October 18, 2015

A Hall Of Mirrors

The second weekend topic, looking forward, is Peak to Peak: Where In Today’s Boom/Bust Cycle Does the U.S. Find Itself? By Danielle DiMartino Booth. The bursting of the housing bubble, which to this day remains a thorn in the lumber industry’s side, and today’s commodities bubble, currently plaguing the global economy, are two bubbles bound by a troubling ‘flation’ paradox. The reaction to the PEAKing in home price inflation led to the PEAKing in commodities inflation. Meanwhile, boom/bust cycles, which stretch back in history as far as black tulip mania and characterize the current era of policymaking will inevitably usher in deflation scares that emanate from bursting bubbles.”

“The debt Band-Aids applied provide an easier path than the restructuring of economies that would make them more productive over the long haul. The absence of such structural reforms leaves countries reliant on re-igniting their sputtering export engines. The only catch is, not everyone can play the same game at once.”

“Where in today’s boom/bust cycle does the U.S. find itself? According to the latest WSJ headlines, ‘Worry Over Low Inflation Kept Fed at Bay.’ And yet, eight days earlier, another headline, this one from the Dallas Morning News angsted over, ‘Area Apartment Rents Rising at a Record Rate.’ Well, which is it? According to two of the brightest minds in investing, Van Hoisington and Jim Grant, the answer is BOTH.”

“At a recent conference, fixed income investing legend Van Hoisington explained why the Fed cannot technically ‘print’ money, at least when gauged by true M2, which is cash, checking and savings deposits and money market mutual funds. Recall that at its simplest, inflation is too much money chasing too few goods. Buying up all manner of debt with the hopes of inducing inflation only works if what the Fed spends circulates back into the economy in the form of M2 chasing goods. But that hasn’t happened. Rather, Fed purchases have been deposited right back at the Fed where they now sit fallow generating a pittance of income that sadly beats the negative rates they’d get otherwise.”

“When money growth stagnates, the economy won’t slip into gear, which is just what we’ve seen for over six years now. (True money printing involves depositing money directly into checking accounts and happens to be illegal for those of you wondering.)”

“Jim Grant of Interest Rate Observer fame concedes that while we have seen little in the way of inflation of goods in recent years, we remain real time witnesses to the effect of the extraordinary amount of credit chasing asset prices from stocks, bonds and commercial real estate to the mountain PEAKs and beyond. Rising asset prices have no place in traditional inflation metrics as they are viewed as misleading economic growth signals. Or, as Grant said ‘The distortion of prices puts us in a Hall of Mirrors.’ It is thus an illusion of prosperity via the prism of asset bubbles that deludes us into believing anything of economic value has been produced.”

“But back to those paradoxical inflation/deflation headlines. The two gentlemen above, along with some acknowledged defects within the Fed’s preferred inflation measure, help solve the riddle. The creation of debt in debt-laden economies accomplishes a whole lot of economic nothing, hence incomes grow at no faster pace than the rest of the economy. That’s what happens when debt levels cross a line in the sand of the whole of a given country’s economic output. (Look no further than Japan’s debt to GDP of 670 percent to understand why that country is flirting with recession yet again.)”

“At the same time, credit has been chasing high-end apartment construction and prices to what is hoped are PEAK levels. At a national level, apartment data miners find that rents are rising at something more along the lines of a five-plus percent pace. The core consumer price index (CPI), which excludes food and energy, meanwhile, reports a more subdued 3.6-percent pace in rental inflation.”

“But that still isn’t the number that poisons the ‘flation’ worry well. The Fed’s ‘preferred measure,’ the core personal consumption expenditures (PCE) gauge, most recently crawled in at a worryingly low 1.3-percent rate, a level sufficiently shy of the Fed’s formal 2 percent target. When numbers are this low, four-tenths of a percent is material. That’s exactly the size of the difference between core PCE and CPI, the latter of which last clocked in at 1.7 percent. The main difference between the two comes down to their shelter weightings.”

“Tellingly, the core PCE also came under scrutiny during the PEAK years of the housing boom because it failed then, as it fails today, to capture the immense drag housing puts on household budgets. Harvard’s Joint Center for Housing Studies most recent data find that almost half of all renters spend more than 30 percent of their income on rent; they call this cohort ‘burdened’ and I’d have to agree. More than a quarter of all renters are ‘severely cost burdened,’ and spend more than half their income, half, on rent. The Harvard data reveal that lower income individuals are even more disproportionately burdened, which distressingly stands to reason.”

“In a recent report titled, ‘The Burden of Shelter,’ Michelle Meyer, Bank of America economist and renowned housing expert, nodded to policymaker’s dilemma: ‘If renters have to allocate more of their disposable income on shelter, there is less money to spend elsewhere, contributing to the disinflationary pressure for consumer goods.’ And that’s just what we’ve seen.”

“As for the prospects for truly normalizing interest rates one day, demographic trends only promise to increase the ranks of severely cost burdened renters in the coming years. Harvard’s data project that due to the rise in minorities and elderly as Baby Boomers age, those who spend more than half on rent will increase by 11 percent over the next decade and that’s IF rental inflation slows to that of income growth.”

“Of course, the opposite scenario unfolding would be ideal – that income growth begins to outpace that of rent inflation. Such an economic miracle, though, will only be possible with a radical change of thinking among policymakers. Policymakers are either blind, or worse, willfully blind to the financial asset price inflation that flashes red today, just as it did during the dotcom and housing bubble eras. If that is the case, the bust to come will be followed by yet another boom in asset prices, one that will require firehoses to douse the flames of impending deflation.”

“At the core of policymakers’ Catch 22 is the fact that there is no easy way out. To borrow from Hoisington’s philosophy – developed countries such as the U.S. are simply too large to devalue their way out of debt by using a depreciating currency to reduce debt loads. That leaves belt tightening which generations of central bankers have been trying to avoid at all costs.”

“Can the same brands of debilitating debt loads that leveled the global economy during the Great Depression be sustained indefinitely? That’s surely the hope as the frequent application of additional debt-creation bandages over the open wounds of high debt levels seem to be the only solution politicians find palatable.”

“Perhaps the privileged skiers atop the world’s financial markets will be nimble enough to avoid sliding on the ice as one season of asset bubble glides into the next creating the illusion of a powdery permanent winter wonderland for a chosen few. Perhaps they can be magically transported from PEAK to PEAK with little in the way of collateral damage.”

“But what of the hard landing on the fully-thawed bare earth at the bottom of the mountain that must be endured by the millions of workers who cannot choose a more accommodating trail to escape their budgetary shackles? Will central bankers always be seemingly divinely endowed with soothing words to calm and assure the masses? After all, inflation in the wise words of central bankers, is only an illusion and does not exist. Except it does exist in a very real way for the masses far below the rarefied air of the lofty PEAKS.”

The Incidence Of Error

The first of two weekend topics, this one looking back at what happened, by Jim Grant. “A review of Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again, by Peter J. Wallison. Fannie and Freddie did the deed, according to Peter J. Wallison’s mortgage-centric account of what really caused the Great Recession. No need to go searching for alternative explanations. The federally chartered behemoths are the guilty parties, they and no one else. A former Reagan White House counsel and a longtime critic of the so-called government-sponsored enterprises (GSEs), Wallison has drawn up a double indictment. The first fingers the government. The second assails any who would not blame the government.”

“This is a very good, very tendentious book. It maps the road to the quasi-socialization of American housing finance, in which condition we find ourselves today. It tells you where subprime mortgages came from and how they metastasized. It parses accounting controversies, explains how regulators favor and disfavor certain categories of investment assets, and chronicles the unnatural rise in house prices between the late 1990s and the mid-2000s.”

“Wallison argues that private actors, while hardly blameless in the events of 2007-09, did not precipitate them. The author rests his case against the government on the fact that, by mid-2008, ‘there were at least 31 million nontraditional mortgages (NTMs)—57 percent of all mortgages—in the U.S. financial system,’ and that three quarters of these securitized turkeys had alighted on federally chartered balance sheets. The comprehensive, persistent decline in mortgage lending standards wasn’t the doing of private lenders, Wallison demonstrates. You may thank Congress and the Department of Housing and Urban Development for that.”

“Between 1991 and 2003, as Wallison relates, Fannie, Freddie, and lesser federal agencies boosted their share of the American housing market to 46.3% from 28.5%. It happened this way. In 1992, the House and Senate directed the GSEs to meet a quota of mortgage loans to low- to middle-income borrowers. Thirty percent, the initial minimum, presently became 42%, then 50%, and finally—in 2008, the year Lehman Brothers failed—56%. Minimum down payments were reduced, too, to nothing at all by 2000.”

“Nor did the upper-income reaches of the mortgage market, a segment not directly served by Fannie and Freddie, remain untouched by this federally induced letting down of hair. Before long, well-to-do people were taking out ‘interest-only’ loans that required no amortization of principal until their maturity date. By 2001, Alan Greenspan—then chairman of the Federal Reserve—was marveling at the ‘very substantial buffer of unrealized capital gains, which are being drawn upon through the home-equity market, through cash-outs, and through the turnover of existing homes, which has been, as you know, quite substantial despite the weakness in the economy.’ The single-family American house was on the way to becoming an automated teller machine.”

“Wallison seems to forget that money isn’t humanity’s best subject. You can satisfy yourself on this point with a simple calculation. One hundred dollars invested continuously at 2% interest since the year of Cleopatra’s death would work out today to $5.3 billion for each of the world’s 7.3 billion people. Of course, the average earthling is worth nothing like that much money. Banks fail, currencies are inflated away, thieves break through and steal.”

“Error is endemic in finance—people will buy high, and they will sell low. Given half a chance, they’ll over-borrow, too. The incidence of error is all the greater when the incentives of law and regulation invite it. Wall Street was no Garden of Eden when financial responsibility rested chiefly with individuals—when, for instance, the general partners of Morgan Stanley were personally responsible for the debts of the firm they led. The Street is that much further from paradise since personal responsibility has given way to corporate responsibility—Morgan Stanley became a publicly traded corporation in 1986—and, increasingly, to collective responsibility.”

“Once upon a time, the stockholders of a bank were responsible for the solvency of the institution in which they held a fractional interest. To restore the solvency of the biggest banks in 2007-09, the taxpayers had to reach into their own pockets.”

“To any who wished to see, it was obvious that house prices were much too high, that the securities fashioned from subprime mortgages were anything but creditworthy, and that some of the biggest Wall Street banks and brokerage houses were wobbling on their high stilts of debt. Grant’s Interest Rate Observer, the financial publication that I own and edit, issued its first cautionary piece on runaway house prices in 2001, its first bearish analysis of subprime mortgage securities in 2006. We were far from alone.”

“There was no ‘perfect storm,’ the author insists, no constellation of causes that form a satisfactory explanation for the calamity of 2008. Those who would argue the multi-causal case confront the insuperable problem of not knowing when to stop listing causes. The more they cite, he insists, ‘the less we learn, and the less the theory can serve as a guide for policy makers in the future.’”

“In the Isaiah Berlin world of hedgehogs (those with a single big idea) and foxes (those with many ideas), there was never such a hedgehog as Peter Wallison. His brief is thoroughly researched, clearly written. He anticipates his critics’ likely objections to his mono-causal view of the crisis and attempts to answer each argument in turn. He succeeds to the impressive extent that his point survives his own exaggerated telling of it—barely.”

Bits Bucket for October 18, 2015

Post off-topic ideas, links, and Craigslist finds here. Please visit my Youtube channel which you can also find here: