Link to: Free PDF Version
Link to: Free PDF Version
Jeremy Grantham's 3Q Letter summarizes what he believes to be the effects that the policies of the Fed, under the direction of both Alan Greenspan and Ben Bernanke, have had on the U.S. and global economies.
"Every closing that we had really was a bait and switch," a loan officer who worked for Ameriquest in Tampa, Florida, recalled. " 'Cause you could never get them to the table if you were honest." At companywide gatherings, Ameriquest's managers and sales reps loosened up with free alcohol and swapped tips for fooling borrowers and cooking up phony paperwork. What if a customer insisted he wanted a fixed-rate loan, but you could make more money by selling him an adjustable-rate one? No problem. Many Ameriquest salespeople learned to position a few fixed-rate loan documents at the top of the stack of paperwork to be signed by the borrower. They buried the real documents—the ones indicating the loan had an adjustable rate that would rocket upward in two or three years—near the bottom of the pile. Then, after the borrower had flipped from signature line to signature line, scribbling his consent across the entire stack, and gone home, it was easy enough to peel the fixed-rate documents off the top and throw them in the trash.
At the downtown L.A. branch, some of Glover's coworkers had a flair for creative documentation. They used scissors, tape, Wite-Out, and a photocopier to fabricate W-2s, the tax forms that indicate how much a wage earner makes each year. It was easy: Paste the name of a low-earning borrower onto a W-2 belonging to a higher-earning borrower and, like magic, a bad loan prospect suddenly looked much better. Workers in the branch equipped the office's break room with all the tools they needed to manufacture and manipulate official documents. They dubbed it the "Art Department."
At first, Glover thought the branch might be a rogue office struggling to keep up with the goals set by Ameriquest's headquarters. He discovered that wasn't the case when he transferred to the company's Santa Monica branch. A few of his new colleagues invited him on a field trip to Staples, where everyone chipped in their own money to buy a state-of-the-art scanner-printer, a trusty piece of equipment that would allow them to do a better job of creating phony paperwork and trapping American home owners in a cycle of crushing debt.
Book: The Monster
From The Big Picture blog.
Today, a large Berkshire Hathaway mystery lifted when a Greenwich, Conn., hedge fund, Castle Point Capital Management, quietly advised its investors that the fund's managing partner, Todd Anthony Combs, would leave to join Berkshire at the end of the year.
But hard-pressed homeowners like Lydia Sweetland are asking why lenders often balk at a less disruptive solution: short sales, which allow owners to sell deeply devalued homes for less than what remains on their mortgage.
Ms. Sweetland, 47, tried such a sale this summer out of desperation. She had lost her high-paying job and drained her once-flush retirement savings, and her bank, GMAC, wouldn’t modify her mortgage. After seven months of being unable to pay her mortgage, she decided that a short sale would give her more time to move out of her Phoenix home and damage her credit rating less than a foreclosure.
She owes $206,000 and found a buyer who would pay $200,000. Last Friday, GMAC rejected that offer and said it would foreclose in seven days, even though, according to Ms. Sweetland’s broker, the bank estimates it will make $19,000 less on a foreclosure than on a short sale.
But less obvious financial incentives can push toward a foreclosure rather than a short sale. Servicers can reap high fees from foreclosures. And lenders can try to collect on private mortgage insurance.
Some advocates and real estate agents also point to an April 2009 regulatory change in an obscure federal accounting law. The change, in effect, allowed banks to foreclose on a home without having to write down a loss until that home was sold. By contrast, if a bank agrees to a short sale, it must mark the loss immediately.
In anticipation of the publication of my book, The New Evolution Diet, I am opening access to my original, but lightly edited, Essay on Evolutionary Fitness. I have lost track of when I first made this available; I think it was around 1995. By then, I had been living this way for about 10 years, with a lot of testing and experimentation with diet and training and play. I think this helped to start a movement, but you be the judge. I am very happy about how this has all played out.
Book: The New Evolution Diet
Here’s the paper referenced in the latest Hussman Weekly Market Comment.
Simply put, monetary policy is far less effective in affecting real (or even nominal) economic activity than investors seem to believe. The main effect of a change in the monetary base is to change monetary velocity and short term interest rates. Once short term interest rates drop to zero, further expansions in base money simply induce a proportional collapse in velocity.
I should emphasize that the Federal Reserve does have an essential role in providing liquidity during periods of crisis, such as bank runs, when people are rapidly converting bank deposits into currency. Undoubtedly, we would have preferred the Fed to have provided that liquidity in recent years through open market operations using Treasury securities, rather than outright purchases of the debt securities of insolvent financial institutions, which the public is now on the hook to make whole. The Fed should not be in the insolvency bailout game. Outside of open market operations using Treasuries, Fed loans during a crisis should be exactly that, loans - and preferably following Bagehot's Rule ("lend freely but at a high rate of interest"). Moreover, those loans must be senior to any obligation to bank bondholders - the public's claim should precede private claims. In any event, when liquidity constraints are truly binding, the Fed has an essential function in the economy.
At present, however, the governors of the Fed are creating massive distortions in the financial markets with little hope of improving real economic growth or employment. There is no question that the Fed has the ability to affect the supply of base money, and can affect the level of long-term interest rates given a sufficient volume of intervention. The real issue is that neither of these factors are currently imposing a binding constraint on economic growth, so there is no benefit in relaxing them further. The Fed is pushing on a string.
"All those subprime and Alt-A mortgages written in the middle of the last decade? They were packaged and sold in securities. They have had huge losses. But those securities had representations and warranties about what was in them. And guess what, the investment banks may have stretched credibility about those warranties. There is the real probability that the investment banks that sold them are going to have to buy them back. We are talking the potential for multiple hundreds of billions of dollars in losses that will have to be eaten by the large investment banks. We will get into details, but it could create the potential for some banks to have real problems."
Real problems indeed. Seems the Fed, PIMCO, and others are suing Countrywide over this very topic. We will go into detail later in this week's letter, covering the massive fraud involved in the sale of mortgage-backed securities. Frankly, this is scandalous. It is almost too much to contemplate, but I will make an effort.
This issue features Steven Romick. Found via GuruFocus.
G&D: In your first letter in 1993, you wrote that you often found niche companies with excellent track records that Wall Street has yet to discover. Is it worth your time looking for these opportunities now that you have $4 billion under management?
SR: I think that I was naïve. What is really undiscovered? I think it‘s morphed from undiscovered to unloved or misunderstood. There aren‘t that many undiscovered names out there.
G&D: How do you go about looking for ideas where there is a gap between perception and reality?
SR: Fortunately, people are emotional and they make visceral decisions. Such decisions end up manifesting themselves in volatility, where things are oversold and overbought. Being a really good investment manager is equal parts being a financial analyst, business analyst, and psychologist with conviction to act when others are panicking.
When we screen, we‘re looking for companies with strong cash flow characteristics and returns on capital, but most of companies don‘t come from screens. What‘s more prominent in our process are monitor lists. There are other areas, like spin-offs, that we monitor because we think there are more natural sellers than natural buyers. We don‘t think spin-offs are terribly inefficient anymore, but there are other things like that that we follow.
G&D: What do you think the impact of that potentially substantive liquidity response might be on the US dollar?
SR: The government is doing its best to destroy the value of the US dollar. We have made efforts to de-dollarize our portfolio, taking advantage of other parts of the world that have better growth opportunities than the US with more exposure to currencies other than our own. We are seeking those companies that are more protected should inflation be more than expected in the future. Now, we are not calling for hyperinflation, but we will not tell you that it cannot come – that is something we view as a real possibility. We are looking for companies where we feel the pricing power would offset the potential rise in input costs. That leads us to a whole universe of companies, while keeping us away from others.
These observations have common conceptual roots. Underlying both lies patience. Patience, or its alter ego impatience, is a key factor shaping inter-temporal decisions. Whether to save or spend, trade or invest, work or quit, stick or twist. As such, patience has important implications for the evolution of economic and social systems.
This paper considers the role of patience in decision-making, in particular financial decision-making. Patience is not static; it evolves. This paper brings together lessons from economics, history, psychology, neurology, sociology to assess patience and its implications for the evolution of economic and financial systems.
Evidence from social and economic systems points to two evolutionary paths. Along one, patience becomes self-reinforcing. For example, financial liberalisation may encourage patience and improve inter-temporal choice, unlocking growth. But there is a second path, along which impatience is self-reinforcing. Financial liberalization can also unlock impatience, generating over-trading and under-investment.
These dual equilibria make choosing the right pace and path of financial reform crucial. Some countries, like China, appear to be proceeding along the patient path. The choice is how to pace reform to prevent overshooting onto the impatient path. For countries which have already liberalised, the choice is how to promote patience while harnessing impatience. These are real public policy choices.
As his friends carried his limp and bloodied body home, he watched life slip away from his physical self, not traumatically but almost flimsily, like some dancing spirit on the “tip of his lips,” and then return. This sublime experience marked the moment Montaigne began a uniquely playful relationship with his existence and was a sense clarity and euphoria about life that he carried with him from that point forwards. Shortly thereafter he took a bold step, retiring from a promising public career—retired to himself, so to speak—and made self-study his official occupation.
Maybe you don’t know anything about this man, Montaigne; perhaps you know him as the bane of your high school existence for inventing the word “essay.” What I’d like to do in this piece is tell you a bit more about him and hopefully remove him from the realm of people-from-history-you-don’t-care-about and place him in his proper context: as our greatest philosopher of life. And Montaigne was a philosopher in the truest sense; he studied life and how we can wring all that we can from the short bit of time each of us is given. Philosophy can seem boring—truthfully, most of it is—but Montaigne is not only incredibly accessible; just a brush with his brand of thinking can change our lives.
Related link: Selected essays of Montaigne
On planet Earth, nothing. The most basic rule of life is SURVIVE. The Biological imperative of living things is to perpetuate their existence — survive, procreate, further the species. It is hardwired in the DNA of every living organism.
Those that do not succeed in satisfying these imperatives are described as maladaptive — not fit to survive or compete in the natural world. It is the most rudimentary law in biology, applicable from single cell protozoa to human beings.
And, it exists in the world of organizations. Entities that are maladaptive — corporations, nonprofits, governments — eventually succumb to their own mortality and collapse. This is as it should be, as there are no reasons dysfunctional corporations unable to perform their most basic function — survival — should be preserved.
This is especially true when it comes to financial firms — banks, insurers, investment houses — whose prime responsibility is identifying potential reward and managing risk. The failure of survival raises a compelling question: Why should firms that fail their most basic charge — survival — be bailed out?
Found via Chris Martenson.
Vaclav Smil, professor of Environment and Environmental Geography at the University of Manitoba in Winnipeg, has written a new book called “Energy Myths and Realities.” In the book, he looks at a number of things he considers myths:
1. The future belongs to electric cars
2. Nuclear electricity will be too cheap too meter
3. Soft-energy illusions (local generation, etc.)
4. Running out: Peak oil and its meaning
5. Sequestration of carbon dioxide
6. Liquid fuels from plants
7. Electricity from wind
8. The pace of energy transitions
Smil is well-respected in the world of energy, so I think it is also worthwhile looking at what he has to say. I think that it is even worthwhile looking at what he has to say about peak oil, because it may give us some insights as to where our thinking needs to be refined, or better explained, if it is to be understood by the “mainstream”.
Bill Gates’ review of the book: A Rational Look at Energy: Energy Myths and Realities
How to value gold is an age old frustration. As every schoolboy knows, it yields nothing and so can’t be valued on cash flows. It has very little industrial use. There is, however, a natural human tendency toward the use of currency so gold is an obvious candidate for a rare, durable, portable, and transferable form of money. There is no printing press (or helicopter) for gold. Thus, throughout history, the yellow metal has been an indisputable store of value, including during periods of inflation like the 1970s. However, its price is volatile and has certainly managed to lose some money for investors over periods shorter than, say, a few decades. In the chart below, we illustrate the point by plotting the inflation-adjusted gold price versus the year-over-year change in Core CPI.
As inflation came down in the early 1980s, gold fell with it. The relationship between real gold prices and inflation seems to break down during the 2000 recession, where inflation began to decline but gold began a new bull market. Current real gold prices are back to levels not seen since 1980, when inflation was running at over 12%, despite current levels of inflation below 1%. Gold must be in a bubble, right?
Not necessarily. Another way to think about gold is as insurance against the debasement of the currency, and against future inflation. Insurance against policies that debase the currency is worth something, because a falling dollar erodes your global purchasing power just like inflation erodes your purchasing power at home.
(Quick last-minute note: I think this (and next week's) is/will be one of the more important letters I have written in the last ten years. Take the time to read, and if you agree send it on to friends and responsible parties. And note to new readers: this letter goes to 1.5 million of my closest friends. It is free. You can go to www.frontlinethoughts.com to subscribe. Now, let's jump in!)
There's trouble, my friends, and it is does indeed involve pool(s), but not in the pool hall. The real monster is hidden in those pools of subprime debt that have not gone away. When I first began writing and speaking about the coming subprime disaster, it was in late 2007 and early 2008. The subject was being dismissed in most polite circles. "The subprime problem," testified Ben Bernanke, "will be contained."
My early take? It would be a disaster for investors. I admit I did not see in January that it would bring down Lehman and trigger the worst banking crisis in 80 years, less than 18 months later. But it was clear that it would not be "contained." We had no idea.
I also said that it was going to create a monster legal battle down the road that would take years to develop. Well, in the fullness of time, those years have come nigh upon us. Today we briefly look at the housing market, then the mortgage foreclosure debacle, and then we go into the real problem lurking in the background. It is The Subprime Debacle, Act 2. It is NOT the mortgage foreclosure issue, as serious as that is. I seriously doubt it will be contained, as well. Could the confluence of a bank credit crisis in the US and a sovereign debt banking crisis in Europe lead to another full-blown world banking crisis? The potential is there. This situation wants some serious attention.
Also embedded in the article is a short interview with Mandelbrot entitled “why ‘efficient markets’ collapse.”
Benoît Mandelbrot, one of the most original and influential mathematicians of the 20th century, has died of pancreatic cancer at the age of 85. He was the father of fractal geometry – finding underlying patterns in roughness and irregularity – and was a key figure in the broader field of chaos theory.
Related previous post: TED Talk - Benoit Mandelbrot: Fractals and the art of roughness
Related link: FOFOA blog post with fractal videos
Despite the probable lack of measureable benefits, further QE poses significant risks. It has already triggered a steep decline in the exchange value of the U.S. dollar, and threatens a destabilization of international economic activity, a loss of confidence, and the creation of a "boom-bust" cycle threatening to choke off any economic recovery that does emerge.
With regard to the U.S. dollar, market expectations of QE have provoked a "jump depreciation" of the greenback in recent months, neatly following the mechanism that the late MIT economist Rudiger Dornbusch described as "exchange rate overshooting" (see the August 23 market comment Why Quantitative Easing is Likely to Trigger a Collapse of the U.S. Dollar). Specifically, the expectation of a sustained period of lower U.S. interest rates, relative to other countries, requires an abrupt depreciation of the U.S. dollar by an amount large enough to set up expectations of a future appreciation. As a crude example, if the Fed suddenly introduces a policy that is expected to depress U.S. long-term interest rates by 1% for a period of 10 years, an immediate 10% depreciation of the U.S. dollar is required in order to preserve equilibrium in the international capital markets. Following the depreciation, international investors expect a 1% annual appreciation in the dollar to compensate for the 1% loss of interest. The plunging U.S. dollar and soaring price of gold in recent weeks are reflections of this dynamic.
Unfortunately, the likely economic impact of this rapid depreciation is not benign. The Fed might like to believe that a cheaper dollar will improve trade by increasing U.S. exports and reducing imports. However, over the past two decades, and particularly in recent years, U.S. imports have been much more elastic in response to fluctuations in the U.S. dollar than exports have been. This suggests that provoking further dollar depreciation is likely to have negative effects on the global economy, owing to a shift away from imports, but with few positive effects for U.S. economic activity. Indeed, a further depreciation would unnecessarily create a negative wealth effect for U.S. consumers facing higher prices for imported goods and services. Any improvement in the trade deficit would be largely offset by downward pressure on U.S. consumption.
As a side note, some observers have suggested that QE represents nothing more than "printing money." While this might be accurate if the Fed never reverses the transactions, the most useful way to think about QE, in my view, is as an attempt to directly lower interest rates by purchasing Treasury securities. This interest rate effect - not any major inflationary outcome - is the cause of the dollar depreciation we are observing here. There is little doubt that the effect of large continuing fiscal deficits is long-run inflationary, but as I've noted repeatedly over the years, there is little correlation between inflation and temporary - even large - variations in the monetary base. Inflation is ultimately a fiscal phenomenon born of unproductive spending, regardless of how that spending is financed.
Interesting the way China came to produce 95% of the global supply of REE. I don’t think they teach the “government subsidizing loans to money-losing operations to create jobs but collapse the price of the commodity and drive away almost all foreign competition theory” in most business schools.
A recent diplomatic spat between China and Japan has heightened territorial tensions and called attention to China’s growing forcefulness with foreign powers. One of the more intriguing aspects of this development was China’s suspension of the export of “rare earth” elements (REE) to Japan. REE comprise 17 metallic elements with a variety of modern industrial and commercial applications ranging from petroleum refining to laptop computers to green energy applications to radar. China produces roughly 95 percent of the global supply of REE and Japan is the largest importer. China’s disruption of REE shipments to Japan has caused alarm among other importer countries, bringing new urgency to the search for new supplies and substitutes.
Chinese control of the base of the REE supply chain has increasingly made China the go-to location for the intermediate goods made from REE. In time, China hopes to extend production into the final products as well. As new REE supplies cannot be brought online overnight, the Chinese will enjoy a powerful position in the short term. The Chinese Ministry of Commerce reports that China has ratcheted down REE export quotas by an average of 12 percent per year over the past five years, further leveraging this position. Reflecting that and the current China-Japan spat, the average price for REE has tripled in the year to date.
Rare earth elements are not as rare as their name suggests, however. Before the Chinese began a dedicated effort to mass-produce REE in 1979, there were several major suppliers. Pre-China, the United States was the largest producer. Appreciable amounts of REE were also produced in Australia, Brazil, India, Malaysia and Russia. Any sort of real monopoly on REE, therefore, is not sustainable in the long-run. But before one can understand the future of the REE industry, one must first understand the past.
So let’s break this down as to the primary concerns. As I see this, what facts are revealed and how these errors get resolved will determine the resolution of the current fiasco, as well as the costs.
Found via Farnam Street.
The study, published October 13 in Nature, was intended to illuminate an issue of contention among archaeologists, anthropologists and historians: whether societies become more complex in incremental steps or sudden bursts, and whether they dissolve in similar fashion.
Over 84 societies in this tree, Currie and Mace overlaid what’s known from archaeological records of their social structure, which underwent “spectacular political differentiation to give rise to examples of the entire range of political organization,” wrote Collapse author Jared Diamond in an accompanying commentary.
When they compared the resulting tree to trees generated by computational models of different anthropological narratives — linear and stepwise, varied and lurching — the researchers found a close match to the linear. Political complexity indeed grew slowly, bit by bit, with no sudden jumps from bands to chiefdoms or tribes to states.
The study will undoubtedly be criticized, especially for its rough categorization of subtle political differences into four hierarchical categories, wrote Diamond. But what’s most important is that the techniques of evolutionary biologists can be applied to anthropology.
Most anthropologists interpret the past “by narrative accounts of individual cases, less often by narrative comparisons of selected cases, and infrequently by comprehensive narrative surveys,” Diamond wrote. “My first reaction to Currie and colleagues’ paper was one of surprise: why hadn’t we used their method before, because it is so obviously superior?”
Related book: Collapse: How Societies Choose to Fail or Succeed
Related book review: The Vanishing
Found via The Big Picture.
This article summarizes the size and scope of the housing crisis, making the point that if governmental policy does not change, one borrower out of every 5 is in danger of losing his/her home. A crisis of this order of magnitude requires both supply and demand side measures. On the supply side, a successful modification is critical. This will require principal reductions to re-equify the borrower. The moral hazard (strategic default) issues must be addressed by first recognizing that this is an economic issue, not a moral one. Second liens must also be addressed. As supply side measures alone are likely to prove insufficient to address a crisis of this size, we discuss demand side measures to increase the buyer base.
Thanks to Kent for passing this along.
From Greg Mankiw’s blog: Barney Frank, Then and Now
The opposite 2003 viewpoint: September 2003 Statement from Ron Paul on the GSEs and the housing market
A couple of good graphs linked to below from Crestmont Research. With the completely unprecedented intervention in the markets by governments to date (see the chart on p. 9 HERE for reference to the U.S.), my guess is that the odds for price stability resulting from all of this are likely quite low. When and to what extent we could get the extremes that lead to P/E’s that look more like a secular bear market low is anyone’s guess, but I continue to think the risk of buying most of the market at these levels is very high, and that one should be extremely picky in individual stock selection right now.
Link to: Inflation & P/E Ratio Graphs
Related previous post: P/E Expansion & Contraction - Secular Stock Market Cycles
Is there a chance that it could work? The short answer is, "Yes, but I doubt it." The whole purpose of QE2 is to try and get consumers and businesses spending. For a Keynesian, it is all about stimulating final consumer demand. That is tough in a world coming out of a credit crisis, where consumers are wanting to deleverage.
But what if they push a few trillion into the economy and it shows up in the stock market? Or the market just feels good that "Daddy" is doing something and runs up on its own? Can that change consumer sentiment? Will we feel like spending more? Could that be the catalyst? Maybe, but I doubt it. But you can bet your last trillion they are going to try.
It is doubtful that any QE2 that is enough to really do something in the way of reflating assets will be good for the dollar. Now, cynics might say that is the point, as a falling dollar is supposed to help our exports (and for my international readers, I get it that this is at the expense of other countries). Do we really want to open the first salvo in a race to the currency bottom? If the Fed does it, it gets legitimized everywhere.
How does one control inflation by printing money on the order of 10% or more of GDP? Is 3% ok? Do you really want to get to 4% and then have to start taking off the stimulus to get inflation under control, and push us back into recession?
You don't get inflation without a rise in interest rates. What about the increased costs of financing an ever-rising government debt? And aren't higher rates what the Fed is fighting? Talk about confusing the market.
Does the Fed really want us to get our animal spirits back up and go back in and borrow more money? Isn't too much leverage what got us into this problem to begin with? Does the Fed really want to persuade us to go out and buy mispriced assets? Should we buy stocks now in hopes that QE2 somehow finds a transmission mechanism and keeps us from recession? If it doesn't work, then all those buyers will get their heads handed to them, making matters even worse.
What if, as I think likely, the QE money simply makes a round trip back to the Fed balance sheet? Do we go for QE3? At the Barefoot Economic Summit I just attended (see more below), one very well-connected economist said he would start getting interested about QE when it approached $6 trillion. That is the number he thinks would be needed to actually have an effect. It raised a few eyebrows when he told that to David Faber on CNBC.
The only way I think they do not pursue QE is if the economic data in the next few months suggests the economy is beginning to heal itself. That will make the next few months worth of data more critical than usual. The stock market seems convinced that QE2 will be good for the economy and the markets, and thus bad news will be perversely considered good.
Sadly, if we go down that path I think this is going to end in tears. There are just too many unintended consequences that can reach up and bite us in our collective derrieres. I am not sanguine about 2011. I dearly, truly hope I am wrong. For your sake, gentle reader, and for my seven kids.
Found via The Big Picture.
Jim Grant, one of the country's premier financial analysts and historians, has had a front row seat on Wall Street for more than three decades. Unlike most people who work on Wall Street, moreover, Jim actually works on Wall Street: His office is right across the Stock Exchange.
A former Barron's staff writer, Jim founded the beloved Grant's Interest Rate Observer close to 30 years ago. Even in an age of 24/7 online news, the publication remains one of the leading authorities on debt, bonds, Japan and the economy.
Jim has a stuffed bear in his office and a sinking-Titanic paperweight on his desk. We sat down with him recently for an exclusive interview to discuss an array of issues, including a possible bond bubble, the state of the union, and the economy.