The Rise And Fall of Finance

In 1979 I had the great good fortune to see the Metropolitan Opera production of "The Rise and Fall of The City of Mahagonny", the political opera by Kurt Weill and Bertolt Brecht that was written back in 1930 - at another time of severe financial trouble around the world.

Since the work is a nightmarish vision of capitalist greed and the power of money, the Met's performance was essentially its premiere in the US, with Teresa Stratas giving a memorable performance as Jenny the opportunistic harlot. Wall Streeters loved it (it takes one to know one, eh?).

Mahagonny's Primary Industry At Work

The final scene depicting the city's destruction by fire has stayed with me ever since. And the opera's title has come in handy several times, particularly when referring to the cyclical and repetitive nature of greed in human history.

Thus, today's title and chart below (click to enlarge). It shows debt of the financial sector as a percentage of all debt outstanding in the U.S. (currently $17 trillion out of a total $53 trillion of debt).

Financial Debt (Data: FRB Z1)

The Rise of Finance, also known in this blog as The Tail That Wags The Dog, can thus be clearly observed in the spectacular rise of financial sector debt as a percentage of total debt. From an inconsequential 1.9% in 1950, it rose inexorably in following years to reach an astonishing 32% today. The importance of finance to our economy and society has risen commensurately - to the great detriment of both, as has now become obvious.

Why and how did we allow a business sector which relies almost entirely on greed and animal spirits to become so powerful within our national ethos? How are we going to stop and quickly reverse this patently destructive process?

Could it be that The Crisis could be a cleansing deluge, wiping away the wretched excesses of finance-as-painted-harlot and restoring her to the back alleys, where she so clearly belongs?

Yes, it could. But not before we stop viewing finance as an industry worthy of being bailed out at every turn of the road and belonging at every street corner, besides. Enough is enough, already..

A Plan For Debt Relief

Following my previous post on The Spectre of Default, here are some ideas for a workable household debt relief program in the U.S. The name is not really important: debt destruction, default, cancellation.. but the end result MUST be the reduction of debt as a percentage of earned income.

(Please note that I do not espouse government debt default. Seeking Alpha, who get a feed of my postings, for some reason initially altered the title of my previous post on their site to The Spectre of Government Default, adding the word "Government" on their own, thus significantly altering its meaning. That was unfortunate.)

Debt relief must happen within the context of comprehensive transformation of the economy. It would make no sense whatsoever to provide debt relief, only to see borrowing come roaring back.

Thus, first some proposals on altering the foundation of our economic and financial system:

1. Tightly regulate money supply by linking its growth to renewable energy and the creation of a Sustainable Economy. That's my Greenback proposal.
2. Start actively dismantling the Permagrowth Economy. Some suggestions could be to tax "black" energy heavily, cap and trade greenhouse gas emissions and impose a national Value Added Tax (VAT) on all transactions.
3. Place the financial sector back at the "tail" of the economy, where it belongs; it is the dog that should wag its tail, not the other way round. One example would be to gradually increase reserve ratios and capital requirements for banks (e.g. Tier I capital to 20%).
   
4. Cease all financial sector bailouts and, where practicable, ask for the government's money back, with interest.

The above measures will not only curtail credit supply (i.e. loans offered by banks), they will also serve to reduce credit demand from consumers and business, immediately and in the future.

As to debt relief and destruction, specifically:

1. Re-work laws to make it easier and less onerous to file for bankruptcy. It should be noted that such laws were made much more restrictive under the Bush administration.
2. Haircut all existing student loans by 50%, with creditors taking the loss. Education is a benefit to the entire society - banks and investors included. It isn't and never should have been a product to be bought and sold on credit. All subsequent loans to be severely regulated and restricted.
3. Re-instate usury laws on all borrowing, future and existing. This would mean the effective reduction in interest rates to a national maximum, say no more than double the equivalent Treasury bill or bond yield, depending on duration. It makes no sense for the people as a whole (i.e. the government) to borrow at 3% and people individually to have to pay 23% (e.g. for consumer credit).
4. Withdraw all government loan guarantees and replace them with FDIC insurance per individual (not account) of up to $500,000.
   
5. Wipe out all second mortgage/home equity loans up to a maximum of $50,000 for those households making up to $50,000/year pre-tax (that's the median household income for the lower 60% of the population). Forbid all subsequent second mortgages - a house is not and never should have been an ATM machine. It's a place to live in, i.e. a shelter.

I do have more ideas, but I have to stop here. A long weekend beckons..

The Spectre of Default

Governments the world over are hoping to publicly borrow their way out of the stupendous mess created by the private financial sector. They are thus engaging in a monetary and fiscal experiment of Titanic proportions, steering a patchwork ship of State constructed from traditional Keynesianism and radical free-market ideology. Unfortunately, they are either blind to, or are nervously whistling past, the largest iceberg field in the history of economic navigation.

We are not going to escape unscathed.

Let's quickly set out what went wrong: oceans of debt blew asset bubbles for everything from clapboard houses and dinky mortgages to smelly shares, hedge funds, LBOs and 2/20 private equity funds. If an "asset" as much as fogged the mirror it was sliced, diced, indexed and leveraged to the hilt, transformed into a creative financial "product". A private banker friend told me two years ago that his nouveau riches customers from as far afield as Bangalore, Dubai, Sao Paolo and Moscow cared about one thing and one thing only: how many times can I leverage this baby up? At the top, if the answer was less than 40-fold they just sniffled and turned their noses away. (That's 97.5% margin, in case you were wondering..).

What happened next, predictably enough, was a debt crisis of historic proportions - and it's still going on. Amazing isn't it, how the newest generation of suckers always jump with glee into the oldest trap in the world* ?

Debt In The Yihaa !! Era

Governments, particularly in the U.S., are now desperately trying to avoid their biggest bugaboo: persistent asset deflation through debt destruction. Why? Because most assets are held by that tiny minority of the population for whom the golden rule applies (he who who owns the "gold" makes the rules). The vast majority of the rest have debts. To get a sense of the vast divide, in 2007 half of all American families had a net worth of $58,000 or less. By contrast, the top 10% had a net worth of $4,000,000 on average.

Chart: Federal Reserve

For a pluralistic republic like the U.S., does it make any sense to salvage the top 5-10% of the population's assets by placing more debt on the shoulders of everyone else - who already own next to nothing? Would it not be better to work out a debt default and reduction plan, instead of pumping the debt bubble even bigger?

But, mention debt default by (intelligent) design during a polite conversation and watch it grow hot and indignant - that's the moralistic Protestant Ethic weaving through most of us, I guess. Putting it another way, the Spectre of Default haunts, increasingly with as much fear as the other one did, back in 1848.

I am starting to believe that what America ultimately needs is a modern-day Solon and a healthy dose of seisachtheia.

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* A short aside about the benefits of a comprehensive education in financial history: an acquaintance just told me he is convinced the economy is on a solid rebound track. When asked how he came to this conclusion, he proudly assured me had taken one (1) year of economics at college, some 20 years ago. Yes, indeed, there's one born every minute... So, at least, read a bunch of books before sententious certainty sets in, eh?

Where Are Profits Going?

This blog's position has always been that the US economy's performance post-2000 has been due to ever-increasing assumption of debt, particularly by households to finance real estate purchases and personal consumption. I don't think anyone can dispute this any more: just look at the chart below (click to enlarge).

The Debt Boom Finally Begat The Bust

Charts: FRB St. Louis

Debt kept accelerating while GDP remained "stuck" at around 5% annually (these are nominal figures). In the end, the debt boom created its own bust and dragged down the entire economy. Cement shoes come to mind...

So, now what? What does the future hold? In particular, I am referring to corporate profits, the fundamental driver of stock market performance. We can analyse markets using a multitude of perspectives from astrological to psychological but, when it's all said and done, what matters is profits.

Since 1997, or so, households assumed ever more debt in order to consume and, thus, increase corporate profits. At the top in 2006 it took an additional $1.3 trillion in household debt to generate an additional $300 billion in profits, i.e. a ratio of 4.3 times (see chart below). The debt intensity of corporate profitability was huge, but it weren't corporations themselves that were going into debt; it was their customers.

Annual Increases In Household Debt and Corporate Profits ($ Billion)

We are now deep in a debt-bust crisis and it is the first time since at least 1953 that household debt is decreasing in absolute numbers, year on year. What does this mean for corporate profits? Based on the relationship above, I expect they have quite a bit more to drop, perhaps after a (very) brief period of stabilization due to cost cutting (see chart below).

Corporate Profits After Tax

I would thus not be at all surprised to see after-tax profits go back to around $300 billion/year, where they were in 1992 at the beginning of the debt acceleration cycle. What does this mean for stocks? Look at the chart of S&P 500 below (click to enlarge).

S&P 500 Share Index

In 1992 S&P 500 was around 400, or 57% lower than current levels. Of course, this is a pretty simplistic and one-faceted approach to corporate profits and the market, dealing as it does only with debt. (But then again... KISS has always been pretty good guidance.)

There is another macro approach to corporate profits, however. As a share of GDP pre-tax profits had reached a record 13% in 2006: corporate greed had reached a peak, indeed.

Data: FRB St. Louis

If the ratio of profits declines to a new low, say 5%, and nominal GDP declines another 10% to $12.6 trillion (not at all impossible in this crisis, it was there at the end of 2005), then we are looking at pre-tax corporate profits of around $630 billion.

Now, include a boost in tax rates from the Obama administration and the $300 billion after-tax number mentioned above does not look so outlandish, all of a sudden.

Flights Into The Unknown

Three charts from the real economy (a.k.a. not finance): passenger and freight ton revenue miles for the U.S. airline system (i.e. domestic and international flights), plus the truck tonnage index.

Airline Freight Down 26%

Passenger Traffic Down 11%

(Data: Bureau of Transportation Statistics)

The data are current to March 2009, so they may not reflect Messrs. Bernanke and Geithner's purported "green shoots". Then again, there may not be any - except those sprouting inside the ever-fertile minds of stock and bond speculators..

Witness, the Truck Tonnage Index (seasonally adjusted, current to April) compiled by the American Trucking Association. According to them, trucks carry 69% of tonnage carried, and collect 83% of all revenue generated, by all modes of transportation.

Truck Tonnage Down 13.2%

Chart: ATA

Deflation v. Inflation

The debate rages on in the financial blogosphere: will the current crisis ultimately be resolved through a period of cataclysmic deflation or in a hyper-inflationary auto da fe, Weimar-style? (Typical of human reactions when emotions run high, very few talk about middle-of-the-road alternatives.)

What do I think? First, some background to set the stage.

In the past few decades we experienced rapid asset inflation, combined with relatively mild consumer price inflation. Many perceived this to be a good development - and up to a point it was. After all, who doesn't want to see their wealth increase while paying low prices for goods?

Trouble is, you can't have it both ways for too long because asset prices must reflect a reasonable multiple of the income they produce ("rents"). Income derived from assets must be high enough to provide a competitive current return and to offset the risk of holding them. That is to say, dividends from shares, interest from bonds and rents from real estate must have reasonable yield ratios.

How do we know when assets reach unreasonable levels, i.e. how do we define a bubble? Greenspan claimed that it was impossible to do so and that we could only identify bubbles after they burst. Obviously, I disagree.

Apart from observing crowd psychology (i.e. maniacal behaviour), I believe the best fundamental indicator of a bubble is the relationship between earned income and debt. Don't forget that asset prices and debt levels are opposite sides of the same card: it takes lots of "money" (debt) to inflate asset prices. Debt, on the other hand, must be comfortably serviced out of earned income: wages, salaries, etc. When the two are considerably out of balance then the debt-asset bubble must and will pop.

Furthermore, things get really ugly when debt and asset prices rise very fast, as happened after 2000 (i.e. Sudden Debt). Earned income then has no chance to catch up to debt in an orderly fashion and the result is debt default and destruction, with a commensurate plunge in asset prices. That's exactly what is going on right now, of course.

Let's look at this relationship more closely. Below is a chart indexing home prices (Case-Shiller National Home Index), share prices (S&P 500), average hourly wages and household debt per working person. Obviously, assets and debt got way out of balance against income, particularly about 10 years ago.

High Debt + Low Wages = Asset Deflation, Eventually (Data: FRB St. Louis, S&P, BLS)

Notice how asset prices have now corrected to a significant degree, but household debt still remains high. That's because the Fed and Treasury are furiously pumping in public debt into banks' balance sheets to avert (and mask) household debt defaults. But this is a fool's errand: in the end all debts, private and public, must be serviced out of earned income. And since income is extremely unlikely to rise suddenly, debt must also come down, sooner or later.

A few months ago this blog's masthead used to proclaim: "We hold this truth to be self-evident: We cannot solve a debt crisis by issuing more debt". By definition, therefore, the only way to resolve this crisis is to allow debt to be destroyed in as orderly a fashion as possible, taking as long as possible in order to avert social consequences.

My view, thus, is that we are in for a long period of persistent asset/debt deflation that will eventually bring debts and asset prices into closer balance with incomes. At least that should be the aim of our policy makers. But, truth be told, I am not sure at all that they see things this way...

Time will tell.

Raise Short Rates?

I just read a very good article in Bloomberg about Bernanke's conundrum, i.e. rising long-term rates even as short rates are kept near zero. I particularly liked this comment by Mark MacQueen of Sage Advisory Services: “You can’t have it both ways. You can’t say I’m going to stimulate my way out of this problem with trillions of dollars in borrowing and keep rates low by buying through the other. I don’t think that is perceived by anyone as sound policy.”

Yield On 10-Year Treasurys (Chart: Bloomberg)

Very simple and very common sense, indeed. But since the Fed and Treasury can't have it both ways, what's the way out?

I understand (but do not applaud) the current monetary bailout reaction, based as it is on America's deeply ingrained Great Depression phobia. Countless economists and Wall Streeters have spent their professional lifetimes studying and war-gaming the 1930's - Mr. Bernanke most of all. Nevertheless, they are completely and totally, knee-jerk wrong; throwing out more money (i.e. debt) will not resolve a problem that was created by too much debt, in the first place. As this blog's masthead proclaimed a while ago: "We hold this truth to be self-evident: You cannot solve a debt problem by issuing more debt".

Board of Governors Monetary Base (Chart: FRB St. Louis)

Like other shortsighted generals in history, our monetary generals are fighting the previous war - furiously building static Maginot lines whilst Guderian is warming up his highly mobile panzers.

Therefore, I strongly recommend that instead of engineering a massive explosion of money supply through quantitative easing, the US should regulate it very tightly. I have proposed The Greenback, i.e. benchmarking money supply on the growth of renewable energy. This scheme will most likely lead to significantly higher short-term rates, at least initially. But, is this so bad? I think not.

For one, higher short rates will promote domestic savings, sorely needed in a period of massive budget deficits and the urgent requirement to invest huge sums in sustainable energy*. For another, such a policy will immediately restore confidence in the dollar and our commitment to service our debt. It is likely, thus, that long rates will drop.

Let's recap: our current expansionary monetary policy is completely at odds with present and future requirements in the real economy, which is challenged by a combination of too much debt, fewer and lower-paying jobs, resource depletion and environmental destruction.

The bond market, those ever-present bond vigilantes, is already warning us that we have got to bring monetary policy in line with reality soon, as opposed to sleep-walking in a rosy dream state.


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*Of course, I take it for granted that the borrow-consume-inflate assets Permagrowth economic model is completely and utterly defunct, de facto.

From Powerhouse To Funhouse

The Employment Situation report for May is scheduled for tomorrow. So, the subject is.. jobs.

Every first Friday of the month we look at the headline numbers from the Bureau of Labor Statistics: so many jobs were added or lost last month; thus, we deduce the economy to be growing or declining. But this is less than half of the story; we rarely- if ever- discuss what kind of jobs are involved. I believe this to be superficial analysis and highly misleading.

For example: a skilled auto worker making $30/hr is fired and gets a job tending bar at $7/hr plus tips. Are these two jobs equivalent? Of course not.

About two years ago ago I started looking at the wholesale disappearance of goods-producing jobs in the US versus the creation of lower-to-middle tier service sector jobs (leisure and hospitality, retail, healthcare and education).

I have now updated the chart presented in the original post; I think it speaks for itself (see below).

Data: BLS

Good, well-paid jobs involve the addition of high levels of value to their output; some because of the high amount of invested capital in plant and equipment and technology (e.g. jobs in manufacturing) and others because they are knowledge-based (e.g. software). What we did in the US, instead of safeguarding these precious jobs, was (and still is) trully moronic, considering we did it willingly and without any outside pressure.

From powerhouse to fun-house, from manufacturing cutting-edge products to consuming bread and circuses.

This is also the reason I am so upset with the continuing sole emphasis of the administration on financial-sector bailouts. The trillions involved are being wasted in keeping a terminal patient on life support, instead of supporting the radical transformation of our energy and resource sectors. And don't forget that these trillions are borrowed!

Sometimes I feel like our Pax Americana is ablaze and we are all gathered round, poking the fire with our marshmallow sticks and laughing, telling each other camp stories.

This insanity has got to stop NOW.

Are You SURE You Want A Mortgage?

Back on the interest rate spread and ratio front, this time on a pair of rates that involve retail banking customers, i.e. you and me: 30-year conventional mortgages (the banks' lending rate) and 1-month CDs (the banks' cost of borrowing funds). We can view this as indicative of gross profitability (gross interest margin) in retail mortgage banking, even though a growing proportion of mortgages are now ARMs (adjustable rate).

As the chart below shows, the spread is back near its all time high, but nothing truly out of the ordinary is happening. Banks are simply making a decent profit on these loans - though they are not making a lot of loans, of course..

Data: FRB St.Louis

But what about the ratio of the two rates? I know many think a spread, is a spread, is a spread - but I hold otherwise. Near boundary conditions (zero nominal rates) ratios matter, too. And here things look extremely extraordinary: conventional mortgages are going for an eye-popping 16 times more than the cost of funds (see chart below). Now that's what I call a profit!

So what, you may ask? Why is this zooming ratio important? Because, if things stay as they are for an extended period of time, new borrowers - wage earners like Mr. and Mrs. Average Joe - have no hope whatsoever of servicing these loans, eventually. Their cost of borrowing is sixteen times greater than the raises they are likely to get at their job - assuming they get a raise or even hold on to their jobs.

Don't forget that the extra money to pay interest has to come from somewhere and for most people it comes from getting a raise at their job. Putting it another way, the incremental cost of borrowing money is sixteen times greater than the incremental benefit of being employed. Are you SURE you want to get a loan right now?

Of course, there is a reason why all this is happening: the expectation of deflation is holding short rates (and pay raises) way down, while the desire to recoup massive losses and control risk is keeping bank lending rates high.

Hmm.. maybe we should move back to imposing strict regulations on retail interest rates? Say... 2-3x cost of funds for mortgages and a bit higher for consumer loans? Just an idea...

P.S. Someone asked me how the Oh, Very Funny Index (tm) is doing now. As of last night, it is up 70.8% from March 2, 2009 so the index is at 170.8. See below for individual performance of its components.

West Liquidates, East Turns Inward

Nothing shouts "West Liquidates" more loudly than the goings-on at Chrysler and GM. The liquidation of capital assets and labor (i.e. plant, equipment and the jobs that go with them) is a phenomenon that will persist in the so-called developed economies for as long as it takes to wring "excess" activity out of a system which had until now relied on debt-fuelled consumption to an unprecedented degree.

In the US, for example, ever more debt was assumed to generate one more dollar of additional GDP; the ratio of annual debt increase to the increase in GDP reached 6x in 2007-08, from 3x in the 1990's. Household debt soared to 135% of disposable income, from 85% in 1990. Trully, this was an economy based on piling debt upon debt.

Thus, today's "Crisis": What the debt bubble giveth, the debt implosion taketh away - and very swiftly, at that. It is a maxim of financial markets that the downside is much swifter than the long climb up. Likewise for the US economy, which had come to resemble a casino more than anything else: everyone "bet" on fast gains on assets (houses, stocks, credit derivatives, etc.), instead of embarking on the long and arduous process of generating long-lasting income streams (good jobs).

We have now entered the inevitable Liquidation Phase; governments all over the West are furiously working to cushion the blow by transforming private debts into public obligations. In layman's terms, governments are taking defaulted mortgages (and credit card bills, auto loans, tuition loans, etc.) off the banks' hands, replacing them with newly-minted treasury bills. How long can this AAA for D swap last is up for discussion, but it is already raising serious concerns amongst those who regularly fund our debts (the Chinese being a prime example).

There are signs that US creditors are incrementaly moving away from the deposit window: the Chinese, for one, are currently on a commodity and used-cargoship buying spree, choosing to invest their money in hard assets instead of promissory notes. Why? My guess is that they are planning for a long transition period for their economy, away from export-oriented growth and towards domestic development.

For example, they are buying lots of older bulk carriers from the secondary market (66 so far this year vs. a total of 80 in all of 2008), instead of building new ones - even though they possess some of the largest and cheapest shipyards in the world. They will presumably operate these ships for their domestic needs (bulk imports), keeping older tonnage in service that would have otherwise gone to scrap. Global charter rates will remain under pressure, all other things being equal, forcing traditional shipowners (Norwegians, Danes, Greeks) to stop placing newbuilding orders to Chinese shipyards; the Chinese apparently do not care if they go against their best customers' interests. The interpretation is that they see global trade as much less of a factor in their domestic economy, in the future: over-indebted Americans and Europeans will consume less and save more.

This is the question that arises for the future of the global economy, then: will Chinese domestic activity be enough to counterbalance the western implosion and liquidation of capital asset values? I am not talking about the next few months, which is already shaping up as a knee-jerk reaction caused by western inventory rebalancing, plus the Chinese demand described above. Instead, I am looking out a couple of decades, or more.

For this time span, my prediction is this: the Chinese will turn increasingly inward and spend their money at home, creating a more modern state with social services, labor rights and environmental regulations. They will rely on foreign trade to a far lesser degree, with obvious domino effects on the ability of western nations to grow through borrowing Chinese savings.

And will the Chinese consume western goods? Well... like what? Just about everything the average western consumer can afford is already made in China and this is even more so for the average Chinese consumer.

The global economy is going to turn bi-polar: the west will suffer decades of Japanese disease and the Chinese-influenced sphere will grow inwardly. Given current absolute economic sizes (big west, small east) overall global growth will likely stagnatee for a long time.

Delenda Car (thago) Est

When I don't have anything intelligent to say, I simply reach into my bag of Graeco-Roman aphorisms, search for the most "appropriate" one and.. voila: A title to go with today's General Motors bankruptcy.

Yes, indeed, I do love history - even if it only applies by forcing linguistics into a horribly mangled state. Hopefully, a scintilla of meaning still manages to shine through.

It was Cato the Elder who ended every speech he made with "Carthage Must Be Destroyed!", the popular rallying cry against Rome's most serious contender for global primacy, during the Third Punic War (149-146 BC). And, to continue mangling associations a bit further, Carthage was located in North Africa, the continent whence our Mr. Obama traces his roots.

Roman Chariots In More Glorious Times

I do hope the administration's plans for the newly government-owned GM involve more creative ideas than selling it to other moribund Roman chariot-makers or vulture funds from further North.

Ave.