Dumb Money Day 1 by Charles Marohn, Strong Towns Jun 10, 2013
This week I want to write about one very technical finance subject and the implications for the housing market and, by extension, for cities and the great reset we are going through). I want to bolster those of you that inherently believe that there is something rotten at the core of the economy. I want to give you context for all the propaganda being thrown at you about how our economy is getting back on track (record stock prices and accelerating housing market being two oft-repeated benchmarks). I don’t want you to slide back into the Ponzi Scheme, especially since the market’s need for dumb money is so intense right now. This week is about giving you confidence to stay the course.
First we are going to start with a lesson on debt and something called the “carry trade.” Let’s start with a very simplified explanation of how debt is used to magnify returns.
Let’s say I have $1,000. I use it all to go out and buy a 30-year treasury note paying 3.5% (roughly the current rate). I now own a $1,000 note that will pay 3.5% ($35) annually for each of the next 30 years, after which my original $1,000 will be returned to me.
With that $1,000 note as collateral, I now go and borrow $900. I have 10% equity here — some skin in the game — but I’m still pledging the entire $1,000 so I can borrow another $900. I get the additional $900 and use that to buy 30-year treasury notes at 3.5%. Understand what I’ve done: I started with $1,000 and now, after one iteration of leverage, I have $1,900 in treasury notes along with a $900 debt. It’s the same amount of money — $1,000 — but deployed differently in the market.
Now I take my $1,900 in treasury notes and I go through this leverage process again, essentially pledging that collateral for a loan of 90%, or $1,710. I promptly buy another $1,710 in AAA rated 30-year US treasuries. Good as gold. My $1,000 has now gotten me $3,610 in treasury notes along with $2,610 worth of debt. I still have more assets than liabilities, meaning I still have equity and everything I owe is fully collateralized with AAA securities.
This cycle continues again and again and again until my $1,000 yields $47,046 in 30-year treasuries along with $46,046 in debt. This is roughly the ratios of leverage that firms like Goldman and Bear Stearns were at when they went under and, reportedly, the levels that many of the remaining Wall Street banks are at today.
Why would a bank take on so much debt? The answer is something called the carry trade. While I said that our $1,000 is being used to buy 30-year notes at 3.5%, I didn’t say what rate we were borrowing at. Obviously, if we had to borrow at a rate higher than 3.5% — which you and I would have to for something like this — we’d lose money in this trade. That’s not how things work for banks, however.
A bank can borrow overnight today at essentially no cost. The bank borrows $46,046 this morning and promises to repay you at the end of the day. There is a tiny charge, but not much. Even if they were borrowing for 90 days — the rate is going to be really low (say, 0.1%) thanks to the Federal Reserve artificially suppressing interest rates. At the end of 90 days, you just roll that debt over into a new 90-day loan.
So the carry trade is simple. You borrow at a low rate and lend back at a high rate. In this case you borrow for 90-days at 0.1% and then lend out at 3.5% for a 30-year note. In the first year, you have to pay 0.1% on your $46,046 debt (that’s $46), but you make 3.5% on your $47,046 in 30-year treasuries (that’s $1,647).
I know this is a lot of numbers, but pause there for a second and understand what you just read. You started this exercise with $1,000. Due to your ability to leverage and the artificially low rates you pay on that debt, you pay $46 in interest expense and have $1,647 in interest earnings. In other words, your $1,000 earned you $1,601 in pure profit. You can sell all your securities, pay off all of your debts and walk away at the end of one year with a profit of 260%. Now just imagine that, instead of $1,000, you were talking about $100 billion.
Generally, it’s not that easy. The carry trade has some obvious risk involved. By financing short term to purchase a long term security, you are taking a very real risk that short term rates could rise and invert the trade. Let’s say short term rates rose to 5%, the historical average over the past thirty years. Now you have a 30-year security paying just 3.5% but you are paying 5% on your financing. You are going to burn through your $1,000 in equity very quickly and then you’re insolvent. Nobody is going to lend to you short term, or any term, and it’s all over.
But what if you just sold your long term notes to pay off the debt? Well, when short term rates rise, long term will rise as well. If I am going to take a long term risk, I’m going to demand a higher interest rate than I could get for a short term risk. So if short term rates go from zero to 5%, long term rates would make at least that bump, from 3.5% to 8.5%.
Why is that important? If I’m in the market trying to buy a 30-year note and I can get one paying 8.5%, how much am I going to be willing to pay you for your $1,000 note that is paying just 3.5%? The answer: a lot less than $1,000. In other words, as those long term interest rates rise, your long term securities are now worth less. This trade is now blowing up on both sides; your financing costs are rising while your asset value is falling. That’s a deadly combination.
So the carry trade has a lot of risk…..that is, unless the Federal Reserve signals very clearly that they are going to keep interest rates low and stable for an extended period of time. When that happens, the carry trade is on and becomes a relatively low risk way to make a lot of money very quickly.
- Big banks and large investors have the capacity to leverage modest amounts of equity into large market positions by taking on debt.
- One form of the carry trade takes advantage of the interest rate difference between short term and long term securities.
- Interest rates kept artificially low and stable reduce the risk associated with that form of a domestic carry trade.
Dumb Money Day 2 Jun 11, 2013
Yesterday we looked at how debt is used to generate high returns, particularly for a small subset of the population and especially during times when central policy makers commit to extended periods of low, stable interest rates. Today we’re going to add a couple more pieces of financial background before we move on and apply this to our current situation.
We all understand how savings work. We put our money in a bank and are paid a rate of interest for our capital. The bank then turns around and loans that money out at a higher interest rate, a mechanism by which they (a) make money and (b) pay depositors interest. If you had a lot of money, you could make your own loans, but for most of us (and even for the wealthy) it makes more sense to diversify over many projects and have the bank, made up of financial experts, evaluate projects on your behalf.
So, in normal times, we must save to invest. The bank is not going to have any money to loan out unless people deposit money into it. (If you want a more detailed explanation, note that banks are part of the process in which money is created, a process described eloquently by Chris Martenson in this Crash Course video.)
Here’s the next critical insight: In a normal market system, interest rates represent the supply and demand for capital. If there is a lot of demand for money from businesses and individuals that want to borrow, then a bank will raise interest rates to encourage people to save more. If the bank has too much money and not enough people asking for loans, then interest rates will drop. Now banks borrow money back and forth among each other which tends to even things out across institutions, but every now and then you’ll see one pop up with a rate quite a bit on one side of the curve. Something’s going on — they either have a big deal and they need some capital or they have too much money and are having a tough time putting it to productive use.
Now enter the Federal Reserve System and national, centralized monetary policy. When the Federal Reserve intervenes to manipulate interest rates, it is distorting the relationship between supply and demand of capital. If the Fed raises rates, it will encourage people to save and if the Fed lowers rates, it will encourage people to do something else with their money. This is irrespective of what would naturally be happening in the market.
This is an accepted practice among nearly all economists. According to their theories, when the economy needs a kick in boot, the Federal Reserve should lower interest rates to make capital easier for people to borrow. When the economy is overheated, manipulating interest rates higher is a way to dampen that.
It is important to understand the mechanism the Federal Reserve uses to raise and lower interest rates. To lower rates, the Fed simply buys treasury notes. When they buy the notes from Wall Street banks, those banks then have a lot of cash and so they need more borrowers, fewer savers. Thus interest rates go down. To raise rates, the Fed does the opposite and sells notes. When it does that, it is putting these US treasury certificates — instruments of savings — out there and taking the cash back in return (which they put under their mattress). This reduces the amount of cash the banks have and, to have money to lend, banks then need to raise interest rates.
So let’s put these two things together; When the Federal Reserve determines that the market is not working correctly — generally that growth, unemployment and inflation are not being optimized — they will intervene to manipulate the market interest rate.
There is one more concept you need to understand: the Mortgage Backed Security (MBS). As an analogy, if you created a company, had that company buy a thousand mortgages, then you sold a thousand shares in that company, each of those shares would be an MBS. With that MBS, instead of owning the debt of one mortgage, you would own 1/1000 of each. You are essentially spreading out your risk over a wider pool, just like a bank does when they do multiple loans.
Mortgage Backed Securities are important for one reason: yield. Yield is the interest rate at which the MBS pays. Due to the fact that there is more risk in an MBS than in a Federal Treasury note — even when that MBS is rated AAA — the MBS is going to pay a higher interest rate.
Now go back to yesterday where I described the carry trade. An MBS with a higher yield and a generally shorter maturing period (few mortgages make it the full 30 years w/o a refi) is a much more attractive than a 30-year Treasury note with a higher return and less long term risk, a nice combo when trying to spur home purchasing.
You may remember the Federal Reserve’s Operation Twist. This was a shift by the Federal Reserve from buying short term Treasury notes to long term notes, driving down the interest rates on those longer notes even further. The effect of this is to make those MBS investments even more attractive by comparison.
- In a normal economy, we must save to invest.
- In a normal economy, interest rates represent the supply and demand of capital.
- When the Federal Reserve determines that the market is not working correctly — generally that growth, unemployment and inflation are not being optimized — they will intervene to manipulate the market interest rate.
- Mortgage Backed Securities provide a higher yielding, shorter term investment than long term Treasury notes.
On Monday, we showed how banks and large investors have the capacity to leverage modest amounts of equity into large market positions by taking on debt. We also explained one form of the carry trade that takes advantage of the interest rate difference between short term and long term securities, a trade that has much less risk when interest rates are kept artificially low and stable.
On Tuesday, we pointed out that a normal economy requires savings in order to have money that can be loaned out by banks and that interest rates are the market’s mechanism for balancing savings and investment. This equilibrium is manipulated by the Federal Reserve to discourage or encourage savings in an effort to optimize market outcomes. Finally, Mortgage Backed Securities — a financial product consisting of home mortgages — provide a higher yielding, shorter term investment than long term treasury notes.
So let’s move on to the red flags, as indicated by the Federal Advisory Council, a group that regularly advises the Federal Reserve. Here is how the FAC is described on the Fed’s website:
The Federal Advisory Council (FAC), which is composed of twelve representatives of the banking industry, consults with and advises the Board on all matters within the Board’s jurisdiction.
The most recent FAC meeting was May 17, the minutes of which can be found here. While the fifteen pages are generally full of statements that support current Fed policies and give endorsement to the notion of a gradual recovery in the economy, the last page has some very revealing insights. The FAC asked their opinion on current Fed policy, which is essentially manipulating the overnight borrowing rate to zero and using quantitative easing to further manipulate downward short term and long term treasuries. Here are some of their statements, which I’ll provide some comments on.
The Fed’s securities purchases have reduced mortgage yields and, to a lesser extent, Treasury yields. Current low bond yields are disruptive to management of fixed-income portfolios, retirement funds, consumer savings, and retirement planning. They may encourage unsophisticated investors to take on undue risk to achieve better returns.
The first sentence is essentially what we’ve been discussing here — yield is the interest rate and the Fed has been driving down rates. The second and third sentences can be read like this: because your savings account is not paying any interest (or your pension fund, 401(k), etc…), in order to have some earnings, you need to put your money elsewhere.
That’s the “undue risk” part, AKA: dumb money.
When your pension fund, for example, is underfunded by 25% and that already assumes an 8% annual return from now on, very low interest rates on risk-free securities means that, to avoid falling further behind, the fund needs to invest more and more into higher risk areas. While we may think of the unsophisticated investor as the kid betting on dot.com stocks, we can just as easily think of them as the pension fund manager being sold the comparatively high-yielding Mortgage Backed Security that is very risky yet rated AAA by Moodys.
Unsophisticated is essentially a euphemism for “dumb money,” which includes everyone not part of the inside operation (and even many of those that are.) This is not a commentary on intelligence, but access to information and, increasingly, access to bandwidth.
The FAC is indicating that, with interest rates directed by the Fed to remain low for a long time, capital is moving from safe to risky investments. Junk bonds are now paying around 5%. Junk bonds are the packaged debt of high risk corporate borrowers. Just a few years ago, these very risk funds paid over 20% interest. So much money is flowing out of zero-interest, safe havens and into high risk places that is huge competition for even junk.
MBS purchases account for over 70% of gross issuance, causing price distortion and volatility in the MBS market. Fixed-income investors worry that attractive mortgage-backed securities are in very tight supply.
Mortgage backed securities (MBS) pay a higher rate of interest than a treasury note. With the rates on treasury notes being artificially depressed, investors like your pension fund are looking to mortgage backed securities to increase the return.
Here’s the problem: the Fed is buying 70% of all mortgage backed securities. The remaining 30% are in high, high demand because they have a slightly higher rate of return and so are fought over by investors (i.e. a fixed income pension fund).
This all drives mortgage rates down, down, down to historic lows. Any mortgage that can make it through the origination process can be purchased, securitized and sold in short order.
Many are concerned about the Fed’s significant presence in the market. They have underweighted MBS in favor of corporate, municipal, and emerging-market bonds.
The term “underweight” here is meant to denote that investors (keep thinking pension funds) are not holding a normal share of MBS and instead are buying other, more risky, bonds. In other words, the Fed is essentially forcing investors not inclined to risk into risky investments. This is why junk bond yields are so low. If fixed-income investors could get their yield in a normal mortgage market, they wouldn’t be buying junk bonds and the interest rate on junk bonds would rise.
There’s also another risk here with the Fed dominating the mortgage market: the carry trade. If the Fed starts to exit the MBS market, rates will go up. That makes the low rate securities actually drop in value (remember: I’m not going to pay you full face value if I can get a higher rate somewhere else). Since few people are going to refinance when rates rise — we’re essentially mining the refi market right now with these low rates — MBS holders could be stuck with low yielding notes for a long time. Corporate bonds, emerging market bonds and other instruments have a quicker turnover and give a little bit more flexibility in a market where rates are rising.
There is also concern about the possibility of a breakout of inflation, although current inflation risk is not considered unmanageable, and of an unsustainable bubble in equity and fixed-income markets given current prices.
Let’s focus on the unsustainable bubble in equity and fixed-income markets.
The equities market is the stock market. The FAC is saying that all of this money printing and frantic search for yield could encourage a lot of people to invest in stocks, something that would drive up prices to unjustified — and thus “unsustainable” — levels. On the way up, this is a self-reinforcing effect; the more stocks rise and the more safer yields are depressed, the more the “dumb money” is lured into the rally. That the “smart money” counts on this reaction is a tragic reality.
Further, current policy has created systemic financial risks and potential structural problems for banks. Net interest margins are very compressed, making favorable earnings trends difficult and encouraging banks to take on more risk.
Banks can’t pay much interest. With banks competing against the Federal Reserve for places to put money, they are left with the same choices everyone else has: make no money or take uncomfortably high risks. Banks that takes risks face huge problems when the market changes.
The Fed’s aggressive purchases of 15-year and 30-year MBS have depressed yields for the “bread and butter” investment in most bank portfolios; banks seeking additional yield have had to turn to investment options with longer durations, lower liquidity, and/or higher credit risk.
With the Federal Reserve crowding everyone else out of the mortgage backed securities market — and thus sucking all the mortgages out of banks (the originators) and into the secondary market — what’s a bank to do? Two things. More transactions, meaning originate more loans and essentially make your money on fees (a dwindling market as the number of homes that could refinance but haven’t is shrinking rapidly) and take on more risk.
For at least a portion, that means that carry trade — taking short term money (deposits that can be redeemed at any time) and buying longer term notes that fewer people want (which is what is meant by “lower liquidity”). This makes the bank financially very fragile.
Finally, the regressive nature of the artificially compressed savings yields creates pent-up demand within bank deposit portfolios; these deposits may be at risk once yields begin to rise and competitive pressures increase.
Here’s the million dollar statement. Or perhaps the trillion dollar statement.
Regressive nature: the Federal reserve policy of low rates and money printing is hitting ma and pa investor really hard.
Artificially compressed savings yield: this means banks are not paying any interest because the Fed is manipulating the rate downward.
Pent-up demand within bank deposit portfolios: Without good options, people are sitting on cash. They wish they could be putting that money someplace productive, yet not overly risky.
Let’s put that together: Federal Reserve policy is hitting the average saver really hard. Those savers are going to bolt to something that pays a market rate of interest when they get a chance.
So when you read the rest of that statement — deposits may be at risk once yields begin to rise and competitive pressures increase — it could be taken one of two ways (or both).
1) When the Fed stops intervening in the market and things go back to normal, depositors bolt immediately to higher yielding securities, say a normal 90-day Treasury paying 5%. Banks, which have been forced to invest in longer term, less liquid instruments risk losing their depositors if they don’t raise rates to match their competition. No depositors, no money, fire sale, out of business. But if they raise rates, they are struck with the downside of the carry trade and burn through their equity with the same result: no equity, fire sale, out of business.
2) I’m not sure if the FAC is going Cyprus on us here, but they could be saying that deposits are at risk, meaning the insolvency of the banks and the sheer scale of the problem could be so great that it would exceed what a depleted FDIC could bail out. If that were the case, then your actual deposit — the money you have put in the bank — could be at risk for a partial or complete loss.
Imagine the US government saying, sorry, the FDIC is insolvent and so we’re going to take twenty cents of every dollar you have in the bank and put it into the bank itself. We’ll give you (non-redeemable) shares in the bank, though, so if it ever earns a profit you can share in that. That’s Cyprus, and probably not what the FAC meant (although some members may have).
Either way, this is not a fun time for the dumb money that is left holding the bag.
Uncertainty exists about how markets will reestablish normal valuations when the Fed withdraws from the market. It will likely be difficult to unwind policy accommodation, and the end of monetary easing may be painful for consumers and businesses.
The Fed may have things under control today, but it is not clear how they are going to remove the fingers from the dike without the whole thing collapsing. And, by the way, the water is building behind the dike and so this can’t go on forever, there needs to eventually be a change in policy back to normal markets.
But look; the entire economy is shifted to either (a) those in cash and desperate for a return to market rates so they can bolt or (b) those who have positioned themselves at great risk with assurances that the Fed will continue to keep rates low. The more people that shift from (a) to (b), theoretically the better the economy will get since there will be less hoarding (saving) and more investing and spending. The problem is, the more people following strategy (b), the more critical it is to suppress rates as rising rates will sink their investment.
And there’s the problem. The Fed is stuck in a trap of its own making. If it stops intervening, bank positions go bad, the equities market falls and mortgage rates climb, depressing housing prices, all at once. If it continues to intervene, it is only making these distortions worse, setting itself up for an even more painful unraveling, a reality summed up in the final sentence from the FAC.
Given the Fed’s balance sheet increase of approximately $2.5 trillion since 2008, the Fed may now be perceived as integral to the housing finance system.
What is your house worth? What is a company’s stock worth? What is your dollar worth? Nobody really knows because there isn’t actually a market for any of those things. Now there’s a “market” where things are bought and sold, but not a market where price discovery plays a role in determining what something costs. The very value of the currency is being manipulated, forced into risky and speculative places where it would not naturally go. We’re living through the greatest, high stakes, financial experiment in human history.
Dumb Money, Day 4 Friday, June 14, 2013 | Charles Marohn
The inspiration for this entire series was a set of people who, independently, expressed to me that there were thinking about either (a) investing in the stock market or (b) buying a home. All cited recent reports of upward trends in the price of stocks and houses as justification for their moves.
I’ve also experienced a lot of enthusiasm for municipal investments to induce growth, borrow more money to get things going and essentially get back to the economy of 2005, which is going to happen really soon for those that get in the game. I also wanted to shatter this delusion.
And finally, I’m just so frustrated with the narrative from the Krugman Keynesians. As they hold out the king-sized candy bar and tell everyone that, if we just ate another, the sugar rush would get us up off the floor and we’d then have the strength in our economy to prosper. It’s true, we can get up off the floor with another candy bar, but a lot of good, prudent and innocent people are going to get slammed hard when the sugar rush goes away. Statements to the contrary are comforting and convenient, but ultimately are reckless and harmful.
Abundant capital is a great thing. On it’s face, that is clearly true. For an economy, abundant capital will provide for investment and growth. Continuing with the human body analogy (another complex system), it is a little like saying “energy” is a great thing. When we have a lot of energy, we can accomplish a lot of things.
(I’ll also note here that too much capital causes inflation while too much energy causes hyperactivity and insomnia — abundant capital/energy has limits, for certain, but what we’re talking about here is a lack of sluggishness.)
We all understand that a body can get energy in productive ways and unproductive ways. Good sleep habits, a healthy diet and plenty of exercise is the healthy way for a body to have energy. This requires discipline and balance and, even when it is not pleasant, it requires one to listen to their body. That sore muscle is telling you something; maybe you need to stretch it more, or make sure it isn’t neglected in your routine. That headache is a good thing if it is warning you that you are dehydrated.
So the human body, a complex machine, experiences volatility and gives off warning signs when things are not optimal. Sometimes we can respond to those signs in a way that is clearly productive — we can drink more water or alter our exercise to be more balanced — but sometimes we have to resort to other means. We can’t solve a torn ACL with diet and exercise; for that we need some surgery followed by some antibiotics and pain killers.
He’s the fine line; we all understand that we ultimately need to shed the pain killers. Even Ben Bernanke and Paul Krugman will say, we ultimately need to shed the pain killers — the low interest rates and quantitative easing — and let this patient (a sick economy) learn to walk again. The trillion dollar question is: when?
This gets me back to the statement I made on Tuesday.
In normal times, we must save to invest.
Savings is the diet and exercise of a healthy economy. We save money — delay the immediate reward of consumption — for the promise of a greater future reward. These savings, in turn, can be productively invested by others today, resulting in growth. The natural regulator between savings and investment is the interest rate.
What economic stimulus does — whether it is manipulation of the interest rate, printing of money or deficit spending — is to give us investment without the need for savings. So we get energy without the need for a healthy diet and exercise.
We can see how, in an emergency situation or on a really bad day, it might be convenient to drink a Red Bull or eat a candy bar to give ourselves an energy boost. A steady diet of Red Bull and candy bars, however, can only lead to disaster.
I have 3 graphs that show how the steady, 60 year diet of Red Bull and candy bars every time our economy has felt a little sluggish has deformed our economy. I particularly want to give some context to the recent stock market highs and housing data.
Here’s our overall economic growth as compared to debt. As we proceeded through the second life cycle of the Suburban Experiment, the lack of real productivity in the economy was replaced with Red Bull (debt). This kept the economy going, allowed us to continue to grow our GDP, but allowed us to also become increasingly unproductive. By 2005, the height of the housing boom, our ability to sustain growth was almost entirely based on Red Bull (debt) and even then, we needed to grow debt at a faster rate than the economy just to manage meager growth.
The gains we are seeing now in the stock market — paper gains — are not based on real productive growth. They are largely the result of cheap credit, something only sustainable so long as the Red Bull continues to flow at accelerating amounts. The crowding out of real savings by the Federal Reserve also means that people are being enticed into stock markets as a way to have any earnings at all. Although people have been shown to be unwilling to gamble where they can lose, when the momentum shifts and perceptions change, people are more than willing to gamble when they believe they will win.
In terms of housing, this was the chart that brought together everything that I’m seeing. We’ve been treated to the media reports that median homes prices are rising. This graph shows how this relates to median incomes.
Home prices might be rising, but it is not a product of us having an economy where people are making more, earning more and having more money to invest in housing. It is an artificial creation of cheap credit. If we were transitioning to a real economy — something stable — that graph should be trending down, not up.
We must save to invest. As we got into the second life cycle of the Suburban Experiment and the growth from horizontal expansion slowed, we replaced savings with Red Bull, putting off a difficult conversation about the wisdom of our approach and, in the process, creating an even larger deformation that we will ultimately have to deal with.
This is an incredibly fragile economy. That fragility is not the construct of recent bailouts, natural economic cycles, greedy politicians, a prolific consumer, lazy freeloaders, the 99%, the 1% or any of the other groups we like to pin the blame on. It is the result of sixty years of deformation, of responding to the aches and pains with Red Bull and pain killers.
Yes, that approach – what has evolved into a supply side, Keynesian amalgamation — allowed us to grow faster, much faster, than we otherwise would have. It allowed us to live large, have an enormous standard of living, and accomplish many, many things that we would not have been able to do were we not taking economic steroids.
Smoothing of the business cycle and decades of this faux-prosperity has all come at a price, however. That price is a great unwinding. On Day 5, I’m going to provide an optimistic roadmap for how a great unwind could happen. On Day 6, I’ll give a less generous version.
Dumb Money, Day 5 June 17, 2013 Charles Marohn
The optimistic and the pessimistic view of the future. He gives the optimistic scenario a less than 5% chance of happening.
If the Federal Reserve’s Quantitative Easing program that artificially suppresses interest rates ends, I explain what would happen in the housing market, the stock market and the federal budget.
On Day 4 I explained that: (1) stock markets gains are not real but simply a byproduct of cheap credit, (2) rising housing prices reflect this same bubble and likewise are not real and (3) we can’t make up for a lack of savings by simply printing money.
Assume, in a very optimistic sense, that Fed interventions have the desired effect, the economy begins to grow on its own and the Fed is then able to reduce QE and allow interest rates to return to market prices.
The housing market is then going to have some huge downward pressure. First, the main buyer of Mortgage Backed Securities (MBS) is now the Fed, which purchases 70% of all new mortgages that wind up on the secondary market (nearly all). Without the Fed buying MBS’s, rates will rise. Optimistically, this will present a buying opportunity for those that have kept cash under the mattress (granted — not sure who those people would be as QE and the other Fed interventions have been designed to get all that cash into the market) and others who are looking for higher yields, perhaps from overseas investors looking for a place to put their dollars (and not worried about recent history in the housing market).
As rates go up, those investors that own low rate MBS sell them to avoid getting burned in the carry trade (see Day 1). While this wave of selling makes rates spike, once the shock passes and banks (and pension funds) have taken their losses, the market stabilizes at a new normal of moderate interest.
Interest rates will rise, by definition, as the Fed stops artificially suppressing them. As rates rise, purchasing power declines as the same payment now buys less house. While this has traditionally exerted downward pressure on home prices, the vigor of the recovery and the pent up demand (?) for housing convinces those (few) people who qualify yet don’t own a home to overlook the fact that they didn’t buy at historically low interest rates. This, along with immigration, allows the housing market to remain healthy.
As part of this, home-builders begin to correct the imbalance between single family homes and households of single individuals. Many 1 and 2 BR unites will be constructed while the number of new 4+ bedroom units declines rapidly. This is a different approach for home builders, appraisers, lenders, brokers, realtors and insurers — not to mention inconsistent with our tax and regulatory structure — yet there are market incentives to make the shift and so it occurs in relative order.
As Baby Boomers seek to sell their suburban homes and relocate to other areas, there are enough Millennials — as well as recent immigrants — with sufficient affluence to purchase all of these homes at higher rates. Some places of the country fare better than others, but the worst performers are not sufficiently bad as to drag down the national economy.
As this is going on, the stock market continues to climb steadily. Stock prices are a reflection of earnings and earnings a reflection of sales and margins. A climbing stock market indicates that companies are still expected to make increasing earnings, improve sales and increase their profit margins while interest rates rise.
Rising interest rates will certainly dispatch some high growth companies whose business models rely on low borrowing costs to build new stores and expand their market position. Rising rates will also force the liquidation of a number of companies that are highly indebted when those companies now have to take their narrow profits and pay competitive rates of interest. These bankruptcies will only make room for other competitors to gain in the market.
As interest rates rise, consumers — particularly the prolific spenders that are carrying high debt levels — will be squeezed by higher debt payments. Home equity loans will no longer be as readily available or as lucrative. Despite this, the growing economy increases optimism about the future. People feel they will have increased capacity in the future so they begin to take on (even) more debt for consumption purposes, despite the higher rates. This allows businesses to continue to grow and expand justifying elevated stock prices.
Despite higher interest rates, commercial construction continues as national chains, and local enterprises, expand to more and more locations. In contrast to the established approach for national retailers, their protocols for store siting, their chains of suppliers and the entire regulatory and tax structure, business models begin to shift to respond to a new geography. Fewer strip malls are being built and business expansion is now taking place within traditional neighborhoods. This transition represents something of a new market niche and profits continue to soar, justifying broadly higher stock prices.
Finally, as interest rates climb and the Federal Reserve backs out of being the primary buyer of US Treasury bills, Congress is forced to deal with the rising deficit problem. A national debt of $17 trillion financed at less than half a percent interest suddenly becomes unwieldy when rates rise to 5%. The “devastating” sequester of $83 billion looks paltry in the face of what is now an additional $800 billion annually just in interest.
So Congress is forced to act decisively. A 2–4% increase in tax rates relative to GDP along with steep declines in military spending (and military commitments) and means testing of Social Security, Medicare and whatever emerges once Obamacare is implemented. These policy changes are made without any defaults and without any downgrading of the US credit rating. Foreign governments remaining willing (and able) to pick up the gap now that the Fed has exited the market, with Europe, China and Japan now buying trillions of dollars of US debt each year.
All of this allows the US economy to sail on, the Great Recession a nasty episode that we resolved by learning the lessons of the Great Depression and acting aggressively in times of crisis.—
A couple of late evening additions….a friend of mine (a banker) emailed me this article from the NY Times. The article elegantly made some of the points I tried to make earlier in this series.
Dumb Money, Finale July 1, 2013 Charles Marohn Also a 5% chance of happening? He thinks this is more likely, but how much more?
Above is the optimistic scenario for how the post-2008 economy resolves itself, an entry that was full of wishful thinking and, in my opinion, a lot of rosy assumptions that have very little likelihood of coming to fruition. I do not think we’ll run the table, that Quantitative Easing ends with a gradual taper, leaving the housing market to rise despite rising interest rates, the stock market to climb despite increased borrowing costs and Congress able to act decisively, in a way that does not negatively impact the economy, when the carrying costs on the national debt soars. While I’ve not conducted a statistical analysis, I would give the optimistic scenario a less than 5% chance it will come to fruition.
That is not so say that the pessimistic scenario I’m outlining today has a high likelihood either, although I do find it more likely. A 5% chance that it will all work out weighed against even a 5% chance that the worst case scenario will happen should raise some doubt on how much we are risking and to what end. Ultimately, our economy is in need of a massive retooling. We’re doing everything we can to keep that from happening. If we succeed, we get the optimistic scenario I outlined, a malaise with modest improvement over where we are today. If we fail, here is one way this could go.
The Federal Reserve is not going to be able to end its QE program. Just the mild suggestion that someday in the future there will be a tapering put the bond markets in an uproar. Nobody wants to be the last one to exit this market, and so everyone sitting on a carry spread has one eye always on the exit. Note that the Fed is not suggesting a return to market rates of interest — they still intend to keep rates artificially low — just that they are going to slow that rate at which they pound rates lower with a weekly QE sledgehammer. There is a prisoner’s dilemma at work here.
So the Fed keeps printing and printing and printing. That is, until inflation shows up on our shores.
There are two important things to understand about inflation. First, the Fed’s actions have produced inflation and are continuing to produce inflation, it is just not the kind reported in the vaunted CPI. For many economists, housing prices can artificially triple from cheap credit and it isn’t inflation so long as milk prices don’t rise. Also, we are exporting our inflation. When our cheap credit allows us to buy imported goods, that money winds up in some emerging economy, driving up their prices.
Think those protests in Brazil, Egypt and Turkey have nothing to do with US monetary policy? The spark may be domestic, but the underlying fuel that burns is rising prices.
The second important thing to understand is that inflation is like ketchup in a glass bottle. You want a little ketchup so you tip the bottle upside down. One shake – nothing. Two shakes – nothing. Three. Four. Five. You give it a sixth shake and a third of the bottle spills out all at once. In other words, it is not like there is an inflation dial you can just gradually move up and down. Inflation could easily spiral if all of those foreign holders of dollar-backed debt (not to mention domestic holders, although they are easier to coerce) logically decided they would rather own acres of cornfield in Nebraska, some oils wells, a couple factories or a few trillion in other real assets rather than a currency that is being aggressively debased.
So the Fed keeps printing until they are forced to stop by a spike in inflation. They may still be unwilling to act, even in the face of double digit inflation, but ultimately they will be forced to abandon QE and raise interest rates. A return to the double digit rates of the early 1980’s would not be without precedent (and may ultimately be an underestimate, given where we are today compared to then).
When interest rates climb, it’s over. The Fed has lost control — or the illusion of control is gone — and the correction that was put off is now in full, unabated motion.
A federal debt of $17 trillion now has annual interest in the $2 trillion range, making things like the 2012 interest payment ($220 billion), the difficult decision of the fiscal cliff ($60 billion) and the horrors of the recent sequestration ($85 billion) seem quaint in comparison. Raising taxes, slashing entitlements, gutting the military and every other formerly unthinkable action now becomes the low hanging fruit in a debate over a federal budget that is nearly 50% interest payments.
Things at the state level are perhaps even worse. Many states have simply given up — states like Illinois, New Jersey and California — and have declared bankruptcy. [JBK Pension? Those pension obligations that were dependent on rates of return 250% greater than historic growth rates are now simply discharged, the pensioners getting pennies on the dollar in a lump sum check. Things like maintaining roads — let alone building new ones — are sporadic, where they happen at all. High speed rail systems half built with borrowed money seem like a cruel joke.
Rising interest rates — and the steep reduction in government contracts — force many businesses to go bankrupt, the artificial gains during the cheap money era now gone exposing poor underlying business models and weak balance sheets. Those that remain have higher prices and a shrinking market. Unemployment consequently spikes and the Misery Index (inflation plus unemployment) is revived. In nominal terms, the stock market may be higher or lower, but who cares because in real terms (inflation taken into account) it is dropping dramatically.
Unlike the early 1980’s, however, housing prices do not inflate, their value already too high from prior attempts to prop up the housing market. These prices remain sticky, refusing to drop substantially. The stagnation in price freezes markets, preventing people from being able to sell and move for new work or better opportunity or being liquidated by price deflation. This is extra unfortunate as price inflation is making everything else associated with home ownership — local taxes, replacement shingles for the roof, fixing a broken window — vastly more expensive. This problem — can’t sell but can’t afford not to — is the most pronounced in auto-based neighborhoods, where demand for housing is lowest, jobs fewest and mobility problematic in the face of inflating gas prices, now over $6 per gallon in some places (even though Americans are using less).
In the end, the economy reaches equilibrium. A market rate of interest is restored, but not until the other imbalances of the economy are largely addressed. Median wages have increased bringing median house prices — which have stayed flat — back in line with income. This has not provided the average family with more resources, however, as it now takes twice as much to fill up the refrigerator and the car each month. Americans become savers again, not by choice but because they can’t afford credit, their houses and 401(k) plans have not kept up with inflation and interest rates on savings are once again respectable. The quality of life for most Americans is dramatically changed to the negative, devastating the poorest of the poor. Riots and large protests are now a common occurrence (although the government, thanks to the NSA, are able to head off the worst of the latter by detaining “evil doers” that are stirring things up).
Finally, following the inevitable path of all great empires, the dominance of the dollar is relinquished. After 70 years as the world’s reserve currency, the dollar now competes with a gold-backed Renminbi, a gold-backed Russian Ruble, and a new, northern-bloc Euro backed by a basket of commodities and currencies. The dollar, too, finds international stability only when it ceases to be a fiat currency and, once again, pegs its value to some sort of “barbarous relic” that is beyond the reach of a government or central bank to devalue.
I’ll close by saying again that this is not a prediction as much as it is an exercise in imagining possibilities. I contend that we’re so fixated on maintaining the status quo that we’re not even considering the likelihood that we’ll be successful (low, in my opinion) or the risk that something calamitous could happen (by no means certain, but much higher than I am comfortable with).
For the time being, we’re simply content with being dumb money.
My comment: I don’t agree with all of the above, but many good points are made, especially about the sneak accounting tricks that make banks seem like they’re doing well, when all they’re doing is borrowing more and more at our and future generations expense. There has to be deflation first, but after that inflation is a possibility. Also it’s unlikely that gold will ever be our currency.