Posts Tagged: Karl Denninger

Banking / Economics / Financial / Real Estate / Sovereign Debt — 0 Comments
28
Sep 11

How Did We Get Here?

Karl Denninger makes a simple but telling point.  Since 1984 GDP growth has averaged 4% per year, debt growth has averaged 7% per year and government spending growth has also averaged 7% per year.  In no quarter did real economic growth exceed credit growth.   Europe Goes Enron (blog radio podcast).   Simply put, we are inflating credit faster than we are raising real economic output.  To repay debt, sufficient income must be generated to reduce this debt.  Thus, when the economy lags in a recession or depression, debt will go into default and must be either written off or restructured.

Also simply put, credit growth unsupported by income growth has distorted the economy.  In essence, the “easy money” fostered in a lax credit environment has sent the wrong signals to the real economy.  Some examples:

Real Estate

Lax bank lending and governmental programs encouraged homeowners to take on more debt.  The mantra was that house prices always rose. So bankers were eager to lend too much and borrowers were anxious to borrow too much, both believing that house price inflation would sustain the process.  Both parties ignored simple economic principles.  Incomes have been stagnating for more than ten years.  The housing boom expanded the supply of housing beyond demand.  Worse, the peripheral costs of owning a home (taxes, insurance, utilities and the like) ate into the income available to service those over-sized mortgages.   Loans were secured with little or no money down.

In the commercial real estate market, we massively overbuilt.   Again we mistakenly believed that inflation would bail out lenders and owners.   The demographic trend is for large companies to reduce use of commercial space.  Increasingly, employees work from home and technology requires fewer workers and less commercial space.  Internet shopping further lessens the need for brick and mortar retailers.  As with homes, the peripheral costs of commercial ownership kept rising.

Government

A falsely expanding, credit driven economy also sends false signals to government and their employees.   Tax receipts were on the rise from real estate transfer fees, expanding income taxes and capital gains from a rising stock market.    But these gains were bogus, a chimera.  And they did not benefit the average consumer.    Why shouldn’t the largesse of rising tax receipts be shared with employees, who also happen to be a powerful voting bloc?   Politicians were all too willing to grant pay increases, job security guarantees and costly pension and post-retirement benefits to government employees, especially those represented by powerful public unions.  Soon total compensation packages for public employees exceeded their private sector counterparts.

Sovereign Debt

And so the good times seemed to roll. What better way to finance government projects and even foreign wars than through inexpensive sovereign debt?  Dick Cheney once loudly proclaimed that “deficits don’t matter.”  Republicans and Democrats seemed to compete to see which party could run the largest deficits.  Believing that debt could be paid off through ever rising tax receipts, the government made more promises (like expanding Medicare coverage to include prescription drugs).   What were they thinking?  Borrow today and worry about repaying and credit collapse tomorrow?

Macro Trends

The credit binge occurred against a background of unfavorable macro economic trends.   First, US and European population growth, and therefore the supply of workers, slowed.  Second, free trade and free movement of capital and technology has exposed the American worker to foreign competition.  Seventy-dollar an hour (fully-loaded cost) Big Three unionized auto workers cannot compete with their Asian counterparts.   [Heritage Foundation study].  Third, technology has viciously cut into employment in the retailing, telecommunications, banking, insurance, travel and other industries.   Software programs now perform the job functions formerly executed by highly-paid skilled workers.  Fourth, zero interest policy has cut the income of savers and pension funds, impoverishing a class of consumers who supported the economy in the past.  Fifth, regulation is on the rise, increasing business operating costs.

The Debt Bubble

Thus, we have inflated a giant credit bubble without the resources to repay these debts. It is happening both here and in Europe.  Each government maneuver to save a bank (Bank of America) or a country (Greece) is merely an attempt to hide the real problem or shift it from private parties to taxpayers.  We undertook debt that we cannot repay.   We need to write off or restructure this debt, and yes, it will result in losses to the government and major financial institutions.  Restructuring could take the form of increasing the time to repay, reducing the interest rate or swapping equity for debt.  This outcome is unfortunately unpleasant but necessary.

Governments continue to conjure exotic, “cutting edge,” “outside the box” programs which merely delay the day of debt reckoning.   We borrowed too much and we now need to pay the piper.

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Economics / International Finance / law / Political / The Federal Reserve — 0 Comments
6
Nov 10

Who Elected Ben Bernanke?

Everyone was focused this week on the mid-term election results.  Instead, we need to focus on another event just as crucial, but less understood by the American public.  Our unelected Federal Reserve Chairman, Ben Bernanke, launched QE2, the outright government purchase of US treasury securities.  The highlights:

-          The Fed is buying $600 billion of Treasuries (in the 5-10 year part of the curve) through mid-2011 and another $250-300 billion via coupon reinvestments, which they were going to do anyway.

-          The key “number” for the markets is that $600 billion figure, which is about $75 billion per month. See Rosenberg Joins Chorus of those Accusing Bernanke of Asset (Read Stock) Price Targeting

In Ben Bernanke’s self-justifying op-ed in the Washington Post, he explained his main goal:

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion. What the Fed did and Why: Sustaining the Recovery and Supporting Price Stability

Dr. Bernanke remained confident he could reverse this policy at the appropriate time.

Nowhere in the Federal Reserve’s mandate is the elevation of stock prices.  Why not target wages and house prices?  Further, the Fed will be continuing to purchase tainted and suspect mortgage backed securities.  These securities are the heart of the current Foreclosuregate controversy.  The Fed is paying full value for a security that may be worth pennies on the dollar.

Unintended Consequences of the Policy

Focusing on stock prices is a little like ordering dessert before focusing on the nutritional value of the main course.  Before now, profits, dividends, discounted cash flow and future growth prospects determined what happened to a company and its stock price.  Now will we have Federal Reserve whim determine stock prices?  QE2 sets the markets up for another enormous bear market when the Fed stops QE2, or when stock-dislocating events overtake the Fed.

The unintended consequences are both legion and wealth destroying:  a weak dollar with surging import prices; soaring inflation in critical commodities such as oil and grain; compressed profit margins caused by higher input costs; further punishment of savers and retirees; trade wars with other nations whose economies wilt under a weakened dollar; and market-wide unstable speculation.

Karl Denninger in Bernanke’s Folly: The End Game explains that the Fed policy is essentially a gigantic hidden tax on businesses and consumers.   The end result will be a downward spiraling economy with businesses forced to lay off more workers to offset higher input costs – anything but the virtuous cycle Dr. Bernanke so fervently seeks.

The Constitution and the Election

Economic blogs are abuzz with QE2 analysis.  One particular area has been overlooked:  the break down in our political system and Constitutional protections.  Dr. Bernanke has usurped the taxing and budgeting authority of Congress.  QE1 and 2 put the taxpayer squarely on the hook for all Federal Reserve losses.  The Treasury is required to make good on Fed losses. So without writing a bill or holding a hearing, Dr. Bernanke launched his quantitative easing campaign and effectively dismantled the legislative process.  John Hussman warns of the danger of this reckless usurping of Congress’ role:

Now, since standing behind insolvent debt in order to make it whole is strictly an act of fiscal policy, one would think that under the Constitution, it would have been subject to Congressional debate and democratic process. But the Bernanke Fed evidently views democracy as a clumsy extravagance, and so, the Fed accumulated $1.5 trillion in the debt obligations of these insolvent agencies, which effectively forces the public to make those obligations whole, without any actual need for public input on the matter.” See Lessons from a Lost Decade

The Farce of the Mid-Term Elections

Tea Party activists are publicly miserable about out of control federal spending, bank bailouts and economic stimulus.  Before the new Congress convenes, Dr. Bernanke has unilaterally established economic policy for both Congress and the Administration.  Where is the outrage?  The Tea Party is so worried about liberty and free market capitalism, why have they not protested the dubious economic policies of an unelected new economic Czar, Dr. Bernanke? After all Dr. Bernanke and the Federal Reserve Governors have the same methods and goals as the former Soviet State Planning Committee.

More practically, why has Congress not held hearings and asked Dr. Bernanke some pointed questions:

  • Why did QE1 not work?
  • When you stopped QE1 in March of this year the markets fell and the economy retreated.  Is there a reasonable possibility that you can ever stop the QE policy without a market crash?
  • Have we just signed on to perpetual QE? If not, explain your exit strategy.
  • What will be the effect on our trading partners and will your policy lead to a currency war?
  • Please outline other risks in your policy and weigh these against the benefits.
  • How much of QE2 will go into foreign market speculation?
  • QE did not work in Japan for the last 20 years. Why will it work here?

Academic Theory

Dr. Bernanke is an academic theoretician. He taught at Princeton and now heads the Federal Reserve.  He has never run a business in the real world.  Quantitative easing is a theory and like all theories needs to be tested and proven.  We do not approve introduction of a new drug without stringent tests and proofs.  Dr. Bernanke is not playing with one drug; he is playing with our entire economy and political system.  QE1 in the United States and QE in Japan for twenty years  proved to be failures.  Why are we repeating failed strategy?

If he is going to target stock prices, then I still have some underwater stock options from a former employer.  Perhaps the good doctor could salvage my company’s stock too.  When one usurps normal market mechanisms, why not?

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Economics / Financial / Political — 0 Comments
5
Aug 10

Zero Interest Rates Equals Zero Jobs

Following World War II, typical economic downturns and recoveries have been “V” shaped.  That is, a sharp downturn in Gross Domestic Product and rising unemployment followed a quick turnaround in both economic activity and employment numbers.   This time is different.  We are witnessing zero or negative job growth and an anemic recovery.

Today’s situation is a different animal: a balance sheet recession.  Both businesses and individuals took on too much debt. And that debt was unsupported by income.  We are now saving to pay down that debt (the most recent savings rate increased to 6.4%), or defaulting on obligations (in May home foreclosures rose 44% to a new record).

Paradoxically, second quarter earnings demonstrate that corporations are beating earnings estimates and reporting healthy profits.   Gluskin, Sheff reports that

…78% of the companies reporting have beaten estimates and earnings per share are up 42% year over year versus initial expectations of 27%.

Companies have focused on tight cost controls to achieve these results.  The most recent durable goods report provides a clue to how costs are being controlled.

Orders for non-military capital equipment excluding aircraft climbed 0.6 percent last month after jumping 4.6 percent in May, more than previously reported, figures from the Commerce Department showed in Washington. See Second Quarter Earnings: Companies Beat But Investors Shrug

Looking further, we see we are in a jobs depression. Karl Denninger slices through the obfuscatory government data and finds that from July 2009 to July 2010 unemployment is 17% worse. See Watch the Birdie (Jobless Claims). After trillions of dollars of stimulus and guarantees and a zero interest rate policy, all we have to show for the effort is zero, or negative, job growth.

My strong suspicion is that management is substituting capital for labor.

A Brief Anecdote

One of my friends is the cost cutting guru for his company.  Always on the lookout for new labor saving technology, he found a type of packaging machine that could replace five employees currently performing the function manually.  His view is that labor saving technologies are the only thing preventing the economy from crashing.  By laying off those five employees, the machine pays for itself in two years or less.

On the other hand, employees unionize, get sick, go on vacation, file worker’s compensation and discrimination claims, and go out on pregnancy and family medical leave.  As an employer, machines suffer none of these disabilities.  Substituting capital for labor is firmly rooted in all corporate cost cutting strategies.

Unintended Consequences

With Obama, Bernanke, Geithner and Summers setting economic policy, I always feel it is improvisation night.   This team seems to bounce from one economic policy to the next with little thought given to unintended consequences.

-          Zero Interest Rates – I have written about the pernicious effect of zero interest rates on savings, especially for senior citizens.  See e.g. Is the Administration Determined to Make the Elderly Poor? Nothing from Nothing.  However, the upside is that low interest rates encourage the creditworthy to borrow for capital investment.  For example, IBM was able to borrow at 1% for 3 years.  If you can purchase labor saving machines with low interest rate loans and tax depreciation savings, why not?

-          Expensive Social Programs – Ignoring high levels of unemployment and economic stagnation the Obama Administration pushed ahead to pass health care reform.  The law does not apply to businesses with less than 50 employees.  The perverse effect is obvious:

…potential tax penalties for employers with more than 50 workers could cause many smaller businesses to rethink any hiring or expansion plans.

“It could have a negative effect on hiring as businesses figure out just how much the new law and offering health benefits will actually cost them,” many … small business clients have kept their staffs below 50 workers to avoid the complicated compliance requirements of laws such as the Family and Medical Leave Act.

“The new tax penalties for businesses with more than 50 employees will certainly make many business owners think twice about expanding and hiring more people….”  See Small Businesses Ponder Impact of Health Care Reform

Add in the threatened expansion of unions through the Employee Free Choice Act and no wonder large and small businesses are reluctant to hire.

Machines Make Better Employees

At its core, the Democratic Administration has failed in its campaign promises to reduce unemployment and get the economy back on track.  Through its zero interest rate policy the Federal Reserve and the Administration have “manufactured” our current high unemployment rate.  Today’s jump in new unemployment claims, to a weekly rate of only emphasizes the point. See Weekly Initial Unemployment Claims Increase to 479,000

The net effect is that machines provide better value than employees.  The labor market has structurally changed and not for the better.  Zero interest rates coupled with zero forethought is harming the working population.

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Banking / Economics / Financial / Political / Regulation — 0 Comments
25
Mar 10

Living in the Land of Pretend

I rarely have the radio on in the middle of the day. But yesterday on the Bloomberg Radio Hays Advantage, Kathleen’s guest was David M. Jones Sr.  Dr. Jones is a professional economist and consultant and the principal in DMJ Advisors. He holds a Masters and a PhD (presumably in economics) from the esteemed University of Pennsylvania.  He was speaking with Ms. Hays on the subject of financial reform and the role of the Federal Reserve.

Departures from Reality

Dr. Jones argued for the centrality of the Fed as chief financial regulator since they had garnered enormous expertise in banking practices in the current crisis. That is a pretty remarkable statement, as the Fed purportedly had a major bank regulatory role BEFORE the crisis. When events exploded, the Fed was clearly part of the problem.  They in fact had condoned shoddy lending practices and therefore contributed to the consequences we face now. (As examples, the Bear Stearns-J.P Morgan forced merger, the Lehman and AIG insolvencies).  On this issue, I guess we should all be glad if the Fed at least has learned that lesson.  But have they? Dr. Jones then lauded the government for the 2009 “stress tests” of the nineteen major banks.  These tests have purportedly restored confidence in our financial system.  Jones maintains that these “rigorous” tests demonstrate the reaffirmed solvency of the banks.

Stress Tests and Public Relations

Dr. Jones is wrong because the stress tests were not valid, but in fact were a public relations stunt.  Independent economists and bloggers such as Michael Shedlock, Karl Denninger and Martin Weiss felt the tests were at best deceptive and at worst fraudulent.  Instead of demonstrating the financial worthiness of the banks, the terms of the “stress tests” exposed fundamental weaknesses in these banks’ financial health.  Let’s look at some of the criteria, assumptions and methodologies the government utilized to assess solvency.

-          Worst case scenario too optimistic – The government assumed that at worst losses would not exceed $950b by the end of 2010. Projected bank losses far exceeded that worst case. The IMF projects a range of loss of 2.4 – $4.1 trillion; Karl Denninger projects residential mortgage losses at 2.5 trillion, and Nouriel Roubini’s loss estimates are in excess of $1.8 trillion.

-          The “Take Home Test” – Using two alternative macroeconomic scenarios, the government required the banks to estimate their potential losses on loans, securities and trading positions, as well as pre-provision net revenue and the resources available from the allowance for loan and lease losses.  Karl Denninger in The Scam of the “Stress Test” commented:

They asked the banks, they did not send in a team of examiners to look at the books independently.  So the base data that was ingested into this process in fact came from the banks themselves, not from independent, outside examination.  As a consequence it is fair to ask where the valuations came from and how they are supported, including the models and other information used to develop these figures.

This data is not disclosed.

Second, some of the data points and “expected losses” are comical.  For example, the banks are expected under the “more adverse” situation to believe that prime mortgage losses will not exceed 4%, and ALT-A (liar loans and Option ARMs) will not exceed 13%.  HELOC loss (most of which is unsecured!) is expected not to exceed 11%.

-          Bank Permission to Massage and Change Results – Some banks did not like the results, so they lobbied for methodology and outcome changes.  Karl Denninger again reports:

Some major banks managed to wrest concessions from the government in closed-door negotiations over their “stress tests” that helped them put the best face on their results, financial analysts, industry officials and sources said.

So in essence the entities being examined became the architects of their own examination.  In what universe do we do that?  Do we allow school students to write their own tests?  The resulting continued wave of residential delinquencies, foreclosures, losses on second mortgages (home equity lines) and commercial real estate demonstrate that the stress tests were flawed.  In fact, utilizing 2010 data from FDIC losses in bank seizures, Mr. Denninger estimated losses at just 4 major banks (Bank America, Wells Fargo, Citicorp and JP Morgan Chase) to be in the range of $1.5 to $3 trillion. See All You Need to Know About Bank Balance -Sheet Fraud

Sometimes the Truth Appears

Yesterday, Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, blasted the current large bank regulatory regime.  See Kansas City Fed’s Hoenig Endorses Volcker. The top 20 banks have a grossly unfair economic advantage by way of explicit government loan guarantees.  Without these guarantees the top 20 would need $210 billion more in new equity, or would need to shrink their lending activities by $3 trillion. How does this need for capital square with the confidence building stress tests?

Dr. Jones is a sad example of economists who slavishly follow the government line of thought.  Dr. Jones should be asking some tough questions: why do we need $23 trillion of government guarantees for our financial system to be solvent? Why are short term interest rates still set at zero for our top banks?  Why have we been in a state of financial emergency since 2008 if the economy is recovering?  Were the stress tests a scam to help the banks raise cheap capital? Given the Fed’s past poor regulatory performance why give them more plaudits and power?

Perhaps the Administration and the Federal Reserve have done a better job at capturing prominent economists and our news media than regulating the banks -  of course, all to the taxpayer’s detriment.

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American Society / Business / Economics / Financial / Political — 0 Comments
20
Dec 09

It Doesn’t Matter Until It Matters

In 1972, I was a graduate student in economics in London.  As an American living overseas in the midst of a Presidential election, I tried to learn everything about what was going on back home.  I distrusted Richard Nixon and was not comfortable with George McGovern.  I became an avid reader of The Guardian.  In his column Letter from America the Guardian’s American correspondent Alistair Cook reported on the implications of the Watergate scandal in the months preceding the November 1972 election. Cook opined to his readers that this was not a “third- rate burglary” as the White House claimed, but rather a major political scandal at the highest levels of government.

Incongruously, the International Herald Tribune (“IHT”) reported on the Watergate story with much less frequency or commentary.  At least during election season, IHT reporting relegated the Watergate break- in to “third-rate burglary” status. The litmus test for the Watergate story was Nixon’s soaring popularity in the polls and subsequent November land slide victory.

The Road from Landslide to Impeachment

Post-election, a different mood emerged.  Events cascaded out of control for the beleaguered Nixon Administration: January 1973 convictions of Nixon aides, G. Gordon Liddy and James McCord Jr.; May 1973 start of the Senate Watergate hearings; July 1973 Nixon refusal to turn over White House tape recordings; December 1973 discovery of an 18.5 minute gap in one of the subpoenaed tapes; July 1974 Supreme Court order for tapes to be turned over to Congress and House articles of impeachment, followed by the August 1974 Nixon resignation.  See Washington Post Chronology. The public mood traveled from landslide support to ignominious impeachment in approximately twenty months.

Also in May 1973, recovering from a bear market low, the stock market hit an all time high.  The final bottom of the multi-year bear market did not occur until late 1974.

The Ongoing Financial Crisis

This blog has discussed the origins of the financial crisis.  Despite protestations of “who could have known” many spotted the crisis ahead of time. See Too Much Information and Too Little Knowledge.   Reckless residential and commercial real estate lending, trade deficits, rampant speculation, credit derivatives, deficits and a host of lax regulatory practices led to the crisis.  All of these behaviors were building over several years.   Collectively, these indicators didn’t matter until they did.

Now, after a stock market recovery, Larry Summers, CNBC and other experts have declared the recession over and “mission accomplished.”  But the same imbalances in the economy have remained.  Barron’s recently polled twelve eminent market strategists on their predicted closing price for the S&P 500 Industrials on 12/31/2010.  Thier predicted low was 1125 and the high 1350.  Friday, December 18th, the S&P 500 closed at 1102.47.  Amazingly, not one analyst believes that a stock market decline is possible in the next twelve months. And some of these analysts pointed out the structural problems with the economy which would slow a recovery and hurt corporate earnings.

Percolating Ideas and the Collective Consciousness

As humans we are not conditioned to hear and react immediately to bad economic or political news.  Perhaps news has to seep into the collective consciousness and anger has to build before the ultimate collective response.  Robert Prechter has postulated that social mood drives financial, macroeconomic and political behavior. He coined the term socionomics for this combination of behaviors. Thus some commentators and critics (like Alistair Cook in the 1970’s) or like Prechter, Michael Shedlock, Karl Denninger and a handful of others during the current financial crisis see the developing events, the implications and the inevitable outcomes of today’s market declines before the general populace does.  Rather than applaud these commentators after the event, would it not benefit all to become more expert in “socionomics”?

What Does this Mean for Investors?

The above commentators may be the intellectual equivalents of the proverbial “canaries in the coal mine.”  That is, these commentators have a greater acuteness and perceptual ability than the rest of us.  However, translating their acumen into investment advice is more difficult.  I use their advice not to sell markets short, but rather to move my own investments out of harm’s way.  Sifting through the mass of data, the more difficult task is to continually discern what does not matter, what does, and when the former becomes the latter.

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