production volumes to cover the fixed charges. The excess money in the economy kept interest rates artificially low, with inflation a non-factor with China and other developing economies tempering those pressures. Then September 11th punctured the tech bubble, and it looked like that saner monetary policies would prevail: that there would be sufficient liquidity to provide an orderly liquidation of bad stock positions, increase in margin requirements, and then a reduction in the money supply to allow the economy to de-leverage from its current high-debt position. Alas, Greenspan and the Federal Reserve pumped more money into the system, and the reflation has resulted in a debased U.S. dollar, inflation, and a housing bubble from easy credit.
- Now Bernake and company are trying one more kick at the can with pumping even more liquidity into the economy. The Federal Reserve has abandoned any pretense of fighting inflation or following a "strong dollar" policy, but is in full Keynesian mode of using monetary policy to fight of a recession. Meanwhile, holders of American dollars are seeing their holdings frittered away from inflation and devaluation - a much more sinister remedy than allowing an orderly (albeit painful) liquidation of excess supply and nonperforming loans off the balance sheet.
- On the fiscal front, the outlook is even bleaker. Congress and the White House have shown no inclination at fiscal restraint. The Democrats want to implement major tax increases that would only exacerbate a tittering economy. Of course, that didn't stop Jennifer Granholm and the Michigan Democrats implementing the largest tax increase in state history in the midst of one of the worst economic crises as well. So, 2010 (expiration of tax cuts from 2001 and 2003 tax reform bills - i.e. 15% dividend and capital gains rates) is looming as a tipping point.
- Any attempt by the Federal government to "fix" the sub prime problem is moot, and will be limited. Allowing bankruptcy judges to amend mortgage agreements would be a disaster on the long run, forcing borrowers to incur additional costs for a bankruptcy premium. Any "bailout" of lenders would have to be minor and targeted, as there is a growing backlash by responsible borrows who will resist having their tax dollars subsidize those who where irresponsible in their financial decisions.
- This is going to get a lot fuglier before it gets better. If we look at ARMs and sub primes independent of the greater credit markets, a lot of this will not get worked out until 2009-2010, as resets work through the system. This, coupled with excess inventories of housing, will keep additional downward pressure on housing markets and bring them back to historic averages. If we look at the Case-Shiller Index of home prices, many markets still have 20-50% downside before they meet historic averages.
- Lower interest rates won't help. Even if a lower rate refinancing would save you money, good luck getting an appraisal that will hold a mortgage if you bought near the top with little money down. The tightening in credit standards mean that most people will not be able to take advantage of low rates.
- Credit Card and Auto loans will have increasing defaults. This ties in with the Greenspan excess money creating easy credit. One could say that a large part of the economic expansion in the past ten years has been debt financed consumer spending. The abrupt change in consumer sentiment, coupled with the evidence of a housing correction and slower economic growth, is leading people to de-leverage. People are either paying off their debts if they have the financial wherewithal to do so, or just defaulting on it and walking away, bankruptcy be dammed. The U.S. economy, if viewed as a balance sheet had inflated asset values, large amounts of debt, and little equity; this worked as long as interest rates stayed low and asset prices continued to climb. Now the asset prices are no longer supporting the debt loads, so leverage is now exacerbating that fall in prices.
- Long-term interest rates are starting a long-term uptrend. Long-term interest rates are cyclical in nature, but the cycles are generational. We are ending a cycle whereby long-term rates were on a downtrend since 1981. This uptrend could last twenty to forty years, which is the historic norm.
- Inflation will be with us for a while. It seems that people forget everything that happened more than a year ago, and now it is a repeat of "That 70's show". Even though Keynesian economics has been discredited by Milton Friedman and the monetarists, the powers that be are all sharing the believe that government manipulation of fiscal and monetary policy can "prime the pump" and avert a recession. I'm still waiting for the "Whip Inflation Now" buttons to come out and then price controls.
- The question is what kind of investment strategy mitigates this risk. Well commodities and non-U.S. dollar assets seems to be a start. Real return bonds is the safest bet on the fixed income side. As for stocks, "buy very very cheap" is the first answer. The second answer is to look at stocks with a very strong balance sheet: low debt, lots of cash, and no accounting gimmicks.