Economic Rebalancing

The global economy is horribly out of balance, with the United States going deeper into debt each year as a result of a huge trade gap. This blog describes the process of global economic rebalancing. If you have any comments or questions about the posts here, please don't hesitate to use the comments section.

Monday, March 26, 2007

So Much for Real Estate Stabilizing

Economists from the government, the Fed and the real estate industry had been sticking to the line that housing was showing signs of stabilizing. Today's data on new home sales shoots that down. This chart shows what the trend looked like before and after todays revisions:

The new data will be revised down next month as well. Besides the fact that March will be horrendous due to the mortgage meltdown, the methodology has led to consistant downward revisions for over a year. New home Sales data makes preliminary estimates based on the amount of housing starts. As I've said many times before, the old estimations aren't working because the housing market has changed. Builders aren't waiting for an order to build like they used to. Now they have way too much land, too much construction equipment and too many employees sitting around with nothing better to do. As a result, they're still trying to race each other to build homes and get rid of them, and the number of finished homes for sale keeps rising.

Those finished new homes for sale have been sitting on the market for an average of 5.2 months - not a good thing if you are a builder with liquidity concerns.

More good commentary here:

Sunday, March 25, 2007

Foreclosure Tsunami Now in the Pipeline

According to some data, foreclosures were up 42% nationally in 2006. That pales in comparison to what lies in store, based on data from sub-prime lender Novastar Financial's recent securitizations.

Some things to note when looking at these charts:
1. Securitizations from 2004 saw a big spike in defaults around months 24-27 when many of the 2-year ARMs reset. Many borrowers simply couldn't make their payments at the higher rates. 2005 & 2006 securitizations have yet to see their spikes.
2. 2006 was a big year for emergency refinancings for people who couldn't make their adjusted ARM payments. Consequently securitizations from 2006 are of extremely poor quality and are going bad very rapidly.
3. Things started getting ugly around November when credit started tightening measurably and borrowers had more trouble getting emergency refis.
4. 2005 mortgages were mostly made at the peak of the housing bubble so homeowners have reduced chances of doing cash-out refis.

OK, that's all bad enough, but now consider:
5. NFI has had to buy back a many defaulted loans out of the newer securitizations due to fraudulent applications and early defaults. So total defaults within the original securitizations are likely much worse.
6. Many of the loans in the earlier securitizations have been prepaid through emergency refis. So total defaults within the original securitizations are likely much worse.
7. NFI's lending practices were probably more conservative than those of the 44 lenders who have already gone kaput".

OK, enough already. Here's the charts:
1. 60+day contractual delinquencies, foreclosures and real estate owned. Each individual securitization is tracked month by month.

2. Average monthly increases in default percentages remaining in securitizations:

3. Average level of 30-59 day delinquencies:

4. Level of 30-59 day delinquencies, most of which will add to March's 60+ totals:


Saturday, March 24, 2007

US Consumer Takes a Dive

It couldn't last forever. The US consumer couldn't just keep building up more and more debt on ever higher levels of spending. Eventually debt service had to overwhelm the US consumer and bring down spending. Perhaps March marks the beginning of the big reduction in US consumerism. Data from ShopperTrak shows an amazing year over year slowdown in the month of March:

On the one hand, this drop is too sharp to be believed. In all the economic data series that I've tracked, data doesn't do that. I expect there will be some sort of bounce back in the coming weeks heading into the Easter holiday. Still, the overall downtrend can't be ignored. The monthly data includes shopper traffic, which dropped off more rapidly than total sales from July through February:

The chart above fits with the premise that wealthier consumers have been spending at a high rate while people on the low end keep getting squeezed tighter to the point that they don't shop nearly as much. The Consumer Sentiment number tends to jump around a lot, but at least for now it is backing up the ShopperTrak data.

March will be a very interesting month for economic data as it will reflect the big credit tightening related to subprime lending. Most of the commentary about the subprime meltdown has talked about it like it is a disease that can spread, but I prefer to think of it as the proverbial canary in the coalmine. Subprime was just the weakest link and therefore the first to be wiped out as the great ponzi scheme begins to come crashing down.

We've also had a big slowdown in construction spending and manufacturing, and leading indicators for February look really bad. Here's something I posted over on the MarketTraders forum:

The leading indicators report is a lot worse than the headlines suggest. Here's the data:

These indicators were all down hard
-0.33 Initial Claims
-0.17 Consumer Expectations
-0.13 Vendor Performance
-0.07 Building Permits
-0.06 Interest Rate Spread

These indicators are just guesses (imputions):
0.02 New Orders for Consumer Goods
0.17 New Orders for Capital Goods
0.05 Money Supply
Last month's New Orders imputions got revised heavily downward, thus the change from +0.1 to -0.3. These types of guesses tend to be notoriously misleading when a trend is reversing.

Leaving only Stock Prices, Money Supply and Workweek reliably non-negative.
0.00 Average Workweek
0.06 Stock Prices

Follow the link above and take a look at the chart on the last page to see that leading indicators have been very good at forecasting recessions.

Here's that chart I mention:

In my mind most of the US economy and most US citizens have already been experiencing a significant recession. Underreporting inflation has helped the government show positive growth numbers, but only the financial sector has really been growing. Based on recent data it seems likely that the slowdown for the rest of us will soon be harsh enough that even the GDP data shows enough negative growth and the recession will be obvious, even to economists.


Wednesday, March 21, 2007

Yen Carry Trade Doesn't Need the Dollar

For many months I've been discussing the role of the Yen Carry Trade in perpetuating global economic imbalances. Recently the issue has been getting more attention in the mainstream media. The point I'd like to make now is that the Yen Carry trade appears to be shifting more toward currencies other than the US dollar, like the pound, the euro and the New Zealand and Australian dollars.

When the Fed lowered short term US interest rates to a mere 1% in 2003 it sparked a rise in the carry trade in the US. As the Fed moved rate up from 2004 into 2005 it made the cost of borrowing in the US too high:

By early 2005 carry traders had begun looking to Japan as their source of cheap short term borrowing, but this also required traders to sell the yen they borrowed in order to buy dollars. The following chart shows the effect this has had on the Dollar/Yen relationship since late 2004 (blue), and how the dollar has done against a broader range of currencies (black):

As long as the fed kept raising rates, the dollar stayed strong. When the Fed stopped raising rates in the middle of 2006, the dollar began declining against most world currencies. However, the Yen itself has been kept weak as the Bank of Japan has been very reluctant to let a strengthening Yen cut into Japanese manufacturing profits.

While the Fed has been reluctant to raise rates, for fear of toppling the various debt pyramids in the US, other central banks have recognized a need to fight inflation and have been continuing to raise rates. Recent efforts in Japan to talk down the Yen have had a more pronounced effect on the Yen Carry Trade with other countries, resulting in the Australian Dollar surging to a new high against the US dollar (among other notable movements). As these carry trades flourish even further, the relative importance of the Yen/Dollar carry trade becomes less of a concern. Japan wants a weak currency, but it can allow some strength against the dollar in exchange for weakness against everything else.

In spite of the wide expectation that the Fed will lower rates later in the year due to a softening economy, I believe that the Fed is more concerned about the status of the dollar. The recent rise in inflation will probably give the Fed an excuse to talk up the need for keeping rates up. We'll see later today how they go about doing this and how the market reacts. The world is very slowly realizing that it can (and will have to) grow without the US consumer as its primary customer. At the same time, speculators are coming to realize that there are better ways to play the carry trade than to expose themselves to the tremendous risks of investing in US dollar denominated assets. Rates in the US will likely rise as attracting capital becomes more difficult over time.

Friday, March 09, 2007

Trends in the Trade Gap Numbers

The 2006 Trade Gap has been revised up to $765.267 Billion.
The 2005 Trade Gap was $716.730 Billion.

But now we've shown year over year declines for the past 5 months, with this January coming in $7.352 Billion below last January. Is the trade gap finally rebalancing? The biggest variable lately has been the size and value of oil imports and that clouds the picture. Meanwhile, the data appears to underscore the following, well established trends:

The rest of the world's economies are growing and developing rapidly, aiding exports.
We're going deeper in debt to fuel consumer spending, boosting some imports.


Goods imports are barely up year over year (+$2.820 B).
Goods exports are way up (+$9.708 B).

We're exporting more industrial supplies (+$2.865 B), and importing less (-$2.348 B). (lower oil prices have much to do with this)

We're exporting more capital goods (+$4.029 B), while also importing more (+$2.610 B).

Auto exports are basically unchanged, while imports dropped (-$1.020 B).

Consumer goods exports are up (+$1,600), while imports are up even more (+3.248 B).

When will the US consumer finally hit the wall? That may be happening right now, with the collapse of the subprime mortgage lending sector. The suddenness of the collapse could spread fear into other credit markets where lenders have been far too aggressive, leading to further contractions.

We'll see if it finally puts a dent in consumer spending later this year. This is the path rebalancing mush eventually take: A major decrease in US consumption.

Monday, March 05, 2007


Over the weekend, it seems, many people finally got wise to the fraudulent ways of the sub-prime lenders:

NEW down 68.87%
NFI down 40.88%
FMT down 32.38%
IMH down 32.05%
LEND down 25.99%

A one-day dive like that doesn't happen often to a group of stocks. But then, these are strange times in the financial markets, and the housing sector has made for a great game of chicken among fund managers. The truth was out there for anyone who payed attention to the warning signs:

A lot of people had the courage and sense to short these guys and have done very well. It's more interesting, however, to look at who has been buying these stocks since the time bomb first detonated back in August.

Top 10 institutional holders of NEW on 12/31/06:
1. Hotchkis & Wiley 3,948,100 shares
2. Greenlight Capital 3,494,700 shares
3. Morgan Stanley 3,022,884 shares
4. Goldman Sachs 2,640,127 shares
5. State Street 2,116,121 shares
6. New York State Teachers 2,011,750 shares
7. Citigroup 1,937,351 shares
8. Barclays Global 1,618,618 shares
9. Deutsche Bank 1,362,819 shares
10. Vanguard Group 1,257,444 shares

Top 10 for shares of NEW purchased during Q4 2006:
1. Ivory Investment Management
2. Wesley Capital Management
3. Jacobs Levy Equity Managment
4. New York State Teachers
5. UBS
6. Chicago Equity Partners
7. Merrill Lynch
8. Two Sigma Investment Managment
9. BNP Paribas Securities
10. Tewksury Capital Management

SC 13 filing in 2007 indicating more purchases:
Cititgroup 2,845,700 shares held on 2/19/07, an increase of over 900,000 shares when they should have known better. Citigroup has a huge sub-prime lending division of it's own, after all.

Many months ago I read an interesting businessweek article that explains why Citigroup, Merrill Lynch, UBS, Goldman Sachs and Deutsche Bank are all getting burned on New Century and others (GS is in the top 5 holders for NFI & LEND as well):

"More surprising, banks are also regularly agreeing to buy huge blocks of stock from trading clients even when they know they will likely lose money on the trade. It's a high-risk, low-reward endeavor designed to keep clients coming back to pay for more lucrative business in the future. Some executives estimate the dollar volume of such transactions has doubled in the past few years. Yet banks have barely broken even on about 30% of their big block trades this year, according to Thomson Financial (TOC ). That's because the share prices often fall during the time they hold the securities on their books. Even so, "banks are falling all over themselves to bid on blocks," says T. Rowe Price's Brooks. "It's not for the faint of heart."

The sub-prime time bomb is just the first is just the first stage in a chain reaction that will engulf many portions of the financial sector. Look for prime lenders, mortgage insurers, the GSEs, savings and loans, commercial banks and investment banks all to experience their own implosions. They may not all get wiped out entirely or as dramatically asthe sub-prime players, but the damage will be extensive.

Sunday, March 04, 2007

The big surges in margin debt in both 2000 and 2007 point out some similarities between the two periods, but there are also some big differences. For one thing, notice the difference in volatility, as demonstrated by the roughness of the chart before 2003 and the smoothness after 2003

Volatility has been squeezed out of the market both via computer trading and the derivatives markets. Hedge funds and trading desks at the major banks have taken the risky side of volatility bets in order to ensure a high probability of a small return. I personally believe that some of the largest players are involved in selling large amounts puts and calls and then using computer trading models to help ensure that volatility remains contained so that their derivative bets remain highly profitable.

As the trend in declining volatility has increased, more and more traders have joined into that game, further compacting volatility, but also increasing the risk of the risky side. The hedge fund compensation model equates to "heads we both win, tails you lose" so highly risky bets are right up the ally of many fund managers.

Last week's decline was not big by 2000 standards, but it was the largest weekly decline in 4 years. Because it was so unusual, it was probably large enough to put a crunch on some overexposed funds. Some large hedge funds blew up last year when energy prices moved against them. In that situation, it made sense for managers to double down with client money and hope for the best. In 2000, buying the dip was an entrenched philosophy for retail investors. In 2007, double-down and pray has become a philosophy for some hedge funds.

Margin debt in 2007 finally topped the 2000 totals, but even more hazardous to the health of the markets is the leveraged nature of hedge funds. Underlying much of the yield chasing bet is a highly leveraged bet against the Japanese Yen via the carry trade. Many traders have borrowed Yen and bought Dollars in order to take advantage of low Japanese rates. A big enough move up for the Yen, and/or a big enough move down in stocks or bonds will break through the resistance set by volatility traders and cause a forced unwinding of those trades. Right now, they are probably pushing back hard, but the weight of global imbalances will likely win out eventually. As I interpreted the charts, on Thursday and Friday the Yen rallied while the Western hemisphere slept, then retreated a little when Western traders got to work increasing the size of their bets.

I see the value of the Yen as my biggest indicator of who is winning out in this battle against the volatile nature of markets. If the Yen continues to rise, then I'll expect that the carry trade is being unwound and that leveraged players are being forced out of their positions. I'm also watching the actions of the Fed and other central banks, which so far are not showing any signs of panic. There was just one large permanent injection early last week of $1.8 billion, and custodial holdings only increased by $7.7 billion (high, but down from recent weeks). Meanwhile there wasn't much movement in the RMB/Dollar rate. I think that China has done a lot to force the unwinding by bringing the dollar down 6.7% against the RMB and they can choose to force things a lot faster if they like. I also think that Japan still wants to keep the Yen weak to protect their manufacturers if at all possible. The BoJ and the Fed still have plenty of ammunition to protect the carry trade if they want to use it.

In 2000, margin debt was forcibly unwound in the month leading up to April 15th (income tax day). Big capital gains tax bills met with a hugely over-saturated market for IPOs and rising short term interest rates to kill off the bull market. The Fed was glad to let overexposed retail investors take their losses. The markets stabilized through the summer, and it wasn't until September, when the technology sector started contracting due to a lack of new investment that the stock market really began their long, bear market. My hunch is that this decline will stabilize before long when the BoJ and Fed decide to get more active, but that the rapid credit expansion of the past 4 years has probably run its course. If that is the case, then corporate profits and the financial markets may begin retreating later in the year from their overextended positions.

When the real decline finally begins, it has the potential to be very sharp, because of the way volatility has been suppressed for so long. Along the way we may see the collapse of many hedge funds, some major defaults in the derivatives markets and a string of shocking bankruptcies and revelations from the financial sector.

Thursday, March 01, 2007

Ponzi Schemes Collapsing Under Their Own Weight

Some portions of the Great American Ponzi Scheme appear to have begun collapsing on themsleves.

The cash-out refinancing cycle kept many borrowers temporarily solvent. Rising home prices enabled overextended homeowners to continue piling on debt. They also brought in an increasing number of home buyers, helping to drive up prices further. Eventually, the supply of new buyers started declining and prices stalled. Defaults are up dramatically bringing an end to the ponzi scheme of lending homeowners far more than they can afford to pay back.

The corporate bond and commercial lending markets have provided homebuilders with all the capital they wanted over the past several years. As a result, they kept buying up land and building homes faster than they could sell them. Suddenly cash is becoming a pressing need for homebuilders. Credit is drying up, which will have far reaching effects throughout the economy. (My comments posted elsewhere are italicized below.)

These are likely just the first two schemes to start coming undone. Loose lending practices in the consumer credit arena will likely lead to a massive unwinding. Lending to Hedge Funds and Private Equity firms is a big potential crisis, and the insolvency of private and public pension plans will likely soon be exposed as a termendous accounting fraud and Ponzi operation. And the biggest of them all is the insolvency of the US government, based on tens of trillions of dollars worth of promises that can't be kept.

WCI wants to generate $1 billion in cash flow from operations this year. Last year they burned $490 million, and they burned smaller amounts in 2004 and 2005, so that would be quite a turn around. Indeed, for many years builders were content to pile up inventory of land and homes for sale, along with mountatins of debt. They didn't care about cash from operations when there was plenty of cash from financing to be had.

Why the sudden need to generate cash?

My take is that the financing is drying up. If builders can't raise cash from operations while the losses are mounting, then they'll have an especially hard time getting lenders to extend their credit agreements. With today's write-offs, WCI is already in violation of their credit covenants. DHOM violated theirs last year and had to renegotiate at significantly higher interest rates. OHB is also on a mission to generate cash from operations.

The sharp decline in housing starts in January was probably a first sign that builders are under pressure to raise their own cash. Residential construction spending will continue to dive as many builders seek to sell off inventory faster than they create it. Because builders capitalized interest and property taxes, along with construction costs on homes under construction, building spec homes didn't hurt earnings in the slightest. Now that the bubble has obviously burst, keeping lenders confident in their solvency will be important in order to maintain that solvency. WCI and OHB won't be the only ones stressing cash flow from operations going forward.