Tuesday, April 22, 2008

Wall Street fairy tale

I wasn't going to write anything tonight, but a visit to Calculated Risk http://calculatedrisk.blogspot.com/ got me started. For those of you that found me from this site, I am glad you came. For those of you that know me from my outrageous posts and my refusal to join the inflation goes on forever to the sky crowd, I am glad you are here.

The news gets more confusing all the time, but the truth leaks out from time to time. The truth is the world has reached the tower of Babel level once more and the tower is about to topple. The size of the world economy has reached a level that is too large for the existing resources to support and too large for the United States credit machine to fund. We have run out of coal to put on the fire, as our housing was the last vestige of a consumer asset we had left. Now we are left to sell our multinationals and our food stuffs, which won't go on for long as the rest of the world could very well buy up the US food supply many times over with the amount of money floating around in the system.

Calculated risk had a short article about Shiller and his forecast that the housing problem might be larger than it was during the depression. There is no doubt that housing has had the means to be inflated onward and upward for several decades. The US isn't like Hong Kong or England, where prime real estate is centered in one special spot, but instead has a wide variety of housing markets, leading not only to more supply, but a harder to drive price spiral. The US has had, for a great number of years, the means to have a housing bubble, but the wide supply range has kept this from occurring.

Not this time. The credit bubble blows bubbles in all directions. What we have today is an unsupportable debt bubble that creates one group, unpayable debts that support through intermediaries, unpayable deposits. The middle men, banks, Savings and Loans, credit unions, brokerage firms and insurance companies to name a few are obligated for the difference between what is collectable and what is owed to depositors. In the meantime, the depositors are stuck with excess cash yielding insufficient interest rates seeking higher returns. The problem is that the buyer and seller merely trade cash and it never leaves unless it becomes the temporary property of the debtor who then puts it out of existence by paying their debt.

This is how bubbles get started. Since high prices lead to higher prices and high prices for assets always lead to low yields, the seeking is for a capital gain and not for an investment. An invetment would imply that the asset purchased could actually carry itself financially. Any examination of speculative real estate will find that it will rarely if ever rent for the payments and if we are talking about paying cash, sometimes it will barely bring back the taxes, insurance and maintenance. It is hard to call a total hedge against inflation as an investment, as there is no return against inflation.

But, once the game is spotted, it becomes a bigger fool buying from the previous bigger fool until they run out of fools. Sometimes the fools they run out of are the fools that finance the stuff, as they eventually are the ones that have to stand for the loss. When this stage is reached to any significant degree, we enter a new game called make believe.

The game of make believe works like this. It beckons back to yesteryear when the outlook was bright and cheery and everything always came back. Every thing always comes back as long as it isn't killed. That is what is different between speculative cycles and bubbles. The cycles always have worked out the make believe, where as the bubbles are a series of make believes come true that turn into a nightmare that doesn't end. The bubble has burst after decades of housing slowdowns being followed by booms and more slowdowns. Each was accommodated by easier credit, as they began to create statistics to show that only occasionally do housing markets get into trouble and they are almost alway local and center around the economy. Well, what happened when the stock market went bust in 2000? A recession? Not in housing there wasn't. Every record that existed in home sales prior to 1997 was decimated every year we were supposedly in a slow economy in the 2000-2004 period. Thus we had a downturn that was a boom in housing. When we should have taken a breath, we sped up. That is what a bubble does, defies economics. It defies the laws of supply and demand, the laws of the business cycle, the laws of risk and return and all the laws, and most certainly the law of reason.

What we are seeing today is the government attempting to keep the bubble going. Previously existing home sales are close to 5 million. This blows away the pre-1997 record of 4 million, but we are hearing about a housing bust, not a housing boom. This means in securities terms that people are buying falling knives and the government is trying their best to finance the speculation. Remember this when you look back at the carnage that occurred from events after this bubble burst because it will have been facilitated by the greatest cover-up in history.

What is the cover-up? I think the real cover-up is that honest inflation is over and deflation starts once the cat gets out of the bag. I am going to pick on Goldman Sachs as an example because I know just enough about Goldman to be found to be ignorant of the entire picture. But what I know is there is something rotten in NY. Goldman paid its 30,000 employees somewhere in the neighborhood of $21 billion last year. That would be a fine place to work with an average paycheck of $700K per year per employee. A good part of this was performance bonuses, I would say likely earned on what are called today, Level 3 assets.

This is a smoky term. Rather than take the write downs that Merrill Lynch and Morgan Stanley took, Goldman mysteriously moved something like $30 billion from Level 2 to Level 3 assets. I think Level 3 derives its value from, well lets look back and use our imagination. Well, I know of some damn nice land that I wish I could get a loan to buy using my imagination of what I think it should be worth. I think I could put 100% of what it costs in my pocket, plus buy a 5 year annuity to make the P&I payments. But, I couldn't sell it for anything close to what I could imagine it to be worth. This is one of the things that makes land investment such a torture. In any case, Goldman paid huge bonuses for stuff that probably bankrupted the company.

What would happen if the auditors went in and declared a spade a spade and Goldman was broke to the world? The world supply of toilet paper would be drawn down in half by noon on such a day and the sewers flooded with you know what. What would break Goldman? The revelation that what they held to be good securities on their books were actually junk and not collectible. Goldman has something like $60 billion of this doubtful crap on their books, twice their net worth. The idea the housing market is going to walk again very soon and walk like it isn't crippled is all that is holding this stuff up to the world as potentially worth anything.

There are a bunch of them out there not coming clean. I think the banks coming clean are doing so only because they want to get the capital infusions ahead of those that might be too late for the willing parties to infuse anything. But, if Goldman came clean, then they would have to give back those huge bonuses that were earned off profit making losing propositions. I am wondering about Wells Fargo, another bank engaged in subprime lending and large in the mortgage business. Where are their losses? Are they God and too damn smart to make bad loans in a market where everyone else pretty much went bust? Hear no evil, see no evil, speak no evil? It goes on and on.

Then we have the import market, the domestic market and the stock market. The US consumer binge has been run off home equity. So has the education system and the stock market. Do you think the earnings of SPX companies are going to sustain themselves in a debt deflation? I think the stock market could fall 90% before this one is done and home prices 50%, enough to wipe out the mortgage lending business.

There is a whole lot at risk here. For one, the deposits in banks don't go away as bank liabilities when their assets go bad. In a sense they do go away with the bank because the only means to pay the deposits is with the deposits. No one else has any money to collect or should I say to pay into an insurance fund. You could say inflation, but what if the value of all deposits in the US fell without any new deposits being created? It is clear with all the junk debt companies out there that debts never die and I would venture there will be a system of digging up corpses to get the gold out of their teeth before this one is done, but in any case money disappears when debt is paid. If we suddenly saw the dollar lose 50% of its value without any new lending, do you think we would have inflation or deflation over a longer term?

There is no doubt in my mind that we would see a huge deflation even though logic would scream inflation. For one, who would be able to borrow money at 100%? Second, the reason we are in this trouble in the first place is debt is going bad, not because it is safe to lend to all comers and all securities can now be made to perform as AAA. That was what got us in this and it won't be done again for maybe 300 years. Third, those with cash balances would likely hoard what they had and not spend it at all for anything other than necessities, leaving consumer goods unsold. People forget those that have cash have it because they didn't give it up. They won't throw it out because they suddenly feel poorer, unless they use it to acquire some asset for sale by some debtor so he can use the money to get out of debt and extinguish it.

Then there is the GSE's. I am getting the drift that the US is done selling the world any kind of debt that doesn't say direct obligation of the US treasury. This means that the indirect guarantees mean nothing. Why buy them if you can get the real thing? It is clear that suddenly if they aren't buying Sallie Mae debt, then the debt of the GSE's, FNM and FRE and their dreaded link to mortgages isn't going to be appetizing for the world markets. We are about to see the Fed have to buy up the credit line of FRE and FNM due to the fact they can't move their own paper. This can't go on for long.

The point here is that we are stuck. Either we enter into mutually assured destruction or we take a chance the market will work its way out of this with new brokerage companies, new bank accounts and some fashion of keep from starving socialism to float the bankrupt. In either case, the country is broke and the world is broke along with the country because all that is owned by the rest of the world was borrowed by the United States. The inflation game has no solution at this point. There is no way that demand can be sustained by inflation, as the only inflation machine in the world is the US. The inflation cookie jar is American housing and American housing is collapsing in price during a boom. What happens when housing sales go back to normal, in the 3.5 million range? It appears to me that we then have as many as 2 years supply of homes on the market and the only remedy for those that have to sell is foreclosure. There are vacant existing homes in the US that exceed 2 years supply at this time, meaning that to solve demand, no one would have to move for 2 years and all the housing needs could be solved. This isn't a situation where we have a 90 day down period and the sales pick up with the economy. In fact, the economy is hitting on all cylinders, except the housing bubble has burst. The only reason we are selling 5 million units a year is the economy is booming. A recession takes home prices to the depths of hell and sales maybe down to 2.5 million, half of what we see now. It also destroys the fairy tale Wall Street has read to us.


greg said...

I have always enjoyed your writing and I feel drawn to your argument here. Nevertheless, I am torn about how to maintain and grow my money because the government seems to always pull rabbits out of the hat and keeps the game rolling. Inflation of things I need verus ultra low interest rates puts me in a real squeeze and I feel that need to speculate to stay ahead.

For now I am being patient. I am thankful I have a high paying job, maximize my retirement savings (money market right now), and live conservatively. I ride a bike to work as much as possible, avoid restaurants, and I use Craigslist to find incredible deals on things I want but don't absolutely need. It will be interesting to see if Mainstreet America starts moving in the direction that I have taken. We would all be better off in the long run although there would be significant short-term pain as the economy adjusts to a new world of reality.

mannfm11 said...

Thanks for the comment Greg. I have a sense about me that the US consumer is about to take a bath. All things are relative. I am reading that emerging markets are about to export inflation. I don't know that. I think the last time we got in trouble with inflation had to do with the NY banks lending to the emerging market governments. This time around, we spent to the emerging markets and they are clearly paying for what we take for granted, materials for infrastructure. Remember, you don't see any international banks hailing from India or China and you probably won't. At best they will buy into American banks and gain some influence, but more likely they will sell for a gain or out of need. Emerging markets don't create inflation or stop it, banks do. The best way to make money is to save it and don't forget it. You seem to know that.

greg said...

I am fascinated with the inflation for infrastructure materials as this has been an incredible story. I remember looking at Dubai photos last year and seeing the massive construction going on with very expensive materials. And then last month I visited Las Vegas and you cannot believe the amount of large-scale construction taking place. All I could think of was how they were paying top dollar in material costs and I cannot imagine how they will get the money back in a reasonable time if ever. China has to be in the same predicament, building massive infrastructure with very high material costs. The world, politic and business, seems to be run by a lot of incompetent fools that buy high and sell low.

My conclusion from this is that the world has been following a flawed economic model of fast growth at any cost driven by easy credit. This is a model that only works well for speculators that get in and out at the appropriate time. For the general human race, it is a horribly inefficient and costly model because it creates unsustainable booms that misallocate capital.

Slow and steady growth would be much more favorable for everyone except the speculators. Too bad they are the ones with all the money and seem able to dictate government policy and drive manic business growth that insiders should clearly know is unsustainable. I am surprised that the bankers got caught in their own snare so bad this time, I thought they would have known better. What a world we live in now.

mannfm11 said...

Interesting you should mention Vegas. It is about to take a bath, as people are going to be suddenly too busted to gamble. I am hearing this is already the worst recession in Vegas gambling since it started. I bet there are $50 billion in losses there before the end of next year.