Joy Division - looking back

I've been on a Joy Division kick the past few months, revisiting a band I used to listen to a lot when I was younger. I find that even at this stage of my life, being a lot older, wiser, etc.. I still find the band as compelling as I did then. The haunting themes of Ian Curtis' lyrics still resonate with the passage of time, and show glimpse into the tortured soul that was Curtis.

My personal favorite song is "New Dawn Fades" from the album "Unkown Pleasures". Better yet, pick up the 4 CD set called "Heart and Soul". Here is a bootleg video of the song:

The mortgage mess

Listening to congress, the Federal Reserve, and the Democrats discuss "the credit/mortgage crisis" is pretty depressing at times. There is plenty of blame to go around:

1. The Federal Reserve has to take its share by creating a credit bubble with articifically low interest rates from 2003-2006. Their easy credit policies started the dot.com bubble then migrated towards the housing market. They created excess amounts of money which went into housing speculation. Worse of all, the Fed appeared to abandon all pretenses of protecting the integrity of the dollar from depreciation and inflation and looked to manage economic growth - a fool's errand. Part of this was using "core inflation" as a key target. Ignoring spiraling energy and commodity costs belies the real inflationary pressures that most families have to deal with in their budgets. As a result, American's have suffered a real drop in their standard of living due to this deliberate devaluation of the dollar, which must be remedied - dynamic economies do not survive on a weak dollar that masks structural weaknesses. It can also be argued that expanding the discount window to non-brokers in the circumstances it did to Bear Stearns/J.P. Morgan is unconstitutional. Although probably necessary - such actions should require an act of congress. Judge Andrew Nepalontano on Fox Business News strongly believes that such actions violate the general welfare clause of the constitution - which prohibits direct handouts to individuals and businesses.
2. Congress - despite all the preening about caring about the "poor homeowners" Congress did it's part in cultivating this problem. Congress had many policies to foster home ownership - often to people who should not be buyers due to bad credit. The Community Investment Act essentially forced banks to lower their credit standards to questionable borrowers to help low income communities. The mortgage interest deduction and property tax deduction gives a tax subsidy to homeowners over renters, further distorting the costs of home ownership over renting. Some of the few saner voices in Congress have noticed this. I can't believe I'm saying this, but Barney Frank (D- Mass), Chairman of the House Banking Committee has said as much, stating that government policies create too many home owners and not enough renters. Current proposals to "fix the problem" only create moral hazard for marginal borrowers who should not have been owners or speculators who could never afford the houses to begin with. Finally, the issues with the "shadow banking system" of broker-dealers were never addressed with the end of the Glass-Steagall act in 1999. Though Congress at the time did not know at the time the ability of these firms to be critical cogs in the banking system, it is another example of the unintended consequences of legislation.
3. Loan securitization - securitization of pools of mortgages started in the late 70's/early 80's, but really took off in the past ten years. The prime driver of this was record low long-term interest rates on Treasuries. With so many institutional investors hungry for yield, as many were required to have minimum fixed income positions, the investment banks stood ready to securitize loans to these investors. The rating agencies slapped a AAA rating on some of the tranches, pocketed the fees, and repeated. This created a viscious circle - lower interest rates created greater demand for additional yield, which created lowered lending standards to create product and nice investment and ratings fees. Securitization also created more revenue for financial institutions than holding them to maturity. If more of these loans were held on the balance sheet, they would be more thorough in terms of due diligence.
   
4. Risk models - all financial institutions use modeling to determine the amount of risk their investments have to a significant decline. These models are quite complex and use a lot of historical data and assumptions. These models, while helpful, have two fatal flaws. The first flaw is that many of these models assume that returns are normally distributed - it under-estimates losses at the extreme ends of of the curve where most statistical relationships fall apart. The second problem is that it fails to account for changes in behavior. In this case, it assumed that homeowners with zero equity in the house would behave the same as homeowners with a significant amount of of equity in the house in the form of a large down payment. People purchasing houses "no money down" have no financial incentive to stay in the homes once they are in a negative equity position - thus the "jingle mail" phenomenon. It appears that these risk models never figured that part
5. Developers. I worked with a lot of construction clients over the years, and many of these people are really smart and successful. What I don't understand is how they could keep building when there is all this supply lying around, thinking that it will sell quickly. The first rule of any business is to minimize inventory - and when stuff sits unsold, then it is time to stop building and take a vacation. Nope, can't do that. Then on top of it, selling properties to people probably have a good idea that they can't afford the house; no worry to them - FHA normally bailed many of these people.
6. Borrowers. If you are looking to buy a home, there are a few cardinal rules: (i) have a good size down payment (i.e. at least 5-10%); (ii) mortgage, taxes, and insurance should take up less than 1/3 of your gross monthly pay with a standard 30-year fixed; (iii) the maximum home price you can afford is roughly 3 1/2 times your annual pay. So, with this in mind, are we surprised that there are foreclosures involving borrowers who bought with no money down for homes that are 8-10 times their income? I have an additional rule - couples, do not buy a home assuming both of you will be working. If you buy based on one income, there is always a good cushion and it opens up more work/life options.
   

Interesting reading

I found this Wall Street Journal article about Hyman Minsky. He was a "post-Keynesian" economist whose writings focused on the inherent instability of financial markets. I found his writings were a good summation of the behaviors that cause financial bubbles. Taken together with one of my favorite books, Mackay' s "Extraordinary Popular Delusions and the Madness of Crowds" - it gives a good explanation of how bubbles happen and burst.

What it should remind people, especially politicians, that human behavior has been a constant throughout existence. Bubbles have happened before, and will happen again.

The week in review

Random observations...

• I was in California for parts of last week, just North of Los Angeles. Beautiful area. I can see how living with perfect weather can make the brains go mushy with silly ideas. I found an eerie new age totalitarianism at my accommodations. The ambient music (though not as good as Brian Eno, and with hints of Zamfir) at beyond ambient volumes, the excessive notices such as "this building may contain materials, known to the State of California, to cause cancer..." These notices are the face of the maternal fascism. It explains why businesses are leaving the state in droves for more hospitable locations.

• Notice the differences between Kwame Fitzpatrick and Eliot Spitzer. Spitzer resigned once all the legal troubles came out. Kwame is still fighting. Eliot couldn't tough it out because he alienated too many people in his own party - the Democratic party in Albany was not going to go to the mat for him. Kwame still has a base, one that does not show up in the polls, and was the basis of the late Detroit mayor Coleman Young's electoral success. Kwame figures he can hang tough and get support by casting himself as a victim of a media inspired "lynching" - playing that card as much as possible. It got him re-elected in a tough campaign against Freeman Hendrix where polls showed Fitzpatrick trailing significantly. Another black mark for the city of Detroit.

• Obama's stupid tax plan. Where do I start? First - exempting seniors who make under $55,000 from income tax (they'll be responsible for bankrupting Medicare and Social Security and we want to reward them by not having them pay taxes?)!? Second, he wants to raise the capital gains tax to 25% from it's current 15% - that'll kill investment in a downturn. Finally, he wants to raise taxes on the rich, whom he defines as the top 20% of all taxpayers. Grab your wallets, because that top quintile begins at $75,000. I know a lot of people who make $75,000 per year and I would not call them "rich" by any stretch of the imagination. If you live in a high tax/high cost of living area like LA, DC, or New York, seventy five grand barely keeps you afloat. And I haven't even got around about his plans on expanding FICA taxes. If I was to summarize Obama's tax plan in one word, it would be "Canadian".
  

We're now in a solvency problem

Now that we have hear news that Bear Stearns needed to be rescued by JP Morgan and the Federal Reserve to cover its borrowings, the real depth of the credit crunch is becoming apparent. We have moved from a liquidity to a solvency issue, where many non-bank lenders are now having extreme difficulty meeting their obligations. The LBO firm Carlyle group defaulted on an investment fund heavily invested in sub prime mortgage.

More and more firms will become insolvent as the assets backing their debts fall in value, forcing loans to be called and additional defaults. Bear Stearns will in all likelihood be acquired by another firm, as will many other companies who leveraged themselves to the hilt on easy credit.

The move by the Fed is a realization that monetary policy will do little to help the situation, and that partial nationalization of bad debts is the only way to avert a full solvency crisis. Better late than never.

All of these problems materialized because of a Federal Reserve, encouraged by a U.S. government that wanted perpetual economic growth, that kept creating money and generating excess credit and a devalued currency. The problem is that the Fed must allow the market to find a bottom and facilitate an orderly liquidation - delaying the inevitable by attempting to protect people from price drops will only exacerbate the situation.

Addendum:

It also appears that Lehman Brothers is having some troubles as well after the Bear Stearns debacle. This will bear watching.

First Kwame, now Elliott

First it's Detroit mayor Kwame Fitzpatrick's text messages about his illicit affair with his chief of staff and potential perjury charges. Now it's New York governor Elliott Spitzer's involvement in a prostitution ring.

As we have seen with Kwame, we will see with Elliott - neither will leave voluntarily. They will cling to whatever vestiges of power they can. They have do regard for the shame and hurt they bring their families and their respective offices. To them, it's all about "me".

BTW - this also applies to Larry Craig too!

Daylight Savings Times Sucks

I'm half awake, but I know John Miller of National Review is onto something on this scam.

What I know, what I'm somewhat confident, and what I think may happen

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):

• 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.

What I think will happen:

• 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.
  

George McGovern said what??

I had to check the author again of this Wall Street Journal article by George McGovern titled, "Freedom Means Responsibility". These nuggets of wisdom actually came from the man often labeled as the most left wing president candidate in modern time. His insight was that,

Why do we think we are helping adult consumers by taking away their options? We don't take away cars because we don't like some people speeding. We allow state lotteries despite knowing some people are betting their grocery money. Everyone is exposed to economic risks of some kind. But we don't operate mindlessly in trying to smooth out every theoretical wrinkle in life.

The nature of freedom of choice is that some people will misuse their responsibility and hurt themselves in the process. We should do our best to educate them, but without diminishing choice for everyone else.

Seems that being out of government is the best way for politicians to realize the unintended consequences of government action, as so eloquently written by Frederic Bastiat in The Law.

Obama's Mendacity on NAFTA

It is fun to watch Barack Obama's contortions over NAFTA.  In the Ohio debate, he talks about how is is going to scuttle the deal unless "environmental and labor standards" are changed (newspeak for forcing Mexico to lose it's competitive advantage by imposing Scandinavian union and environmental laws).  He repeats during the Cleveland State debate how he is going to "unilaterally" pull out of NAFTA unless these changes are made.

Of course, it is then reported on CTV (Canadian Television Network) that a "senior Barack Obama campaign staffer" went to the Canadian consulate in Chicago to assure them that Barack's rhetoric is merely political and he has no intention of repudiating the treaty should he become president.

Let's look at all the inconsistencies on Barack's NAFTA bromides so far:

1. He is looking like a typical left-wing demagogue with language on this.  Not very presidential.  The back channel reassurances to the Canadian government illustrate that Obama is just a hypocritical as any other Democrat on trade.
2. The Democratic party has gone bezerk the last 7 1/2 years decrying the "Bush unilateralism" on the ABM treaty, Iraq, Afghanistan, etc.   At least we can say that  such unilateralism was in the sphere of what some would call America's security interests.  Instead, the Democratic presidential contenders would unilaterally  scuttle trade agreements it has with its neighbors.  So it appears that the Democrats want to be nice to Iran, Cuba, Venezuela, and North Korea; but will jerk around Canada and Mexico.
3. Obama's contradictory stands on Mexico.   Obama has said the best way to stop illegal immigration from Mexico into the United States is to develop the Mexican economy so that the economic incentives to illegally cross the border are gone.  This is a very sensible point.  However, when you then turn around and threaten to kill the trade deal that has created hundreds of thousands of good paying jobs in Mexico.  Just imagine the torrent of illegals migrating Northbound if that happened.
4. The United States, both economically and politically, has a weak hand to force any changes.  With oil north of $100 a barrel, the dollar tanking with no end in sight, and the economy weakening, what are we going to get if Obama did open up negotiations with Canada and Mexico.   Mexico could turn around and say that they will sell their oil elsewhere.  They could also really turn a blind eye to drug and human smuggling across the border.   The Canadian government could pull the preferential treatment of oil exports to the U.S.  (Canada is the largest supplier of oil to the U.S., Mexico is second - so you can see the weak hand the U.S. would have).  Canada would also want to reverse the softwood lumber tariffs, put restrictions on water and oil exports to the U.S., etc.   Canadian Prime Minister Stephen Harper has already made that point.