Posts Tagged: Michael Shedlock

American Society / Financial — 0 Comments
26
Jun 11

Is Debt Ever Good?

All debt is not created equal; some is productive and some is not.  The subtle difference between the two types of debt eludes many economists.

But why is this important?  Why do economic theorists and those who make decisions need to pay attention?  Because the quality of the debt determines whether or not it can be re-paid.  And if we cannot repay our debts in a productive way, we all suffer.

Productive Debt

Productive debt creates wealth.  When we borrow to start a business, expand an existing factory, or purchase needed supplies at advantageous prices we create productive debt for a valid reason.   The borrower is utilizing capital to generate returns in excess of the cost of capital.   Further, prudent borrowing holds out the possibility of “sustainability”:  meaning that the created wealth can be replicated.  Borrowing to expand a semi-conductor factory spurs further production, creating jobs, orders for suppliers and tax payments.  The lender has the security of a productive asset and a stream of income to ensure re-payment of the loan.

Non-Productive Debt

During the credit expansion of the last decade non-productive debt proliferated.  Borrowing took place to buy automobiles, plasma televisions, appliances, single family homes and snowmobiles among other consumer items.  Each of these “assets” depreciates rapidly and has attendant upkeep costs. The debt-laden purchase of any of the above items never led to increased wealth, it merely added another consumer trapped in a debt-ridden life.  In the case of debt-laden purchases of single family homes consumers saddled themselves with mortgage, taxes, insurance and other upkeep costs. Lenders exacerbated non-productive debt through lax lending standards (lending to sub-prime borrowers) and innovative financial products (adjustable rate mortgages, 125% loan to value, second mortgages).  Lenders believed that they would be bailed out of bad loans through ever-rising house prices.  Unfortunately, we learned that this was a faulty assumption.

A second area of non-productive debt is equally pernicious.   Ultra low interest rates have encouraged speculation in stocks and commodities.   Leveraged investments de-stabilize the economic system through inflating asset values, spurring commodity inflation and ultimately creating bubbles and inevitable crashes.

The Shangri-La of Non-Productive Debt

Doug Noland characterizes the United States as the worst offending country in the making of nonproductive debt. In his analysis, he is critical of the loose policies of the Federal Reserve, which encourage unsound lending and have contributed to our bogus boom and inevitable bust:

First of all, booms create a fragile mountain of debt not supported by underlying wealth-creating capacity.  Second, Credit Bubbles inflate various price levels throughout the economy, creating systemic dependencies requiring ongoing debt and speculative excess.  And, third, the boom in non-productive debt will tend to foster consumption and malinvestment at the expense of sound investment in productive capacity.   When the boom eventually falters, market revulsion to unsound debt, the  economy’s addiction to uninterrupted Credit expansion, and the lack of capacity for real wealth creation within the (“Bubble”) real economy ensure a very severe crisis and prolonged adjustment period.  These dynamics become critically important as soon as a government (finally) loses its capacity to perpetuate the Bubble (i.e. Greece, Portugal, Ireland, etc.)

As a crisis unfolds, the markets eventually must come to grips with a very harsh reality:  There will be denial and it will take some time to really sink in – but the markets will come to recognize that too little of the existing debt is backed by real wealth.  Non-productive Credit booms are, after all, essentially “Ponzi Finance” schemes.  See The King of Non-Productive Debt

At this point, the Federal Reserve is faced with severe choices.  It can risk economic implosion, or it can continue to mainline “the debt addict” with greater and greater infusions of new debt.  As we are now witnessing, this money is going into speculation in the commodity and stock markets rather than into productive investment in the “real economy.”  Real economic activity is suffering at all levels as income is diverted to debt re-payment and prices of key commodities soar.

Built on Sand?

A visual metaphor can help us understand how dangerous, unstable and fragile an economy becomes with a mountain of non-productive debt:

What makes sand piles so interesting is the usually seamless transition from stability to collapse. One can add grains to a sand pile for quite some time without disturbing its stability – it simply grows bigger and bigger. Alas, eventually the point is reached when one grain too many is added or is put in the wrong place, and an avalanche and collapse of the sand pile will ensue.

These sand pile dynamics appear to have a lot in common with the modern-day financial system – they serve at the very least as a good metaphor. Of course a crucial difference is that grains of sand do not exhibit purposive behavior, whereas the financial system is populated by thinking and acting human beings. Nevertheless, there are some interesting parallels. Just as a grain of sand near the bottom of the pile has no direct connection to one lying at the top, the various cogs in the financial machinery are likewise not necessarily connected directly with each other, but what happens in one area of the system nonetheless tends to reverberate through the whole system.  See The Edifice of Debt

Collapsing Castles

There are two simple principles to consider in evaluating the ongoing financial crisis.  First, does individual income, or tax collection generally, support our current level of outstanding debt?  Second, is Michael Shedlock’s admonition true:  “what cannot be paid back, won’t be paid back“?  Fantasies of resolving our debt in creative ways, like selling national assets such as road systems or national parks, are just that – fantasies.   Selling physical vestiges of our national heritage is not only soul-destroying and stupid, it just won’t work.

And yet we continue to accumulate non-productive debt at an alarming rate.  Was the collapse of the sub-prime market the “grain of sand” that caused near systemic collapse? What will be the next grain of sand?  What will be the consequences?

 

 

 

 

 

 

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American Society / Banking / Business / Municipal Finance — 0 Comments
14
Jul 10

Distortions

One theme we have explored in past posts is the negative role government has played in the economy.  See e.g., Let it Be and Can You Invest in the US Equity Markets? Government intervention in a capitalist economy distorts economic behavior.  Further, government anoints winners and losers without subjecting market participants to the rigors of a free marketplace.  See Government Intervention and Bowmar Brains.  Interventions occur on both state and federal levels.  Let’s examine some of the recently reported inevitable distortions.

Federal Employment

Andrew Briggs and Jason Wine examine the disparity between federal employee and private sector pay.  Federal employees with the same experience and education as private sector employees make 24% more.  Federal employees also receive generous health and pension benefits.   See The Government Pay Bonus.

In addition to compensation and benefit advantages, federal workers are shielded from layoffs and terminations.  Finally, I have extensive experience working with federal employees.  Do not expect that your phone call will be returned after 5 PM.

State Contractors

Illinois, like many other states, has out of control budget deficits and massive pension underfunding.  Michael Shedlock highlights the overweening sense of entitlement displayed by highway construction workers whose pay scale is determined by the state prevailing wage laws for public projects.  While making $50-$68 per hour, these workers are threatening to strike to increase their wages 5% per year to offset increased health care costs.  In contrast, hundreds of unemployed applicants have besieged Walmart to obtain $9.50 per hour positions in newly opened stores in the Chicago area.

Saving the Favored Banks

Amazingly, the top six banks’ holding companies made $51b in 2009 while the other 980 banks lost money:

Focus hard on this shocking Wall Street reality: The top six bank holding companies earned an aggregate of $51 billion in pretax income in 2009. We’re talking about JPMorgan Chase, Goldman Sachs, Bank of America, Morgan Stanley, Citigroup and Wells Fargo.

All of this pretax income can be attributed to their trading revenues of $59.7 billion. The proprietary trading operations of an oligopoly of banks, saved from disaster by Uncle Sam’s largesse and subsidized with cheap money from the central bank, was the single driving force behind the restoration of their fortunes and the renewed surge in their stock prices.

For those willing to go long when the outlook was the bleakest, they’ve banked a double in JPMorgan Chase, scored a quadruple in Citigroup and nearly a quintuple in BofA.

Some of the other 980 bank holding companies–like Bank of New York Mellon, PNC Financial Services, U.S. Bancorp and M&T Bank–lost an aggregate of $19 billion for the 2009 year. Bank of New York Mellon had the seventh-largest trading revenue–it was just 1.6% of the total. By comparison, Goldman Sachs had 36.2%, Bank of America 18.8%, JPMorgan Chase 15.4%, Morgan Stanley 11.3%, Citigroup 6.9% and Wells Fargo 4.2%. See Six Giant Banks Made $51 Billion Last Year; The Other 980 Lost Money

I suspect that much of the vaunted trading revenue came from Federal Reserve borrowing at 0-.25% interest rates, and then buying higher yielding treasury securities.  Would you call that investing or just “shooting fish in a barrel” courtesy of the US taxpayer?

Government Intervention and Economic Recovery

Distorting economic incentives is one factor retarding economic recovery.  Crony banks are guaranteed profits while eschewing Main Street lending.  Private sector employees face insecurity in the workplace;  that does not translate into robust discretionary spending.  Further, while not currently a problem, and with abundant surplus labor, private sector employers ultimately will compete with government compensation packages 24% higher than the private sector.

This is a smattering of the distorted economic incentives in the world of Obama, Geithner and Bernanke and their state counterparts.   Their constant meddling and direct interference in the private sector guarantees that we will have plenty of distortions  in the future.

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American Society / Economics / Political — 0 Comments
15
Jun 10

Bailout Nation Lives: Revisited, a Short Update

A mere two days after Bailout Nation Lives was posted, the President urged Congress to bail out states to avoid massive layoffs. The President

…urged reluctant lawmakers Saturday to quickly approve nearly $50 billion in emergency aid to state and local governments, saying the money is needed to avoid “massive layoffs of teachers, police and firefighters” and to support the still fragile economic recovery.  In a letter to congressional leaders, Obama defended last year’s huge economic stimulus package, saying it helped break the economy’s free fall, but argued that more spending is urgent and unavoidable. “We must take these emergency measures,” he wrote in an appeal aimed primarily at members of his own party. See Obama Pleads for $50b in State, Local Aid.

The price tag for this proposal will be $50b.

The Problem

  1. We continue to foster profligate spending
  2. We spare states the need to make the hard choices of picking which employees need to be laid off (it does not necessarily require states to lay off police or teachers); raise taxes or cut spending in other areas.
  3. Knowing that this proposal is unpopular, we get another weekend announcement to deflect criticism.  Where is the vaunted transparency the Administration trumpeted? See Shredding the Social Fabric where we discussed the pre-Christmas Eve unlimited bailout of Fannie Mae and Freddie Mac.
  4. Given all the Administrative propaganda on the robust recovery, why must we take “emergency measures” to support the “still fragile recovery?”
  5. Are ANY groups not entitled to a bailout?

Where is Your Money Going?

The savvy view is that Obama is just buying the votes of public sector union members in key states.  See Obama Once Again Wants to Buy Union Votes with your Tax Dollars. Our money is going to pay very rich public sector salaries, pension and health benefits.

Juxtapose the problem of underfunding state pension plans with rich salaries and benefits in the public sector.   Michael Shedlock points out that seven state pension funds will be out of money in 2020 and twenty state pension funds out of money in 2025.  See Seven State Pension Funds Out of Money by 2020.

At the same time we learn that 100 top administrators have earned pension benefits that actuaries value from $7m to $26m. See Make this Story Go Viral – You Thought California State Pensions were Out of Control? Wait Until You See this List from Illinois. The Illinois state teachers’ pension fund is 61% underfunded and is employing risky strategies using derivatives to try to achieve full funding.

Why shouldn’t we get “back to even” with risky investment strategies that smack of “doubling down” in Vegas?  Obama has our backs and is sure to bail us out when we inevitably fail.

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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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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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