Sunday, December 9, 2007

The False Prophets of Wealth

A Sunday Sermon

Watch out for false prophets. They come to you in sheep's clothing, but inwardly they are ferocious wolves. By their fruit you will recognize them. (Matthew 7:15-23)


In a world where debt expands much faster than our ability to put it into productive use generating income, are we cursed to lurch from one asset bubble to the next?

In the late 1990's we experienced one of the most powerful popular delusions in financial history: that the average person could sit in front of a screen and get rich by day-trading shares of companies with little intrinsic value, other than a and a Hail Mary business plan. Popular Capitalism, we called it, blissfully ignorant of the inherent oxymoron. The end came swiftly and painfully. Within just two years in 2000-2002, $7.1 trillion of stock market wealth evaporated, representing an astonishing 73% of GDP.

The shock to the economy was expected to be so severe that the Fed, perennially terrorized by its institutional memory of the Great Depression, went into panic mode, slashing interest rates to fifty-year lows. The objective was to prevent the stock crash from turning into something far more menacing - and it succeeded, at least temporarily.

Data: FRB and World Fed. of Exchanges

The sector chosen to produce America's urgently needed rebound was real estate. Mr. Greenspan made no bones about it: he constantly emphasized that average Americans had much more wealth locked up in housing than in stocks and that low interest rates would release this "frozen" capital, letting it loose upon the economy as debt-driven consumption. Moreover, the low cost of borrowing would increase new housing demand, create jobs in construction and finance, and raise existing real estate prices. When the follow-up effects of new housing were added (furniture, appliances, services), the economy was expected to enter another virtuous cycle.

It all went according to plan, until greed once more overcame common sense and yet another pernicious bubble formed. As the nation had already become accustomed to viewing capital gains as a birthright, people predictably jumped from flipping stocks to flipping houses. Stock margin was replaced with no-money-down liar loans and house prices were off to the races. The asset class that was supposed to act as the golden anchor of family savings was pulled up, melted into coin and spent like so much pirate loot. By the time the real estate market peaked in 2006, all it took to go from one bubble pop to the next was a breathtakingly short six years.

The mess is only now starting to hit home. Structured finance vehicles like CDOs, SIVs and ABCP allowed mark-to-market losses to be obscured by opaque pricing. For as long as end-user investors did not need the money, it mattered little; dealers could claim that prices were whatever came out of mark-to-model black boxes. But when the money was needed - for example, to pay schoolteachers in Florida - the trouble surfaced to the "real" economy. Investment bankers now blame it all on unpredictable 20-sigma events, but this is like Casablanca's Capt. Renault professing to be "shocked, shocked to find that gambling is going on here", while a croupier hands him a pile of money, saying: "Your winnings, sir".

As with stocks in 2000-02, real estate wealth is wasting away. The drop isn't as fast or as severe, but it affects a far greater number of Americans. What Greenspan saw as the main advantage of a housing boom, i.e. wide participation, is its greatest shortcoming, as it turns into a bust. When stocks drop $100 the loss to 80% of Americans is just $9. But in the case of housing they lose $35 - four times as much. The impact on the mood of the consumer, the so-called "wealth effect", is likewise severe - though with a significant delay, because house prices are not tied to a daily Dow Jones-type ticker. People have difficulty accepting that their own house is now worth significantly less. They too, are marking to model or, more accurately, marking to dream.

This is not lost on the Fed and the administration, both of whom are once more in thinly-veiled panic mode. They keep throwing up all kinds of misbegotten plans to save the day: the super-SIV, lifting lending restrictions to bank subs, encouraging Discount window borrowing, freezing ARM rates - BandAids, all. Perhaps they will try another tax cut soon?

The false prophets of wealth are finally seen for what they really are: pushers of debt and needless consumption. They preach that if debt is made cheaper, if the liquidity taps are opened wider, if we just borrow more, we us all shall be wealthy. But in a global financial system that is already awash in liquidity, what need have we of more? What is there left to speculate on margin, that is not already levered to the hilt? Nothing.

Enough with the sermonizing. The practical question is: what should be done? If lower interest rates and the various government plans are not the solution, what is? I shall revert with concrete proposals, but in the meantime please read what someone had to say about this very subject over two thousand years ago. It is to be found underneath the blog title at the very top. Some things never change.


  1. What could be done and what will be done are two different things and most likely would not change the eventual outcome. Like the Roman or British empires we to are on the same path and will face the same faith, empires come and go like the tides the new rising super powers lay in the east and wait for our fall. The question one should ponder is whether it will be in a sudden collapse like the Soviet Union or after years of war and death.

    There will be another bubble it is the nature of man and maybe nature itself, this in some ways seen in the wolf and sheep populations as one species grows larger the other shrinks until this can not continue any longer and then balance is slowly restored.

    As a nation we are spiritually, morally and financially bankrupt. This to will revert to the mean but not after much pain and suffering.

  2. Father Hellasious,

    'Twas a fine sermon there Father, and don't ya know my head didn't bob even once.

    And by the way, would you care to look into your prophet's looking glass to discern where the next bubble will be so I we us can all have that dream of lining our pockets again with profit and do the dance all over again?


  3. “The things that will destroy us are: politics without principle; pleasure without conscience; wealth without work; knowledge without character; business without morality; science without humanity; and worship without sacrifice.” Mahatma Gandhi

  4. Dear Hellasious,

    I'm confused by all the talk of liquidity coming to the market's rescue. The transmission mechanism for this appears not at all certain or even probable. Doesn't money,ie credit/liquidity, have to be borrowed into the system? I wonder how making credit available would help if no one wants or needs to borrow or lend. The word Saturation comes to mind. Does the Fed induce this outcome by forcing the real rate of return negative to increase money velocity? This becomes difficult if borrowing costs to businesses and consumers remains stubbornly high. Just look at LIBOR. Any thoughts? Even though it is widely dismissed, I can foesee how deflation (of the asset kind) can weave its way into the markets. This is why I cannot embrace the commodity bull thesis right now. I would be much interested in your thoughts.

    GMG in Nashville

  5. Dear gmg,

    My thoughts exactly. You must have been reading my next post, somehow!

    The Fed can do very little, if anything. It is a fiduciary crisis, not a liquidity crisis. And if it plays out as feared by many (myself included), then deflation is indeed the outcome.

    Forcing negative interest rates on the dollar will mean the end of its global reserve status. I am not sure if the US monetary and political powers want this, but perhaps they may see it as the lesser of two evils, who knows?


  6. Hellacious:
    Matthew is my favorite new testament book and your quoted passage one of my favorites. That said, I disagree. The Fed was created to inflate and inflate it will. The Fed will not let Citigroup, et. al., go bankrupt. Hence, the US dollar will. As I have said for 27 years, "In the old days you went bankrupt, you sold your assets, you paid the bank 50 cents on the dollar and went on. Nowadays, you go bankrupt, you go to the Fed, get reflated and pay the bank 100 cents in 50-cent dollars". Got gold? As Will Rogers said, "Invest in inflation. It's one of the only things sure to go up".

  7. A biblical analogy is quite appropriate. I've got about as much "faith" in the bible as I do in federal reserve notes. So holding US dollars is fine with me, as long as they're silver eagles. Trust but verify.

  8. Independent accountant said:

    "The Fed will not let Citigroup, et. al., go bankrupt."

    That's what I call faith-based investing :)


  9. Hel,

    Much has been written about mark-to-market losses of level 3 assets at major banks. It is harder to find an estimate of how serious losses to level 2 assets could be if mark-to-market happens there. The big banks have 80% or more of their assets in the level 2 category.

    If deflation of financial assets occurs , and I agree with you and GMG that this is a possible outcome, then couldn't the losses to level 2 assets exceed those to level 3?

    What's your take on this?

    Also, do you think the Fed can prevent junk bond yields from getting up to the 16%+ level? If that happens, and if it is sustained, there are sure to be more bankruptcies and writedowns. Could we not then see a period in which total debt stays flat or declines slightly (YoY declines in total debt are extremely rare)?


  10. In a world where debt expands much faster than our ability to put it into productive use generating income . . .

    A foolish question doubtless betraying astonishing naivete:

    Why can't we put this debt into long-term investments, such replacing or maintaining infrastructure or developing alternate sources of energy? Seems to me that would be a productive use - but such thoughts also seem to cross the minds of few possessors of leverage. Instead, we pursue short-term yet risky gains in M&A/private equity, CDS, CDOs, etc., that arguably are not productive in any other than a financial-metric sense.


  11. gmg

    "I wonder how making credit available would help if no one wants or needs to borrow or lend."

    Excuse my lack of economic knowledge. Isn't credit going to be need when the holders (municipalities e.g.) of the financial vehicles (CDO e.g.) need to cash out.

    Not the Fed but the people in the pocket of Citi will bail them out. Faith-based? No, reality-based

  12. Re: Junk bonds to 16%.

    If such rates happen in the overall junk market, then we will see a rash of bankruptcies as big as 1932, or Japan in the 1990s. Hope not...


  13. As it regards 3Q Flow of Funds, according to this site: index...bleBulletinHome

    Credit/borrowings have increased substantially in the 3Q, as indicated in fed's 3Q Flow of Funds.

  14. "Credit/borrowings have increased substantially in fed's 3Q Flow of Funds."

    No kidding.

    delta(TCMD)/delta(national income) is more than 10 for Q3, 2007.

    What can be done?

    Real transparency would help. Bernanke could regularly appear on C-span and answer questions from the little people instead of giving us more frequent economic palm readings.

  15. Dear Marcus,

    Overall net selling of assets, whether they be stocks, or bonds, or houses, or commercial property, would be indicative of asset deflation as investors shun holding riskier assets and seek liquidity (cash or gold) and safety. As a result, money would pile up at lending institutions. Money returning to the banking sector to minmize debt would result in the money supply contracting, causing a downward chase in asset prices. The question becomes for the banker and the borrower, "Does the investment climate offer me an opportunity to compensate me for my RISK?" If not, velocity of money falls, possibly even at ultralow interest rates as people restore their balance sheets. I hope this answers your question.

    GMG in Nashville

  16. No one's remarking on the end-of-year (except NASA, who announced they won't try to fly the shuttle til early January to avoid problems with software in flight, over the end of the year).

    Lots of people still have money being poured into 401ks, and have to spend their medical reimbursement accounts, and so on.

    Doesn't that stuff always bump up the economy?

  17. GMG in Nashville,

    Thank you very much for a clear explanation.

    Can you give the counter-scenario or argument for inflation? Could it happen by a combination of government support of bad assets and a new creative financial vehicle, for example CDO 2.1?

  18. Dear Marcus,

    One argument for inflation concentrates around the German inflation that took place after World War I (Weimar Republic). Essentially, the German government authorities devalued its currency to repay its war debts resulting in hyperinflation. Some believe that the Fed could similarly relfate the US economy by monetizing the bad loans in the banking system. The banks would exchange these non-performing loans for Fed reserve dollars. This would recapitalize the banks, but the banks would still have to have incentive to lend and borrowers to borrow. This is a giant leap of faith with a whole lot of other things to consider like a falling dollar, restoration of confidence, and the US being able to attract foreign capital. As you can see, there seems to be no good choices here.


  19. Can you give the counter-scenario or argument for inflation?

    Another scenario...

    In response to a recession the government passes wave after wave of fiscal stimulus packages while the Federal Reserve holds interest rates at zero percent.

    The government debt becomes so large that it creates a public debt trap. Meaning that interest payments on the public debt are so high that raising interest rates threatens the solvency of the US Government.

    At that point the Federal Reserves only course of action is to monetize the US Government's debt.

    A public debt trap has always (to my knowledge) preceeded hyper-inflation in industrialized countries.

    The other instances of hyper (or even high) inflation has been in situations where government policies subsidized consumption and penalized investment (Venezuela, Chavez) or systematic looting of the country by officials (Zimbabwe).

  20. greenie,

    < When US dollar loses that status (i.e. final collapse of Bretton Woods era), then US becomes equivalent to any other country in the world.... >

    Exactly. If oil is priced in Euro only, that's the beginning of the end. However, if oil is priced in basket, then I agree that we have to wait and see how things develop, as USD may still continue to be world reserve currency. But claiming to have zero-consequence in any way is a bogus clim I think.

    If you look at the Wikipedia extensive analysis, you could find that the leading cause was private current account deficits.

    Fixed exchange rate was wrongly stated as the reason -- today most Asia economics have pegged currency, yet why no currency crisis? With such strong foreign reserve, even if there is a recession today, do you really think there will be a repeat of 1997 Currency Crisis? In fact, there were strong arguements that it was the later PEGGING (as a matter of fact) that saved these countries from further currency issues.

    Blaming the crisis on Pegged currency was a total ignorence by various articles too. Then China had the most stringent pegged (not even floating) since 1990, yet Yuan was never impacted, and the pegged was never shaken a bit during the 1997 crisis.

    Again, Asia currency crisis was not fundamentally due to Japan or what so ever in my opinon. Facts:

    1) Economy boom and bust is always a cycle, but not every cycle bust is termed "Currency Crisis".

    2) There was a reason for the term "Currency Crisis" for Asia 1997.

    Overheated economy + Recession + Exit of FDI (foreign direct investment) all compounded the problem.

    But made no mistake, Low Foreign Reserve (running deficit) was the main culprit. Once the citizens realized their respective country did not have enough reserve to meet foreign inport/export demand, more head to exits.

    Anyway, appreciate your inputs so far.

    Sorry Hellasious for taking over the board.

  21. Hellasious,

    < What could be done? >

    My 2 cents tells me that there is an equally important question to yours: "What could happen"?

    Because, what could happen would drive What Would FED/Government do.

    Deflation or not, I think it boils down to one fundamental cause -- as Roubini argue, is today crisis a Liquidity, or a Solvency one?

    To extend that, at what break-point will the overall american debt become intorelable? should the debt level be done in American consumer, or at government level, or both? As far as my eyes see, it would probably easier to analyze at cosumer level, since US government debt will always be granted AAA and someone will buy it up (unless Oil is totally unpegged and priced in Euro).

    My more immediate concern is Bernanke. Until it concludes, I would not count him out. He spent his life analyzing Great depression and the solutions for it.

    Greenspan pull out a trick in 2002 possible depression to blow housing bubble "echoing" Bush's American dream. Now, would Bernanke pull out a new trick in 2008, possibly in Stock Market again?

    I know Stock and Housing are the 2 biggest asset to support economy. I always wonder what is the 3rd asset class, or if the 3rd is big enough this time? Maybe Bernanke will blow Stock + 3rd asset class to get us through?

    Hm ... a lightning just cross my mind -- remind me of 1997 Asia Currency Crisis. When demand collapse internally, the government resort to micro-managing the currency to low value, and create a boom to factory expansion and export growth.

    Would Bernanke + Paulson lower the interest rate to 0% nagative interest rate, and forcing other countries economies to overheat, dollar continue its downslide to cash index 40, therefore attracting foreign money?

    You will be surprise that back here in Ohio, there have been Call Centers moving back from India!! Also, Russia is building its Steel factory here.

    Why??? One common reason cited -- Cheaper USD and therefore cheaper cost. Quality is higher, therefore it makes more business sense to build factory and cheap call centers here (imagine those $6/hr minimal labor). Plus, don't underestimate the power of cleanest indutry -- tourism, as well as the buying power of Canada$ or British$ or Euro$, as they have shown their strength during the Thanks Giving shopping period.

    I tend to think FED/Government plan is to extend or blowing a bigger bubble and problem, rather than to face the issue and resolve it.

  22. This is sort of an impossible question to answer, but I noticed it mentioned in other posts. What's the point of critical mass? When do consumers finally realize the direness of the situation and everything starts unwinding?

    I am not so sure that there is a definitive point that could serve as the answer, but it seems like a question worth asking.

  23. Re: consumer critical point

    In my opinion the best number to look at for such a critical point is the weekly initial claims for unemployment insurance. Americans live hand to mouth (near zero saving rate). When they get laid off they HAVE to cut down.


  24. somewhat OT but related to discussions in previous threads about higher education costs/loans.

    Today's Boston Globe has a story that should be headlined "Harvard announces nobody can afford it; those making under $500k to get need-based aid."

    They are no longer calculating financial aid based on the expectation of loans. Apparently the smart kids aren't even bothering to apply because they don't want to be 22yo and 6 figures in the hole. Even better, if you make $60,000 or less your kid can go to Harvard for free, because according to them, you can't afford to pay anything for college.

  25. < ... best number to look at for such a critical point is the weekly initial claims for unemployment insurance ... >

    Not sure if I can agree on that.

    We have seen many months of below average job growth this year compared to last year, as well as the required 150K jobs per month to maintain umemployment rate.

    Also, we know those bogus claims from BLS on Birth/Death model, as well as household survey (if I remember correctly) that is actually showing tons of jobs losses in the past few months.

    However, with continuing claims remaining high and seeing lots of jobs reductions, I find it strange that the Unemployment Insurance claims still remain close to historical low.

    Maybe the claim number is "massaged" too?

  26. Take a look at the Housing bubble blog

    Houses seem to be worth less than used cars.

    Really worrying.

  27. What a responsible steward would do is raise interest rates: call it a short squeeze on the liquidity pimps. Sure the US would go itno recession but it would also be a resounding mniddl;e finger to all those "decoupled" economies. America has long since forgotton about the national interest and hence don;t hold your breath. Now ios the time for Americans to hike up thier trousers, bite the bullet and acceopt the sacrafice so many in DC called for a few short years ago. It is about time we had a little social darwinism. Americans need to get used to the fact that the drugreenspan induced haze of the past decade was a fleeting dream. What is that saying: wwelcome to NY you ain't in Kansas, I mean Abu Dhabi, anymore.

  28. I agree with everything you say, but wasn't the fact Greenspan raised interest rates, what, eight times in 2000 to, in his words, slow the economy, a factor at all in the 2000-2001 market correction?

    Because he sure didn't mind lowering them back down immediately after the election year. Nor did he oppose unbalancing the budget with the obscene tax cuts for the very top income earners in 2001, either.

    After being such a balance the budget hawk while Clinton was in office.

    I also seem to recall Bush stating, incorrectly, that we were in a recession early in his first term, and the markets fainted.


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  36. Interesting. I guess efficient market theory is in a way defined by exceptions and examples of irrational hype like these. It would be interesting to see your perspective a couple of years on from this post, now that the iphone has been around and sold in record numbers, despite the price barrier. Was that speculation really irrational or was it justified? Also was it (or behaviour like it) a precursor to the burst bubble marketplace we are in today?

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