Housing stall, after all?

Looking at the economy now, we have to go well beyond subprime, and consider the general value of housing. Karl Denninger repeats that, in the long term, average house prices are three times income, but at the same time observes that they are "sticky". No-one wants to crystallise a loss, and you have to live somewhere, so why sell now?

If the financial victim next door has to sell his house at a 50% discount, that's all the more reason for you not to sell yours. If no-one sells voluntarily, how do you determine a real, as opposed to forced-sale value? So one effect of the housing drop could be a general slump in sales - with maybe a rise in home swaps for those who need to go to a different geographical area, perhaps for job reasons.

But what about people caught in negative equity? Here in the UK, ditching the house for less than the outstanding loan could leave you being chased for the balance, for years, unless you opt for bankruptcy. However, in the USA, many mortgages are on the roof but not on the borrower, leaving the lender short if the homeowner mails the keys back. Denninger has said more than once that borrowers need to consider this option solely on its financial/legal merits, as he thinks many lenders lost the moral argument when they knowingly advanced far too much to people who they knew couldn't maintain the loans. Now this could really upset the applecart.

Michael Panzner features a piece by FT columnist Martin Wolf. Wolf wonders what may happen if a high proportion of negative-equity homeowners default. The economic impact may be closer to Nouriel Roubini's $3 trillion, than to Goldman Sachs' more sanguine $1 trillion (the latter itself is a massive increase on the sort of figures bandied about before Christmas). Wolf sees two options:

There are two ways of adjusting the prices of housing to incomes: allow nominal prices to fall or raise nominal incomes. The former means mass bankruptcy and a huge fiscal bail out; the latter imposes the inflation tax.

But either option is so unattractive that (despite Denninger's image of paddling furiously as we head for the waterfall) there is a very strong incentive for fudge and delay. We've seen central banks pump many billions into the system in the last few days; and the ratings agencies seem to be trying their best to help maintain the status quo by not downgrading lenders as quickly and severely as some think they deserve. But again, housing is intrinsically illiquid, and houses aren't turned over rapidly like shares, which is why we have "mark to model" instead of "mark to market". What's the rush to crystallise a terrible loss now? Better a Micawberish hope that "something will turn up" than a grim Protestant insistence on an immediate collapse which would benefit very few people.

Assuming wages continue to rise over time, the gap between prices and incomes will lessen. If the homeowners can somehow be reassured that the government is determined to support house prices, then the sell-to-rent speculators could be caught out in their attempt to "short" the housing market. Can they be sure that, having sold their nice house, they can buy another such in the right area for much less, later? What will they do meanwhile?

The real threat is this "jingle mail", and the potential consequences seem so dire that something creative may be done. Bankruptcy rules might be modified to protect lenders; maybe portions of recent loans may be written-off. How about part-ownership, part-rent, as with UK housing associations - having escaped the trailer park, many first-time homeowners may want to keep their foot on that first rung of the ladder. Not everyone will want to pour engine oil into the carpet and trash the light fittings.

So I think we will have fudge, delay and attempts at more creative solutions, and a long stall in the housing market. Unless there's another hammer blow that the system simply can't take, such as an explosion in the financial derivatives market, as arch-doomster Marc Faber expects and (in his inherited Swiss Protestant way) hopes. In that case, every sign we've seen so far is that our governments will run the money-presses white-hot rather than face major deflation. We all have an incentive to paddle away from the brink.

Put your hand in a parting wave

Frank Barbera discusses the implications of Elliott Wave Theory for the current stock market and concludes, like Karl Denninger, that there's at least as much bad news ahead as we've had already.

Unbelievable, unimaginable

The problem with looming economic disaster is that you look out the window and since what you see is normal, you wonder what that mad Cassandra is wailing about.

Michael Panzner reproduces an article by Paul Farrell in MarketWatch about the absolutely enormous international derivative market, currently estimated at $516 trillion. Those numbers are beyond imagining, but if 2% goes bad, that's equivalent to 20% of the world's annual GDP up the chimney.

Lessons from Japan

Krassimir Petrov looks at the Japanese experience of deflation - 17 years and counting. A monetarist view would require the following steps to end it:

• Condition 1. Bad loans made during the boom years must be written off as losses during the bust. This cleanses the banking system from the toxins of the boom.

• Condition 2. Weak businesses should be liquidated during the bust, rather than propped up by the government or the banks. These bankruptcies and liquidations shift scarce resources to more productive uses

• Condition 3. Finally, Interest rates must rise sufficiently to restore proper valuations in the capital markets, and therefore allow stocks and bonds to fall in value relative to consumer goods. This realigns properly the price ratio of capital goods to consumer goods.

Now, I suppose, it's our turn.

Money has poured out of Japan over the years, looking for better yields elsewhere, but Petrov is not at all sure that when the "carry trade" reverses, the Japanese market will rise. He thinks a more interesting bet is on the rise of the Yen in the foreign exchange market. And that's a poker game I don't have the confidence to join.

Pure gold

Karl Denninger offers a couple of very valuable insights today:

1. He thinks that we're only part way through the stock market decline:

Have you ever noticed that the "crooners" on Television never tell you to get out at or near the top, and call it a "buying opportunity" all the way down? Well gee, the last time they did this it only took 7 years before you were back to "even", and of course that's before price inflation ate up all your money.

I think he's right - mostly, the financial sections in the papers seem to me hardly better than celeb gossip.

2. Following on from this, he offers a technical tip on spotting turning points between bull and bear markets

... you buy the SPY (or a S&P 500 mutual fund such as VFINX) when the 20 week moving average crosses the 50 week moving average by more than 1%, and you go to cash (or treasuries) when the 20 week moving average crosses the 50 week moving average in the downward direct by more than 1%.

Being in the right asset class at the right time, as judged by this measure, beats those who stay in the market all the time. Denninger does warn that although it's been true for the last 20 years, it may not hold true forever.

Why safe investments aren't

Michael Panzner's latest explains a point I've learned and repeated here before: "refuge" investments like gold are not as safe and predictable as you might assume. Borrowing money to invest boosts prices, and then when credit becomes tight, forced sales can deflate prices just as rapidly. We're all in a bouncy castle, like it or not.

Property slump or stall?

Karl Denninger says house prices over the last 100 years have averaged three times income. What's the implication for us?

This BBC survey says the average semi (a standard unit of housing, one would think) is "worth" slightly over £200,000; official statistics put household income at £33,492. So houses cost around six times earnings.

That suggests a 50% drop is due. But as Keynes observed with wages, house prices tend to be "sticky downward": no-one is in a hurry to realize a big loss on their home equity. Death, divorce and redundancy may force some sales; others may choose to wait, or go for house swaps.

Or wages could double. Up till recently, it was a standard assumption that "inflation" would run at 2.5% p.a. and wage increases 2% above that. Using the "Rule of 72", it would take 16 years of 4.5% wage increases to double nominal incomes.

Whether wages will always rise in real terms, is another matter. One of the effects of globalization is to hold down wages in the developed countries; and food and energy costs look as though they will continue to rise as the rest of the world gets richer and more populous.

Marc Faber speaks on the crisis

Video here on Bloomberg. Summary and comment on Contrarian Investor. Some points he makes:

Bernanke's policies will destroy the dollar; he should have gone to Zimbabwe. Property assets in a bubble, but bonds (except maybe for some carefully-researched junk bonds!) also likely to be a victim of inflation. Emerging markets worse than the Dow. Deflation may hit the dollar through devaluation, rather than the nominal value of US equities. Commodities (e.g. gold) were at an inflation-adjusted 200-year low in the late 90s, so even after the recent rises they're not overvalued. Derivatives (NOT the packaged ones) will blow up in the next 3 - 6 months. He hope a major bank will fail and reintroduce discipline into the system.

Have you noticed how cheerful gloomy types get when disaster hits?

Another toiler in the vineyard

Safe Haven features an article by "Randy", who predicts that the American economy will go haywire. The good news is that, within a generation, poverty will make the US economically competitive again.

That's not an ironic comment. It seems to me that America's most precious heritage is not her wealth, but her love of liberty and her distrust of power. She has been seduced by Mammon and Empire, and the undoubted difficulties we face may turn out to be the last-minute rescue, the ram caught in the thicket.

Cash is king

Robert McHugh confirms my feeling: sit it out, hold cash.

Deus ex machina

You know you're in trouble when you have to appeal to the Great Leader to do something. Karl Denninger publishes an open letter to the President, the Presidential candidates and others.

1. He complains that 23A exemption letters and the recent TAF facility are being used to hide the scale of banking problems from the public.
2. He points out that over the last 100 years, local house prices trend to 3 times median local income (work that out for your own house).
3. He lists action points to make the system transparent and honest - even though some lenders will be immediately destroyed, like the little slips of flash-burn paper used by spies in Sixties movies.

Being right is not nearly enough - work it out for yourself:

1. Imagine the conversation between interns on receipt of Denninger's fax;
2. List the not-to-be-published reasons why nobody who could solve the problem, will;
3. Compose the official reply.

Now, head for the tree line.

Another Ranter

Alex Wallenwein goes schlock Gothick:

Employment figures, the Thornburg collapse, Carlysle Group troubles, sky-high oil prices, rampant inflation, the dollar-crash, and neverending Fed bailouts of fast failing super banks are pounding the stake deeper and deeper into the global debt-vampire's heart. He will find his much-deserved rest before long. Unfortunately, the portfolios of careless and gullible retail investors, consisting largely of Dracula's debt-spawn, will die along with their master.

I'd give him a "Highly Commended" in the Sackerson's Prose Prize competition for that first, rolling sentence. But he gets pretty apocalyptic, too:

The next Dow-bottom will plumb depths not seen since the early 1990's, maybe even the 1980's!

The early 90s saw the Dow around the 3,000 - 5,000 range. Eat that, Robert McHugh.

Then he shoots for the moon:

... gold can easily go past $3,000 per ounce this year

- and makes a reckless recommendation:

If anyone still has money in any stocks or mutual funds, it's time to exit.

Overstated, I think - but completely wrong? Maybe not.

Another 42 stars?

"Deepcaster" continues to hint at the operations of "The Cartel". His theory is outlined in this post of August 11, 2006. In a nutshell, there's a plot (a) to dissolve the US and make a new entity by combining it with Canada and Mexico, and (b) ruin the dollar in order to replace it with the "Amero", presumably to recommence the thieving by inflation. So it's like what some think the EU project is about.

Except I don't think the EU or its North American equivalent are driven by sinister motives; just venal ones. Concentrating wealth and power makes very juicy opportunities, provided you can simplify the command structure. All that consulting the common people and getting their agreement is so tedious.

America grows. She acquired 29 states in the nineteenth century and five in the twentieth. Where next? Canada has 10 provinces and 3 territories; Mexico has 31 states and one federal district; Greenland is owned by Denmark but has been granted home rule. But Canadians, Mexicans and Greenlanders may have their own views about assimilation.

Democracy is inconvenient, by design. I think the thirteen stripes on "Old Glory" remain there, not just as a historical quirk, but to remind the Federal Government that it's very important to say "please" and "thank you". Even in the first go at making the nation, Maryland, Delaware and New Jersey chose to delay the ratification of the Articles of Confederation, until certain issues had been resolved to their satisfaction.

Here's to the awkward squad.

The Grand Union Flag of 1775, flown by John Paul Jones

Survivalism

Michael Panzner finds another useful article, this time by Laura Coffey on making contingency plans for losing your job.

I sent a circular to my clients in the late 90s, urging them to take out redundancy insurance, because I thought the coming stockmarket crash would be followed by recession; but of course I didn't anticipate that the government would use monetary inflation to defer the reckoning (and, I now fear, make it worse). Articles like Coffey's are straws in the wind, I think.

Diversity, dispersion and disconnection

Karl Denninger continues his heroic (it's always lonely out in front) campaign to call the banks and the regulators to their reckoning. As he points out, we're all tied together, and instead of making it better, that makes it worse, as non-Americans will find out:

The dollar will bounce around before starting to take off. So far, we've not seen people figure out the "rest of world will be f***ed", but if you think the exchange rate problems won't lead to that, you're sadly mistaken. Beware.

The bigger they are, the harder they fall

Michael Panzner refers us to a Financial Times article on the (overdue) dwindling confidence among our youngster trading community. The piece includes this paragraph:

Unlike past housing crises, the banking sector is far less well equipped to cope with the fallout because of the wave of banking consolidation in the last decade. [...] This means the pain has become concentrated among a small handful of institutions, all of whom play a crucial role in keeping all markets liquid.

I recently quoted this Contrary Investor article, which includes a graph of the ballooning exposure of American banks to credit default swaps (CDS), under which arrangement everybody insures everybody else. The risk is 99%+ concentrated into only SIX banks.

Who benefits from such concentrations? I commented on Panzner's site:

Concentration of finance into an ever-smaller number of giant banks is inherently dangerous. You reduce the risks of small hazards, but you increase the potential damage from a Black Swan / fat tail event. Systemic safety is in diversity, dispersion and disconnection.

There is increasingly a conflict of interest between those who benefit from concentrations of power and wealth (think of the bonuses and cushy jobs), and the general populace. Wasn't the US Constitution itself specifically designed to prevent such concentrations?

In my view, the sub-prime contagion is not only spreading to other sectors of the economy, but beginning to call into question how big government, high finance and monstrous companies impact on the fundamental values of our (systematic and real in the USA, ramshackle and sham here in the UK) democracies.

It seems to me that small-scale democracy-cum-economy is not only an historical reaction to the centralist authoritarianism of George III (who meant well, I am sure), but a kind of imitation of Nature, which has endured the most massive disruptions (a planet encased in ice, or burning from a massive meteor strike) because of my alliterative trio of survival traits: diversity, dispersion and disconnection.

Ten years after the stock market bounce

The FTSE is currently at 5,664.60. It stood at 5,782.90 at the end of trading on 6 March 1998. Has your wealth kept pace with inflation?

There's lots of ways to figure inflation. Monetary inflation is like pumping up an air bed (or a Space Hopper): if you squmph one end down, another part will swell, and that makes it hard to estimate the effect in any particular sector. So let's go back to the major source of inflation, and assume M4 (bank lending) has increased by an average 10% p.a. - I don't think that's far off.

According to this article (which also predicts even lower returns in future years) the total return on equities over the last 100 years has averaged 10.1%. That'd be nice. Now let's assume dividends averaged 3% - and let's assume you kept it all, instead of what really happens, which is you pay much of it to intermediaries, stockbrokers, fund managers and the taxman. To get the rest of this monetary-inflation-matching total return, we'd have to see 7% p.a. capital growth.

7% compounded for ten years makes 96.7%. So if you had bought the FTSE ten years ago, it would need to be worth around 11,375 today. After taxes, fees and charges. And then it would have to be worth even more, to make up for the fact that you don't keep all of your dividends, either.

Oh.

From soup to nuts

Steve Moyer gives a pretty clear (occasionally a bit aerated) potted history of the woeful train of events, over the ten years from the start of the technology stock boom to the popping (and it's only just started) of the real estate bubble.

Nobody had to invest in tech stocks, but we all have to live somewhere. A bubble in housing is really pernicious, because it has implications for almost everyone.

Low interest rates inflated property prices, which led to much larger mortgages. Deflating valuations by raising interest rates would trap many mortgage-holders who have taken on big loans and kept up a good credit history so far.

Therefore, unless the government is willing to deal with the political pain of accelerated mortage defaults, interest rates must now stay low-ish for a long time. So I guess that credit risk will be adjusted not by price, but by access: it will simply get harder to find a willing lender. If there is less lending, then that (it seems to me) is deflationary.

I don't believe that the burden of the monster mortgage will be reduced by rapid general inflation of both wages and prices as in the 70s and 80s. Increased world demand for food and energy will inflate prices, but globalisation means that for many - especially the poorer sort - wages won't keep up. The cost of housing will be a generation-long millstone around the neck.

Inflating the currency won't help. It will reduce the wealth of savers, but if we are importing not only luxuries but (increasingly) necessities, inflated wages will be gobbled up by inflated import prices.

Some may argue that currency debasement will make our exports more competitive. But for a long time now, manufacturing industry has been disappearing like snow in midsummer. Even if our export prices should become more competitive because of foreign exchange rates, domestic productive capacity has shrivelled: whole factories and shipyards have gone abroad, and the related human resources have withered, too. You can't reconstruct the proletariat and their workplaces overnight. Gone are the days when the Midlands engineering worker tinkered with metal in his garden shed, showing his son how to use the tools. Half a mile from where I live, one of the big engineering plants set up by the Birmingham-based Lucas family was taken over first by the Italian Magneti Marelli, then by the Japanese super-corp Denso, and now it's been stripped of its machines and will be demolished to make way for... housing. Goodness know how the mortgages on them will be paid.

I think Karl Denninger is right: the banks must be made to eat some of the debt they fed us. Either they will be ruined, or we shall be.

They knew it was coming

Karl Denninger looks at the cash-rich balance sheets of non-financial companies, many of which could now pay off all their bank debts from the kitty. Whatever they may have been telling you, it looks as though they've been voting with their wallets.

Succinct

See this and more in Chris Puplava's piece.