Economic Rebalancing

2009-11-10T09:29:00.000-08:00

It's Not Risk, It's Fraud

We hear everywhere about the "risks" bankers took and how their bad bets came back to haunt us all. It's gotten so that every time I see the term "risk," I cringe.

The problem is not that they made reasonable bets and just got unlucky, as the term "risk" implies. The problem is that they fudged their accounting to show inflated profits over a period of years. This was done primarily through absurd loss assumptions on loans and the use of complex and deliberately confusing derivatives. Eventually the fraudulent schemes had to collapse under their own weight. Many of us saw it coming and warned others about it repeatedly and fruitlessly (read my posts on this blog over the past three years for proof of that).

The problem is systemic. Corporate executives want accounting rules that allow them to commit fraud and they lobby Congress aggressively to prevent fair and accurate accounting. The net effect of years of systemic fraud is that we have created huge amounts of imaginary wealth that inevitably will collapse. This occurred with the deflation of the internet stock bubble. It is occurring now in unwinding of the housing bubble. It will occur on a much larger scale as the liability for around $20 trillion worth of Federal, state and municipal government debts get transferred to the people. It will hit retirees especially hard as pension plans come up far short of being able to meet their obligations.

Inflation will likely be the primary means of transferring the losses to the masses. The Federal Reserve will choose to print the money it needs to keep our government operating after our foreign creditors finally stop throwing good money after bad. Salaries and pensions may or may not fall in dollar terms, but as the dollar loses value and inflation mounts, the real value of our salaries and benefits will decline.

We can reduce the damage we'll have to absorb in two main ways:

1. Individually, we can invest wisely. Many try to hedge their inflation exposure with investments in precious metals, but this strategy is not income generating, and fundamentally it just seeks to limit losses. A more practical approach is to invest in foreign assets that generate positive returns in other currencies.

2. Collectively, we can recognize that the problem is one of fraud, work to correct the systemic flaws that encourage and facilitate this fraud, and make sure that the individuals and institutions responsible absorb the greatest share of the losses. That means creating accurate and conservative accounting rules, breaking up the big banking powers to limit their excessive power, and forcing insolvent enterprises through a quick, efficient, orderly and honest bankruptcy process so that they can continue to operate free of fraud.

2008-03-09T07:07:00.000-07:00

How to Make Money in a Recession... (If You Are a Big Banker)

So you've just taken over as CEO of SuperMegaMonster Bank. Your predecessor skated off into retirement with a $200 million golden parachute, leaving you to manage $200 billion in bad loans and assorted toxic waste just as the economy is plunging into recession. What are you going to do?

Step 1: Write-Offs
Take huge one-time hits to your earnings and balance sheet and blame it all on the last guy. You'll be able to show a profit sooner if you don't have all these losses trickling in over time. When you do start claiming positive earnings again you'll get all the credit and big bonuses too.

Step 2: Offload Risk
Shift ownership of as much of your toxic waste as possible to the government and retail investors. Scare the crap out of government leaders and the Fed by telling them our entire economic system will come unraveled if they don't save the big banks. They'll enact a wide range of idiotic policies designed to bail you out of the mess your firm created and profited from in the first place. Public pension plans can be suckered into any investment so load them up with the worst of the worst.

Step 3: Credit Crunch
Call in loans to hedge funds, mortgage REITs and other investment schemes. They've served their boom cycle purpose and now they are expendable. Use the money that comes flowing back in to your coffers to purchase the securities that they are forced to unload at a steep discount. The Fed will loan you extra money at ultra cheap rates with your existing securities as collateral so that you can leverage up on even more cheap investments. Don't buy the hopeless stuff, just buy the higher quality stuff that will survive the recession or senior debt that will survive the bankruptcy process.

Step 4: Ride the Carry Trade
With short term rates low and yields high you can play the carry trade for maximum profit. Panicked investors will put their money in low yielding savings accounts and money market accounts and you can invest this in the long-term, high yielding stuff you soaked up in the credit crunch. As short term rates continue to fall, the spread widens and your profit margin increases.

Step 5: Kill Off Struggling Entities
Identify any exposure you have to companies or municipalities that are likely to become insolvent in a recession. Make sure you sell off any equities or long term debt you hold first. Then pull their short term funding to force them into bankruptcy. Layoffs and general panic will help you pick up more securities on the cheap.

Step 6: Eliminate the Competition
Take advantage of the struggling economy to wipe out any competition that grew too quickly in the last boom cycle. Sub-prime lenders? Savings and Loans? Small, local banks? REITs? Fannie Mae? Kill all you can while you can, as you don't want them to compete with you for banking business in the next boom cycle or investing opportunities late in the bust cycle.

Step 7: Debase the Currency
Lobby the Fed for low rates and the Federal Government for deficit spending. Remember that you are now a carry trader, rather than a creditor. It doesn't hurt you if borrowers pay you back in a debased currency because you get to pay back depositors in a debased currency as well. To the extent that you have equities, real estate and other hard assets on your books offset by short term debt, inflation actually works in your favor. Paper gains on these assets will help your case with the compensation committee around bonus time.

Reality
No doubt, the big banks are in a very precarious situation right now, but they have their tentacles wrapped around Washington and the Federal Reserve System. There is a clear path to banking profitability and it will come almost entirely at our expense as citizens, investors and taxpayers. All of these steps overlap in the timing of their effectiveness, and I expect we'll see most of the same themes continuing to pop up over the next couple of years as the recession deepens. So far we've seen:

1. A huge "stimulus" package that will help some distressed borrowers make some more mortgage payments. (Step 2)
2. A big increase in FHA, FHLB, Fannie Mae and Freddie Mac backed loans and securities to take up some of the load off of Wall Street with regards to the mortgage mess. (Step 2)
3. The invention of "Term Auction Credit" as a way of helping big banks sustain or increase their investment portfolios. (Step 3)
4. Falling short term rates to lower the borrowing costs for big banks. (Step 4)
5. Widening spreads to increase the profitability of banks that purchase new assets. (Step 4)
6. A large credit crunch that is forcing hedge funds and other investment vehicles to sell into a difficult market, with investors taking the losses. (Step 3)
7. Continuing rapid growth of the money supply. (Step 7)
8. Struggling municipalities. (Step 5)
9. Rising inflation. (Step 7)
10. A declining dollar. (Step 7)
11. A variety of measures designed to help forestall foreclosures and let banks fudge their accounting for bad loans. (Step 2)
12. The VISA IPO. (Step 2)
13. Big banks helping Thornburg Mortgage raise $230 million in stock offerings in January, only to give them big margin calls in March. (Step 5)
14. The collapse of hundreds of smaller banks and lenders. (Step 6)
15. The abandonment of the Auction Rate Securities market. (Step 3)
16. Seizing control of hedge funds to liquidate their assets. (Step 3)

Eventually the economy will hit bottom and the banks can go back to their even more profitable boom cycle business plan, where they make money by extending credit to anyone who wants to take risks and can make the payments in an expanding economy. It might take awhile for the dust to settle this time though, because the big banks sure managed to mess the economy up badly this time.

2007-06-23T08:47:00.000-07:00

Bear Stearns' Billion Dollar Hedge Fund Bailout

The news that two Bear Stearns hedge funds were being forced to liquidate is a big sign of trouble in the bond markets. My previous post showed how the market for the types of securities held by the Bear Stearns funds was tanking. Had the forced liquidations gone through, they likely would have been a serious strain on the market.

Bailing out the fund by taking over the creditor role from Merrill and others saves the bond market from more forced sales and saves Bear from the negative publicity. As the mortgaged backed bonds continue to deteriorate the losses will go back to being slow and steady, rather than dramatic and eye catching. Meanwhile, high risk MBSs continue to tank. Bear will probably pull the plug somewhere down the line so that hedge fund investors are the big losers and Bear as creditor will be largely protected.

For now, Bear's response falls in line with what everyone in the industry seems to be doing - Pretend on your books that your asset backed securities or real estate owned is still worth far more than the market will actually bear. If you don't try to sell and continue to expand your borrowing you can keep up the charade for a long time. Eventually, losses will overwhelm the securities holders, but that doesn't have to be anytime soon if firms like Bear keep stepping up with more financing.

2007-06-19T18:11:00.000-07:00

Toxic Waste Hitting New Lows

Mortgage Backed Securities are split up into different tranches so that fund managers can choose between securities that will actually make good on their promised yield and securities that will generate a high return for a short while before blowing up. The highest rated MBSs are holding up OK these days, but the toxic waste is trading down to new lows. Besides the direction of the chart, also note the coupon yields. Suckers who bought the highest yielding junk are not getting a good enough yield for the risk they took:

AAA Coupon 0.090%
AA Coupon 0.150%
A Coupon 0.64%
BBB Coupon 2.240%
BBB- Coupon 3.890%

These are 2007-01 securities. If you took the BBB- with the extra 3.890% interest, you're already down about 40% if you Mark to Market:

Most of the AAA rated bonds don't deserve the high ratings. Underwriters play games and work with the ratings agencies to get the ratings they desire and the agencies have a big conflict of interest the encourages them to overrate bonds. AAA stuff holds up because there is far too much money being created and stored in money market accounts that has to buy something. This chart from the St. Louis Fed is very telling:

2007-06-15T11:10:00.000-07:00

Rising Interest Rates and the Carry Trade

Rising 10-year yields have been getting a lot of attention, although the rise hasn't been anything out of the ordinary given the uptrend in yields over the past 4 years:

It's also interesting to note that the yield hit a wall when it reached the same level as Fed Funds (5.25%). In normal times the 10-year yield would be considerably higher than Fed Funds.

However, it has made a big difference for home purchasers with the average 30-year contract rate up to 6.61% from 6.1% 5 weeks earlier. As rates rise, the "affordability" of homes for most buyers declines, adding more downward pressure to home prices. This all puts a greater strain on the consumer driven US economy. As I expect most long term US treasuries will either default or be devalued through inflation to the point that they deserve far higher rates to make up for the risk.

Rising yields also means falling market values for bonds already in the portfolios of carry traders. Fortunately for them, the dollar has also been rising fast enough against the Yen to avoid creating much margin pressure or forced liquidations.

Why yields are rising remains in question. Over the past two weeks custodial holdings of treasuries and agencies haven't increased at their usual rate, leading some to speculate that a lack of foreign buying is behind the rising yields. There have been plenty of statements from monetary officials suggesting they'd be reducing the rate at which they acquire new US treasury debt. This is probably having a small impact on rates, but I'm more inclined to stick with my original observation that primary dealers are the main factor influencing the shape of the yield curve.

The 1 1/2-month-stale data on TIC flows came out today, showing that private foreign investors were net sellers of treasuries, but that's normal in April because of the surge in US tax receipts. Major Foreign Holders TIC data showed that Official accounts also reduced short term treasury bill holdings.

Japanese Money Supply data keeps getting revised upward, suggesting that the carry trade is having a bigger impact than authorities realize. I expect that the Broad Liquidity is actually growing at about a 4-5% rate given the way the Yen has been pushed down in recent months, although it may take the Bank of Japan several more months before they realize this and respond to it:

Commentators have been asking for years what would happen if foreign demand for US debt declined. The answer now appears to be that US debtors would just start borrowing in foreign currencies to fund their needs. In my view this represents another escalation in the extent to which the global economy has become unbalanced. It's hard to imagine another escalation that would go beyond this, but with the versatility of the derivatives markets I won't assume this is the last stage. With the government providing tax free status to Samurai bonds it appears that those in control in Washington realize that expanding the debt pyramid is essential to keeping the game going for now.

2007-06-07T06:55:00.000-07:00

This is Just Criminal

On Wednesday stock of Novastar Financial was up almost 11%. The day before the stock of Accredited Home Lenders was up a similar amount. The excuse to pump up the stock in both cases was that the companies had found a way to transfer much of the toxic waste they had created to unsuspecting investors. In the case of Accredited, the company may arrangements to be acquired by Lone Star, a private equity fund. The investors in Lone Star 5, most likely pension plans and public endowments, will be stuck holding the bag for the defaulted loans stinking up Accredited's portfolio (it's so bad that their auditor quit and they still haven't filed their Q1 report with the SEC). In the case of Novastar they managed to complete another securitization for $1.4 billion of their subprime garbage. It's hard to imagine a responsible investor purchasing new Novastar securities after seeing what has been happening in the way of defaults within recent securitizations:

Each line above represents a different securitization over time. The y-axis shows the percentage of loans in the securitization that are at least 60 days delinquent, The x-axis shows shows the age of each securitization. The February 2007 loans are going bad even faster than the amazingly bad 2006 loans.

May was an especially bad month for loans entering the 30-59 day delinquent category. Most of these will add to next months 60+ numbers:

30-59 day delinquencies on the February 2007 securitization rose from 1.44% in April to 2.55% in May as the newer loans are going bad in a hurry.
On the March 2004 securitization they rose from 1.23% in April to 2.94% in May likely as a result of resets of 3 year ARMs resulting in higher payments that can't be met.

Countrywide Financial's Real Estate Owned has reached $1.75 billion dollars as of June 5th (real estate listed for sale on their website). Of course Countrywide is just one of many lenders who are riding a wave of foreclosures and putting off the day when they'll have to recognize the losses.

The sub-prime time bomb has not been contained, and it hasn't difused. It's been getting steadily worse, but the bond market hasn't had a dramatic reaction. This has given Wall St. time to dump toxic securities and companies into the portfolios of public and private pension plans.

2007-06-05T19:00:00.000-07:00

Retail Sales at a Snail's Pace

As a greater percentage of US consumers struggle with large debt burdens and tighter credit standards, this is predictably hitting the retail sector. Companies like Bed, Bath and Beyond have begun issuing earnings warnings, and it's not just home related retailers. According to the chain store sales data even Apparel stores were hit hard in April (only drug stores did well).

April was off partly because of the earlier Easter, but a larger downtrend is evident among multiple data series. Chain Store Sales:

ShopperTrak:

Jobs:

Russ Winter has been doing a great job tracking data on shipping volumes and sales tax receipts. It all points to a slowdown in sales, with debt service burdens being a likely culprit. Now that retail jobs appear to be in decline, the problem could compound as unemployed consumers will have even less to spend.

On the bright side retailers who cater to high end consumers still seem to be doing well. These firms showed good year over year comparisons for April:
+7.3% JoS A Bank
+1.0% Neiman Marcus
+3.1% Nordstrom
+11.7% Saks Inc.

2007-06-01T10:44:00.000-07:00

Bond Curve Normalizes Following Sub-Prime Meltdown

There has been a very interesting divergence in the direction of short term vs. long term treasury yields since the market turbulence of February and March:

The yield curve had been severely inverted for many months, but with long yields rising and short yields falling most of the curve has normalized.

The uptrend for long yields and the downtrend for short yields have been very steady and well defined:

My best guesses at what has been happening behind the scenes are:
1. Primary Dealers want higher long bond yields and lower short term rates.
2. Excess liquidity has created high demand for T-bills for money market accounts.
3. The opening of new carry trade positions has hit a fevered pitch in the past 3 months. Short term treasuries were the highest yielding and most liquid part of the curve, so much of dollars purchased with borrowed yen ended up there. The Yen has been pounded down by new carry trades and now is threatening to break through long term resistence in the 122/Dollar range:

Demand created by carry traders for leaves banks with very little desire for cash from the Fed. The repo rate has been well below the fed funds rate since Mid-April and Fed repos have been low.

Meanwhile, foreign investors are still buying very large amounts of Treasury Bonds, probably because theiry the ones with the most dollars in need of a long term investment vehicle. Just about all of the Indirect bidder orders get filled as they still don't seem to be very price sensitive. (Indirect bidders are largely foreign central banks and overseas hedge funds.)

Primary Dealers, on the other hand, make up the biggest percenatage of bids and have (by far) the most unfilled orders at each auction. What they as a group are willing to pay effectively determines the interest rate coming out of auctions. They're generally the ones who are hurt the most by an inverted curve because their traditional business is to borrow money at short term rates and lend it out at long term rates.

Therefore, I expect primary dealers are the ones who are normalizing the curve on both ends as they seek to boost their profits in a time when they're facing large losses from mortgage defaults. This may help them in the short run, but it is having the effect of raising interest rates for new mortgages and refinancings. This will only put more pressure on the housing market as homes become less affordable to new buyers.

We'll see where rates go from here. There should be some resistance for 10 and 30-year bonds at 5%. That may put a lid on rising rates for a little while. Housing was in bad enough shape as it is. If rates break out above 5% that could be a nail in the coffin.

2007-05-28T19:51:00.000-07:00

Futures: The Easiest Way to Play the Yen Carry Trade

Tired of seeing hedge funds have all the fun? Want to play the Yen Carry Trade (YCT) like the big boys? Well, all you need is a futures trading account and you too can make huge, leveraged bets that the dollar will stay strong against the Yen. Of course you'll get wiped out like the rest of them if the Yen gets stronger in a hurry.

Here are some quotes for the Dollar/Yen on the New York Board of Trade futures markets. Notice that:
the June '07 contract closed at 121.325 Yen to the Dollar, while
the September '07 contract closed at 119.925,
the December '07 contract closed at 118.610, and
the March '08 contract closed at 117.360.

These prices reflect the interest rate differentials for Yen and Dollars. If you sell Yen by purchasing any of these futures, and the Dollar/Yen exchange rate remains constant, then the value of your futures will gradually rise over time. Buy enough futures contracts and you'll have a highly leveraged bet on the Yen appreciating relative to the dollar at a rate less than 4.5% per year. Here are some Yen/Dollar contracts graphed:

When you buy (Dollar/Yen) or sell (Yen/Dollar) the appropriate futures, the counterparty is typically a large banking institution like JP Morgan, Citigroup or Goldman Sachs. The big banking houses will usually then hedge their futures positions by borrowing actual Yen and then selling them for dollars on the Foreign Exchange markets. Together with the banks, your trades will amount to a full blown YCT that helps prop up the dollar and fuel America's excessive consumption.

The difference in Japanese short term rates (0.5%) and US short term rates (5.25%) is generally enough for the commercials to score a nice profit on the fully hedged position. If the exchange rate stays constant, you get around 4.5% with considerable risk, while they get around 0.25% with little or no risk. Of course fees, commissions and spreads cut into everyones profits. The numbers above are just for illustrative purposes.

Here's a nice chart showing the open interest as well as the relative positions of commercials and large and short speculators as reported to the Commodity Futures Trading Commission:

A year ago, Open Interest in futures contracts was low and the Commercials had gone short the Yen after a big unwinding of the YCT. Since then there's been a substantial increase in the size of the YCT, as reflected in futures positions, with two notable dips along the way (Oct-Nov & Feb-Mar). Neither of those dips in YCT positions was enough to push the commercials into being short Yen futures, but both coincided with sharp drops in the dollar relative to the Yen:

The Yen has been trending down against the Dollar since the beginning of 2005 when the interest rate differential between the US and Japan got large enough to make the YCT attractive. With commercials again very long Yen futures and rates more stable of late, it appears that the Dollar is poised for another sharp decline relative to the Yen. Of course the YCT could get more overextended before the next decline begins. Betting against the YCT can result in a very long, painful waiting game, as most small futures speculators have discovered this year.

2007-05-26T08:18:00.000-07:00

Japanese Investors and the Yen Carry Trade

Japanese retail investors have become very active in the Yen Carry Trade, helping to keep the value of the Yen suppressed for now. Here are some interesting quotes from a Bloomberg article:

Trading of currencies in Japan using borrowed funds rose 41 percent in the first quarter to 109 trillion yen ($896 billion), exceeding 100 trillion yen for the first time, the Financial Futures Association of Japan said.

Japanese individuals' trading volume accounts for 20 percent to 30 percent of the interbank foreign-exchange market in the Tokyo time zone,'' Fukaya said. "They are also active in London time after going home. They are becoming a rival to be reckoned with for institutional investors.''

The rise of the carry trade among Japanese retail investors is a good indication that it won't continue much longer. When retail investors arrive on the seen it provides cover for the bigger players to exit. To the average retail investor what's been working lately will probably always work. They here their friends boasting about their easy profits and they hop aboard the train, not realizing the risks they face if their highly leveraged bets go bad from a rising Yen. Just as marginated Nasdaq investors got cleaned out quickly in the sharp decline of early 2000, I expect that many japanese retail investors will have their accounts purged early in the game when the Yen Carry Trade starts to unwind. When it does, over a hundred trillion Yen could potentially be subtracted from the money supply to pay off margin debt. In the meantime, it's the YCT is providing a lot of interest income and trading fees for Japanes banks and brokerages.

Lately the YCT has been working espeicially well for anyone playing it, with the Yen falling against the dollar adding to gains from interest rate differentials:

2007-05-25T10:28:00.000-07:00

Next Stage of the Housing Meltdown

It took the homebuilders a long time, but they may finally be figuring out that they're in for a long, painful downturn. Their problem all along has been that they were building far to many homes for the nation's needs. The homes were selling well, up until late 2005 as speculators bought homes to flip or rent out and baby boomers bought retirement homes in advance with the help of low interest rates. But just as those trends were reaching saturation, builders got greedy and greatly expanded their inventory of land and communities under development. Rather than hold off on development as buying slowed, they rushed ahead with projects in the hopes that the customers would return in large numbers. When that didn't materialize, it took a long time for most builders to figure out that they were facing a long term liquidity crisis based on having too much debt and inventory that they can't easily sell.

Judging by the April Existing and New Home Sales numbers, it appears that reality has finally set in and builders are slashing prices to move inventory. New Home Sales numbers were up substantially in April from the first three months of the year on much lower sales prices, and inventory of finished new homes was down as well:

We probably haven't seen the peak yet, as the biggest rise in finished unsold homes usually comes in the second half of the year, but it's progress. The current group of finished homes for sale have been completed for 6 months, up from 3.9 a year ago, suggesting that not as many new finished homes are joining the group and bringing down the average. Meanwhile, the median price of new homes sold fell from $257,600 to $229,100 likely reflecting big price drops to move inventory. (I've heard of $220,000 price cuts in the Sacramento area.)

If builders have finally shifted into price cutting mode then it shouldn't take long for price cuts to hit the Existing Home Sales numbers. Today's release reflects sales made a month or two ago, but the inventory numbers are current and they jumped from 3.806 million homes for sale to 4.2 million. With an 8.4 month supply sellers are going to have to get more aggressive if they want to unload their homes.

The biggest sellers are now the mortgage lenders who've had to foreclose on large numbers of homes. Countrywide financial had over 8,000 properties listed for sale on their site as of 5/22/07, with total listed prices over $1.5 billion. Looking county by county at RealtyTrac yields some amazing "bank owned" numbers (5,706 in Sacramento County, CA for example and 11,578 in Los Angeles county). These guys probably have the most to lose from a drop in prices, as they've mostly avoided taking charges throughout the mortgage crisis so far. Their ability to get financing depends on an appearance of solvency.

As we head into the next phase of the housing downturn, we should see prices decline more rapidly in most areas, with builders leading the charge, followed by desperate homeowners (there are enough of them still out there with equity to preserve if they can avoid foreclosure with a sale). I still expect most lenders to drag their feet on lowering prices, and the ones who are getting liquidated are most likely the ones bringing large numbers of homes to auction these days.

2007-05-22T21:05:00.000-07:00

How Yen Carry Trade Benefits Japan

(I was asked about the unwinding of the Yen Carry Trade on another forum, so I wrote up this quick summary.)

Hedge funds playing with other people's money borrow Yen, which they'll eventually have to pay back with interest. As they buy dollars and other currencies with the Yen it drives the Yen down for now and helps Japanese manufacturers sell their goods.

It also creates profits for Japanese banks who normally have trouble finding enough Japanese to borrow money and keep the money supply growing. I estimate around $50 Trillion Yen have been created out of thin air by Japanese banks for Yen Carry Trade related borrowing. Interest on this new money is pure profit for japanese banks. Call it $10 Billion in profits annually for Japanese banks with other economic benefits as long as the carry trade continues.

The YCT is a Ponzi scheme with the BoJ acting as chief schemester. To keep the yen suppressed requires ever more borrowing of Yen to be sold for other currencies, which in turn leads to greater profits for the Japanese banks. Also, most of the trades entered into by hedge funds playing the YCT accept very high long term risk in order to maximize short term gain. Eventually, however, long term realities coupled with the weight of the Yen denominated debt and the will bring the majority of hedge funds playing the trade back down to earth. As the trade unwinds, the Yen rises and carry traders will lose out on the conversion back to Yen, resulting in a very large gain for Yen holders (i.e. the entire Japanese economy).

The BoJ tends to go for extreme economic interventions to benefit the Japanese banks. It pumped a huge amount of liquidity into the Japanese economy during the recession years, then drained it out during big carry trade years. The Yen created by the YCT sit in Japanese accounts waiting to be converted in to foreign assets when the trade unwinds. The BoJ can create as much new liquidity as it likes to offset the conversion of those Yen into foreign assets when the YCT unwinds.

There will likely be a very large economic shift when the trade does unwind. Japanese manufacturers will be at a huge disadvantage, but Japan will be sitting on monstrous amounts of foreign reserves. The Japanese consumer sector will likely take off as Japan adjusts to a much higher standard of living.

In answer to your question about the Japanese stock market, I'd expect the Japanese manufacturers with enough overseas production to do well, while those will all their production in Japan should have trouble. I'd also expect Japanese retailers and service providers to do well. For now, however, the YTC continues stronger than ever and the Japanese consumer sector has been weak.

2007-05-21T14:07:00.000-07:00

These Stories Tell the Sad Story of the US Economy

The US economy is dying a slow painful death. The body is suffering as many consumers are buried under a mountain of debt, foreclosure rates are soaring and the housing market is awash with vacant homes that can't sell.

Life support for this terminal case comes in the form of foreign purchases of US assets, the Yen Carry Trade and credit creation to increase leverage and risk in the business sector. The infusion of cash drives up profitability of US businesses, provides jobs and creates an illusion of financial health that can only be considered temporary.

Debt burdens are already at levels where they can only be serviced by the addition of more debt. Without foreign investment and rapid money supply growth the profitability of most American businesses would tumble. Without private equity capital, hedge fund borrowing and increasing corporate leverage the stock market would tumble. A look at the contributions of each of the leading economic indicators, gives a good "indication" of where the US economy is being led:

Negative or Flat Economic Statistics:
Average Workweek = -.06%
Initial Claims = -.12%
Vendor Performance = -.07%
Capital Goods Orders = -.08%
Building Permits = -.25%
Interest Rate Spread = -.06%
Consumer Expectations = -.08%
Consumer Goods Orders = 0%
Subtotal: -0.72%

Positive Stimulants:
Money Supply, M2 = +.12%
S&P 500 Stocks = +.15%
Subtotal: +.27%

Total Leading Economic Indicators: -0.45%

M2 and the stock market are being manipulated upward with easy credit and the huge flows of borrowed and foreign money into equities, which in turn is providing a great deal of short term economic stimulus. If not for this, all the other indicators would be down worse and the total measure of leading economic indicators would be pointing toward a very sharp recession.

Wall Street understands the sad state of affairs very well, but rather than seeking constructive reform of the financial system a feeding frenzy has erupted among the sharks circling the carcass. New money is being created to fund private equity deals at an accelerating rate and US assets are being sold off as quickly as Wall Street's dealmakers can find willing sellers. It's as if there is a mad rush going on to extract the most fees possible before the day comes when there's nothing left to plunder. The following articles give a snapshot view of how the flood of foreign and new money are propping up stocks and the economy for the time being:

1. Saudi Firm Buys GE Plastics for $9 Billion.
"General Electric Co. said Monday it will sell its GE Plastics division to petrochemicals manufacturer Saudi Basic Industries Corp. for about $11.6 billion.
GE said it would use the proceeds primarily to increase its planned 2007 stock buyback program. It now expects to buy back $7 billion to $8 billion in stock, up from the previous plan of $6 billion. The deal is expected to create a net gain, after taxes, of $1.5 billion for the conglomerate."

With hundreds of billions of US dollars to invest, oil producing nations are gobbling up bonds and equities on a massive scale. Meanwhile GE seeks to prop up their stock price and increase leverage through greater share repurchases. Credit problems at GE Capital may be beginning to put some pressure on GE's liquidity. Much of the money they receive from the Saudi's will probably get loaned out to other businesses through GE Capital. The Saudi's are letting us sell off our hard assets in order to fund excessive consumption of oil.

2. Countrywide Financial Raises $4 Billion.
"Countrywide Financial will use a portion of the net proceeds from this offering to fund repurchases of up to 23 million shares of its common stock simultaneously with this offering and expects to use the remainder for general corporate purposes."
It came from new convertible debt in a private placement and Countrywide will use around a billion of that to buy back stock. With defaults leading to a liquidity crisis for many lenders countrywide is trying to buffer their cash position with low interest debt at the expense of future share price appreciation.

3. China Takes a $3 Billion Stake in Blackstone.
"The agreement gives China's government a stake in the private equity boom sweeping the globe and hands a key alliance to Blackstone at a time foreign investors struggle to gain support from the Chinese government for takeovers of domestic assets."

Like the Saudi's, China is rolling in trade gap dollars and getting tired of piling them into US treasuries and agency debt. They're looking for investments that won't lose as much ground to inflation as faith in the dollar begins to unwind.

Every day seems to bring more stories like the ones above - money being created to fund share repurchases, US assets being sold to fund the trade gap. When the game comes to an end it sure won't be pretty.

2007-05-19T09:08:00.000-07:00

China announced that they are widening the trading band for the RMB last week. That's a way of saying that they are going to let the dollar fall faster. As the Chinese are already accumulating far more dollars than they want, their choice is either to keep the accumulate more or let the dollar fall. I did a quick graph of each time the dollar dropped 5 fen (0.05 yuan) and the dollar has been faster lately:

In contrast, the dollar has been rising against the Yen over the past year:

I attribute the falling Yen almost entirely to a Yen carry trade that has gone completely out of control. When the market for high yielding, subprime mortgage backed securities (a favorite of carry traders) started to reflect the reality of the housing market back in February and March, the Yen strengthened initially but then came tumbling back down as carry traders increased the size of their bets. Against the Euro, the Yen's extreme recent weakness has been especially clear:

With the US bull market on it's last legs, the Dow Jones Industrial Average keeps making new highs. The recent strength of the large cap stocks relative to everything else suggests a desperate prop job:

The most successful hedge fund over the past two years continues to pile into stocks, and especially Dow stocks, the performance of the stocks they've chosen hasn't been good, but that doesn't really matter if the rising tide is lifting all boats and their leverage is high enough:

Renaissance is just one of hundreds of hedge funds borrowing Yen and buying up large cap stocks these days. As long as the game is working, they'll keep playing. Just don't expect it to go on forever.

2007-05-06T17:16:00.000-07:00

How Big is the Yen Carry Trade?

In this article Japanese bureaucrat Hiroshi Watanabe says that there won't likely be a "hasty unwinding" of the Yen Carry Trade, and hints that the total size of speculative carry trades is around $100 billion, rather than $1 trillion as some estimate. I'm skeptical of these claims, as I believe the YCT suits the profit motives of Japanese bankers very well for now. It's also providing cover for the Bank of Japan to reduce its US treasury holdings, and if the trade doesn't keep expanding, then the demand it is creating for trade gap dollars and new US debt will disappear, pressuring the Yen back up, which doesn't suit the Japanese government's political motives very well at the moment.

To try and get an idea of how big the YCT has become I took a look at grwoth in various portions of the Japanese money supply:

Based on an exchange rate of 120 Yen = 1 Dollar...
From April of 1998 to April of 2001 Japanese M2+CDs grew $471 Billion, while M3+CDs grew $636 Billion (meaning non-M2 components of M3 declined sharply) and Broad Liquidity grew $1,020 Billion.
From March of 2001 to March of 2004 Japanese M2+CDs grew $956 Billion, while M3+CDs grew $61 Billion (meaning non-M2 components of M3 declined sharply) and Broad Liquidity grew $328 Billion.
From March of 2004 to March of 2007 Japanese M2+CDs grew $281 Billion, while M3+CDs grew $626 Billion, and Broad Liquidity grew $902 Billion.

As I read it, the Japanese government and Bank of Japan were busy running up debt and stuffing money into people's pockets as an attempt to stimulate the economy during the recession years of 2001-2003. Since then they've been draining liquidity, but the Yen carry trade has picked up the slack, causing the total money supply to grow much more rapidly.

For the $100 billion estimate to be true, domestic Japanese credit expansion would likely be responsible for the bulk of the surge in broad money. For the $1 trillion estimate to be true the Yen carry trade would likely be making up for a several hundred billion dollar liquidity drain by the BoJ. My own hunch is that the total amount of borrowing in Yen for speculative carry trade bets by investors outside of Japan is probably over $500 billion. On top of that, the amount of official Japanese money invested abroad is about $1 trillion and there may be another $1 trillion in private Japanese money invested abroad.

The borrowed money for speculative purposes is quite a racket for Japan, where a portion of global investment returns are steadily cyphoned off by Japese banks. Watanabe doesn't forecast a "hasty" unwinding, but a slow and painful unwinding would be just as bad for the pension plans and other investment pools run by global hedge funds. Keeping the slow bleed going forever is probably plan A. Japan has the ability to stuff liquidity back into the system, just as they did during 2002-2004 in a way that can keep the Yen's rise unhasty. Foreign borrowers will have to pay back their Yen loans at a greater cost than they bargained for if the BoJ handles things in the best interests of Japan. Western politicians and bankers play along because for now it means a stimulated economy and short term profits.

If plan A fails, and some systemic shock causes a sudden rush by carry traders to get out, then plan B, a hasty rise in the Yen and forced liquidation of foreign carry traders probably works out best for the Japanese as they wouldn't want to let foreign hedge funds get off too easily. After a thorough cleansing of the trade I could see the BoJ rushing back in with another round of liquidity to return the Yen to manufacturing friendly levels. With the Yen near four year highs, entering new carry trades is probably an especially bad idea around now, and its not surprising to see the Watanabe trying to be more encouraging of sucker bets. While he says that the trades "won't be unwound in a hasty way," the 20% rise in the Yen we saw in 1998 would work very well as part of plan B today.

The Yen Carry Trade has been a big part of global economic imbalances and like the rest of the imbalances I believe it must eventually come back into balance one way or another. As we see the rebalancing process taking hold via a strugling US economy and declining US consumer purchasing power, I expect we'll also see a big drop-off in US investment returns as a result of either a gradual or "hasty" unwinding of the carry trade.

2007-05-01T10:59:00.000-07:00

A Possible Rate Cut Next Wednesday?

The Federal Open Market Committee meets next Wednesday, and I haven't heard any speculation out there about a rate cut on the Fed Funds target from 5.25% to 5.00%. However, the daily Repo rate has been below the target for the last two weeks. Today it was 5.06%, with somebody having the nerve to bid 4.98%. I personally take this as a signal to the Fed that certain banks want short term rates lowered.

The member banks want lower rates and a normal yield curve. Inverting the curve was fine and dandy for squeezing out competition from the subprime lenders, but now big banks are getting in trouble too. They'd like to cut the rates they have to pay depositors and boost the rates they collect from borrowers. That will restore some profitabilty to their core business to offset some of what they are losing through defaults.

A Fed Funds rate cut would not be good for the dollar, although it's the higher yielding long term securities that matter the most for carry traders. If longer term yields fall (boosting the price of securities) it helps those already in carry trades, but it discourages new traders for entering into them and sucking up supply of trade gap dollars. That could lead to a falling dollar, much higher long term rates and a falling stock market.

Up until now, the Fed has been on the side of protecting the dollar and US banking profits tied to the Yen carry trade. If the Fed goes through with the rate cut next week or at the June 27/28 meeting we could be in for some dramatic changes in the rebalancing process.

2007-04-29T14:33:00.000-07:00

The Carry Trade and the Supply of Japanese Yen

Money is created by banks when people borrow it into existence. In the US, there are no shortage of people wanting to borrow money for consumption or investment. In Japan finding borrowers is a bit problamatic because, culturally speaking, the Japanese are very good savers. The Japanese government has done it's part in running up huge debt until recently:

In June 2003, with the Fed cutting interest rates to an ultra-low 1.00%, and deflation remaining a real problem in Japan, the Bank of Japan went wild printing Yen and buying dollars. This forced the Yen down and boosted Japanese manufacturing, allowing the the BoJ to ease off. Since then the BoJ has wisely been selling US treasuries and soaked up much of the liquidity they had added to fight off deflation:

More recently, I believe foreign carry-traders are behind much of the borrowing that has kept deflation from taking hold in Japan. In June of 2004, the Fed began raising US interest rates from 1.00% all the way up to 5.25% two years later. With each hike, the value of the dollar was boosted relative to the Yen because of the Yen carry trade became much more attractive. As more carry traders borrowed Yen and purchased US dollars or other currencies it helped expand the Japanese money supply.

The carry trade is serving the policy needs of the BoJ and Japanese government very well for now. With each new Yen borrowed into existence, it stimulates the Japanese economy. Japanese exporters have an easy time unloading the dollars they receive from American consumers and Japanese bankers profit from interest payments on the money they create and loan.

On the American side, Wall Street is making a killing off of the easy short term gains. Bonuses for investment bankers are at an all time high. Unfortutely the profits are mostly temporary. The carry trade is so large that it cannot be unwound successfully for most participants (who are mainly hedge funds). The Bank of Japan will be in control of the exchange rate as carry traders get squeezed out of their positions. I expect it will slow and steady, so that Japanese banks get repaid on their loans before most of the capital . Meanwhile hedge fund investors will be the ones left holding the bag.

2007-04-27T08:44:00.000-07:00

Vacancies as a Function of the Rebalancing Process

The favorite vehicle for foreign investment into the United States over the past two years has been mortgage backed secuirities. Fannie Mae and Freddie Mac offer a guarnatee that their secuirities will make their payments, which creates an impression of safety for a huge portion of the MBS market. Money pouring into MBSs has fueled extreme levels of housing construction, to the point that American builders have been adding far too many homes to the market. This shows up in the vacancy data released today:

Vacancies for rent rose steadily from 2000 through 2003 in bad economic times, while the sharp uptick in vacancies for sale has likely been a more recent function of the end of the speculative bubble and the mortgage squeeze. Vacancies are likely to continue rising both because the market and economy are continuing to weaken and because homebuilders haven't reduced construction enough. Today MDC Holdings released their numbers and they show an increase in homes under construction without buyers (year over year):

This is true for virtually all the builders, as they have too much land on their books and too many communities still opening up. They ignored the building inventory problems and in 2005 got extremely aggressive with their expansion plans just as the market hit its peak. MDC is still opening up new communities in the worst markets:

As the rebalancing process proceeds, Americans will continue to lose purchasing power. That should be incorporated into the homes they live in. Just as people will have to downside their consumption of imported goods, they'll have to downsize their homes. Single family detatched housing was the biggest product of the housing bubble. The vacancy rate for 1 unit homes is up to 2.5% from 1.5% just 2 years ago. Stress will continue to build in this area as builders like MDC add to inventory at a time when fewer Americans can afford to live in McMansions.

2007-04-25T11:46:00.000-07:00

Hedge Fund Borrowing Propping Up the Dollar and Stock Market

Yesterday I read an article listing the 10 highest paid hedge fund managers in 2006. Topping the list for the second year in a row was James Simons (go bears!), so naturally I wanted to find out what I could about how his hedge funds make their profits.

According to the article, "the hedge fund firm employs roughly 80 PhD's who develop computer programs to seek out price anomalies in a wide range of markets, including equities, commodities, futures and options." I don't have any insights into what Renaissance is doing in the commodities futures and options markets, but at least in terms of equity holdings, the record is pretty clear. The fund began buying aggressively in Q3 2005 and got more aggressive each quarter, almost tripling their equity holdings during 2006:

Before fees, Renaissance's Medalion fund earned a return of 79% (44% after fees). With the stock market up just 15% last year and Renaissance's holdings spread out among almost 3,000 different equities, it's safe to assume that a large amount of leverage was employed to boost the return numbers. Most likely the Fund borrowed Yen during 2005 and 2006 and used these funds to buy dollars and then US equities and other investments. With the Yen down against the dollar over the past two years, highly leveraged borrowings would have greatly increaed the overall returns. Of course a falling dollar and/or a falling stock market would have led to magnified losses, rather than magnified gains.

The biggest spike in buying came during Q4 last year, and the holdings numbers are still fresh, showing which positions were added to and which were reduced. One thing that jumped out at me was that the 4 stocks where the most new capital was directed were all Dow Industrials:

The three stocks getting the most new capital on average accounted for more than triple what other top investments received. Dow Stocks also made up 3 of the top five on the sell side. In all, a net of $2.5 billion was poured into Dow Industrials by Renaissance during the last quarter of the year. This likely helped boost the Dow, as the total index was up 6.71% during the quarter, while the 10 Dow stocks purchased by Renaissance rose a weighted average of 8.11% and the 6 stocks sold only rose a weighted 6.33%. Interestingly, the Dow stocks with shares bought by Renaissance in Q4 were poor performers in Q1 2007 (falling 1.85%) when compared to the good performance of their recent sells (+1.30%), implying that they really weren''t good stock pickers.

When the 80 PhDs go looking for "inefficiencies" I don't get the impression they are doing much analysis of value in a traditional sense. It is noted that Simons hires mathematicians, rather than MBAs, so the soundness of a companies business model and it's future projected earnings are not likely to be a big factor in the computer driven trading strategies. In looking at the stocks where they took on a position of over 5%, there were plenty of stocks with negative earnings per share and high price to book values:

While I believe the 80 PhDs are extremely good at creating successful computer models and trading strategies, I don't need a PhD or a sopisticated computer to figure out what are likely to be the main underlying secrets to their success. The biggest and most lucrative inefficiences to exploit are technical in nature (rather than fundamental). The computer models are probably especially good at detecting when too many people have shorted a stock or when to arbitrage profits out the greedy short term bets options traders like to make. Prices can be manipulated for short term gains or they can simply be driven up almost endlessly for positions the company already holds. The following table shows the date when Renaissance reported going over the 5% ownership threshold for stocks (prior to the start of Q4), and then includes the number of shares added during Q4, presumably boosting the net asset values of the fund:

The next table shows the increasing number of new positions that went past 5% during Q4:

Buying up a large enough number of shares in a stock can drive up the price. We can be sure the programs have concluded that thiswill improve their performance, but given the complexity of the programs involved we can't be sure if the people behind the programs really understand the difficulty of reversing course when the fundamentals of a company or the market deteriorate. The chart of Renaissance's total equity investment over time has the look of a system out of control. It is probably indicative of the our whole financial system, dependent on ever higher rates of borrowing and credit expansion until the day when finally credit from abroad is cut off. Perhaps Simons is already well aware of this and sees no choice but to head forward at full steam.

I don't think "inefficiencies in the markets" is as good a description as "flaws in the system" when it comes to describing the success of computer trading models in generating high returns for hedge fund managers. In my opinion, the stocks Simon's holding are valued less efficiently as a result of his actions rather than more efficiently. Also, in my view, the market as a whole is driven higher through the leverage he and other hedge funds employ, while long term economic instability they are creating should be pointing toward lower valuations.

In an abstract, disconnected kind of way, the computer models probably account for the basic conflict of interests in the hedge fund compensation model: Heads we both win, tails you lose. If the models seek to maximize gain for the hedge fund managers, then they will seek to elevate risk to a very high threshold. While the fund has a track record of earning 36% per year for almost 2 decades, one year of 100% losses would of course negate that for anyone who let their profits ride or came late to the party. I could concoct a scheme to guarantee 50% returns on aveage. Three years of 100% gains, followed by one 100% loss equates to an average return of 50%, but a net loss of -100% for the investor. Meanwhile, I as manager would be syphoning out my 20+% per year before blowing all the rest of the investors money in the final year. If I programmed a computer to simply maximize my projected gains as the manager, an extremely high risk strategy would be the result.

Renaissance is taking on a very high degree of risk. With over $47 billion leveraged into the stock market, they won't have a fun time trying to get out once the market finanally turns ugly. How deeply the bias toward risk is represented in the core mathematical models is a question for the PhDs. Simons has reportedly collected around $3.2 billion in compensation during the last 2 years alone. When most people see those kind of numbers the reaction is that nobody could possibly deserve to make that much money. In my view, Simons has created a brilliant business model that takes advantage of flaws in the system. To the extent that he is profiting from the mistakes of other traders there is no real harm done to the economy. Indeed Simons has done a lot of good through his charitable contributions. However, to the extent that Renaissance is creating systemic risk by (possibly) playing the Yen Carry Trade, creating excess liquidity and promoting malinvestment Simons may be doing substantial economic damage to this country and the world.

The thing I'll be most intersted in watching is wether Renaissance has the ability or desire to reduce its risk exposure before it is too late of if they'll just continue taking on more risk until the system reaches its final limits. Hopefully I'll find some more clues to this in the Q1 holdings report they'll release in May.

2007-04-19T11:47:00.000-07:00

Trends in the Jobless Claims Point Toward a Slowing Economy and More Foreclosures

The housing slowdown has gone through two distinct stages so far. The first was related to the rapid exit of flippers who had been putting down deposits on pre-construction homes and then selling them for a profit before the homes were finished. Speculators created a demand vaccuum when it realized they needed to get out of contracts and inventory early last year. The second stage has been related to the tightening of credit and a shift in market psychology cutting into the number of willing and eligible buyers. Usually speculators and easy credit policies complete their cycles without too much of a an impact on the market, but this time they've been big enough to make for a very noticeable slowdown.

The third stage will likely be due to the more traditional cause of housing slowdowns - job losses and a slowing economy. During the last recession, initial jobless claims climbed up over 400,000 per week, but have hovered around 300,000 much of the time since then. People losing jobs is traditionally the biggest cause of mortgage defaults (rather than reseting ARMs). Looking at the seasonally adjusted Initial Claims data demonstrates a rising trend:

The big spike last May was due to the brief shutdown of the Puerto Rican Government. Other than that, the rising trend seems clear and fits well with the well established slowdown in residential construction.

Looking at unadjusted numbers year-over-year (over-year), the recent rise over 2006 levels is clear, although the numbers are now roughly where they were in 2005:

Unemployment levels are still low historically and there isn't likely to be a big uptick in mortgage defaults based solely on the new claims we're seeing right now. The seasonal December and January layoffs may be adding to the rise in recent delinquencies we've been seeing, but it won't be until July when we get another seasonal spike. In September and October of 2005 we saw spikes from the big Gulf hurricanes.

In Year-Over-Year percentage terms, the uptrend is especially clear:

The rate of change in 2006 was mostly negative, even without the hurricane comparisons. The rate of change began to swing sharply positive in February 2007.

Job losses may be contributing to the rise in foreclosures, although resetting ARMS, stagnating price and tightening credit standards are almost certainly the largest causes for now. It'll be interesting to watch the foreclosure numbers when job losses do pick up. Here are a couple of charts from RealtyTrac's monthly foreclosure press releases:

Realtytrac is not exactly a reputable source when it comes to producing economic reports, and it is clear their data is far from perfect. Nevertheless it generally conforms with what other data sources are saying: The economy is on shaky ground and millions of middle-class Americans are feeling the squeeze.

2007-04-17T18:03:00.001-07:00

Shoppertraking the Retail Slowdown

Russ Winter has been reporting a wide range of indicators showing a slowdown in retail sales over on his blog. He's been watching the mainstream retail sales numbers as well as tax receipts and other obscure indicators.

It's a little hard to see through the the seasonal variations due to the earlier Easter this year. Nevertheless using a six-week moving average smoothes out Shoppertrak's data pretty well:

I've maintained for a good while that government and banking interests are geared toward prolonging the status quo, so it's the final exhaustion of the US consumer that will have to bring the global economy back into balance. For now, consumers don't seem to be willingly giving up their buying habits, so poverty is the face of the exausted US consumer: NY Times article on US poverty levels

2007-04-16T12:44:00.001-07:00

Contradictions Between the Treasury and the Fed Data

According to the Fed's H41 statements, Marketable securities held in custody for foreign official and international accounts went from $1.176156 Trillion on 1/31/2007 to 1.205004 Trillion on 2/28/2007, showing an increase of about $29 Billion for the month of February. Meanwhile, the Major Foreign Holders portion of the TIC data released by the Treasury Department today shows Foreign Official accounts only increasing by about $3 billion to $1.451.3 trillion. Estimating January's custodial additions as $17 billion contrasts against the Treasury's reported official subtraction of $3.6 billion.

First I have to say I think that the treasury data is the less reliable of the two and subject to large revisions like the one that usually occurs in June. Also, since the Treasury data has been higher than the Fed data going back as far as this source of historical Treasury MFH data goes.

If we assume that both data sets are reasonably accurate then one of these appears to be a likely explanation:
1. Official foreign accounts at the Fed were big net buyers while official accounts not at the Fed were big net sellers.
2. Non-official international accounts at the Fed were especially big buyers.
3. Both of the above.

Who is buying remains the big question, and I can only find clues, not answers. Total foreign holdings rose $24.3 billion, so non-official investors were likely buying. As a whole, Japan's estimated holdings dropped by $10 billion in February, calling into question my thought that it could be the Bank of Japan intervening as the did in 2003-2004. The total decline was probably down closer to $12 billion because Japan's June series revision was down $21.5 billion. Year over year Japan is down $38.6 billion. China, meanwhile was up $16.3 billion in Feb, had a +$44.3 billion revision in June and is up $97.8 billion year over year. Chinese and Japanese official accounts could be the culprit, if China was buying through the Fed and Japan was selling outside the Fed. However, evidence below suggests that China may not be buying primarily through the Fed.

I've seen the conspiracy theory floated around that the Fed is using secret offshore accounts to buy up US treasuries. IF these accounts actually exist and are included in the non-official international accounts data then they could also explain the big disconnect between TIC and H41 numbers. However, that conspiracy theory has been around for more than a year and prior to the last two months Treasury data was rising faster than Fed data.

The June series revision is the result of a survey sent to institutional bond holders to find out what countries they were really holding securities for. The UK always sees a huge downward revision because it is a major financial center holding bonds for investors from all over the world. Last June UK holdings dipped by $155.6 billion on the revision. Japan also dipped substantially (by $21.5 billion). The biggest gainers were Foreign Official, China and (by default) the United States. Foreign Official and the US both rose by around $120 billion, while China added $24.3 billion. China probably made up a significant chunk of the Foreign Official additions. US institutional investors, and especially hedge funds, probably made up most of the share of treasuries that were being held abroad for US investors.

Still more questions than answers. All comments and theories are welcome.

2007-04-14T22:08:00.000-07:00

Banking System on the Verge of a Major Crisis

A couple of posts ago, I described how the delinquencies were creating a liquidity crisis for mortgage lenders. Many of them have had to declare bankruptcy because they haven't had enough financing to make up for the lack of cash flow they are facing due to rising delinquencies and defaults.

The overall leverage of modern US banks and their exposure to real estate loans has become extreme just at the point when loan defaults are getting out of hand:

The lessons learned from the bank runs that led to the Great Depression have long ago been forgotten by regulators. Banks need to have reserves on hand in order to remain solvent in difficult economic times. Unfortunately holding cash reserves cuts into profit margins, so banks have lobbied the Fed to reduce reserve requirements and allow much greater leverage. Now that banks are developing a strong need for cash many are realizing that they don't have enough of it available:

Both of the above charts display historical data from the Fed's H8 reports. Looking at more recent H8 data gives an indication of how the current banking crisis is unfolding. Over the past year, Banks were very aggressive in expanding real estate lending, commercial lending, corporate bond purchases and lending to securities speculators. Meanwhile, they were extremely lax in setting aside reserves in cash, US treasuries and Agency debt. Here are the year over year increases from March 2006 to March 2007 for the main categories of banking assets:

Real Estate Loans and Leases: +10.56% to $3,316 Billion
Treasuries and Agency Debt: +1.96% to $1,186 B
Other Securities: +12.72% to $1,051 B
Commerical Loans: +12.78% to $1.074 B
Interbank Loans: +21.30% to $365 B
Security Loans: +15.99% to $313 B
Cash Assets: -6.27% to $294 B
Other Loans and Leases: -1.59% to $525 B
Total Bank Credit: +8.40% to $8,366 Billion

Up until Mid-February, most banks didn't think there was a whole lot to worry about because they were able to sell off as much real estate exposure as they liked to investors through mortgage backed securitizations. That source of liquidity came to a grinding halt a couple months ago, and since then there have been some eye-catching developments on banking balance sheets. Real Estate Loans and Leases suddenly reversed course, recording the largest single month decline on record (-1.83%). Cash assets also declined suddenly (-3.32%). In the past, February and March have been big months for banks to acquire US Treasury and Agency debt, as the Treasury faces its tightest season before Tax day in April. Here's the February+March net buying totals for the last 5 years:

2003 $36.2 Billion in Treasuries and Agency Debt to $1075.7 B.
2004 $95.8 Billion to $1200.2 B
2005 $33.3 Billion to $1217.4 B
2006 $34.3 Billion to $1185.9 B
2007 $11.1 Billion to $1209.1 B

The lack of buying by US banks is probably another reason why Foreign Official Accounts had to step up in a big way during Q1 (adding over $140 Billion in securities during the 13 weeks ending last Wednesday).

In recent years banks have been net sellers of treasuries and agency debt from March to January. This time they'll probably be especially large sellers as the need for cash increases. Foreign official accounts are probably the buyers of 2nd-to-last resort, but many of them have been indicating for awhile that they want to reduce their exposure to US debt. The Fed is the buyer of last resort for treasuries, as they can create as much money as they desire and purchase treasuries with permanent injections (they did two last week). Of course doing this would be highly inflationary at a time when inflation numbers seem to be coming in above the Fed's acceptable range.

How long will foreign officials and investors be willing to buy up US debt at these historically low interest rates?
How sharp will the contraction be in real estate lending?
How many banks will be ruined in the process?
How long will it be before other areas of excessive bank credit begin collapsing under their own weight?
How deep of a recession will this all cause?

Stay tuned. As the data keeps coming in, I'll keep blogging what I see in the numbers.

2007-04-13T11:36:00.000-07:00

Regional Factors in the Rebalancing Process

February's Trade Gap numbers showed a sixth straight year-over-year decline, strongly suggesting that the trade gap really has begun to rebalance. When you look at specific countries and regions, you can get a better idea of how and why it is happening:

While China continues its upward trend (ignore the seasonal fluctuations), Japan and Canada have been flat and Europe has shown a significant decline.

The biggest factors for the regional differences (in my mind) are related to individual currency strengths. The Euro has been on the rise since late 2005 and it eventually had the cummulative effect of narrowing the trade gap with the US. The Yen and Canadian dollar, meanwhile, have been volatile but essentially flat over the last year (Canada making up most of the North American trade gap). China has been slowly increasing the value of the RMB, but China's infrastructure and technical expertise are improving so fast that their competitive advantage is rising in spite of the currency shift.

Japan probably isn't happy about their stagnating exports to the US. They faced a similar problem in late 2003 and early 2004 with slowing export growth and a rising Yen. Back then they went balistic with currency interventions, selling Yen to buy US Dollars in order to surpress the value of the Yen. The strategy worked, and the trade surplus with the US began growing again:

That extreme intervention showed up as a big surge in Official Custodial Holdings at the Fed, but that is now being dwarfed by a new buying surge that has taken place in the first part of 2007:

Is Japanese intervention again behind the surge? I think in part it is. The other part is probably a result of the massive Yen carry trade in play. As Yen are borrowed into existence by hedge funds, and sold for dollars, these dollars find their way back to the Bank of Japan and then get spent on US debt securities. My casual observations of the US markets have had the appearance of a strong increase in carry trade activity, with the Yen weakening pretty much every time the US markets rally.

The carry trade has a huge positive long term impact for Japan. The Japanese banking system creates Yen out of thin air and loans them out at around 2% interest. If foreign investors are borrowing about $1 trillion per year, that's $20 Billion in profit for the Japanese economy, assuming that currency rates stay level. Of course the Bank of Japan will be in position to control the exchange rate as they have in the past. When it comes time to end the game, they can let the Yen rise in a controlled fashion to squeeze carry traders out of their positions for an additional 5, 10, 15% profit.

Defaults are a minor concern, so I expect the eventual rise of the Yen will be controlled. This would also protect Japanese manufacturers from a sharp, disruptive rise. Hedge fund managers will normally close down their funds and pay back their creditors before they go totally bust. This enables them to get back in the game because pleasing financiers is more important than pleasing investors. If played right, the Yen Carry Trade is free money for the Japanese economy at the expense of global hedge fund investors.

As for China, it is clear that the rate of change in the RMB simply hasn't been fast enough to reverse the growing trade gap with the US. However, the US consumer appears to be running out of fuel. With the mortgage equity engine stalled, and consumer debt burdens overextended, the US trade gap with China may soon contract under its own weight. China has already begun preparing for the day when most of their exports are to other regions and where domestic demand is increased with a rising standard of living.

Even with manipulation of the currency markets by Japan and China, global trade imbalances appear to be on an unavoidable path toward rebalancing.

2007-04-12T09:28:00.000-07:00

Foreclosure Pipeline Update From Novastar

NFI was kind enough to provide their monthly update on the status of their securitizations and the good news is that 30-59 day contractual delinquencies were down on almost all of their issues. The bad news is that's normal for March and that the default levels are still very high. The peak for new delinquencies may have occurred in December, as many subprime borrowers appear to have chosen a lavish holiday season over making their mortgage payments. Those defaults hit the 30+ day threshold in January and 60+ threshold in February. Time will tell whether or not the tightening of credit in March leads to a big enough surge in defaults to top December's levels. The total percentage of borrowers failing to make monthly payments continues to grow steadily as more loan begin defaulting each month.

The following charts show the composition of bad loans for the securitization of December 2005 and the two securitizations of June 2006 as they've grown month by month:

Credit quality in the 12/05 issue was bad enough, and the level of defaults continue to rise. Delinquencies in the June 2006 issues are already twice as high as they were at this stage for the 12/05 issue. One interesting thing to note is that lately NFI has been much quicker to push delinquent loans into and through the foreclosure process in the hopes of raising some cash.

Even more importantly, we should note that Novastar has only just begun to recognize losses on the portfolio. To do so would be to call into question their solvency at a time when they are worried about creditors cutting off funding. Meanwhile the number of homes in the foreclosure process and the number of homes on the books waiting to be sold is ballooning out of control. As long as Novastar avoids selling those homes at a loss they can pretend there has been no hit to earnings. However, the lack of mortgage payments flowing in must be made up for by NFI when they make interest payments to the investors who bought the securities.

Right now, Novastar is facing a liquidity crisis similar to the one that forced New Century into Bankruptcy. Consequently, Novastar is desperately "exploring strategic alternatives" to declaring bankruptcy themselves. It's hard to imagine that anyone will be foolish enough to bail Novastar out of their terrible position.

Let's be perfectly clear here:
1. Cash is tight for the lenders because many borrowers aren't making their payments.
2. It's going to get tighter as the percentage of defaults continues to rise.
3. This is just the first stage, a liquidity crisis that is wiping out many lenders as their creditors scramble to protect themselves.
4. The next stage will cut to the core of the ponzi nature of our financial system.
5. Homes sitting on the books and in the foreclosure process are increasing much faster than they are being sold.
6. The big losses haven't even begun to be recognized yet by mortgage lenders, mortgage insurers and the GSEs.
7. The losses will be massive and spread out over a long period of time as home prices enter a long, steady decline.
8. The liquidity crisis faced right now by the subprime lenders will spread to almost anyone who's solvency is in question.
9. Huge amounts of imaginary wealth will be wiped out in the financial sector and in the greater economy.

During their conference call today Mortgage Insurer MGIC Investment Corp. was pressed on Novastar's condition, and did their best to dodge the issue. MGIC is Novastar's main insurance writer and they maintained that Novastar has been a good customer. That may change soon when Novastar has to start pushing through more loss claims. For now, MGIC is in complete denial, thinking that the market overreacted to the subprime crisis during the first quarter. In addition to primary mortgage insurance, MTG also has large invesments in joint ventures that buy distressed consumer credit receivables (Sherman Financial Services Group) and invest in and service subprime loans (C-BASS). Denial is probably the best way for them to preserve their sanity these days. (The last 10 minutes of the call is the most worth listening to.)

2007-04-06T03:23:00.000-07:00

Tight Correlation Between Dollar/Yen and Major US Indices

The chart below tells the story:
1. Borrow Yen
2. Buy Dollars
3. Prop up the major US indices.

There wasn't a strong correlation until the subprime market started getting ugly in mid-February. Since then the financial markets have been miraculously saved by an inflow of new money via the yen carry trade. Whenever the Yen has been down or falling the US markets have rallied.

This pattern started with a sharp sell-off in the mortgage bond markets. For a time it appeared that certain yield chaising strategies were blowing up. However, rallies in the Yen likely saved many players for the time being. It has appeared to me that most of the Yen selling has been taking place during US trading hours. My hunch is that the Yen carry trade has become far more leveraged in recent weeks with an even greater systemic risk now in place if it unwinds forcibly.

2007-03-26T08:05:00.000-07:00

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: http://immobilienblasen.blogspot.com/2007/03/new-home-sales-lowest-since-june-2000.html

2007-03-25T09:34:00.000-07:00

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:

2007-03-24T06:46:00.001-07:00

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:

http://www.conference-board.org/pdf_free/economics/bci/lei0307.pdf

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.

2007-03-21T06:26:00.000-07:00

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.

2007-03-09T11:17:00.000-08:00

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.

Consider:

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.

2007-03-05T17:12:00.000-08:00

Ka-Boom!!!

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:

http://rebalancing.blogspot.com/2007/02/subprime-timebomb-explosion-continues.html
http://rebalancing.blogspot.com/2006/08/sub-prime-time-bomb-detonated-today.html

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.

2007-03-04T08:17:00.001-08:00

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.

2007-03-01T09:47:00.000-08:00

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.

2007-02-28T07:31:00.000-08:00

It Ain't About China

The talking heads mostly seemed to focus on the fall in the Chinese stock market as the reason for the global selloff. That's missing the point.

Over the past quarter century, the debt bubble has ballooned out of control:

Government debt
Corporate debt
Mortgage debt
and more recently...

Speculative debt

That last one, speculative debt, provides demand for all the other types of debt securities and boosts the pool of investment capital for equities and hard assets. It's money created purely to create demand for investments and it has gone wild, especially during the recent hedge fraud and pirate equity romp. Speculative debt chasing yield has helped fuel the bull market in bonds, equities and commodities. Along the way, yields have been compressed far out of line with true risks.

Now that some of those securities have begun crashing under their own weight, they begin forcing margin calls, tightening up demand for all debt and equities.
With the Yen's recent strength, it further pressures the pool of speculative debt.
China gave a massive margin call on Tuesday, calling in another huge chunk of speculative debt.
China's continuing devaluing of the Dollar puts steady pressure against leveraged Dollar/Yen plays.

Will the debt bubble burst violently? Probably not, IMO. The Fed and other central banks can provide a huge infusion of reserve credit if they want to.
However, a lot of security classes are likely to collapse under their own weight, and many others have a major adjustment to undergo before they price risk reasonably.
Meanwhile, there are a lot of overleveraged speculative interests ripe for a reaming. Mr. Market is probably in the process of wiping some of them out right now, and I think the Yen carrry trade will experience some wild swings going forward, taking out the overleveraged on both sides.
Risk aversion may become a theme over time, and with it a substantial bear market would ensue.

2007-02-24T08:39:00.000-08:00

The Subprime Timebomb Explosion Continues

The meltdown of Subprime stocks continues to get attention, and the problem will get much worse from here. To Recap:

In 2003, rates hit historic lows and 3 year-ARMs were popular as an especially low rate option that provided 3 years of stable payments.
In 2004, rates began rising and 2-year ARMs became more popular due to lower initial interest rates.
In 2005, low APRs were gone but ultra-low teaser rates for 1-year ARMs sucked in many new borrowers.
In early 2006, all three of the above mortgage classes began resetting in large numbers, but emergency refis were available for many distressed borrowers.
In late 2006, subprime lenders began tightening up because they were forced to repurchase too many of their new loans due to early defaults.
In 2007, credit is tightening severely in the subprime market because the market for subprime securitizations has been crashing. Meanwhile record numbers of ARMs are resetting as loans facing their first reset in 2007 are added to the surviving loans that reset for the first time in 2006 and now must reset again.

As credit tightens, default rates are escalating. The game is finally over for buyers who bought more than they could afford. With home prices stagnating and declining, the cash-out refinancing game is also coming to an end. All this will put much greater pressure on the housing market in 2007.

Credit hasn't tightened as much in the Alt-A and prime spaces, but the markets for those securitizations has begun to fall as well. Given that the main difference between subprime and prime is just a credit score, the numbers of overextended prime borrowers is probably very large.

The following chart is based on data from Novastar Financial's securitizations over the past 3 years:

The vertical axis shows the percentage of loans that are contractually delinquent or defaulted on by 60 days or more, including foreclosures and real estate owned.
The horizontal axis shows how old the securitizations are in months.

The chart shows a few things, including:
1. Recent loans are going bad much faster and at a higher rate than loans made earlier in the cycle.
2. There has been a rapid increase in delinquencies and defaults in the past year, since ARM resets took off.
3. The increase has been accelerating in the past 4 months, since credit began tightening.

This was all before the market for subprime securitizations crumbled. Now things will really get ugly for distressed borrowers.

Meanwhile the execs at major subprime lenders are giving the same sort of surprised and bewildered responses that homebuilders gave when their industry began to stall. There are plenty of market commentators and biased industry economists arguing that this is just temporary, but we're really just in the early stages of the housing and mortgage market implosions. It was all very predictable, just as the path forward is predictable given the factors I've discussed. Industry execs can't possibly be as clueless as they sound, can they? Regardless, they are sure to fare much better than their shareholders as they already pocketed huge salaries and bonuses based on the years of overstated profits they enjoyed before the bubble burst. Unfortunately the millions of overextended borrowers who are watching all of their previously imagined wealth evaporate aren't going to fare nearly as well.

There's a whole lot of pain being felt on Main Street.

2007-01-28T14:38:00.000-08:00

Housing Led Recession May Eventually Lead to Rebalancing

I believe global economies will eventually rebalance, although the timing and manner of this rebalancing remain in question. As I see it, at least four unsustainable efforts have been prolonging and compounding the problems that go along with the global economic imbalances:

1. The financial markets are still heavily manipulated by banking institutions that have an interest in keeping the dollar strong relative to the yen. This prevents prices from adjusting to cut substantially into American consumption.

2. Foreign investors and institutions remain willing to absorb around a trillion dollars per year in new US debt.

3. Rapid money supply growth is generating enough economic growth and operating earnings to keep many heavily indebted enterprises afloat.

4. The rapid growth of derivatives markets and the hedge fund world has enabled the creation of tremendous amounts of imaginary, paper profits, that will some day disappear, along with many of the companies participating in the massive fraud.

As there seems to be no let up in the pace of these actions from foreign and domestic perpetrators, it is becoming more likely that the system itself may have to break down before economies will be allowed to rebalance. If that is the case, then the housing sector seems likely to be the first major domino that would lead to a global rebalancing, given its prominent place in the economy.

The Janaury Market Observations post over at Contrary Investor does a good job of trotting out the charts that show what has happened in past housing booms. This one has been larger than any in the past 50 years and the resulting bust is likely to be longer and deeper. Here's just one chart lifted from that site:

To that work, I'll add a few things. Here's a chart, showing how private contstruction spending has already turned down:

Residential construction spending is going to get much worse. Order backlog for most builders entering 2007 is less than 60% of what it was going into 2006. Orders are down, cancellations are up and they are sitting on a growing number of finished, unsold homes:
Starts are down, but not nearly as far down as they'll be a year from now. The bottoms of past housing cycles typcially came during economic recessions. Those recessions often started out with a slowdown in residential construction. We can expect housing to put a substantial drag on GDP growth for the next several quarters.

Additionally, much recent consumer spending has been related to the wealth effect and equity extraction that has been made possible by the recent housing boom. As the housing market slows and prices begin to fall, it should but a significant damper on consumer spending. It will be interesting to see the latest impact on these numbers in the GDP report next week.

One important thing that makes this bubble worse than past bubbles is the extent to which publicly traded builders are now responsible for a much larger portion of new home construction. As with many publicly traded companies, corporate executives ran many of the builders in a way that maximized short term and personal gains while creating massive systemic risk for shareholders and the economy. Meanwhile, Wall St. provided funding far beyond what regional banks loaned out in past cycles. Even as the market was cooling, the large, publicly traded builders were rushing to open new developments. Collectively they borrowed billions of dollars in 2006 to build homes that they were having trouble selling, and housing vacancies piled ever higher. Consequently, vacant homes for sale entered this slowdown at about 1.5% of the total housing stock, while the past slowdowns examined by contrary investor began with less than 1% of housing stock listed as vacant for sale.

It is my expectation that this housing bust will be much greater than any of the past busts, with the economic fallout leading to a pronounced slowdown in the consumption of imported goods.

2007-01-21T13:42:00.000-08:00

Rebalancing on Hold

As long as foreign central banks are willing to stockpile dollar assets, the rebalancing process is held in check. The US goes futher into debt and the dollar stays up against the Yen.

Here are 2 different graphical views showing an uptick in the custodial accounts managed for the Fed on behalf of foreign official institutions during Q4 of 2006. The first shows average weekly purchases of treasuries and agency debt during the past 12 quarters:

The second shows total holdings over that same period, with a noticable uptick during q4:

If that wasn't enough buying in itself, the Fed also got busy during Q4, after stepping back in Q3:

It's not like the Fed needs to help the banking sector juice the money supply any more than they have already. M2 grew at a 7.8% clip during Q4, and the lone remaining component of M3 (Institutional Money Funds) at a 23.1% annualized rate (showing who the real beneficiaries of recent growth were).

Three unsustainable forces keep the status quo alive for now:

1. Rapid money supply growth is needed to fuel the ponzi scheme that the American financial system has become.

2. Suppresed interest rates, thanks to an explosion in the derivatives markets, keeps the debt service burden from growing too large for the government and indebted companies/individuals.

3. Support for the dollar prevents the Yen carry trade from collapsing in on itself.

All three are worth watching to see when the rebalancing process will be allowed to proceed. Until then, American wealth continues to evaporate.

2006-12-04T20:36:00.000-08:00

The rebalancing process didn't seem to make much progress in the first half of November, as the financial sector stepped up money creation and the stock market rallied. In the last two weeks, however, the dollar has taken a bit of a dive against the Yen, the RMB and (especially) the Euro:
Once year end bonuses are paid out on Wall St., it may finally be time to let the rebalancing process go forward at full strength.

Meanwhile, the housing market continues to stall. Lately the National Association of Realtors seems to be acknowledging that the market is bad, but has been trying to call a bottom with every new data point. Their spin on the latest Pending Home Sales numbers is that they are "stabilizing." Hmmmmm. Doesn't look very stable to me:

2006-11-09T06:28:00.000-08:00

A Simple Reason for the Decline in the Trade Gap

The trade gap for September was down $4.658 billion from August to September ($68.958B to $64.300B).
Petroleum exports were down $4.689 billion.

Part of this was due to lower prices for crude ($62.52 vs. $66.12).
Part of this was due to a normal seasonal decline in imports during September:

Total Energy-Related Petroleum Products
Thousands of Barrels and Value in Thousands

2001
July - 370,199 - $8,437,810
August - 371,249 - $8,509,619
September - 344,231 - $8,199,657
October - 385,580 - $7,826,543

2002
July - 363,153 - $8,789,117
August - 376,323 - $9,415,863
September - 338,099 - $8,778,753
October - 381,444 - $10,239,471

2003
July - 422,313 - $11,598,132
August - 398,306 - $11,306,914
September - 393,522 - $10,686,495
October - 404,183 - $10,902,171

2004
July - 408,626 - $14,177,570
August - 430,232 - $16,080,613
September - 388,526 - $14,971,323
October - 411,620 - $17,686,358

2005
July 419,157 - $21,046,507
August 433,073 - $23,534,564
September 389,645 - $23,332,358
October 432,162 - $25,567,322

2006
July 423,624 - $28,438,931
August 450,451 - $30,497,305
September 413,659 - $25,808,397

Petroluem product imports represented 23.6% of the trade gap in September or 2002.
The represented 40.1% in September of 2006.

We can expect that next month there will be a large increase in the trade gap as oil imports pick back up.

As the economy slows, the trade gap is likely to decline, but the trend should be much slower than $4 billion per month.

Note that during the 2002 slowdown petroleum product imports were down. Declining living standards should eventually force oil consumption down in the US.

2006-11-07T06:55:00.000-08:00

Burning Through the Backlog

Toll Brothers gave the first indication about how the housing market fared in October (horribly). Net orders for their quarter ending 10/31/06 were down 57.56% nationally year over year. The order decline was worst in the previously hot Southeastern region, -77.8%.

Toll traditionally kept about 1 year's worth of orders in backlog, so it has taken a long time for closings to decline substantially. Profits remain strong for now, but they'll fall going forward as closings follow orders and backlog down:

2006-10-31T06:05:00.000-08:00

Chinese Foreign Exchange Reserves

Chinese reserves reached $988 billion by the end of September and are now most likely over $1 trillion. China's wealth continues to increase, and this is leading to a rise in Chinese consumption.

Even more importantly, the skills of its labor force, the quality of its educational institutions, and it's manufacturing base continue to grow in strength, suggesting that China will continue to be a manufacturing power even if it's currency is allowed to appreciate. So the dollar is now falling against the Chinese RMB:

While trade imbalances have been responsible for much of the growth in reserves, there has also been a large amount of foreign investment into the country. The world's largest IPO took place last week, raising around $22 billion for the largest Chinese bank, but that is just part of a long series of Chinese IPOs and foreign ventures into the country.

With so much capital already accumulated in the country, it might seem strange for officials to try and attract more. Indeed, Chinese policy makers have been trying to reduce foreign speculation into the country. However, the banking sector in China has made itself vulnerable by extending too much credit to manufacturers and real estate developers. The real estate bubble in parts of China resembles the real estate bubble in the US. (I'm not sure which bubble is worse, Shanghai or Florida).

The big banks have billions of dollars worth of problem loans on their books. To me it seems as though the recent string of bank IPOs are at least in part a way to shore up the balance sheets of Chinese banks on the backs of foreign investors. If so, then it is an improvement over the methods used by the Japanese and American central banks to protect their banks from their own excesses.

In Japan, after the real estate and stock market bubbles collapsed, Japanese banks were technically insolvent. The banks were allowed to stay open while the country instituted a zero-percent interest rate policy to boost banking profitability and eventually bought up stock positions from the banks to preserve their liquidity. After a long period of time, most of the banks had worked themselves out of the hole. Zero-percent interest rates, however, have led to speculative excess in Japan and throughout the world as a result of the Yen carry trade.

In the US, many banks were in trouble after the stock market bubble burst. The Fed lowered interest rates to boost profitability and stimulate the economy, but this dramatically inflated the housing bubble, fueled credit expansion on many fronts and allowed for a dramatic worsening of the trade gap and national debt. The result has been the creation of a much more precarious economic situation.

When the chickens finally come home to roost, and the global economy rebalances, I expect we'll see that the Chinese economy, monetary and banking systems all come out looking the strongest.

2006-10-28T08:14:00.000-07:00

A Long, Cold Fall and Winter

For most people trying to sell homes this Fall and Winter, it will be a long, cold 5 months. We've entered the slow season, when many sellers simply choose to take their homes off the market. However, with ARM resets and affordibility issues hitting many, the number of distressed sellers continues to rise.

Looking at Existing Home Sales data from the past two years, the seasonal buying pattern is clear:

When we compare the monthly sales totals with the inventory totals, we can get an estimate of the percentage of homes on the market that actually sold during the month:

In September of 2004, around 24.01% of homes on the market sold.
In February of 2005, around 17.25% sold.
In June of 2005, around 28.12% sold.
In September of 2005, around 22.73% sold.
In February of 2006, only around 13.43% sold.
In June of 2006, only around 18.70% sold.
In September of 2006, only around 14.07% sold.
In February of 2007, perhaps less than 10% of homes on the market will sell.

2006-10-27T04:25:00.000-07:00

Homebuilders Digging Their Own Graves

Standard Pacific Homes released a surprisingly large amount of information Thursday afternoon that underscores the trap the homebuilding industry has placed itself in.

Among the highlights:

1. Revenues were down from $937 million to $834 million, just an 11% drop, not a big deal in an of itself.

2. EPS was down to $0.47 from $1.37, so they still appear to be profitable. Nothing to worry about, eh? The housing market will turn around in the Spring, right?

3. Net new home orders for the quarter were 1200 vs. 2888 the year before, a 58% drop, so future quarters should be much, much worse for profitability.

4. Average number of selling communities for the quarter was 209 vs. 165 last year. That equates to 5.74 net orders per community this year vs. 17.05 last year, a 66% decline. Standard Pacific, like all publicly traded builders, tried to expand aggressively just as the market ran out of steam.

5. Inventories are up by over $600 million this year, while liabilities are up by over $700 million. It is only an illusion that this company is profitable. They capitalize construction costs and interest expense for now, but will eventually have to take large write-offs or sell homes at a substantial loss.

6. Backlog of ordered homes is down to 4426 from 7762, or 43%. This should lead to a dramatic slowdown in construction going forward. However...

7. Homes under construction totaled 5657, down from 7649, so the company is building over a thousand homes now that haven't been sold.

8. Completed and unsold homes now sits at 623 vs. 247 last year, and the total should continue to rise given the construction vs. backlog numbers above.

9. Building sites owned was 37,609, up from 35,547, although sites optioned was down from 26,630 to 13,196. Like most builders, Standard Pacific has been writing off options contracts, but they aren't willing to cut their losses on owned land.

10. Joint venture activity is especially suspect, as orders at JVs were only 5 per community (55 total), while construction vs. backlog was 718 vs. 255. Like most builders, the company has off-balance sheet arrangements with mysterious outside investors (think Enron). Activity at JVs suggests somebody's interests are being protected, and it most likely isn't Standard Pacific's shareholders.

As I've said many times before in many different forums: The builders are digging their own grave by building too many homes. They are doing this because they bought too much land and they want to put off taking losses as long as possible. Of course this only means that the eventual damage will be much greater.

The housing market is going to get much, much worse, due to both the overbuilding problem and the rising foreclosure problem. We can thank builders like Standard Pacific and lenders like Accredited Home Lenders for this problem.

2006-10-20T06:00:00.000-07:00

A Warning of Things to Come

Sub-prime mortgage lender Accredited Home Lenders issued an earnings warning yesterday morning, citing three main reasons for their disappointment:

"-Origination volume and loan submissions have not increased as much as the company anticipated and continue to be adversely affected by a combination of pricing competition and product contraction that has been prevalent in the market throughout 2006.
-Whole loan premiums and securitization returns are under more pressure than previously anticipated, caused a decrease in whole loan investor appetite for certain products, as well as changes in credit standards and equity requirements promulgated by the various rating agencies.
-Delinquency from production periods in 2005 and 2006 has risen above previous expectations, which requires the company to further bolster its reserves to prudently value the loan portfolio and potential exposure."

They claim not to have anticipated these developments, but all three were predicted by many commentators.

-Even in good times the Ponzi business model employed by most of the mortgage banking industry required ever increasing loan volumes to keep default rates down. New loans typically don't go bad as fast as bad loans, so the rapid growth rate of the sector helped hide the truth about the quality of their holdings. Now that the sector is having trouble growing, reported default rates are on the rise and profits are evaporating.
-The market for mortgage backed securities grew far too rapidly, and the supply of easy credit had to end. Now there are far fewer suckers out there who want to buy securitized sub-prime loans because the housing market has turned and foreign investors and portfolio managers are recognizing more of the risks.
-Imaginary profits were boosted by low reserve allowances. Their loss estimates were based on default patterns during the housing boom, not during normal times or a housing bust. As they have to increase reserves to cover real losses, their imaginary profits of the past turn to today's losses.

Most lenders are trying their hardest to postpone the bad news to keep their stocks afloat and their credit ratings intact. The situation is surely much worse than they are willing to admit. The mere fact that that more of them have started to give warnings is an indication that things are getting really bad in the industry.

(Additional problems in the lending industry were desribed in an earlier post.)

What is happening in the mortgage industry gives a good indication of what will soon be hitting the entire economy. Just as the mortgage lenders required an exponential increase in lending to preserve an illusion of prosperity, our economy has required exponential credit expansion and borrowings from foreigners to preserve the illusion of economic strength. For the past half century (and especially since the Reagan years), we've cycled through various sources of credit expansion, from government and industry to consumers, and finally to the pure speculation of hedge funds. Our main funding sources, aging baby-boomers and foreign central banks, are reaching a limit in their willingness and ability to extend credit, and the borrowers are reaching a breaking point with regards to debt service.

According to Moody's (and just about every other reporting source out there) defaults and delinquencies are up shaply this year. That's what happens to problem borrowers when they reach the limits of their ability to borrow. As it is happening to many homeowners, it will happen to many companies, many leveraged investors, and eventually the US government.

I cannot believe that Accredited's managment didn't see this coming long ago. When the company eventually fails, leaving shareholders with nothing to show for their investments, the executives will still retain the millions of dollars worth of compensation they've collected over the past few years. Likewise, when the US economy is brought back down to size, the financial industry executives who created great systemic risk and politicians who squandered the nation's wealth will most likely be living comfortably on their profits and pension benefits. Because our system compensates managers based on short term objectives, we get short sighted policies that have eroded our financial strength.

It isn't difficult to understand why Accredited is in trouble, nor is it difficult to understand why the US economy and government is in trouble. The difficult part is figuring out what the rest of us can do to protect ourselves when things really get ugly. (So far the short list includes paying down your debt and reducing exposure to risky investments.)

2006-10-18T05:53:00.000-07:00

August Treasury International Capital Flows

TIC data for August came out yesterday, showing a remarkable surge in foreign buying of US securities. According to the latest release, Net long term flows were as follows:
May = $67.0 billion
June = $75.5 billion
July = $32.9 billion
August = $116.8 billion

Treasury purchases saw the sharpest rise, but Agencies and corporate bonds also saw big inflows:

The buying was spread across many countries:
Japan added $7.6 billion in August
China added $8.7 billion
Canada added $4.9 billion
Brazil added $11.5 billion
The UK added $11.1 billion, but most of that was purchased for investors from other nations.

The purchases were typical of China, but Japan had not been decreasing holdings for over a year. Canada has doubled its treasury holdings (to $47.2 billion) over the past year, while Brazil's holdings had hovered around $32 billion until the August surge.

With all this August buying going on, the Dollar strengthened against the Yen and held its own against the RMB. As long as the dollar stays strong, US consumers can continue to consume more than they produce. As long as foreign investors are willing to accumulate US assets, the dollar can stay strong.

Russia has one of the largest foreign reserve positions in the world, but it doesn't show up on the list of Major Foreign holders. Their US holdings are unique in that they are overwhelmingly weighted toward short term debt. Asian nations typically hold large long term debt positions in the US, while European nations and Canada are more balanced between Equities and Long Term Debt.

Japanese treasury purchases could likely be related to the Yen carry trade and are subject to reversal if the speculative climate changes. Russia recently announced that they'll be accumulating Yen reserves, which most countries have shied away from because of low interest rates. The bulk of this is supposed to take place in 2007. Such a move could result in the purchase of tens of billions of dollars worth of Yen, putting pressure on Yen carry traders. I wouldn't expect much of a move before 2007, as hedge fund managers are likely to defend their 2006 gains (and bonus checks) vigorously during the final months of the year.

2006-10-16T06:13:00.000-07:00

Squeezed to the Breaking Point

Foreclosures continue to mount in much of the country, according to RealtyTrac. September's national totals were down 0.96% from August, but up 63.5% from the previous September. The 5 States with the highest foreclosure rates in August (with at least 1 foreclosure for every 564 homes) all had significant declines in homes in foreclosure for September, while foreclosures were up 8.5% over August for the rest of the nation.

Anecdotally, many counties are being overwhelmed by the number of foreclosures, causing processing problems, while many lenders are dragging their feet on reporting loan delinquencies as a way of pretending things are OK. It's hard to know exactly how big the mortgage default problem is currently.

California had the biggest affordability problems and the greatest use of high-risk mortgages. With an an 18.54% rise in September on top of a 24.75% rise in August, it appears these high risk loans have squeezed many to the breaking point and are beginning to take their toll on lenders. Florida and Colorado foreclosures dipped by over 20%, but the rates are still among the nations leaders for the foreclosure process. Connecticut (+556%) and Massachusetts (+373%) saw remarkable monthly spikes.

Here are updates of the three charts I posted last month:

Through all of this, the job market remains strong, even if pay levels and job quality aren't keeping up. Foreclosure rates normally spike during recessions when people can't find jobs, not when plenty of jobs are available. Increased debt service levels and high risk lending appear to be behind the current rise in foreclosure rates. According to the Fed's Houshold Debt Service report, several new records were set for debt service and financial obligations ratios in Q2. Those numbers don't include each houshold's share of Federal Debt service, which has been rapidly rising and now sits at over $400 billion per year.

Keeping the US economy growing now requires a steady infusion of new debt. However, as the debt burden rises, the country as a whole becomes a greater credit risk. Foreclosure numbers are one small indication of what is happening on a grand scale to the US economy. The US government is as bad a credit risk as the typical subprime borrower. It's only a matter of time before the whole debt bubble bursts.

2006-10-13T04:50:00.000-07:00

Another new trade gap record was set in August. On the whole, I'd have to say that the rebalancing process was not moving forward this summer. A large number of consumers were feeling the squeeze, but the nation as a whole is consuming more than ever before and debt has been piling up higher. Gross External Debt topped $10 trillion in Q2:
Even with oil prices falling sharply during the month, petroleum products were the biggest reason for the rise:

We imported 343.485 million barrels of crude oil in August, up from 321.576 million barrels in July. Among our top 8 suppliers for crude oil:

54.433 million barrels came from Canada
49.845 million barrels came from Mexico
45.322 million barrels came from Venezuela
44.446 million barrels came from Saudi Arabia
27.901 million barrels came from Nigeria
22.876 million barrels came from Iraq
16.435 million barrels came from Algeria
15.686 million barrels came from Angola

Canada, Mexico and Venezuela are in the Western Hemisphere, so it makes sense that they are the largest suppliers.
Saudi Arabia is the world's largest producer, so that makes sense too.
After that, what do the other four have in common? Perhaps it's just me, but I associate those names with civil war and internal violence. Just a coincidence?

A search for "Angolan Rebels" turned up this:
"Angola, too, has diamond and oil wealth of enormous value, yet a quarter of all Angolan children die before the age of five. Angola’s diamonds and oil were used by rebels and the Government to enrich themselves and to buy arms to fight one another at the expense of an impoverished, brutalised population."

Algerian Rebels turns yields 937,000 results, and Nigerian Rebels yields 2.08 million results.

Given the pattern of violence in US oil trading parters and how the violence doesn't seem to bother US oil companies, one has to wonder if the violence in Iraq is all according to someone's plan.

2006-10-11T06:10:00.000-07:00

A National Housing Slowdown

DR Horton calls itself America's builders and wanted to be the "Walmart" of homebuilders by growing rapidly and entering many smaller markets that other national builders weren't interested in. They are much more national in scope than other builders and charting their net new orders gives a general idea of the slowdown nationally:

The slide accelerated in all regions last quarter, in spite of heavy use of incentives. The Southwest finally went negative, and probably still has the farthest to fall from here. The economy has gone bad in the midwest and has taken housing with it.

Small Ohio and Kentucky builder Domininion Homes reported sales that were off 50% year over year last night. WCI Communities (which builds mostly in Florida) reported year over year declines of 80% last week.

Summing up the regions, we have:
Florida as the worst, the Midwest second worst, and California the third worst.

Speculation was the biggest problem in Florida, and it has caused a violent snapback. Credit expansion put too much money in the hands of speculators.
A bad economy is the biggest problem in the Midwest and I expext the rebalancing process to cause a slowdown in the national economy over time.
Affordability issues and rising interest rates pushed the California market over the edge. Too much easy credit was created through global imbalances and it fueled the sub-prime, no-doc, high LTV explosion.

Builders got carried away in the euphoria of the housing bubble and ramped up their expansion plans just as the market was reaching the breaking point. Now they are getting stuck with too much land and unsold inventory and the resulting debt burden is putting a large strain on their financial situation. Finished homes for sale are still on the rise:

Large incentive packages haven't been enough to keep sales up. Kara Homes may be the first large, privately-held homebuilder to declare bankruptcy in this down cycle, but they won't be the last. Dominion Homes will probably be the first of the publicly traded builders to do so, and many more will probably follow.

2006-10-07T06:01:00.000-07:00

Where's all the Money Coming From?

The Fed stopped counting M3 back in March, but you can still get a pretty good estimate of it by looking at a couple of other numbers they publish. Both of those numbers were rising at an accelerated rate already this year, and really took off in August and September.

Institutional Money Funds rose by about $10.6 billion per month for the first 7 months of the year, but rose by $27.6 billion in August and around $20 billion in September.

Large Time Deposits at Commercial banks in the US were rising at about $25 billion per month for most of this year, but rose by $31.9 billion in August probably even more in September.

The money has to come from somewhere. In this case it appears to be coming from two places. The first being that it is being squeezed out of the hands of average citizens, and the second is that it is being created in the form of new commercial debt.

Consumers aren't borrowing as much as they used to. Consumer Credit was up only $5 billion in August, after rising $8.3 billion in July and $34.7 billion in Q2. Real Estate loans at commercial banks were actually down $0.6 billion in August after rising by about $30 billion per month for most of the year. With home prices stagnating, and consumers already overextended, credit appears to be tightening.

Since they aren't borrowing, they appear to be drawing down their checking and savings accounts to make ends meet. M1, the money people intend to spend, is down $4.1 billion in August, and is down $25.4 billion from a peak of $1393.6 billion in May. M2 is up, but there is a divergence within that measure. Savings deposits were down $9.8 billion in August and are down $41.8 billion from a peak of $3657.3 billion in February. Meanwhile, small time deposits jumped $23.4 billion to $1107.7 billion and Retail Money Funds rose $11.5 billion in August.

On the whole, a lot of new money was created in August but it didn't flow into the hands of consumers. Instead it appears to be in the form of commercial lending. Commercial and Industrial loans at Commercial banks rose by $27.4 billion in August, more than doubling the rate of increase over the past year. I'll credit hedge funds for much of that borrowing and builders for another large portion (as they continue to build homes but have trouble selling them).

All this new money was desperately needed to fund the federal deficit and keep the economy kicking. With many consumers choking on too much debt and leading indicators pointing toward recession, money creation to finance hedge fund speculation and surplus housing appears to be all that our financial system can muster. Neither of those sources of money should be considered sustainable.

2006-10-05T04:45:00.000-07:00

Dollar Update

The dollar slide against the RMB was accelerating and it appeared to be breaking down against other currencies, but then end-of-quarter demand from Yen carry traders gave it a a boost against the Yen. This week China is enjoying aa vacation, so the RMB rate is fixed. In the meantime, the dollar has been catching its breath.

In general, the rebalancing process seemed to take a break in much of August and September. More on that after I see the data from the Fed tonight.

2006-09-28T06:27:00.000-07:00

New Home Sales Distortions

The Census Bureau put out their monthly misinformation report on new home sales. As usual, there were steep downward revisions from past months that made the current totals appear to show a bounce in sales. This chart shows the trends for preliminary, revised, re-revised and final numbers:

Usually the bad initial estimate can be blamed on data for housing starts. Because builders are starting more homes now that haven't been sold yet, the old methodology for estimating sales yields bad results. However, the starts data was way down in August, so that excuse appears weak:

I think it is safe to assume that the data is being intentionally fudged to hide the nature of the housing market. The data is bad enough as presented, but the true story is probably getting worse all the time:

Builders keep building too many homes because they have too much land and don't want to write off the losses. Until they they let demand catch up with supply, housing will continue to go down. Plain and simple.

2006-09-23T05:02:00.000-07:00

Dollar Under Pressure

Year to date, the dollar is down 1.87% against the RMB, but the rate of decline seems to be accelerating.

2006-09-18T21:31:00.000-07:00

Energy Price Fluctuations and Hedge Fund Implosions

Oil and Natural Gas prices are bouncing all over the place and I think a good part of it has to do with games being played in the financial markets.
A couple of large hedge funds have blown up from the natural gas price fluctuations. MotherRock was too short and Amaranth was too long and steep moves wiped them out.

Given the nature of hedge fund manager compensation, the manager has no incentive to play it safe when he's down a lot on the year. He may as well increase the size of his bets hoping to swing back into positive territory so he can score some big fees. If the manager gets hit really hard, then he closes out his positions so that he can pay back his bankers and gives the remaining funds back to investors (often some poor pension plan).

On Wall Street news events and fundamentals are playing less and less of a roll in moving prices as large players leverage up to squeeze whatever paper profits they can out of the market. Since year end bonuses depend on paper profits those are as good as any as far as the traders are concerned.

Oil spiked up around the time BP announced they were shutting down a major pipeline in Alaska. Since then US crude inventories have been dropping, but the price has been dropping sharply in spite of that.
I suspect some oil traders have been wiped out along the way, as they are forced to unwind their positions at the bottom. Meanwhile, commercials have been unwinding their short positions at a tidy profit:

It looks like more traders and the hedge fund investors they represent have been taken for a ride.

Long term, energy prices will probably have to rise substantially in dollar terms if Americans are going to reduce their energy consumption and unwind the trade gap. In the meantime anything can happen to energy prices and volatility in these markets seems to be on the rise for now.

2006-09-16T07:29:00.000-07:00

Nouriel Roubini put out a nice, 8-page .pdf disecting a lot of the nonsense out there describing the trade gap. While I think that he produces almost as much nonsense as he debunks, it's still a good read. Here's my critique, where I address all of his main points:

Interpretation one: many blame the global imbalances on the US’s twin budget and current-account deficits.

Roubini rates this as the most plausible explanation, but in my mind it really misses the point. The current-account deficit doesn't cause the problem. It is the problem. Meanwhile, the huge federal budget deficit does promote the trade gap because consumers don't factor in their share of the national debt in estimating their own net worth. Roubini's description of swings in savings and foreign investment patterns is basically irrelevant to the problem of why the trade gap exists, although it does help explain some interesting phenomena like the tech bubble, the housing bubble and the bond conundrum.

Two: Ben Bernanke, Alan Greenspan’s successor as chairman of the US Federal Reserve, claims the imbalances have little to do with the US’s fiscal deficit – because the world is Ricardian, that is, consumers and companies offset an increase in government borrowing by saving more, in anticipation of the future tax rises needed to be pay off the extra debt – and are instead caused by a “global savings glut” triggered by developing countries saving too much.

Roubini is being very polite in saying Bernanke "overstated" his case. I believe Bernanke (and Greenspan before him) have had the politically motivated goal of shifting blame away from the Fed and US Government for the problem. At best the savings glut concept is an idiotic rationalization and denial of responsibility. At worst (and far more likely in my view) it is a blatant attempt to mislead the investing and voting public. It would not be "responsible" for someone in Roubini's influential position to tell the truth about the Fed.

Three: others argue that the imbalances are largely due to a global investment drought rather than a savings glut.

Roubini gives credence to interpretation three, ignoring the obvious other side to the equation: Extreme money supply growth around the world is creating far more investment capital than can be invested at a reasonable rate of return. The problem is especially pronounced in the US, resulting in rapid M3 growth (and thus the discontinuation of the measure) as cash piles up in money market funds. Plentiful investing opportunities would exist if much of the third world was not kept in an impoverished, perpetual state of war and unrest.

Four: in the Bretton Woods II hypothesis advanced by Michael Dooley, David Folkerts-Landau and Peter Garber, China and other emerging markets are causing the imbalances by keeping their currencies artificially low so as to boost their export-led growth.

Roubini says there's some truth in interpretation four, but then makes a logical leap to say that those promoting the view think the imbalances are good. There's a disconnect here, because much of the Economics Underground believes the Bretton Woods II argument while still recognizing that the imbalances are leading toward an economic disaster. In my view, Bretton Woods II has been the biggest cause of the trade gap problem since the early 1980s, because it is the most significant cause of dollar overvaluation. Bretton Woods II only recently has given way to the Yen carry trade in terms of significance in promoting economic imbalance.

Five: the imbalances are caused by China’s excessive saving, owing not to its exchange-rate policy but to the structure of its financial and economic systems.

Roubini gives this some credit, but I don't. Reforms I've seen in the pipeline (like allowing Chinese citizens to invest directly in foreign stocks) would tend to exacerbate the problem, rather than solve it like Roubini asserts.

Six: Richard Cooper argues that the imbalances are caused by demographics and low productivity growth – Japan, Europe and China need to save a lot because they are ageing very fast, while low productivity growth in Japan and Europe exacerbates this need.

Roubini gives this reason a small amount credit for Japanese and European trade imbalances, but discounts it for China. I can agree with him on that.

Seven: housing bubbles in the US and a handful of other countries, caused in part by easy money, are responsible for the imbalances, because they have increased investment (in housing) while leading to a consumption boom, and hence reduced saving.

Roubini calls these a promising partial explanation, but I think he's mixing up cause and effect. The trade gap boosted the housing bubble, rather than the other way around. Foreigners collected dollars because of currency imbalances and then plowed them into US debt of all kinds, which helped promote the housing bubble. He brings up some interesting connections when he mentions the Yen carry trade and decline of various foreign currencies that were boosted by it, but discounts them as a thing of the past. While there may have been a partial unwinding of the Yen carry trade earlier this year, I believe it has come back in force, and the rebound of the New Zealand dollar provides further evidence for this idea. The Yen carry trade deserves to be addressed fully in his discussion, but perhaps it is too important and truthful to be given full treatment if this paper is indeed bent on misdirection.

Eight: financial globalisation is the explanation, because as investors are diversifying their portfolios and investing more of their funds abroad, foreigners’ demand for US assets is greatly increasing.

I'm with Roubini in discounting this theory, but for different reasons. Roubini tries to argue that foreigners are selling US equities. However, according to TIC data, foreigners are not pulling out of equities. Instead they more than doubled net equity purchases to $116.9 Billion in the 12 months ended June 2006. They've been especially keen on buying US corporate bonds, which tend to be more secure than other types of US assets. For me, again, this theory is another example of confusing cause with effect. The strong dollar forces the accumulation of trade gap dollars which eventually get invested back in the US. Meanwhile, savvy US investors are pulling out of US assets and investing abroad before things really get bad in the US.

Nine: Ricardo Hausmann and Federico Sturzenneger argue that the US current-account deficit is a statistical illusion, because “dark matter” – the intangible value of US-owned foreign assets – is not measured correctly.

Roubini is right that this is nonsense, and partially right that US held foreign assets tend to earn more than foreign held US assets. However, he neglects to address the two main reasons for this, which are the long term decline in the value of the dollar and the suppressed yields of US assets due to excessive dollar creation. He also avoids mentioning an important reason why the actual current account deficit is actually much worse than the published numbers, as described by Raymond Baker in his book Capitalism's Achilles Heel Specifically, a great amount of money from international organized crime rings and corrupt third world leaders is extracted from poor people and invested into the US without detection in official figures.

Ten: the oil exporters are to blame, because they are saving rather than spending their huge windfall gains from rising oil prices.

Roubini discounts both the size and importance of the trade gap with oil exporting nations. He doesn't seem to realize that the trade gap for petroleum products has been accelerating and is now over $25 Billion per month. Meanwhile, the US consumer is gasping for breath and the trade gap for non-petroleum goods appears to be in decline. Roubini is right to suggest that the US will need to reduce energy usage, but I think he is wrong to suggest that this can or will be done voluntarily or without significant economic damage. The way things are heading, it will eventually require a steep increase in the price of oil due to a sharp decline in the value of the dollar that would force consumers to cut back due to lack of funds.

To sum up my position:
The dollar had been kept low because of Bretton Woods II currency peggin and intervention by the Bank of Japan. More recently, the Yen carry trade has played a greater role. This is the primary cause of the trade gap.
A secondary cause is the illusion of wealth created by over-stimulation from the massive federal deficit and loose monetary policy. Excessive oil consumption is a large and growing part of this.
A third cause is the feedback of investment dollars coming back as the result of the trade gap, although this is decreasing in significance as intervention by foreign central banks has declined.

What to Do

Roubini insists that the global imbalances can only be unwound if several countries take action. He wants the US to reduce its budget deficit and increase private savings and I agree that both steps would be beneficial. However, the most important step for the US to take would be to cut short term interest rates and intervene in the currency markets to bring down the value of the dollar. That isn't going to happen because Wall St. is in the insurance business and a stable dollar is essential for protecting the profits of big banks like Goldman Sachs and JP Morgan.

Roubini wants China and other nations to relax their pegs to the dollar and for Europe and Japan to accelerate structural reforms. China has been doing their part in strengthening against the dollar in a very responsible and steady fashion, while the Europe has been grudgingly and whiningly been doing theirs as well. Meanwhile Japan is predictably pursuing its own best interest by keeping the Yen weak. This keeps Japan's economy humming and provides cover for the BoJ to reduce its holdings in US treasuries. As they do this, large amounts of US Treasury and now Agency risk is being transfered to the pension plans of American workers.

Roubini also wants oil exporters to relax their pegs, but this is meaningless because labor in these countries does not compete with labor in the US in any meaningful way. (Excluding Venezuela) wealth from oil exports goes into the hands of the wealthy while the masses receive little benefit. Increasing consumption in these nations would require a substantial redistribution of wealth and power rather than a currency revaluation.

The solutions to reducing the trade gap are amazingly simple. Yet, they go directly contrary to the interests of America's ruling elite. That is the reason the gap has persisted in growing to such dangerous levels. That is also the reason why Economists like Roubini aren't able or willing to tell the true story about global economic imbalances. To do so would be to put their own careers at risk. I am grateful, however, for economists like Nouriel Roubini and Steven Roach who at least are willing to bring attention to these issues. Along the way they provide many interesting statistics and facts that improve the analysis of people who are able to read between the lines.

2006-09-14T04:53:00.000-07:00

Here Come the Foreclosures

Foreclosures fluctuate seasonally, and they normally trend down through the summer months, which are prime selling months for real estate. This year, however, foreclosures picked up in July and took off in August, when the housing bubble finally burst. I expect foreclosures will accelerate more dramatically from here, as the normal pattern is for increased foreclosures in the Fall and Winter, and the number of distressed borrowers is rising.

The following chart shows one company's tally of homes in various stages of foreclosure nationally:
-Many distressed borrowers now have their homes on the market and will give up on selling their homes as the buying season ends.
-I expect banks will see an especially large surge in defaults in October, November and December, especially in California and Florida where more borrowers are overextended.
-Banks will tend to accumulate more real estate owned during the winter months and try to put it back on the market in Spring, especially in Rust Belt states.

The following chart shows California homes in various stages of foreclosure:

-Affordability issues are killing the market in California and other coastal areas.
-As home price appreciation disappears, cash out refinancing ceases to be an option for most overextended borrowers.
-Notices of Default pick up first, followed quickly by Notices of Trustee Sales.
-Lenders haven't accumulated much real estate because it has been easy to unload homes in foreclosure sales up until now. Some lenders may choose to accumulate real estate and inflate its value on the books, rather than write off losses.

The following chart shows Real Estate Owned by banks in Michigan and Ohio:
-These markets have been relatively soft for a long time, so real estate owned is much higher here than in California.
-Banks have had a cyclal pattern of accumulating real estate in the Winter and selling it off in the Spring.
-These markets are showing the first actual price declines because of forced sales into a saturated market.

Overbuilding led to the rise of surplus inventory. That eventually caused price appreciation to level off. The next big wave has now begun, where distressed borrowers are forced into selling at lower prices. Now we'll start seeing large price declines, as home values decline toward levels that average people can afford. Of course home prices have a long way to fall before they reach those levels, and economic processes take a very long time to unfold. I'm not expecting a bottom in the housing market for at least another 4 years, and probably longer.

Follow-up
Just to share a couple of quick comments I got as a result of posting this item to a board on the Motley Fool...

From a realtor: "Great post, and I agree with one of your key points that this may get much worse in a hurry this winter. The already unfavorable ratio ofsellers/buyers will get much worse."

From a mortgage broker: "Currently banks are simply delaying the proceedings of foreclosure, often times letting the occupants ride free for months and months...

You see... the PUBLISHED REPORTING of the foreclosures could have significant effects on the bank stocks, and the portfolio bond yields... so, we're simply observing the real-world results of yet another slice of unregulated accounting manipulation in the banking industry."

2006-09-12T06:22:00.000-07:00

New Monthly Record Trade Gap

The trade gap in July set a new record at $68.044 billion.
The prior record had been $66.598 billion, set in October of 2005.

The big culprits were:
Net imports of petroleum products, which were up 35.98% year-over-year to $25.576 billion,
Exports of goods, which fell by $1.3 billion,
Imports of goods, which rose by $2.1 billion.

Looking at the longer-term trends that got us here, imports of petroleum products are really killing us. Imports of other goods still appear to be trending down, but petroleum imports are curving upward:

I don't buy the hype in the mainstream financial media that says the commodity boom is over. While we may be heading for some form of global economic slowdown, I'm inclined to believe that the growth engines of the developing world will continue to create heavy demand of industrial supplies. If nothing else, the huge foreign currency reserves amassed by China will allow them to continue purchasing industrial goods to build out their infrastructure in the face of an eventual export slowdown.

Net exports of services are now down year-over-year to a feeble $5.395 billion as our edge in knowledge and technology continues to decline. The main way we can hope to begin reducing the trade gap is to reduce our net imports of goods. For that to happen, the dollar must fall, but unfortunately the foreign currency markets are refusing to let that happen. After an initial dip, on today's numbers, the Dollar actually rallied back stronger against the Yen. Japanese and American governments and central banks seem unwilling to pull the plug on the Carry trade. It may be up to China to force the issue, after adding another $19.6 billion in trade gap dollars to their monstrous pile in July.

So another month passes, and Americans go another $68 billion deeper in debt. The longer the world puts off a substantial decline in American living standards, the ore severe that decline will eventually be.

2006-09-10T16:09:00.000-07:00

Builders Burning Through Cash While Amassing Inventory

The publicly traded homebuilders were amazingly aggressive in their land acquisition strategies over the past several years, and they are paying for it now in interest expense and write-downs. On their income statements all but 3 of the smallest builders are still showing large profits. However, cash flow statements show that the builders are burning through cash and increasing borrowings at an alarming rate. With sales in the early stages of a long, steep decline, they are putting themselves at the mercy of creditors, which I expect will result in bankruptcy for some of them. I took a good look at the cash flow statements of all the publicly traded homebuilders.

For the group of 15 builders who have reported cash flows for a quarter ending 6/30/06:

1. Their total cash position dropped $908,566,000 during Q2 '06, vs. $132,668,000 during Q2 '05. It's normal for the builders to use cash building homes in Q2 that will be closed on in Q3 and Q4. However, this year builders are spending much more money on spec homes that haven't been sold yet and are seeing many more last minute cancellations that leave them short on cash.

2. Along those same lines, net borrowings increased by $2,942,020,000 during Q2 '06 vs. $1,483,781,000 during Q2 '05. That's an additional $1.5 billion borrowed by perhaps 15% of the nation's total homebuilding industry. Multiply that out, and you have a pretty substantial boost to the money supply. Much of it was just the expansion of credit facilities, but a good portion was also in the form of new long term bonds. While builders are burning through all this cash, they are booking most of it as inventory and thus avoiding a blow to profits, but in the meantime...

3. They increased money spent on share repurchases to $558,006,000 during Q2 '06, vs. $207,069,000 during Q2 '05. Just as they thought increasing land holdings to 6 years supply or more was a good idea in 2005, many of them seem to think that borrowing money to repurchase shares is a good idea right now. While share prices are low now relative to the same time last year, I believe that several builders will see their prices fall all the way to zero before the current shakeout is complete.

Not all builders are responding to the slowdown equally. NVR, MDC and TOA all borrowed less this Q2 than they did last Q2 and their cash positions fared better this year as well. MDC and TOA never spent money on share repurchases and NVR dramatically reduced theirs when the market turned, spending nothing during Q2 '06. By accepting the harsh reality of the bursting housing bubble early, they greatly increase their chance of surviving it.

On the worst end you have WCI, with a rapid deterioration of their cash position (93% lower than a year ago), a 461% increase in Q2 borrowings (to $217.8 million) and $43,580,000 spent on share repurchases last quarter. They face huge problems with about half of their revenues historically coming from Florida condo sales and the story is being told in their cash flow statements. Perhaps they are repurchasing shares because they are dumb enough to think their stock is a bargain right now. Perhaps they just want to prop up the share price long enough for insiders to cash out before the collapse.

The biggest builders were of course the biggest borrowers, with DHI, PHM & CTX borrowing $687.4, $716.1 & $840.5 million respectively during the quarter. How long their creditors will continue to finance their building of more homes than people want to buy remains an important question. DHOM already seems to be hitting a financing wall. If they can't get enough money to pay the bills from customers or the banks, then bankruptcy will soon follow.

All of the data above covers the June quarters, while cancellation numbers didn't really turn ugly until July and August. TOL and HOV report quarters ending July 31st, but they are more conservative than most. TOL followed the trends of the June builders, but the damage wasn't too extreme. HOV should file its 10-Q next week. KBH and LEN report quarters ending August 31st, and it should be especially interesting to see the fincing portion of their cash flow statements as they are two of the more aggressive builders.

2006-09-08T05:11:00.000-07:00

Some Counter-Arguments

Mark Lapolla blogs some interesting market observations and views, but I think he's trying to rationalize his directional leaning too much in this recent entry.

In response to his quotes, I offer the following opinions:

"The Global Economy is slowing. I believe everywhere--including China."

Many consumers are hitting a wall in the US, but that's because of debt burdens and cost increases. Globally, economies continue to grow, and will continue to grow if the rebalancing process goes smoothly.

"Central Banks are at the end of a MASSIVE, coordinated tightening."

They raised interest rates, but they didn't tighten credit. Money supply continues to expand rapidly. Much of it due to hedge speculation and the Yen carry trade.

"Global inflationary pressures are benign. Labor does NOT have pricing power in the developed world. Period."

That all depends on what you are measuring for inflation and how. Hedonic adjustments help keep CPI low, but monetary expansion keeps building pressure on resource costs while driving down investment returns. Governments and monetary authorities can't resist the inflation temptation for long.

"The World is awash in capacity--China will lead a new round of Global dis-inflation within the next year or two."

The China I've been watching has begun raising prices, and will likely continue to raise prices with foreign currency reserves already approaching $1 trillion.

"Oil is going lower. Period. Intermediate goods pricing will not translate into sustainable end user price increases. Commodity prices will peak and go lower--soon."

Oil has already come down about 15% which is probably enough for producers to ease off of production a little and for China to consider filling up their reserves a little. I expect other commodities will have technical corrections like Oil, but capacity is not rising fast enough to keep up with growing demand.

"The US Housing Bubble is NOT a Bubble. Some US housing markets ARE Bubbles: South Florida condos to name one."

It most definitely IS a national bubble. Easy credit was available everywhere, and hordes of amatuer investors from California leveraged themselves up to buy into markets with lower prices. If prices didn't go up in a region, it was because the economy stunk there and people didn't want to live there. Those factors are getting worse, and rust belt markets are actually leading the nation in price declines as the bubble bursts. As debt burdens become overwhelming, the deleveraging process will hurt prices everywhere.

The media finally caught on to some of the oversupply issues, but they don't understand why builders are choosing to continue building too many houses, and they don't understand the effect foreclosures will have on the market in 2007 and beyond.

2006-09-06T19:30:00.000-07:00

While the dollar has fluctuated widely against the Yen, Euro and Canadian Dollar, the Bank of China has engineered a slow steady decline of the dollar against the RMB.

A couple of years ago, I expected the RMB to repeg pegged to a basket of currencies because that would allow the RMB to stay relatively weak in a global sense, while disconnecting itself from a deteriorating dollar. That was the policy announced last July, but it really hasn't been in effect over the past 14 months. Repegging to a basket may still be the eventual goal, but China appears to have an intermediate stage in mind right now, where the RMB gradually strengthens against the dollar regardless of what the dollar does relative to other countries.

The above chart demonstrates a few interesting points:
1. While the dollar was falling against almost everything in April and May, the RMB actually remained pretty flat relative to the dollar. One would expect the RMB to appreciate more when the dollar was declining against everything else.
2. The Yen has been weakening relative to almost everything since mid-May, presumably because of increased use of the Yen Carry Trade. The Yen declined especially abruptly in August.
3. China and Canada run the greatest trade surpluses with the US and their countries have been strengthening the most relative to the dollar over the past month. (Japan runs a close 3rd to Canada.)

By the end of July, China had accumulated $954.5 billion in foreign reserves, exceeding 2nd place Japan ($864 billion in June), 3rd place Taiwan ($260 billion in July) and 4th place Russia ($259 billion in August). The net wealth of the average Chinese citizen is increasing rapidly (both because of the growth of the foreign reserve pile and because of the rapid infrastructure build that is taking place within the nation) even if most Chinese aren't aware of the long term implications of the country's gains.

Chinese officials talk as though the pile of cash is getting large enough to pose a systemic problem and propose minor changes to try and slow the flow. But in truth I suspect the Chinese government wants to continue amassing wealth as long as foreign governments are willing to let them.

The rate of decline in the dollar/RMB has picked up recently and I suspect the dollar will continue to fall against the RMB because imbalances are so great. Against the Yen, however, the dollar has been very strong of late. Something should eventually give, and as the Yen's weakness is based on trading activities rather than fundamentals I expect a strengthening Yen is the most likely outcome.

2006-09-04T15:28:00.000-07:00

Construction Spending

Construction spending is only about 8% of GDP, and provides only about 6% of non-farm employment. However, it is probably the most vulnerable portion of the economy to recession, and private construction is even more vulnerable than public construction. Many observers are calling for a recession led by housing. I tend to think that excessive debt is causing the economy to stall and a slowdown in housing will increase the severity of the problem. (Because the debt problem is permanent, rather than a function of the credit cycle, I see and economic slowdown as part of the rebalancing process that moves us toward a more sustatinable level of consumption rather than a cyclical recession... now back to the topic of construction spending)

Non-Residential Construction was booming during the late nineties and 2000, as tech companies took their IPO and SPO dollars and built big corporate headquarters. That went into a long, steep slowdown when the bubble burst and the easy money dried up.

Residential Construction has had two brief periods of decline, related to rate hikes and economic slowdowns in 1995 and 2000. It took especially long for housing to roll over this time because rate hikes were met with new waves of lowered lending standards. Excess residential construction the past 3 years will likely give way to several years of slower construction as surplus housing inventory is absorbed.

The housing bubble appeared to be deflating on its own at the end of 2004, but then foreign investors started snapping up Agency debt, which helped fund a new round of easy lending and home buying. With housing prices on the decline in most areas, Agency debt has become a poor risk and foreign investors may start to shed holdings the way they've been reducing treasury holdings of late.

2006-09-03T10:56:00.000-07:00

Post Labor Day Breakdown?

I've observed over the years that holidays often mark major turning points in the market. According to my theory, families and friends get together over the holidays and talk often turns to how great their portfolios have been doing (or how poorly they've been doing). Coming out of the holiday, the greatest fools try to jump on the bandwagon just as the market reverses course.

The current situation bears some remarkable similarities to the market situation in 2000. Six years ago, the tech bubble had already burst, but the broader market still struggled through the summer and appeared to be rallying into Labor Day. After falling from an all time intraday high of 1552.87 on March 23rd, the S&P 500 rose from a low close of 1419.89 on July 28th to a high of 1520.77 on Friday September 1st. Buy-the-Dippers were celebrating their success at family barbeques. By Christmas, the market was down to 1305.95.

This year is similar in that the housing bubble has clearly burst. The S&P500 peaked around 1326 in May. Then they took a dive to 1234.28 on July 17th but have since bounced back up to 1311.01 on Friday September 1st. This year's group of buy-the-dippers are probably congratulating themselves this weekend.

With the S&P500 and Dow30 doing much better than smaller stocks over the last three and a half months, and the big permanent and temporary injections of last week, it smells like a possible top. Of course these rallies usually go on longer than I expect them too.

Even with the major market indices rallying during the month of August, the short portion of my portfolio had its best month of the year. Retail, Builders and Sub-Prime have been taking an early dive as they should be given the macro-economic climate. Consider this updated chart:

That account, based on the principals of the rebalancing trade, is up 62.8% since the end of April, after being down 26.7% over the first 4 months of the year. The short positions in that account are typically the individual companies I think are most vulnerable to an economic slowdown in the sectors that I think will be hardest hit by the rebalancing process.

(So here it is, Labor Day Weekend, and I'm talking about how great the short half of my portfolio is doing, and expecting it to do even better if the broader market starts to slide. It'll serve me right if the market rallies and takes the garbage stocks with it.)

In my view, fuel for the market prop job has probably been coming from hedge funds borrowing yen, buying dollars, then sinking them into treasuries and large cap stocks. While the RMB continues to strengthen against the dollar, the Yen has remained weak. This chart shows a fairly strong correlation between the Dollar vs. the Yen and the performance of stocks and five year bonds:

Carry traders picked up the slack when the Bank of Japan began reducing their treasury holdings. The BoJ is probably willing to let carry traders continue to pile on the risk for now before they start a long, slow squeezing process that bleeds all the profit and money out of the hedgies. Japan wouldn't want a rapid unwinding because that would cause a shock to their own money supply.

All this leaves me torn between expecting a change of direction over the labor day weekend, leading to a broader market decline, and a continuing prop job to get Wall Street through one last Christmas bonus cycle before things break down in January. The fact that Mauldin also noticed the similarities with 2000 and broadcast his thoughts to a wide audience, tends to make me lean toward a continued prop job through the end of the year. Time will tell.

2006-09-02T09:07:00.000-07:00

Mainstream Economist Lies

Pending home sales took a steep dive in August, as the housing bubble continued to deflate. It still has a very long way to go, but you wouldn't get that impression from listening to high-ranking housing economists. To them the bubble was a permanently high plateau when we were at the peak and any decline is part of a soft landing.

Pending home sales are one of the most current indicators of the housing market, and they took a steep dive in July:

David Lereah is the chief economist of the National Association of Realtors. His job is to spin the data to the best of his ability so that people want to rush out and buy homes, making money for the membership of his organization. Here's what he's been saying ever since the Pending Sales peaked and turned downward.

September 1st, 2005: “The Pending Home Sales Index is at the fifth highest reading on record, meaning we can expect historically high home sales to continue in the months ahead,” he said. “The index has been fluctuating in a fairly narrow range over the last six months – a very high range – so the overall market is moving forward with a lot of momentum.”

October 5th: “...national sales should stay close to record levels over the next two months and housing will continue to support the economy.”

November 3rd: “We’re still seeing a post-Katrina boost in home sales activity, where the needs of displaced residents are supplementing a fundamentally strong market,”

December 6th: “The drop in pending home sales is an affirmation that we are experiencing a modest slowing in the housing sector,” he said. “The index is pointing to a soft landing for home sales, which will help to correct the inventory shortages that have dominated housing over the last five years. This should restore balance to the market.”

January 5th, 2006: “In other words, home sales have been peaking for the last five years and we will land on a high plateau in 2006 – a market that will be healthy for both buyers and sellers. Investment fundamentals for housing remain solid, preserving generally favorable affordability conditions while offering solid returns as well as a place to live.”

February 1st: “In many recent transactions we’re looking at a delayed effect of mortgage interest rates that peaked in November but are now lower than expected. Mortgage applications have trended up in recent weeks, so we shouldn’t be surprised to see pending home sales rise in the next couple months.”

March 6th: “This looks like we’re touching down for the soft landing we’ve been expecting,”

April 3rd: “We can expect a historically strong housing market moving forward, earmarked by generally balanced conditions across the country and fairly stable levels of home sales with some month-to-month fluctuations,”

May 2nd: “Home sales rebounded from the slide that started last fall, but the pending sales data is showing a dampening effect from rising mortgage interest rates that have been trending up since January,” he said. “This means a modest slowing can be expected in the sales pace in the months ahead, although the market will hold at historically strong levels.”

June 1st: "I see this time of adjustment as being a trough in home sales that will more or less level out toward the end of the year. Over time, homeownership remains the best investment a family can make.”

July 6th: "“The slight change in pending home sales indicates the market is beginning to level out,” Lereah said. “This is consistent with our forecast, which is showing a soft landing for the housing sector. We are entering the second phase of the transition period from the housing boom, in which sellers are becoming more realistic about their expectations – sales are stabilizing and annual home price appreciation is returning to historic norms.”

August 1st: “The housing market is striving for balance – a process that will take several months. A quieting in the movement of indicators should restore confidence to home buyers who’ve been on the sidelines, waiting for the right time to get into the market, and now is the best time we’ve seen since the 1990s in terms of housing choices and flexible terms.”

September 1st: “Psychological factors are causing some buyers to remain on the sidelines, waiting for prices to stabilize or for more favorable news about the market and the economy. Contributing to this hesitancy is a lot of negative news stories, but in the end we believe that underlying market fundamentals will prevail.”

OK, Dave, here's the fundamentals:

Builders have built way too many houses and they are still building too many because they're stuck with too much land.
Borrowers have overextended themselves and the defaults and foreclosures have only just begun to rise.
The economy is begining to roll over and things will get really ugly when the recession begins.

You know this, Dave but you continue to lie through your teeth to promote a narrow, selfish agenda. Hopefully someday someone will take you to task.

2006-08-31T17:15:00.000-07:00

Economic Report Summaries

A lot of economic reports came out today, underscoring the deteriorating state of the US economy.

The Personal Income and Spending report showed that spending continued to grow faster than income, with a negative net savings of $83.5 billion for the month of July, or -0.9% of disposable personal income. That's a record, but the data doesn't even include mortgage interest payments. Mortgage debt service had risen from 9.04% of DPI in Q1 2000 to 10.49% of DPI in Q1 2005 to 11.41% of DPI in Q1 2006. That percentage is growing rapidly because this is the year of sharp adjustable rate resets.

The Chicago Purchasing Managers' Index came out as well, showing a declining trend in employment and a rising trend in prices paid. The Fed can fight one or the other, but not both. Prices Paid are heading up toward levels not seen since the 70s:
Employment appears ready to roll over and play dead:

The Kansas City Fed reported similar trends.

Initial Unemployment Claims remain subdued for now, although insured unemployment continues to rise. Tomorrow's employment numbers could reflect this.

Finally, the Fed's H.4.1 came out today, showing a big surge in Reserve Credit ($13 billion) just in time to goose the markets for this week's auctions and the close of the month. Meanwhile, official accounts shed a couple billion in treasuries, but with the big 2 and 5 year auctions this week they probably added a bunch at today's settlement that will show up next week.

2006-08-30T19:52:00.000-07:00

The Importance of the FX Carry Trade

Trade gap dollars come back to the US economy via several routes:

Foreign central banks can acquire US assets, including treasuries, agency debt, corporate debt and equities. They can get these dollars when they intervene in the foreign currency markets with dollar purchases or when foreign exporters convert dollars to their local currencies. Either way, the foreign central banks bolster their balance sheets and keep the dollar propped up by creating demand for dollars.

Foreign corporations can also buy US assets, doing their own part in maintaining the strong dollar and keeping up demand for their products. When foreign companies build factories on American soil they also improve their competitive position relative to US companies.

Private foreign investors also buy US assets. While foreign investment in US stock markets has declined since the dot-com bubble, the acquisition of entire companies may be picking up.

The three routes mentioned above all result in wealth transfer from the US to the rest of the world, but they seem to be declining in popularity as the US becomes a poor credit risk. Over the past couple years the trade gap has grown with the dollar remaining strong due to a dangerous and unsustainable function of the financial markets.

When the Federal Reserve started raising short term rates substantially it created a new avenue for trade gap dollars to flow back into the country via the FX carry trade. Hedge funds and other currency speculators could borrow foreign currencies at low rates, purchase dollars on the open market and then invest those dollars at higher US rates.

This form of the carry trade works as long as the dollar doesn't decline rapidly against the foreign currency where debt is incurred. The more people playing this trade the better it works because surplus dollars are soaked up out of the forex markets and put into the US investment pool. The dollar stays strong and the value of US assets get a boost as well. Of course the unwinding of these trades could be rapid and devastating if things get out of hand.

An unfortunate side effect is that the tremendous amount of money being borrowed into existence is inflation and foreign central banks around the world are boosting rates to combat it. The fed has to continue raising rates relative to other central banks or the forex carry trade could be forcibly unwound. Meanwhile short term rate differential must be maintained via rising fed funds rates in order to soak up dollars via the FX carry trade. At the same time, bond yields must be kept down so that current carry traders aren't unwound by declining bond values. Finally, the dollar must also stay strong to keep carry traders above water.

With foreign official purchases reversing to sales, the treasury may now be meeting its demand for funds thanks to hedge funds employing the FX carry trade. Fund managers are collecting their management fees based on their paper profits for now, but there is no way they'll be able to get out cleanly when the system eventually breaks down. I suspect (Goldman Sachs CEO turned Treasury Sectratary) Paulson is scrambling to buy time for insiders to get out of unstable positions and secure their 2006 Christmas bonus checks before it all comes crashing down.

2006-08-23T14:56:00.000-07:00

Please take a look at today's entry in the Corrupitalism Blog.
Please spread the word if you think others might benefit from reading it.
Please comment if you have suggestions on how to improve it.

I occasionally add an item to that blog that is more political in nature and intended as a long lasting reference iterm that I can go back to and edit.

I'll probably be posting less freqently over the next week, so take a look at the Table of Contents If you missed earlier posts or don't have anything better to do.

2006-08-22T22:03:00.000-07:00

The Economics Underground

The field of economics is corrupted by large financial institutions, government agencies and trade organizations. Most economists employed in by these bodies have an institutional bias they have to promote in their writings. The government has to paint a positive picture of the economy and lend credibility to policies that favor whichever party is in power at the time. Trade organizations like the National Association of Home Builders and the National Association of Realtors want to spin economic news in a way that creates more business for their members. Wall Street economists, of course, are the worst of all, consistently urging the public to buy when their firms want to sell and to sell when their firms want to buy.

The polite explanation for the inaccuracy of economic forecasts is that economics is an inexact science, but I believe the truth is that economics is inexact by design. The Nobel Prize in Economics typically goes to an individual or team that does a very good job of rationalizing why rich people must be rich and why poor people must be poor. University economics departments tend to go along with the status quo because of a revolving door with industry and a need to help lead graduates into jobs with corrupt institutions. There are certain, unwritten rules of politeness that prevent “respectable” economists from telling things like they really are.

Economic analysis is not especially difficult, and it is not surprising that a vast number of websites have sprung up on the web attempting to give better analysis than that which is given by the economic establishment. Many individuals and organizations have created websites that call it like they see it, and this blog fits into that classification. These opinions are often branded as “gloom and doom,” “fear mongering,” “conspiracy theories” or with other derogatory terms in an attempt to discredit the views expressed, although the arguments are seldom countered in a rational manner.

Having observed and followed the “Economics Underground” (as I choose to call it) for several years, I find it to be a valuable source of information, but also susceptible to a form of groupthink that often leads to false conclusions. Indeed I started this blog because I feel the Economics Underground is totally missing the story of the Rebalancing process.

Economic Undreground sites tend to focus entirely too much on Austrian Economics, the Gold market, and manipulative actions by major financial institutions. While the Austrian school offers much to the understanding of economic conditions, we are now living in a Keynesian world, and the rules of the game have been altered. Booms and busts are still very much a part of the landscape, but credit contraction and deflation are not the dominant forces that Austrians tend to predict. Many in the underground elevate gold to a standard that is not realistic in the modern world. The actions of financial institutions are two often assumed to be manipulative or part of a larger conspiracy.

In general I think the Underground looks for clues in the right places, but does not view events in the proper degree or with an open enough mind. To the extent that members of the underground seek to gain attention with radical claims the educational goals of the underground can be undermined. To the extent that the underground fails to thoroughly debate its claims and accusations, it fails to improve its message and arrive at a better understanding of the economic landscape.

I realize that I have to guard against making the same mistakes and keep an open mind to differing viewpoints on the issues of the rebalancing process. To that end I welcome debate on the ideas I present on this blog. Failure to thoroughly understand the process could have direct financial consequences for my investing portfolio and it would do a disservice to anyone reading the blog.

Of all the sources in the economic underground, my favorite has to be the Mogambo Guru as his columns mix in a number of interesting economic facts in an entertaining format that catches the Cassandra complex we all deal with as enlightened economic observers.

Russ Winter also has an excellent blog that I check daily that is full of interesting links and statistics, even if I think he often goes overboard on his analysis. He’s run a message board on Silicon Investor for a long time and has a large following that contributes interesting links and ideas.

Mike Shedlock also runs message boards and has a good blog, that is educational, even if it doesn’t have much of value for my investing purposes and the rebalancing concept.

Those are just 3 sites that belong to hard working individual members of the Economics Underground. There are many more extensive and professionally done websites and newsletters out there. If any readers have their own favorite sites, please go ahead and share them in the comments section.

2006-08-21T20:06:00.000-07:00

How Could This Happen to Us?

America's days as a dominant economic power are numbered. The remaining days of middle-class excess are even fewer. When we go to the mall and see people with bags of goodies they don't need, and when we're stuck in traffic surrounded by gas hogging SUVs, and when we're walking through the financial district of a big, bustling city it doesn't seem like the country is on the brink of an economic meltdown. You only get that impression by looking closely at the numbers and really understanding what they mean: We are hopelessly buried under a mountain of debt so large that it will soon radically alter our standards of living.

This blog entry isn't about exactly how big that debt is. I've been charting, quantifying and explaining that for the past month and a half. This entry, as the title suggests, is about how we got into this position. Simply stated: It happened because certain people in power wanted it to happen and because other people in power didn't care or didn't understand what was happening but benefitied from it anyway.

Here's who made it happen:
Foreign governements
Multinational corporations

Here's who let it happen:
Politictians
Wealthy Americans
Clueless Voters

Friday I outlined how the mounting trade gap benefitted foreign countries by building up their wealth and infrastructure relative to the US. US-based multinational corporations have been instrumental in this process as their profits have grown tremendously as a result of outsourcing cheap labor and growing sales in developing markets. Looking at statistics for employees, capital expenditures and sales for US multinational coprorations it is easy to see how their growth has shifted away from the American marketplace.

From 2000 to 2004, US multinationals:
Reduced US employment by 10.93%.
Increased foreign employment by 1.55%.
Reduced US capital expenditures by 21.55%.
Increased foreign capital expenditures by 15.06%
Increased US sales by 2.55% (a substantial reduction in real terms).
Increased foreign sales by 30.91%.

As American business leaders sought to boost profits, it made good business sense to look abroad for growth. Along the way, they lobbied our leaders in Washington for "free trade" agreements that have undermined the competitive advantages of Amercian production and the standard of living for American workers. The US consumer temporarily benefited from the inflow of cheap goods and easy credit, but will soon be left with a massive debt hangover and reduced earning power when the bills come due.

Politicians have needed the financial support of large corporate donors to win elecions in media dominated campaigns. They've passed the laws the multinationals have written for them and they have made the profits of multinational corporations the basis for international policy. In pursuit of their own, selfish political objectives, they've let the problems grow.

Wealthy Americans have also been complicit, as they've invested in the multinational corporations and benefited from cheap foreign and immigrant labor. Wealthy Americans prosper when the masses can't bid up the prices for luxury items and travel packages. They're existing assets have been inflating as the the global economy became imbalanced, and they'll be able to pick up the assets of middle-class Americans on the cheap as the rebalancing process takes its toll, so whether or not they understand the system, they are glad to let it continue.

Clueless voters don't understand the nature of our political process and how it serves multinational corporations. They don't understand how the national debt and trade gap are undermining their future living standards. Clueless voters know that life is hard, but the change has been so gradual that they can't connect the dots. They continue to get sidetracked by the usual divisive issues lobbed at them by the two political parties and miss the big picture.

The rebalancing process does not have to be painful, but based on the actions and interests of people in positions of power, it appears certain that it will be. Perhaps a sharp economic shock is necessary to wake people up, as the voting masses and people who would otherwise care don't seem smart enough to understand where things are heading and how to reduce the suffering it can bring.

2006-08-20T09:39:00.000-07:00

Rebalancing Takes a Step Backward

The Fed caught a breather on all three of the main threats it faces from the rebalancing process:

Options expiry week is always an interesting time in the market and with the rebalancing process underway it tends to be a time for the process to step back and let the risk underwriters reduce their pain. Not surprisingly, it wasn't a good week for the short side of the rebalancing trade:
It's a common trap for investors and traders to blame manipulation by the big boys when things don't go their way. Personally, I blame myself when I don't correctly predict which way the big boys will manipulate things.

I see some interesting themes in looking at these charts of the Commitment of Traders data.

Commercials are the traders who take positions mainly for hedging purposes. As I understand it, the big broker banks tend to make up a large portion of the commercial position. If manipulation of the markets is taking place, then it could show up in the commercial position. The commercials also tend to be on the winning side of trades, because they are the ones who are big enough to influence the markets and manufacture their own good fortune. They make their bets, then make their bets successful, unless they try to push it too far.

Looking at commercial positions in various areas of the futures markets:

Currencies:
Euro = 15% bullish, choppy = Extremely Short
British Pound = 20% bullish, declining = Way Short
Swiss Franc = 65% bullish, rising = Long
Japanese Yen = 62% bullish, rising = Long
Canadian Dollar = 34% bullish, choppy = Short
Mexican Peso = 35% bullish, declining = Short

I tend to think the Euro is being held down by commercials. A lot of speculators probably bought the Euro and Pound on the recent pause by the Fed and surprise hike by the Bank of England. If the Fed starts raising rates again, it will probably boost the dollar relative to the Euro and give commericals a good exit.

Long the Yen? Perhaps betting that Japan will tighten more.

Short the Loonie and Peso? Perhaps they are related to the Euro/Pound as an dollar boosting story.

Commodities:
Crude Oil = 47% bullish, declining = Slightly Short
Natural Gas = 45% bullish, declining = Short
Gold = 24% bullish, flat = Way Short
Platinum = 16% bullish, declining = Extremely short
Silver = 24% bullish, flat = Way Short
Copper = 55% bullish, rising = Slightly Long

Speculation into Oil hitting $80 or $100 on the pipeline closure appears to be wrong in the short term. Commercials probably sold into the panic buying and will ride it out as traders give up and take losses. These are the widely traded contracts, so 47% can still be a big bet on the short side.

Bankers hate precious metals. They once were the bane of fiat currency and extreme credit expansion. Now fiat is here to stay, but bankers still hate them.

Equities:
Dow Industrials = 30% bullish, flat = Short
S&P 500 = 49% bullish, rising = Neutral
Nasdaq 100 = 55% bullish, choppy = Slightly Long
Nikkei = 43% bullish, declining = Slightly Short

Nasdaq took its lumps early in the bear market. Large caps towards the end?

Bonds:
30-Day Treasury = 51% bullish, declining = Neutral
2-Year Treasury = 54% bullish, rising = long
5-Year Treasury = 53% bullish, choppy = Slightly Long
10-Year Treasury = 45% bullish, declining = Short
Treasury Bond = 55% bullish, choppy = Long

Here's our perverted yield curve, with the 2 and 5 year strangly down with the 30 held down too:

Speculative hedge funds may be betting on a return to a more normal curve in the mid range, leaving commercials to keep buying those durations, pushing down the yields. They don't have to be fundamentally right to win. They just have to last longer than the specs.

2006-08-18T09:00:00.000-07:00

Foreign Official and International Accounts at the Fed bought up over $25 Billion in treasuries over the past month, bailing out the treasury and contributing to a sharp decline in long term yields. Nice work, Paulson!

Just as in February, they came through when the US government was most desperate for cash. Unlike in February, however, this time foreign buyers stopped buying Agencies while they were gobbling up treasuries. Except for the February and August surges Treasury demand has been weak from foreign official accounts:

Looking at a longer term view, we see Japan's big currency intervention in early 2004 leading to a surge in treasury holdings. That leveled off into a relatively steady accumulation of treasuries. Then there was a large shift out of treasuries into agencies:

Have we reached another turning point where agencies also go out of favor? I can't fault the strategy of foreign central bankers:
Step 1. Drive your currency down to decimate the American manufacturing base and boost your own productive capacity.
Step 2. Fund the US government's military misadventures to bankrupt the US and cause destruction in other developing parts of the world.
Step 3. Fund the overconsumption of the American consumer, turning them into your debt servants through mortgage backed securities.
Step 4. Use your wealth to command the lion's share of the world's natural resources in times of scarcity.

2006-08-17T08:38:00.000-07:00

Homebuilders know something is wrong with their industry. They just haven't figured out what it is yet (hint: it's the rebalancing process). Homebuilder confidence has taken the biggest and steepest dive ever, and it isn't anywhere near over yet:
They are still selling a lot of homes, just not as many as they were over the last two years, and not as many as they thought they'd be selling when they made their business plans for the coming years.:

Thanks to an endless supply of misinformation from industry economists, the public has been very slow to realize that housing is heading into another multi-year decline. Ignoring the extreme froth of the past two years, housing demand remains high on a historical scale. It still has a long way to fall from here because American homeowners aren't going to be able to afford as much home over the coming years.

Builders don't understand that the rebalancing process is slowly but surely squeezing people out of being able to afford to buy and live in typical single family homes. Foreign purchases of mortgage backed securities over the past few years provided easy credit for home buyers, but that credit is drying up and many borrowers are realizing they can't make the payments now that living expenses are rising and their ARMs are resetting. The number of existing homes for sale on the market is exploding:
Vacant units are at an all time high, with rental vacancies declining, but still historically high. Meanwhile vacant units for sale keep rising because homebuilders have been building far more homes than the country needed:

Seeing the trend in rising demand for new homes and condos, builders bought up land and made plans to keep building at an accelerating rate on into the next decade. The trend changed direction and caught them off guard. They're cancelling land option contracts, but still have far too many communities and condo towers under development. Many unsold condos will end up as rental units eventually, so the condo boom isn't all that bad a thing, but the single family residences in the outer suburbs are going to be an albatross around the builders necks. Eventually Americans will come to realize that the single family McMansion with a 1 hour commute isn't a cost effective way to live. The rest of the world already has cost effective housing. America will be forced to adopt more of it as the rebalancing process continues.

Orleans Homebuilders is arguably the worst run of all the homebuilders based on their stock performance over the past 5 years and the abysmal failure of most of their acquisitions. Orleans set a new standard for futility in Q2: They reported negative New Orders for a region.

On the conference call they mentioned that they had 99 cancelations and 51 gross sales for net sales of-48.
Another oddity: Total average selling price is higher than average selling price in any one region. That's because Florida's average selling price is the lowest of their regions and subtracted a smallish amount from total net sales. No doubt low-end buyers are feeling the squeeze hardest and first. This, along with the incentives builders are opting for rather than price cuts, is masking the fact that home prices are now declining in most areas. That trend will get much worse as a rising number of foreclosures wreaks havoc on the market.

Dominion and Levitt were the first homebuilders to report losses (in Q1 of this year). Comstock joined them in Q2. Orleans hasn't joined them yet, but they did lower guidance from $3.05ish to $1.88ish for the year ending 6/30/07, this with backlog down from 1406 to 715 year over year. That new estimate is still too high, and I'll be surprised if they don't start showing losses (along with most builders) in the March quarter of 2007.

Q2 was actually still a good quarter for the industry. Sales began falling much more rapidly in July and August, as evidenced by the builder confidence chart. As I keep repeating: This housing slump is only just beginning because the rebalancing process is only just beginning.

2006-08-16T07:39:00.000-07:00

Inflation and the Rebalancing Process

Inflation is good if you are deeply in debt. The relative size of your debts shrink, as the value of the dollar declines. The roughly $10 trillion we owe to foreigners will be very easy to pay back if we just print up the the money and ship it to our creditors on the next boat heading out of port. Unfortunately, that would be just a wee bit inflationary. As of last Wednesday there was only $795.862 billion of currency in circulation. Banks wouldn't want to increase the size of their deposits and loans more than 10-fold, and as people, companies and governments tried to spend and invest the money, the price of just about everything would shoot up by a factor of at least 10.

Nevertheless, the size of our debts has become so overwhelming that continued monetary expansion seems to be the only way to keep up with payments. Most of our main creditor nations appear to have pulled the plug on our credit lines, leaving the Fed to inject more when needed and hedge funds to borrow more money into existence to buy up new Treasury debt. Other countries helped keep inflation down in the US for a long time by building up reserves of dollar denominated assets, but they seem to be reaching a saturation point. For those reasons, we can expect inflation in the US to be high for many years to come.

Inflation in the US is the worst among 9 major economies. While the countries in that report all use slightly different methods and inflation numbers are highly politicized, I think the general impression given by the report is valid:
1. Inflation is rising globally.
2. Inflation is worse in the US.

As bad as the published numbers are, the real story is probably much worse. Our government tries to keep published numbers down to maintain confidence in the economy and keep the cost of entitlement programs under control. It does this in 4 main ways:
1. The use of hedonic adjustments to lower price increases on goods that are supposedly improving in quality. (note that I've never seen a downward hedonic adjustment for all the goods and services that have deteriorated in quality)
2. Adjusted weightings to favor goods that have slowly rising costs over goods that have rapidly rising costs.
3. Excluding the effects of supply disruptions that boost the costs of certain goods.
4. Focussing on a "core" rate that ignores the rise in cost of the things people need most to survive.

Even with all the fudging that goes on, inflation remains high in the US economy, with the CPI coming in at 4.1% over the past 12 months and a 4.5% compound annual rate over the last 3 months. Anything over 2% is considered unhealthy because it distorts economic decision making, so we still see rationalizations and excuses whenever the Fed or government officials are feeling pressured by the numbers.

It's a game that has been going on for over a year now and should continue going forward. The Treasury needs money supply expansion (and therefore inflation) to keep paying its bills without draining to much money out of the private sector. The Fed will keep talking down inflationary risks and long term interest rates and talking up the dollar to protect the primary dealers. Yet, the dollar will continue to trend down, the economy will contract, and the purchasing power of the American consumer will erode. Measuring the rate, timing and nature of those declines is a major purpose of this blog.

2006-08-15T11:01:00.000-07:00

TIC Trends

June TIC data came out today, showing more of the same themes:

Reduced purchases by official accounts and net sales of US treasuries.
Private foreign accounts picked up the slack, but I suspect those are largely hedge funds doing the buying and borrowing much of the money into existence to do so.
Corporate bonds remain a favorite of foreign investors.
They've been deserting US equities, lately.

The more interesting data is found in the Major Foreign Holders report that the media always seems to ignore. The data is important for the rebalancing process because it gives a clue as to how much money is being invested by foreigners back into treasuries and how much Americans have to print to pay the bills. The data is revised after processing a big survey every June, and current data hasn't been revised yet. The revision recalculates how much of the treasury debt that is sold into major banking centers (like the UK and Switzerland) is being held for investors from other countries. Trends in that data are interesting enough on their own.

Here are a couple of charts I conjured that includes historical MFH data:

The above chart shows that in the past couple of years much of the money bought into foreign banking centers was actually purchased for US clients. Consequently, major foreign holdings will likely be revised down substantially when the next data series begins next month.
The chart also shows that official accounts clearly began reversing course in March, about the time the dollar took a dive.

The second chart shows how Japan, China and Oil Exporting countries have been the largest financiers of the Federal Debt. Japan has been reducing holding substantially, and since they appear to have become a financial center, we'll probably see a good downward revision after this year's survey is processed.
China has seen the biggest increases in past surveys, and we'll probably see a huge jump this year based on the rapid growth of UK holdings over the past 12 months (UK holdings always get revised down the most). Oil Exporters and Caribbean banking centers typically get a big boost with the revision, so we'll get a hint about the role of Caribbean hedge funds (relative to UK based hedge funds) in financing the debt with the next revision as well.

Other data I've been watching suggests that China is letting the dollar float a little more freely and slide at a faster rate, so they may be buying even less debt now, leaving hedge funds and oil exporters to pick up the slack. It's an evolving story, and one I'll keep watching.

2006-08-14T08:25:00.000-07:00

Seeking Comments

The comments readers have offered so far are greatly appreciated. I apologize that I generally don't have time to respond directly to comments. Time will be getting even shorter in a couple of weeks, so I'd like to hear from visitors to this blog what they've found to be most interesting so far and what they'd like to see more of in the future. Links to related articles and websites are also appreciated.

Feel free to respond anonymously and to any post that you like. I get an email whenever someone responds to any post, so don't worry about me missing it.

2006-08-13T20:09:00.000-07:00

Car Makers and Car Dealers Have a Growing Problem

Retail inventories have been in a long-term downtrend as retailers have become more efficient at inventory management. That trend is shown in this chart of inventory to sales ratios from the Census Bureau:

The times when Inventory/Sales ratios are rising typically come in economic slowdowns and recessions, as seen in the 1995 and 2000-2001 periods. If those ratios are picking up now, then it provides further evidence that we are heading into an economic slowdown.

Automotive sales make up about 1/4 of total retail sales in the US. When there is a big uptick in car sales it has the effect of bringing down inventory to sales ratios for the entire retail sector. I created my own chart based on data from the Census Bureau, adding a couple of lines with a calculation of retail I/S excluding automotive sales:

It is interesting to note the way automotive inventories have run counter to the broader trend in retail. Except for a couple of notable downward spikes, automotive inventories have been building and took an especially large jump in May and June to new record highs. Short sighted decisions by auto executives have handcuffed Detroit's big car makers, leaving them on a path toward bankruptcy:
-In order to keep wages down, they've made job security guarantees that prevent them from cutting production in the face of falling demand.
-They've opted to produce mostly high margin, gas guzzling muscle cars and SUVs instead of going after first time buyers with economy models.
-They've made generous promises regarding retirement benefits that have proven impossible in the era of escalating health care costs.
-They've stuffed dealer lots full to the bursting point so that they can report those cars as sales in their quarterly earnings reports.

All this leaves Detroit in a bind where they have to keep producing more cars than they can sell profitably. Periodically they try to promote their way out of the problem. They had great success post 9/11 with a patriotic call to Americans to defeat terror by purcahising gas guzzlers with 0% financing. They also did very well by offering deals on unloved models at employee pricing last summer. While those efforts cleaned inventory out of dealer lots, they also resulted in substantial financial losses. In both cases it didn't take long for inventory levels to bounce back up to new highs after the promotions had ended.

The upswing in overall I/S of the last several months coincides with the onset of global economic rebalancing and shows that the retail sector has begun feeling the pressure of the rebalancing process. It should get much worse before it gets better, as the rebalancing process has a very long way to go.

Here's part of an old post of mine from 12/22/05 going into greater detail on the nature of GM's problems:

The two most spectacular stock meltdowns of this century have so far been Worldcom and Enron. GM has the potential to outdo both of them in terms of total damage. While vast amounts of shareholder wealth were lost as the first two frauds unraveled, GM's eventual default will likely result in far more lost wealth. Worldcom had roughly $30 billion in debt when it went under, but GM has almost 10 times that amount.

Not included in GM's official debt is over $60 billion in unrecognized benefit plan losses. My reading of the last 10-K has GM with a "fully funded" pension plan that has $38 billion in Pre-paid expenses recorded as assets offsetting $36 billion in unrecognized loses. In other words, GM is pretending to have $38 billion in pension plan assets that really don't exist because they haven't gotten around to admitting how much money the pension plan has lost. On the Other Benefits side, they've recognized $28 billion in losses so far, and eventually expect to recognize another $28 billion. The main reason why the pension plan trust is fully funded is that the law requires it. Meanwhile, the laws governing Other Employee Benefit Plans are not as strict and there is a mere $16 billion in assets in the benefits plan trust while GM calculates it would need to have $61 billion in the trust for it to be fully funded.

In both cases accounting laws allow GM to dramatically overstate earnings and book value by postponing the day when the expenses are recognized. With so few assets set aside in the benefits trust, it fell behind by an additional $4 billion in 2004, even after GM added $5 billion in assets to the plan. In my mind this constitutes somewhere around $8 billion in losses that should have been reflected on GM's earnings statements. While not recognizing those losses may have been legal under current accounting standards, the earnings as stated to the public are highly misleading. At the end of 2004, GM had only $27 billion in shareholder equity. Had those pension and benefit plan losses been recognized, GM's shareholder equity would have been less than a negative $30 billion. In the first 9 months of 2005, GM's liability for other benefits increased by $4 billion and they have reported $3.8 billion in net losses as reality began catching up with the company.

A big lesson learned from Worldcom and Enron is that a fraud can go on as long as creditors are willing to lend cash to the fraudulent enterprise. Once creditors lost faith in those two companies they had to declare bankruptcy. GM is far more dependent on the faith of creditors as its finance division has been their main source of apparent profits in recent years. GM borrows hundreds of billions of dollars and lends it out to its auto customers and to homeowners through its mortgage lending unit (Ditech). With GM's credit rating cut to junk status, the profit margin it can make in its financial unit is reduced. As GM's financial conditions continue to deteriorate, the supply of willing creditors will continue to diminish, and eventually GM will be bankrupt.

Just as GM has much flexibility in the way it chooses to recognize or postpone recognition of benefit plan losses, GM has great flexibility in the way it books earnings from the loans it makes. If it conservatively assumes that many of the loans will end up defaulting and costing the company money, then it will set aside substantial reserves and book smaller profits. If it assumes that good economic times will continue and few loans will default, then it can book much higher profits. Given the way GM has chosen to account for their pensions and the way their backs are pressed to the wall with their creditors, I'm willing to make the assumption that they are similarly overstating earnings in their finance unit through aggressive accounting. If this is so, then we can expect a large number of write-offs as deteriorating economic conditions force GMAC customers into default...

When it all shakes out in the bankruptcy courts, the bag holders will be many. As an S&P 500 and Dow Industrials component, GM is a core holding in almost every retirement plan in the country. Those plans will all face additional losses as a result of the disappearance of GM's imagined wealth. This in turn will eventually impact the bottom line for other companies pension plan operations. GM has over $400 billion in liabilities, including about $250 billion in debt. These liabilities will probably be repaid at some fraction of their stated value, meaning the corporate debt market and its many highly leveraged hedge fund participants will take a highly leveraged blow to the gut. There could be much forced selling as corporate bond positions lose value and wipe out fund equity.

Enron taught us about off-balance sheet debt, and how many risks aren't known to shareholders even if they take the time to read a company's financial statements. In the case of GM, a vast, unknown quantity of off-balance sheet liabilities exist because GM guarantees payments on many of the loans they sell and service. If and when the economy slows and defaults rise, GM has guaranteed the purchasers of hundreds of billions of dollars worth of asset backed securities that GM will make up for missed the missed payments of borrowers. Of course an insolvent GM won't be able to make good on those promises and much imagined wealth will evaporate.

Perhaps the full scope of the situation and the lack of any viable solution has led GM executives, Wall Street, and Washington to turn a blind eye to GM's problem. Perhaps individual greed and systemic neglect has led many to profit off the situation, rather than attempting to fix it. GM's implosion has of course been building in degree for many years, but nobody was willing to take leadership in dealing with it. As a result of avoiding the problem when it could be officially dealt with in good times and a strong economy, GM's crisis must now come unraveling just as the government is facing its own growing debt crisis and as the pension problems in both the public and private sector are coming to a head. Worldcom and Enron finally imploded when (and likely because) the economy was in recession. The fact that GM appears to be imploding when official government numbers are showing solid economic growth is both an indication of the massive underlying problems at GM, and the massive underlying problems within our economy as well.

2006-08-12T09:17:00.000-07:00

The Financial Markets and Global Economic Rebalancing

The Rebalancing Trade has had a pretty amazing run of late. Here's the recent performance of a leveraged, mostly-short account that makes up part of my rebalancing hedge strategy:
That account is balanced against another account that is mostly long and unleveraged. Combined, the accounts constitute the rebalancing trade, which has been working since November, about the time I estimate the global economic rebalancing proces reached an important turning point:
Some important disclaimers:
1. There has been a lot of luck involved, as well as a lot of time spent researching individual stocks, some active contrarian trading and a little bit of sector rotation. These results are a very crude gage of the overall rebalancing strategy.
2. Usually when I have a run of good fortune like this, it is quickly followed by a period of getting knocked on my behind by the markets. With that in mind, I reduce the overall risk and leverage in the accounts when they are having a good run. If anything, recent success should be viewed as a predictor of imminent failure in the markets.
3. The size of the accounts is relatively insignificant. I'm not rich, and I'm sure I'd be doing much worse if I had to manage millions of dollars over the long term. If I was managing a large amount of money, I wouldn't be sharing my thoughts on the markets for that matter.
4. I don't encourage anyone to try and duplicate my trading strategies. The stock market has a way of making sure the masses lose out. The more people trying to play the rebalancing trade, the more likely it is to fail.

That said, I believe that my recent good fortune adds evidence to the idea that the rebalancing process is well underway. I think that the markets have been demonstrating this strongly over the past 3 or 4 months and the charts above provide evidence for the main ideas of this blog.

In the 8+ years I've been trading stocks, there have been periods of time when I believe the markets have been moving away from what I consider to be reasonable valuations and periods of time when I think the markets have been moving toward reasonable valuations. That holds true for the market as a whole, as well as for individual sectors. As the rebalancing process still has a long way to go, I think it likely that the rebalancing trade will continue to work on some level.

2006-08-11T11:30:00.000-07:00

Who's Buying Treasuries These Days?

The treasury has been issuing a large amount of new debt recently as July and August are slow months for tax revenues. Total debt went from $8.420 trillion on 7/28/06 to $8.460 trillion on 8/10/06, with another big chunk being funded on 8/15. With Japan and Korea reducing their treasury holdings in recent months, it appeared that the Treasury would have a difficult time and rates were likely to rise. Finding buyers for the upcoming auctions was probably on somebody's agenda for the G-8 meeting in Russia July 15-17.

The auctions have gone surprisingly well, even though President Bush failed to make new friends in Moscow. Indirect bidders have taken a good percentage of the debt, and foreign official and international accounts have surged in the past 3 weeks. So the question that comes to mind is: Has the foreign investment part of the rebalancing equation been put on hold?

To try and answer that, I want to know who is doing the buying. The Major foreign Holders report for July won't be out until mid-September, so I look for clues in foreign currency fluctuations:

Of the main currencies I track, only the Won is up since the G8 meeting. Perhaps the South Korean central bank decided to boost treasury holdings. The Korean national pension fund recently said they be buying fewer US treasuries and more agency debt in the future. Interestingly, agency holdings declined by the most since the last week in March of 2003.

China added $15.3 billion in treauries through the first five months of 2006. The Chinese currency began it's sharpest rise against the dollar at the end of May (see chart below), so it may be that they've already joined Japan and South Korea in shunning US treasuries.

The other main candidates would be whoever has been snapping up treasuries in the UK and Oil Exporters. The UK gobbled up $28.7 billion in treasuries through May (probably hedge funds), and oil exporters increased treasury holdings by $24.6 billion during the first 5 months of the year, while Japan was reducing holdings by $31.1 billion. No doubt oil exporting countries are rolling in surplus dollars these days. The Saudis may have gotten a friendly phone call from the new bond salesman from Goldman Sachs. The Hedge Fund angle remains just a theory because hedge funds don't typically disclose their holdings or who's giving them money. To me it seems most likely that puppet governments in the Middle East and puppet hedge funds in the Channel Islands have been doing the buying ever since the legitimate buyers got wise and began an orderly exit from the market. Both of those groups may have custodial accounts at the Fed. I remain skeptical other foreign holders have decided to reverse course in the last 3 weeks. We'll know more in a couple of months.I don't think Korea, China or Japan have been big buyers, which leaves two main candidates:

2006-08-10T08:57:00.000-07:00

June Trade Gap Numbers

Trade gap figures for June came out today at $64,804,000,000.00.
May was revised up from $63.835 billion to $64,974,000,000,00.

Some things that jumped out at me from the report:
1. The trade surplus in services declined for the second month in a row, including a significant downward revision in May's number.

Reaching this point was likely, given how America has sold off so much intellectual property and how the rest of the world has caught up enough in terms of education, training and expertise. If the dollar can fall substantially, then the service surplus may start rising again. The powers that be don't seem willing to let that happen, so we'll be forced to sell off a more of our economic advantages and assets.

2. The petroleum trade deficit has risen to 35% of the total goods deficit, up from 28% a year ago.

This should get even worse with BP taking 400,000 barrels of Alaskan production off line. It could add about $1 billion to the trade gap each of the next couple months, depending on oil prices and whether or not we tap into the strategic reserve. When BP was allowed to purchase ARCO a few years back, it was another example of the US selling off important economic interests to fund the trade gap. Foreign acquisitions of US companies and assets have continued at an accelerating rate, and we can't expect foreign companies to run their US subsidiaries in the best interests of the US economy.

Brazil has achieved energy self-sufficiency with it's ethanol program. We could do the same and be world leaders in the field of alternative energy sources... just not with this president.

3. The trade deficit for non-petroleum goods has been trending down all year and is down year-over-year.

This is where the squeezing of the American consumer is showing up. Rising energy prices and debt service aren't leaving much money left for discretionary spending.

The following chart shows recent trends from the Trade Gap report:

2006-08-09T15:25:00.000-07:00

The Sub-Prime Time Bomb Detonated Today

Take a look at today's performance for publicly traded sub-prime lenders:

LEND -17.24% (lowered earnings guidance by about $3 per share)
IMH -11.31% (somebody goofed and filed the 10-Q an hour early)
AIC -10.85% (being acquired by LEND)
NEW -6.22%
NFI -3.82%
DFC -2.03%
ECR -2.44%
SAX +26.16% (being acquired by Morgan Stanley, just in time to save somebody's behind, as earnings stunk as badly as the rest of them)

These upstart lenders fueled the housing bubble by loaning far-more-money-than-they-could-ever-pay-back to people-who-never-should-have-been-buying-homes. It was only a matter of time before defaults got rolling to the point that the sub-prime lenders took a big hit on earnings. Of course it will get much worse from here. The rebalancing process is only just beginning.

From listening to the Accredited Home Lenders conference call it seems clear that LEND and other sub-prme lenders iare getting squeezed on multiple fronts:

1. Competitors from Alt-A have gone from 680+ down to 620 FICO, muscling in on LEND's sweet spot.
2. The secondary market for High LTV, Stated income, and low FICO has dried up. Investors don't want the garbage anymore.
3. In 2005 they relaxed standards and are now seeing more defaults. They've decided to tighten up some.
4. Sales people quit at LEND because they were pushing quality and margins. Salespeople are getting big bonuses at small upstart companies. The execs wouldn't answer the question as to whether the upstarts are private equity funded.

LEND is being forced to repurchase bad loans they had previously sold to investors. If a loan defaults in the first year or so, the investor can make them buy it back. This is also true for loans where there's obvious fraud. It seems that the investors are quick to find reasons to send problem loans back to LEND. These don't show up on losses, but instead get resold at a discount and cut into margins of new sales. LEND thinks this trend will wind down by the end of the year. I think its just beginning.

From LEND today: "Delinquent loans (30 or more days past due, including foreclosures and real estate owned) were 3.76% of the serviced portfolio at June 30, 2006, compared to 2.47% at December 31, 2005 and 1.79% at June 30, 2005."

From AIC today:
"Percentage of delinquent loans serviced (period end)"
June 2006: 8.2%
December 2005 5.4%

From SAX today:

($ in thousands)        June 30, 2006  March 31, 2006   June 30, 2005
                       --------------- --------------- ---------------
                       Principal       Principal       Principal
                        balance      %  balance      %  balance      %
                       --------- ----- --------- ----- --------- -----
30-59 days past due    $370,309  5.53% $273,044  4.20% $307,766  5.04%
60-89 days past due    $ 92,635  1.38% $ 82,061  1.26% $ 83,148  1.36%
90 days or more past
 due                   $ 72,494  1.08% $ 58,311  0.90% $ 46,542  0.76%
Bankruptcies (1)       $121,559  1.81% $128,280  1.97% $126,391  2.07%
Foreclosures           $127,185  1.90% $118,140  1.82% $105,782  1.73%
Real estate owned (2)  $ 53,234  0.79% $ 50,039  0.77% $ 41,972  0.69%
Seriously delinquent %
 (3)                   $435,268  6.50% $397,474  6.12% $367,013  6.01%

From IMH today:
"60+ day delinquency of mortgages owned"
June 30, 2006 = 4.16%
December 31, 2005 = 3.12%
June 30, 2005 = 2.01%

The tide has turned for the American consumer, and sub-prime borrowers are feeling it the worst.

Here's something I posted about the Sub-prime lenders on my board on the Motley Fool back on 12/26/05:

Sub-Prime Time Bomb

Quick Summary: 2006 and 2007 will be bad years for Sub-Prime lenders because of rising delinquencies, reduced originations and tightening profit margins.

The housing market and interest rate environment has been good to lenders over the past decade. From 1993 to 2003 interest rates trended down, while home prices trended up. Charge-off and delinquency rates on real estate loans were low, and even during the 2001-2002 recession, they stayed much lower than the 1991-1992 recession.

The peak delinquency rate on residential loans was 3.36% in 2nd half of 1991, and the low point was 1.42% in Q1 2005.
The peak charge-off rate on residential loans was 0.27% in 2nd half of 1992, and the low point so far has been 0.07% in Q4 2004.
http://www.federalreserve.gov/releases/chargeoff/default.htm

Will we cycle back up to high charge-off rates?
-No if you believe that the economy is sustainable and doing fine. However, my answer is:
-Yes, if we have an economic slowdown with falling home prices, or
-Not yet, if we have inflation continually driving up home prices and allowing more cash-out refinancing.
Lately the trend has been toward rising rates and falling profit margins on existing fixed rate loans. We are also seeing more defaults on ARMs and the carry trade would suffer on fixed rate mortgages.
We would probably need to see a big uptick in delinquencies before charge-offs increased substantially, and that may be on tap for 2006.
When hurricane losses finally get recognized (postponed to December, then February) we may see the delinquencies and charge-off rates move noticeably.
There may also be some increased action as the result of the bankruptcy surge in Q4 2005 and the reduced ability for bankruptcy filers to keep their homes under the new law.

From the latest Accredited Home Lenders (LEND) 10-K:
"We focus on borrowers who may not meet conforming underwriting guidelines because of higher loan-to-value ratios, the nature or absence of income documentation, limited credit histories, high levels of consumer debt, or past credit difficulties."

This period has been especially good to sub-prime lenders who've done well by taking on higher levels of risk. Their markets have been expanding as homeownership rates rose from a cycle low 63.7% in Q1 1993 to 69.1% in Q1 2005. Sub-prime lenders are generally the ones operating on the margin as the change in the percentage of people who can afford 20% down payments is likely low over time. Indeed, affordability is at an all time low in most regions, so sub-prime lending makes home ownership possible for a large segment of today's market. The growth of the sub-prime market has been extreme because of both the refinancing boom and the housing boom:

New Century Financial grew from $606 Million in revenues in 2002 to $975 million, to $1.7 Billion in 2004.
Accredited Home Lenders grew from $201 Million in revenues in 2002 to $435 million, to $661 Million in 2004.

Have we seen a peak in loan demand?
Interest rates were higher in 2005, cutting into refinancings, but property values and new home sales rose (until prices edged down late in the year).
Homeownership rates reached record highs in 2004 and appear to be sliding back down.
New home sales surged to new highs, but housing vacancies are also at record highs, so housing sales and prices probably won't rise and may soon fall.
To me the trends appear to be pointing toward a significant decline in demand for mortgage originations going forward. Sub-prime lenders would be affected most because they are the ones operating on the margin.

From the last 10-K for LEND:
50.3% of 2003's loans were 3-year ARMs, 16.2% were 2-year.
20.3% of 2004's loans were 3-year ARMS, 46.9% were 2-year.

Demographically speaking, there is a very large wave of ARMs resetting in 2006 and causing a big payment shock. That wave is not likely to be as big at other lenders as it is at Accredited because of their particular focus on 2s and 3s. I expect a significant rise in delinquencies of 90 days or more during 2006 as a result of this ticking time bomb. Delinquencies are a blow to the cash position as the lender has to keep paying interest on financing and make up the shortfall on securitized financing deals.

Interest-only loans can be ARMS or fixed rate at Accredited and usually become principal paying 25 year loans after 5 years.
0.5% of 2003's loans were interest-only, 14.2% were interest-only in 2004, and a much higher share have likely been interest-only in 2005.
This could make for another wave of payment shock and rising delinquencies in 2009/2010.

From the latest LEND 10-Q:
"the occurrence of a natural disaster that is not covered by standard homeowners' insurance policies, such as an earthquake, hurricane or wildfire, could decrease the value of mortgaged properties. This, in turn, would increase the risk of delinquency, default or foreclosure on mortgage loans in our portfolio and restrict our ability to originate, sell, or securitize mortgage loans, which would significantly harm our business, financial condition and liquidity. While we have not completed our assessment of potential losses stemming from the recent hurricanes in the southeastern United States, we do not expect the resulting losses to have a material adverse impact on our business, financial condition, liquidity or results of operations.

That's a little hard to believe given the high number of homes that were destroyed without adequate insurance in the Gulf Coast area this year. Delinquencies may not show up until the June quarter because most lenders and the GSEs keep extending grace periods, but losses on many loans will eventually be much larger than for typical foreclosures where homes were completely destroyed.

Accredited's ability to lend comes from five main sources:
1. Warehouse Lending Facility, with $4 billion in short term loans, mostly from big investment bankers (Goldman Sachs, Morgan Stanley, Merrill Lynch, Credit Suisse, & Lehman).
2. Commercial Paper. $1 Billion in ultra-short term financing.
3. Securitized Financing. They sell securities using loans held for investment as collateral for financing new loans. 1 to 6 year terms on the securities.
4. Whole Loan Sales. Accredited sells most of their loans, pocketing quick profits on originations and funding new loan originations.
5. Preferred REIT Shares. $100 Million paying 9.75%.

LEND has kept their financing terms short to boost profit margins, but this adds greatly to the risk factor. They can hedge the risk of rising rates on fixed rate mortgages, but they can't hedge the risk of rising defaults and real estate losses. If Wall St. watches closely, the big investment banks can cut off financing or demand high rates of return to compensate for rising risk. When and if Wall Street pulls the plug, LEND will be bankrupt in short order.
-Warehouse loans are mostly 1 year deals. Underwriters can choose not to renew or jack up the interest rates based on percieved risk of the underlying securities.
-Commercial Paper is similarly susceptible to perceived risk.
-Securitized Financing fuels the Ponzi scheme, where they overestimate their profits and leverage up based on imagined wealth. If loans underperform, then LEND eats the losses. If delinquencies and losses rise, then the leveraged nature of these bets unwinds their equity fast, and they also have to pay higher yields to holders of existing securities to compensate for the added risk.
-Whole Loan Sales are at market rates. The amount of loans held for sale and delinquencies within that pool are rising. Profit margin was down from 1.86% in first 9 months of 2004 on $5.8 Billion in loan sales to 1.41% in 2005 on $7.9 Billion. They can sell loans at a loss if they need to raise cash, but not if it wipes out too much equity.
-The Prefered REIT Shares give an indication of what LEND would have to pay to borrow money at longer term rates, and it is more than they charge borrowers on most loans. No wonder they need to pursue so much short term financing.

The Sub-Prime risk game is making big profits for company executives, Wall Street banks and major homebuilders. Salaries, bonuses and banking fees are pocketed now.
If defaults rise, then first in line to take losses will be the shareholders.
After the lender's equity is wiped out and they are forced into bankruptcy, then creditors take losses on underperforming loans.
A sudden collapse takes out the Warehouse lenders, while a slow death lets them cancel facilities and force LEND to sell more mortgages.
A continuing rise in the cost of short term borrowing means bigger profits for Wall St., eroding profits for the mortgage bankers and great pain for anyone saddled with an ARM.

Therefore, I think the most lilkely scenario going forward is:
Continually rising short term rates from the Fed, leading to...
Mounting delinquencies from sub-prime borrowers, leading to...
Widening spreads and increased borrowing costs for sub-prime lenders, leading to...
The gradual collapse of sub-prime lenders, leading to...
The cancelation of warehouse facilities (protecting Wall St.), leading to...
Credit contraction in the greater economy, leading to...
The bankruptcy of the sub-prime lenders (bag holders), and
Poor returns for asset backed securities (bag holders), eventually leading to...
Market crash, leading to...
Wall St. using up cash and picking up assets on the cheap, leading to...
Ultra-low rates and steep inflation.

2006-08-08T15:14:00.000-07:00

Fed Marks a Turning Point

The statement came out with the usual BS, blaming the slowing economy on a cooling housing market and rising energy prices while giving themselves credit for past rate hikes:

"Economic growth has moderated from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices."

They try to make the case that they've done enough tightening already to tame inflation going forward, even though inflation is clearly accelerating:

"inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative effects of monetary policy actions and other factors restraining aggregate demand."

While it's customary for the Fed to give reasons for their actions, those reasons don't amount to much. They could have looked at the same data and hiked rates or cut rates and come up with a rationale after the fact. As is usually the case, the Fed took their marching orders from Wall Street and did what was best for bankers.

The fed futures called for keeping the Fed Funds rate at 5.25%, so the Fed obliged today.

The primary dealers chimed in this morning as well, with a stingy set of bids on the Temporary Operation.
So the "pause" appears to have been a done deal, but the real question is one of why Wall Street wanted the Fed to stop hiking.

The dollar had been slipping a little, but not falling outright, with custodial accounts building back up a little over the last two weeks. So there wasn't much urgency for higher rates on the Forex front.

Treasury yields had been dropping and stocks had been stable, so there wasn't any urgency for an actual rate cut.

The upstart mortgage bankers have been clamoring for an end to the hikes for a long time, and are reporting a spike in delinquencies this quarter, but the Fed hasn't really cared about that so far, so I don't think they really cared about that this time.

Wall street's bread and butter has been the trading activity generated by hedge funds, and they had another bad month. Fear of more failures could have been the straw that led bankers to halt the rise in hedge fund borrowing costs.

While this is being billed as a "pause," I think it more likely that this is marking another key turning point in the rebalancing process. Heavy inflation will probably stay with us, as that is a way the country can shortchange foreign investors and preserve more wealth for Americans. The economy and financial markets, however, are likely rolling over slowly like a massive oil tanker. Once the process starts, it probably can't be stopped.

It may or may not be the end of rate hikes, as the status of the dollar is a key factor there. It probably is the end of the current economic expansion, for better or worse.

2006-08-07T16:18:00.000-07:00

Consumer Credit Takes a Familiar Twist

Consumer debt keeps piling up as the average American continues to spend more than he earns:
(Upspike was due to the big Microsoft dividend. Downspike was due to lost Katrina rent.)

Living beyond your means is easy when you measure your net worth by the inflated market value of your home. Throughout much of the past 5 years, homeowners have been consolidating their credit card debts into new home equity loans. Now that real estate prices are hitting the wall, home equity extraction is becoming impossible for many. Changing habits is a slow process, so for now, consumers are back to running up the credit card debt.

Revolving debt is spiking again, as it did leading to the economic slowdowns of 1990, 1995 and 2001. Consumers are getting squeezed and it is showing on their credit card statements. This will create a greater squeeze in the near future, and rising defaults will eventually bring revolving debt down again.

Meanwhile, consumers are starting to cut back on the big ticket items that usually get financed with non-revolving debt. (Nonrevolving debt includes automobile loans and all other loans not included in revolving credit, such as loans for mobile homes, education, boats, trailers, or vacations.)

Consumer Credit cycles are shown in the following (3-in-1) chart:

Pools of securitized, revolving, consumer credit continue to decline, while securitizations of non-revolving debt picked back up in 2005, mirroring a shift from unbacked US treasuries to asset backed Agency debt. Savvy foreign investors will want to claim some hard assets when the defaults hit. Even if they end up being worth a fraction of the original debts. Something is better than nothing, in return for financing the great transfer of wealth and production capacity out of the US.

Credit is not tightening yet because commercial banks are doing most of the financing now for revolving debt. The banking sector is already so extremely exposed to the great pyramid of debt, that it might as well front some more cash to hopelessly indebted consumers and book profits at 20% interest rates for just a little while longer. If you're an executive at a major bank, the long term risk is the shareholders' and the greater economy's and not yours. Since a big share of the profits goes into this year's bonus check you'd better take it while you can get it.

The same themes continue in consumer credit as in almost every other part of the financial sector:
Foreign investors skate off cleanly from high-risk, unsecured debt into asset backed debt.
American banks take on more risk to keep things afloat just a little longer.
US consumers leverage themselves deeper to put off default and bankruptcy.

It's as if the people in charge of the government and financial sector want the blow up to be as big and painful as possible in the good ole' USA.

2006-08-06T06:51:00.000-07:00

Housing Vacancies

Americans aren't just over-consuming electronic toys and gadgets. They're also over-consuming housing. Thanks to foreign investment in Mortgage Backed Securities, there has been plenty of easy credit for people wanting to purchase more home than they can afford, and plenty of easy financing for builders who want to boost construction. The average size of new homes has increased substantially in recent years, and the number of vacant homes on the market has been climbing rapidly.

In the introductory post of this blog, I provided a chart showing how the trade gap, economic growth and the dollar were all related. In 1987 the trade gap was reaching a short term peak, with the economy overstimulated and the dollar poised for a sharp decline. Housing vacancies were also peaking at that time, and those same conditions are setting us up for an even bigger economic decline going forward.

Rental Vacancies peaked at 8.1% in Q3 1987.
Homeowner Vacancies peaked at 1.9% in Q3 1989.

There was a huge stock market crash in 1987 but the economy didn't slow dramatically until the 1990 to 1992 period when the housing market slowed nationally. There is a wealth effect that goes with stock market bubbles but housing bubbles involve far more real jobs and much more credit expansion. When housing bubbles burst, they have a bigger impact on the greater economy and a slowing economy further suppresses housing prices.

Fast forward to the present situation.
Rental Vacancies peaked at 10.4% in Q1 2004.
Homeowner Vacancies set a record high of 2.2% in Q2 2006.
There are many reasons to fear an even greater economic slowdown starting in 2006 based on a more dramatic rise in home prices and extreme private and national debt levels.

(Vacancy data can be found here.)

Looking just at the vacant homes that people are now trying to sell or rent, it becomes clear that too many homes have been built in recent years:

Housing price appreciation led to speculation, which led to increased construction. Prices have begun leveling off and now mortgage rates are putting the squeeze on homeowners who took on too much debt. 2006 is a big year for adjustable rate mortgages to reset, including 3-year ARMs that were popular in 2003, 2-year ARMs that were popular in 2004, and teaser rate mortgages that were popular in 2005. Delinquencies, defaults and foreclosures are on the rise throughout the country, and the number of homes on the market is spiking:

Supply and demand issues will lead to a substantial real decline in the value of housing. Distressed borrowers continue to add to supply (and I count both homeowners and homebuilders in the distressed borrower category) and a decline in the excitement around housing continues to cause a decline in demand. The housing market will get much worse before it gets better.

This is all an unfortunate and painful part of the rebalancing process. Over-consumption of housing went along with the rise of the trade gap as the result of easy credit for Americans. People foolishly saw purchasing a large home (with little down) as an investment, In truth, buying more home than you need is both speculation and consumption. The wealth effect of rising home prices over the past 10 years has helped fuel excess consumption. As housing prices decline, US consumption of imports should also decline because homeowners won't have access to the lines of credit that rising equity provided.

Homebuilders have too much land on their books, and rather than eating their losses, many are still trying to rush new homes onto the market and hoping buyers will materialize. The number of Spec. homes being built is rising rapidly, as new home sales are off about 25% from their highs, but housing starts are only off about 10%. Until we see starts dropping down below a 1.5 million annual pace, the vacancy problem will continue to grow.

Eventually, however, builders will slow construction to the point that demand can catch up with supply. This will have a chilling effect on the economy, as it did in the 1990 to 1992 period. That's just one small example of how the mounting global imbalances of the past 30 years are going to take a toll on the American economy. Many more will be detailed on this blog over time.

2006-08-05T08:53:00.000-07:00

Anatomy of a Housing Bubble

MDC Holdings breaks down their data better than any of the other homebuilders and it tells a story of how the builders got themselves in trouble and how bad things will be in the housing sector going forward. This first chart shows year over year percentage changes for a number of important items:

In 2003, the housing market was booming, thanks to record low interest rates and easy lending practices. MDC was making big profit margins on every piece of land they developed. With rapid appreciation in force, the more they bought and the longer they held land, the larger their profits were. Also, the more they grew the easier it was for executives to justify higher salaries and bonuses. They got caught up in the euphoria and from Q4 2003 to Q3 2004, MDC went on a land buying binge that almost doubled lots under control. What makes sense for executives often runs counter to what makes sense for long term investors and the health of the economy.

The surge in land acquired in 2004 led to a surge in new communities opened in 2005, but new sales and closings grew at a more modest rate during 2004 and 2005 and sales per community actually declined as too many developments came on the market nationally. The quantity of developments increased sales numbers nationally, but an inventory problem was clearly brewing:

After a final surge in Q3 2005, MDC's sales hit a wall in the latter part of Q4 2005 and have tumbled into 2006:

The number of unsold new homes has continued to rise through 2006, as national homebuilders act on plans made when sales were stronger. Regionally, the slowdown hit first in the big bubble areas of California and Nevada had big initial declines, but bounced in late 2005, only to tumble again in 2006. Arizona has been in a steady decline since Q2 2005, Virginia's decline started the next quarter and pretty much everything fell off the cliff starting in Q4 2005. (Texas is an aberration because MDC is exiting the region as quickly as they can, and Utah is still living in fantasyland for now.)

Because builders have far too many communities under development and land on their books things will continue to get worse. MDC has actually been very conservative compared to most other builders when it comes to land acquisitions. Q3 2006 will provide an especially harsh comparison because of the surge in Q3 2005.

Referring back to the original chart:

MDC began canceling land options and stopped acquiring new land. They've also held off on opening up some new communities to keep costs down. MDC is responding more quickly than most of their peers, but their years supply of land based on sales has taken off because of falling sales. The average national builder went from having about 3 years worth of land under development at normal rates of sales to having 5 or 6 years at extreme rates of sales in a massive land grab (MDC went from about 2 to about 3). As sales decline, that turns into 10 years of supply or more. Pursuing rapid growth strategies was great for short term stock appreciation, but once the bubble started bursting the long term risks were exposed. Builders with too much land and debt on their books won't be able to exit without taking huge losses or will get buried under the weight of their debt burden.

Profits are still high at homebuilders because closings lag new orders and backlog. They also capitalize much of their interest expense, so on their books land is still appreciating even if the market value of the land is tumbling. Q3 and Q4 are usually the biggest quarters for closings, but will be down sharply year over year this time for most builders. Two small builders (Dominion and Levitt) reported losses of the first half of 2006. Beginning in Q1 of 2007, I expect almost all builders to report losses. Dominion may be bankrupt by then, and I expect a string of bankruptcies to follow until finally the supply of housing is back in line with demand.

That could take many years because builders are have been flooding the markets with spec houses and condo towers just as the economy begins slowing. Housing booms and busts typically last about 5 years each. This boom, however, lasted about 10 years and was much larger than any past boom. The resulting bust should be about the same size proportionally:

2006-08-04T10:02:00.000-07:00

The economy shed 1,266,000 jobs in July, which normally is a big month for layoffs. Seasonally adjusted the economy supposedly gained 133,000 jobs, but seasonal adjustments don't make mortgage payments. Here's a chart showing unadjusted jobs numbers:

Things to note:
Jobs normally grow slower from July to January.
Jobs started going downhill in 2001, and didn't rebound until 2004.
2004 numbers started using the Birth/Death adjustment to boost totals.

Certain sectors are likely to contract as a result of the rebalancing process, like retail, consumer credit and construction. Areas which saw seasonally adjusted job declines in July include:
Residential specialty trade contractors: -9,300
Motor vehicle and parts dealers: -2,600
General merchandise stores: -8,200
Real estate and rental leasing: -2,900

While many realtors still have jobs, few are making a good living these days. I'm afraid the jobs slowdown is only just beginning, and people without jobs generally can't make their mortgage payments or buy luxury items. Defaults were already rising based on interest rate resets, but jobs losses traditionally have a much larger impact.

Here's a chart of M1 money supply, which roughly measures the money that people intend to spend soon:

The portion of money in people's pockets (and checking accounts) has begun contracting. Normally this money grows steadily with inflation and population. The inflation adjusted number gives a crude estimate (-0.5% adjustment per month) of what is really happening to the accounts of the average American. People are getting squeezed and this will ripple through the entire economy over time.

2006-08-03T15:16:00.000-07:00

The Middle-Class Squeeze
Many middle-class Americans have been facing tighter budgets as food, energy and housing costs have been rising faster than their income. Democratic strategists are catching on to this and using it as a campaign theme, but they aren't explaining the root cause of the squeeze, which is the rebalancing process. Voters don't want to be told the part about how they have been consuming too much and saving too little. They'd rather hear the part about how Republican policy makers have been squeezing the living standards of the middle-class in order to boost the living standards of the rich. While the second part is valid, it doesn't diminish the importance of the first part.

Over Consumption
On average, Americans consume far more resources than the rest of the world. As a nation we most likely got in the over-consumption habit by having a great deal of productive land at our disposal with a relatively small population. Later, our economic and military dominance enabled us to exploit the resources of many developing nations. Recently, American over-consumption has come as a result of our taking on massive amounts of debt and selling off productive assets to foreigners at a rate of over $1 Trillion every two years. With consumption on the rise in developing nations, and America's financial and military influence on the decline, the level of consumption in the United States is likely to decline substantially in coming years.

Forced Reduction of Consumption
If Americans could become savers again, the rebalancing process could proceed without a forced reduction in consumption. Culturally and psychologically, that isn't going to happen. People aren't likely to voluntarily reduce consumption just because it is an economic inevitability. Most people will be forced to reduce consumption as a result of a decline in purchasing power in a changing economic landscape. Two of the main ways that this is likely to occur have already begun having an impact on American consumers. The rising cost of essential goods, like food, energy and housing, cuts into the quantity and quality of goods people can consume and greatly reduces their ability to buy non-essential items. Rising interest rates place a further burden on discretionary spending by increasing monthly expenditures for Adjustable Rate Mortgages and consumer debt service. Two additional factors that will lead to an even sharper decline in consumption have not yet begun and are currently prolonging the period of over-consumption. Easy access to credit from private banking institutions and record federal deficit spending have helped many Americans temporarily keep up high levels of consumption at the expense of their wealth and financial security. Viewed independently, all four of these areas might appear to to be short term, unrelated factors, but viewed in the context of a necessary decline in American consumption it becomes apparent both how closely they are all related, and why their convergence means we've reached an inevitable turning point that has marked the beginning of a long period of declining standards of living.

Who Gets Hit the Hardest?
Demographically speaking, the American middle class is responsible for the largest portion of discretionary spending and should therefore face the greatest decline in living standards. There are many poor, but their ability to decrease consumption without dying is less. The wealthy consume a great deal more, but their numbers are few and raising taxes isn't likely to slow their consumption much. Dividing the economic pie is a political game and there is little doubt that wealthy Republican supporters have been spared much of the pain as there people have been in control in Washington. Asset prices have soared while corporate profits and executive salaries have grown rapidly in the first part of this century. Meanwhile, working class and poor Americans have been taking on a disproportionate share of the pain as rising expenditures for heating, transportation, housing and debt service have cutting into already tight budgets. Going forward, there is likely to be much more pain to share (especially from rising energy costs) and political change is possible if there is enough outrage over declining living standards for middle and working class families. Whether or not the political focus shifts to providing a better safety net for the poor while raising taxes on the wealthy, the continuing Middle Class Squeeze will be necessary to reduce American consumption to ecologically and financially sustainable levels.

The following chart was provided today by New Century Financial, America's second largest sub-prime lender:

It shows delinquencies of 60 days or more for ARM and fixed rate mortgages originated in 2003. They boast about their delinquencies being lower than the industry averages, but the sharp rise up to 15% indicates conditions are rough for a rapidly growing segment of the population, and the ARM reset cycle is only just beginning. The pressure of the middle-class squeeze is causing one borrower after another to financially implode.

2006-08-02T07:31:00.000-07:00

The Rebalancing Trade

For over a year, I've been structuring my portfolio around what I think of as "the rebalancing trade." Most hedging strategies involve some type of trade where the goal is to profit on differences between two types of asset classes. In merger arbitrage, one company will be shorted and another held long as a way to bet on whether or not a merger will go through. In the carry trade, short term bonds are shorted (or money borrowed at short term rates) while long term bonds are purchased as a bet that interest rates will stay constant or go down. In the rebalancing trade, I short US companies that depend on excessive US consumption and go long on foreign companies that are likely to profit from increased consumption overseas, especially in China. My bet is that US consumption must decline relative to international (and especially Chinese) consumption.

With most hedging strategies, there is very strong correlation between the components of the trade. While one might expect a high correlation between foreign and domestic consumer cyclicals, I've found that the correlation hasn't been very strong and that there have been days and periods where the trade has either worked very well or very poorly. I suspect there is a large amount of hedge fund activity in the rebalancing trade in one form or another, and that many funds play somewhat related trades, hedging inflation (foreign currencies, gold and other commodities) against US stocks. Many hedge fund managers do understand the inevitability of global rebalancing, even if the mainstream economic news totally misses the issue. I suspect the activity of momentum oriented and leveraged players in the trade are largely responsible for the low correlation between certain classes of foreign and domestic stocks in recent months.

Recently the rebalancing trade has been working very well. Builders have been trending down for about 9 months, but mortgage lenders and retail joined the fall the last couple of months. On the other side, China has been outperforming most other global equities markets.

The gold bug websites tend to focus on total market liquidity, usually ranting against the excessive use of liquidity. I don't worry about that as much, but I see the world's central banks trying to make the global rebalancing process go as slowly and painlessly as possible. The air is being taken out of the US economy slowly now, which is why the rebalancing trade has begun to work well. I see the rebalancing trade working successfully for a long time, with traders piling in out in front of the central banks, forcing them along a little faster than they'd like to go.

I do not encourage others to try the rebalancing trade for themselves. For one thing, I believe the markets are rigged to take advantage of people's natural tendencies. If you can't trade objectively and cautiously, you'll likely get taken to the cleaners. For another, when too many people are shorting stocks they can be manipulated to take advantage of those shorts. I'd rather not invite manipulation in the stocks I trade or have to compete with others in searching for shares to borrow and short.

I think that most people should try to stay out of the market entirely. It is much better to pay down your debt than to carry a large mortgage along with exposure to the markets. Nothing is really safe in today's markets. As I've mentioned elsewhere, there is a potential for massive defaults in the banking sector because of extreme risks taken through the derivatives markets. Short term treasuries will probably avoid default for a few years, but the US government will not be able to make good on all of its promises in the future. Even money market funds are vulnerable to default if enough of the underlying short term bonds end up being worthless.

It's probably best to keep your debts low and enough cash available in savings accounts to get your through a few months of hard times if the job market suddenly heads south. If things really get shaky in the financial markets, then it could pay to move a large chunk of cash our of the bank and into your mattress.

2006-07-28T06:12:00.000-07:00

Extended Weekend

I'll be away for the weekend. Next post will probably be next Wednesday.
There's lenty of reading material in the July archive if anyone gets bored.

2006-07-27T08:45:00.000-07:00

Hedge Frauds and Pirate Equity

I suspect that hedge funds and private equity funds are the answer to one of the biggest mysteries of the current rebalancing process: Why are components of M3 growing at a rate of about 10% even though consumer and mortgage debt have slowed their growth?

Hedge Funds
Most classes of hedge funds, including private equity, borrow great sums of money into existence in order to leverage their strategies. Part of this is because many hedging strategies are low risk and low return by nature, and extreme leverage is the only way to make the trade strategies viable. Another part of this is because the hedge fund compensation scheme rewards managers for taking large risks with their clients' money - managers collect a large percentage of paper gains, but losses are born totally by investors.

The money borrowed by hedge funds flows directly into the financial markets as securities are traded and typically ends up in an institutional money market account somewhere. These accounts mostly purchase treasury, agency or corporate debt to fund government spending, mortgage borrowing or corporate activities like share repurchase programs.

Hedge fund activity is key to meeting the short-term needs of government and the stock market, even though it introduces great long-term risk into the total economy. Hedge funds can be wiped out in a short amount of time. The leverage they employ can result in fantastic paper profits, or it can result in rapid losses. The story of Long Term Capital Management is an important cautionary tale. If not for a $3.5 billion rescue package arranged by the Fed, over $100 billion in borrowings by the firm would have been repaid or defaulted on as the firm liquidated its holdings.

The hedge fund world has grown manyfold since 1998, with about $1.2 trillion in estimated assets now under management. Many funds have been employing high-risk strategies in the attempt to generate attention grabbing returns, boost their assets under management and collect large fees. In a volatile market, the total amount of assets wiped out and the size of the margin calls could be much larger than those faced by LTCM alone. While the money supply and economy have benefited from the growth of the hedge fund world, the potential for a rapid contraction is increasing all the time.

Most hedge funds performed well when the yield curve was steep and borrowing costs were low. When rates began rising in 2004, returns began declining. Hedgefundresearch.com has an index that estimates average hedge fund returns of 13.39% in 2003, 2.69% in 2004, 2.72% in 2005 and 2.19% so far in 2006. At best, those returns fail to keep up with inflation and benchmark indices. At worst, those returns are inflated by accounting tricks and increasing leverage and risk.

The rapid growth rate of 2003 has tapered off for many hedge funds, partly due to diminishing returns, partly due to declining investor interest and partly due to limited investment opportunities. The following chart, based on SEC filings, shows how growth has slowed for 4 large funds that I track:

Private Equity
Private Equity funds are currently the hottest area of the hedge fund world. They are generating tremendous liquidity and boosting asset prices through their leveraged buyout operations, but this is only a temporary benefit. Soon the wreckage left behind by private equity funds will be a major problem for the economy.

A leveraged buyout (LBO) occurs when a party borrows enough money to purchase all of the shares of a publicly traded company in order to take it private. LBOs introduce a lot of new money into the money supply and the stock market, but the newly private companies operate under a massive debt load and are vulnerable to economic downturns.

Leveraged buyouts are becoming hot again, as they were in the early 1980s, but there are some big differences this time. Back then, after the long bear market of the 1970s, beaten down stock prices made many companies a bargain for buyout firms and management teams. Executives could also run the stock prices into the ground with negative news and earnings reports and then make buyout offers at low prices. After the buyout was complete, the companies would suddenly become much more profitable and the executives would become extremely wealthy. Hostile takeovers became common for companies with low share prices as outsiders sought to exploit the situation whenever management didn't have the guts or gall to do it themselves, and "greenmail" became popular as a way to extort company money when management teams didn't want to give up their control of a company.

The LBO game worked extremely well for several years, but as the size and quantity of deals increased, and as market valuations rose, the profitability of LBOs declined. Buyout teams went for increasingly risky deals as competition among them increased and suitable targets decreased. Spectacular blow-ups late in the cycle caused a huge scandal, leaving many junk bond investors holding the bag and landing key players in jail.

The early success of private equity firms in this cycle was largely achieved on merit. As more firms have entered the arena, they are engaging in more questionable deals. Now stock prices are much higher in terms of price to earnings and other valuation measures, and good targets are becoming harder to find. To make an LBO profitable private equity firms need to exploit other victims, rather than just existing shareholders. The new LBO strategy is to find a company that has a lot of cash or assets that can be easily sold. The LBO team borrows enough money to buy out existing shareholders, then lays off employees, neglects maintenance and customer service, and otherwise destroys the long term value of the company in order to milk as much cash as possible. The exit strategy for private equity firms is usually to take the remains of their company public in a big IPO. As long as there are unsuspecting mutual fund managers out there who are either oblivious to the rules of the private equity game or who think they can run up asset prices in the short term, then private equity firms can exit unscathed. They take their profits and move on to the next set of victims.

However, a big problem is brewing in the private equity field as more and more firms enter the game. Pension plans, desperate to make up for poor returns of the past 6 years, are foolishly investing billions of dollars in private equity schemes late in the cycle. The number of IPOs will grow too large, just as it did when the technology bubble burst in 2000. There won't be enough clueless or greedy buyers for the IPOs. The results will be very bad for pension funds, the stock market and the economy as a whole.

2006-07-26T09:26:00.000-07:00

The Perverted Yield Curve

There has been some hype in the media about the yield curve inverting and how that often leads to a recession. I have three main points to make:

First, the yield curve has not inverted, it has been perverted.
Second, the US treasury yield curve has become perverted by huge distortions and imbalances in the greater global economy.
Third, it's all relative.

With regard to the first point:
The following chart shows the yield curve at certain key points in time:

1/2/01 was when the curve was most inverted before the 2001/02 recession.
6/13/03 was when rates were lowest, during the deflation scare.
6/29/04 was when the curve was steepest, one day before the Fed started its current series of rate hikes.
1/17/06 was when the curve became most inverted early in the year.

When prices change, there is money to be made. It follows that those with the power to move rates have the power to make money for the well positioned. Some might argue that fluctuating interest rates reflect uncertainties in the economic landscape. I contend that large movements in interest rates are controlled to meet the political and financial goals of key institutions. I use the word "perverted" to describe the curve, rather than "inverted" because I think the yield curve is intentionally distorted by the Fed and Wall St. institutions.

Let me suggest that the yield curve became "inverted" because the Fed intentionally tightened interest rates too much during the 2000 presidential campaign to help undermine the Democratic candidacy. With the stock market crashing, the Fed continued to boost interest rates into May and kept them high until after the election. Soon after the election was over, the Fed conducted 2.5% worth of rate cuts in 5 months.

Let me suggest that the yield curve became lowest in 2003 to help stimulate the economy for the 2004 campaign. The stock market had bottomed in October of 2002, but the Fed cut rates another 0.75% to absurdly low levels and stoked fears of deflation. As ridiculous as that sounds in the era of fiat money, the markets reacted to it.

Let me suggest that the yield curve became steepest in 2004 to help stimulate the hedge fund industry as a way to boost Wall Street trading volumes and profits. Short term profits became automatic as fund managers were able to borrow at ultra low rates an invest in any asset class imaginable. Of course this created huge long term risks, as there are always too many managers eager to seize short term profits.

Let me suggest that the curve has become "perverted" now as the Fed desperately seeks to prop up the dollar without wrecking the carry trade excesses of the last 3 years. The carry traders have their backs to the wall, as their borrowing costs have risen and they can't afford to have bond prices fall on rising long bond yields. Meanwhile, the US government's debt service has risen to over $400 billion per year. Meanwhile, the mortgage industry is feeling the squeeze as borrowers get scared away by rising rates. Long bond rates must stay low, or the system unravels. Active intervention is needed to override natural market forces.

The 2000-2001 inversion correctly forecast falling short-term rates into 2003, but the current perversion isn't really forecasting anything, as far as I can tell. One could argue that the curve is calling for an extended period of unchanging interest rates after a few more hikes, but then the entire yield curve would still be too low relative to inflation.

In recent months, interest rates have been allowed to move up gradually. I expect that a rapid rise would break the system, while a slow rise keeps the derivatives markets intact and the dollar afloat. Here's a chart of the yield curve at various times this year:

The curve has steepened and perverted alternately as pressure has built on long bond yields and then subsided. January 17th, saw the maximum perversion before treasury demand in February and March drove rates up. Now the curve is perverted again, but that may be difficult to maintain. We'll see how Paulson does as head of the treasury.

With regard to the second point:
My take is that yields are suppressed by artificial demand on the short end and in the 5-10 year bonds and by limited supply on the long end. There may be many potential explanations for this, including:

1. Derivatives underwriters may have high demand for 5-10 year treasuries. There has been an extreme expansion of the mortgage market based on surging home prices, 0% down mortgages and cash-out refinancing. This has mainly been fueled with short term financing and many of the investors in mortgages have sought to hedge away interest rate risk by purchasing interest rate swaps and other derivatives. The underwriters have then sought to balance their own risks by purchasing 5-10 year treasuries. This has had the added effect of keeping mortgage rates down, with fixed rate mortgage rates linked closely to 10-year treasury yields.

2. The Government has created a shortage of supply on the long end. The US government has been seeking to bring down interest expense on the national debt by issuing more short term securities relative to long term securities. They've done this to the extreme point that the entire range from 6-months to 10-years is now essentially flat. There should be much more risk associated with the longer term bonds based on the risks of rising inflation and even potential default in a nation with over $8.4 trillion in debt and a $700+ billion current account deficit. Suppressing long term yields through reduced supply creates further risk of higher rates in the future as too much debt will be rolling over in near future. The government is sacrificing future security for lower interest payments today.

Composition of Marketable Securities
November 2005...November 2000
Bills............983 B.......682 B
Notes.........2339 B....1590 B
Bonds........516 B.......629 B
TIPs............327 B......121 B
FFB................0 B.........15 B
Total..........4166 B.....3037 B
% Bills........23.6%......22.5%
% Bonds....12.4%......20.7%
Bills are 1-year or less when issued.
Notes are 2 to 10 years.
Bonds are more than 10 years.

There is an added short term economic benefit to suppressing longer term yields in the way the mortgage financing and hedging cycle gets a boost, prolonging the housing boom. Of course the potential for sharply higher rates in the future means that a subsequent housing bust could be much worse.

3. Yield chasers could be driving demand for longer term notes and bonds. Pension managers needing to produce high returns to meet payment expectations can come closer with higher yielding long term notes, even if the risks are greater. Similarly, mutual fund and hedge fund managers hoping to outperform their peers can do better most of the time by taking larger risks.

4, 13 and 4-week bills could be a low-risk and flexible storage of wealth for foreign investors more than a pure investment. Many investments in the US economy have been net losses recently for foreign investors, but the total amount of wealth outside the nation continues to grow as the trade gap continues. From a national perspective, foreign governments and central banks may see economic growth and profitability as the main goals, and through willingness to accumulate US debt and invest it at low yields they further their narrower goals. It doesn't matter if the earnings from their wealth are high as long as the earnings from their exports are high.

5. Surplus money supply may be boosting demand in the short durations. Extreme amounts of money creation by the Fed and banking system and a lack of suitable investment opportunities have forced surplus cash into money market accounts, which in turn is largely invested in short term treasury bills.

The more money the Fed helps create, the more money is forced into treasuries, causing the "conundrum" of low treasury yields in spite of a rising federal funds rate. The 4-week is now about 75 basis points below the federal funds rate even though more rate hikes are expected going forward. Has this ever happened before?

The yield is out of whach from 6-months to 3 years, but why would anyone want to buy those bonds at these prices? It takes a hidden agenda to want to buy the short-term and long-term treasuries, and there isn't a very good reason for big players to invest in those middle range options.

And finally, with regard to the third point:
The Fed did a study awhile back and discovered that the best predictor of recessions was the inversion of the yield curve. OK, fine, but:

1. An official recession is an arbitrary measure of a slowdown in economic growth (i.e. 2 quarters of negative real growth). If GDP slows to 0.1% for 20 straight quarters, that's not officially a recession, but it sure is a bad economy. What really matters (at least in the short term) is the rate of growth, not the term recession.

2. Inversion is also arbitrary measure. When the yield curve tightens (whether or not it inverts) that discourages money supply expansion by rendering the carry trade less profitable. That tends to reduce the rate of economic growth. (This makes the continued rapid expansion of the money supply especially suspicious.)

3. There are of course other important measures of economic stimulus that can outweigh the yield curve. The most important ones, IMO, are money supply expansion and the amount foreign investment capital flowing into the country. Both of those were very high in 2004, and based on the government's reports (if you believe them) they trumped the tightening of the yield curve to produce continued economic growth. With foreign investment weakening, however, money supply growth has been the primary fuel keeping the economic engine running. The longer term cost of this is inflation, however, which can wreak widespread economic damage if it gets out of hand.

2006-07-25T08:05:00.000-07:00

Stock Market, Treasuries, Dollar, Oh My!

Since the rebalancing process got rolling the Fed has had to perform a difficult juggling act with the stock market, treasuries and the dollar. With the consumer driven economy beginning to sputter, and without enough support from foreign investors there is downward pressure in all three areas. Below I've include a chart I created based on data for 10-year treasury yields, the Dollar in Euros, and the Nasdaq-100. It provides a rough measure of the relative strength in the three areas and shows how the rebalancing process is eroding the wealth of American investors:

The average of the three stopped moving up in November, about the time I've chosen as the official start of the rebalancing process. Not surprisingly there was a bit of a lag before the financial markets felt the full weight of shifting capital flows. Beginning in late January, the average of the three started moving down somewhat rapidly, with treasuries suffering first, the dollar second and stocks third.

A typical diversified US investor does poorly if his stocks or bonds fall in price or if the value of his dollar denominated assets decline against other global assets. The investor might not feel it right away, but a declining dollar eats away at his wealth through inflation. That's my rationale for using an average of all three measures as a gage of how the US financial markets are performing.

The Fed doesn't want to see any of the three fall rapidly because it could cause a financial crisis. If treasury prices fall too rapidly then a sudden shock would hit the economy in interest rate sensitive sectors (although a long term decline could be just as damaging). Perhaps more importantly in the minds of the Fed chairman, a quick movement in interest rates could bankrupt highly leveraged derivatives players like JP Morgan and potentially cause panic in the derivatives markets. That would be really bad for bankers.

If the stock market takes a dive then the Fed will face trouble on several fronts. The economy will slow via the wealth effect. There will be a political uproar over falling stock values. Many hedge funds will get slaughtered, deleveraging the money supply as they go. The nation's pension plans will be exposed as horribly underfunded ponzi schemes, leaving corporations and government entities deep in the hole. The average working American would suffer greatly.

If the dollar falls rapidly, than the rebalancing process will accelerate and compound the Fed's problems with treasuries and stocks in the near future. Inflation will also pick up with the Fed taking the blame. If the dollar appears weak it could also trigger a flight out of US dollar based assets, again compounding the Fed's problems. Former Labor Secretary Robert Reich suggests that Hank Paulson gave up being CEO of Goldman Sachs to make sure the dollar's decline is orderly. I agree and think he has his eyes on interest rates as well.

All of the above problems will probably be felt to a substantial degree in time, but the Fed is hoping that none of them will be felt strongly enough to get people so upset that it undermines the power of the banking cartel. The best they can hope for is to let all three continue to decline gradually together. It appears that this is the way the Fed is playing things. Whenever one market gets dicey they talk it up at the expense of the others. When the dollar was falling, they began talking tougher about interest rates and inflation fighting. This caused longer term rates to rise, so they let stocks to fall with talk of a slowing economy and an eventual pause. Of course the Fed always understates the current level of inflation and overstates the long term strength of the economy, as false confidence is the main thing keeping the whole system afloat.

Allowing the money supply to grow rapidly has helped the Fed slow the rate of decline in stocks and bonds, but has created greater inflationary pressures for the near future. Increased liquidity has been the easy and short-sighted way to boost stock prices and pervert the yield curve (tomorrow's topic). Dollar weakness has been tempered by raising short term rates to attract foreign currency arbitrage players, but that will create even bigger problems when the arbitrage equations shift.

Based on the policy decisions of the Fed up until now, and the slowness of the rest of the world to realize the challenges of the rebalancing process, I'm expecting the stock market, treasuries and the dollar to accelerate their declines going forward. A financial crisis in the United States is not in the best interests of foreign investors or the global economy. Through awareness and teamwork the central bankers of the world could engineer the rebalancing process in a manner that minimizes financial turmoil. However, if the banks continue to try and protect their own narrow interests, the US and global economies could face dramatic shocks.

2006-07-24T05:30:00.000-07:00

The Turning Point

In 1976 the US came out of a recession to run a trade deficit and has run a trade deficit every year since then. That trade gap has grown substantially over time, resulting in tremendous global economic imbalances. I believe those imbalances will reverse themselves and that the rebalancing process has already begun.

If I had to choose a day when the Rebalancing process officially started, it would probably be 11/17/2005. On the 16th, the dollar hit a short term peak of 87.3509 against an index of major currencies. In my mind the inflated status of the dollar has been the single largest factor behind the growth of the trade gap and global imbalances. As the value of the dollar comes down, Americans will be able to consume less and export more. The following chart shows the Dollar against several important currencies:

October was the peak month for the trade gap, at $66.598 billion. The trade gap is fueled by excessive consumption by US consumers (and government) on one side and by excessive investment by foreigners in US assets on the other side. The two are closely related, but the correlation isn't perfect. Either one could lead a charge or retreat that would influence the other over time.

On the consumer side, mounting debt burdens eventually had to restrict consumption and the first strong signs of this occurred in October. Consumer Credit was flat in November and down 4% in October. Mortgage Applications began a substantial decline in October. Personal Spending slowed in October as well. October was the final big peak for New Home Sales, with a sharp seasonally adjusted decline occurring in November.

On the foreign investor side, the first signs of a significant slowdown occurred in November. That was a month when the Federal debt rose by a large $65 billion, $32 billion of it the week of 11/14-11/18. Japan was a net seller of US treasuries in November, while the UK picked up an impressive $35 billion. (I continue to believe that UK demand for US treasuries represents highly leveraged hedge funds, possibly linked directly to the Fed.) TIC flow data showed a peak in total net inflows in October and a big decline starting in November and increasing in December:

While consumer credit was tightening, overall credit was expanding (suspiciously). M3 went over the $10 trillion mark in October rising 0.824% for the month (M3 reporting was discontinued in March). Rapid money supply growth is fueling inflation which stresses US consumers and discourages foreign investment, putting the brakes on the trade gap.

January's trade gap of $66.216 billion came close to setting a new record, but another wave of credit tightening in February and March pushed it back down. The federal debt rose $74 billion in February and $101 billion in March. Foreign treasury purchases slowed again and the dollar took another dive. In March the trade gap fell to $61.862 billion.

With foreign buyers shying away from treasuries the voracious appetite of the US war machine is putting a major strain on consumers through tighter credit and mounting inflation. It is also hurting foreign confidence in US assets. July and August are big months for new treasury debt and we can see what's happened to the US markets so far in July. This doesn't bode well for August either. Foreign official accounts have reduced treasury holdings by $13.5 billion over the past 4 weeks, and demand for Agency debt is down from recent highs.

Looking further back, the trade gap hit a high of $58.407 billion in November of 2004, which wasn't topped until June of 2005. It's possible the trade gap will pick up again after the current period of decline. June was a relatively large trade gap month in 2004 and 2005 and probably in 2006 as well. However, I think the real turning point has come and gone. Reseting ARMs in 2006 are putting a substantial squeeze on consumer discretionary spending. Asian central bankers had to see this coming and this probably contributed to their declining investments in US assets in late 2005 and early 2006. The plight of the US consumer is getting worse and the demands of the US treasury are putting a serious strain on the whole economic system. The rebalancing process had to happen eventually. The longer we waited the worse it had to be.

2006-07-23T07:16:00.000-07:00

I Don't Like Gold as an Investment

Gold has outperformed the S&P for the last 6 years, or should we say that the S&P has underperformed gold. A lot of people are excited about that and justify gold and gold miners as an investment mainly because everything else is so unstable. But how stable is gold? Its value is purely a function of psychology. It doesn't earn you anything, like other asset classes.

In my mind, gold is a tool for speculators. One may be able to predict its movements based on macro-economic projections, but on the other hand it is especially ripe for manipulation to clean out small traders and force them into losses. Since there is no fair value for a commodity with only psychological value, Wall St. can squeeze the traders, while central banks can squeeze people who bet against their fiat regimes.

Former Goldman Trader Mark Lapolla blogged some good comments on gold here: Sixth Man Research: Don't Overthink Gold

The whole piece is good, but a couple of quotes in particular caught my eye:

"To economic and market forecasters, gold--and its ratio/relationship to other things--has been THE inflationary expectations indicator."

This bears watching, as I think inflationary expectations are very low right now, relative to the potential inflation that exists in the money supply right now. If confidence is lost in the dollar, a flood of currency could be returned to marketplace unleashing a tremendous wave of inflation in commodities, equities and property (going counter to the loss of faith in equities and property). This process has been going on for the past couple of years, but it could accelerate dramatically. Gold may be an early indicator or it may be suppressed.

"Gold mostly goes up because it's rising marginal price lends credence to its' mystery, and it falls, mostly because its' falling marginal price scares speculators."

This quote describes the psychology of the metal very well, in my opinion.

2006-07-22T19:15:00.000-07:00

Wall Street's Risk Game and Rising Volatility

As the global rebalancing process continues, much stress will be put on the American financial system. The great depression began with a major collapse of the banking system, with small depositors losing their life savings and banks losing their ability to lend. While our government has taken measures to protect against the specific problems that arose in 1932, the financial sector has found ways to magnify the total systemic risk manyfold. How the financial system handles a rise in volatility and risk aversion will be well worth watching in the coming months.

Businessweek ran an article last month entitled Inside Wall Street's Culture Of Risk that provides a nice overview of how the big investment banks have shifted their business models toward generating trading profits, while at the same time introducing tremendous systemic risk to the greater economy. As this is a mainstream media article, there is a conscious effort to avoid stating how bad things really are or make accusations as to the hidden motives of the players involved.

For those who don't have the ability to read between the lines, I'm glad to provide my own observations and context. I suggest opening the article in another window and reading the whole thing while following along as I quote from the article in italics and add my own comments:

"Wall Street has always been about taking risk. But never has the "R" word been such an obsession for the men and women who rule the nation's biggest investment banks."

Never have the profits been so large. Never have the government and fed been so thoroughly controlled by Wall Street. Never has it been so easy to transfer the full burden of Wall Street risk taking to Main Street.

"Goldman Sachs' CEO Henry M. Paulson Jr. has led the charge. Major Wall Street firms have watched with envy as Goldman has repeatedly racked up record earnings on the strength of its trading business."

And now he's taken on so much risk at Goldman that he had to take over the reigns himself as chief plunge protection officer. And he traded in 10s of millions in annual compensation for a government salary. Things must indeed be getting interesting on the street.

"Now, virtually all banks are making huge bets with their own assets on many more fronts, and using vast sums of borrowed money to jack up the risk even more."

If it was just their own money it wouldn't be so bad. However, they've created tremendous systemic risk. Everyone they've borrowed from is at risk. All of their counterparties are at risk. Everyone who works for their counterparties is at risk. The whole economy is at risk.

"What's more, banks are jumping into the realm of private equity, spending billions to buy struggling businesses as far afield as China that they hope to turn around and sell at a profit."

Buy the whole business and you can book it almost any way you like. Turn a money losing stock bet into a guaranteed profit overnight... never mind the bloodstains from the red ink.

"If banks succeed, they'll rack up even bigger earnings. But if they borrow too much money for their trades or take on more risk than they can manage, the wreckage could be considerable."

Success on past bets has largely been achieved by taking on ever larger new bets. It's a big ponzi scheme, and the question isn't one of whether it will work, but rather one of how long it will work.

"As the banks trade in ever-more-obscure products with ever-more-opaque clients such as hedge funds, observers worry that they might not be able to settle their trades in the event of a market shock, intensifying the damage."

That's putting it mildly.

"Suspicions are rising that bank traders are acting on nonpublic information gleaned from their clients."

Count the Fed and the Treasury Department among their clients, and that's probably the mildest way that the game's been rigged.

"The Securities & Exchange Commission has "very active examinations and investigations under way," says Lori A. Richards, an agency director."

There you go, Lori. Find us a couple of scapegoats so that we can pretend the rest of the crowd isn't robbing investors blind.

"Yet for all the risks they're taking on, banks insist they're safer than ever. They've hired many of the greatest mathematical minds in the world to create impossibly complex risk models."

It takes a really good theoretical mathematician with no real clue as to how the market works to come up with a model that says everything is OK.

"And traders have been feathering banks' nests for five years."

That's why the next Goldman boss was their most successful trading guy.

"They've produced record earnings and boosted asset bases to unheard of sizes, making even bigger bets possible."

That's not just the model for Wall St. It's the model for the entire US economy: Book false profits... leverage up... book more false profits... leverage up...

"The degree to which risk management has evolved in the past few decades is astonishing, say analysts."

What's astonishing is that the American public has allowed Wall Street to risk their own security.

"Some on the Street argue that such confidence is misplaced, and that the relative stability in the global markets since 2003 has lulled traders into a false sense of security."

That false sense of security is the only reason for having confidence.

"One senior bank executive thinks so. He worries that at any moment volatility could spike to levels never seen before."

Read volatility as a collapse in asset prices and the rapid disappearance of wealth. Why worry? Better just plan for that rise in "volatility."

"How the markets will respond to such an event "is up in the air," says Leslie Rahl, president and founder of Capital Market Risk Advisors Inc., a New York-based consultancy. That's because banks are dealing more with unpredictable clients like hedge funds and in less familiar financial products like derivatives of derivatives."

"Up in the air" or "up in smoke?"

"On the very next page of the JPMorgan report, the bank tells investors that losses could have soared to as much as $1.4 billion over, say, a four-week period last year if an abnormal event had occurred."

Not quite what the report actually said. Rather, they said " Based upon the Firm's stress scenarios, the stress test loss (pre-tax) in the IB's trading portfolio ranged from $469 million to $1.4 billion..." Of course JPM designs their own scenarios and I doubt they included the full potential of their derivative hedging bets blowing up on them when "volatility" soars.

"Goldman's Paulson was asked to talk about his readiness for a big blow to the financial system. Paulson issued a litany of warnings. The main risk measure Goldman discloses, VAR, "always assumes that the future is going to be like the past," he said. And even though the bank regularly uses many different models to test its resiliency to various disaster scenarios, no one can correctly predict where the next disaster will come from."

Sounds like Greenspan saying that nobody can correctly predict when a bubble is forming. Why'd you change jobs, then, Hank? Dedication to public service?

"banks' aggressive moves into trading threaten to scare off clients who wonder where they will rank if a panic triggers a sell-off. Will the bank perform its fiduciary responsibility to its client and execute its trades, or will it cover its own hide?"

When the markets are going craziest, it provides the best cover for Wall Street firms to screw their clients.

"Big firms can no longer subsist on underwriting or stock and bond trading as the combination of more rivals and cheap electronic trading drives down profit margins. "Wall Street doesn't get paid to not take risk anymore," says Merrill Lynch & Co. financial-services analyst Guy Moszkowski. The big investment banks add value by "absorbing the risk that their clients are looking to get rid of.""

And risk these days is really just a euphemism for profiting through accounting fraud.

"Businesses that once accounted for most of the profits at investment banks are now viewed more as gateways that lead them into the lucrative land of risk."

The only way to stay in the game is to play along.

"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."

It's also a good way to keep the markets propped up and prolong the game a little longer.

"In the bond markets, money managers ring up traders routinely and ask them to bid on messy multibillion-dollar portfolios of bonds and other financial products with expiration dates ranging from 2 to 10 years. "You have a trader committing in one or two minutes to a trade that could lose or make tens of millions of dollars," says Thomas G. Maheras, head of capital markets at Citigroup."

That's an interesting turn of events. It used to be the traders calling the managers and ramming trash down their throats. Now the traders don't mind eating the garbage that the managers are dumping back on them. Heck, it'll all blow up soon anyway. Give me any old trade so I can book a profit, please.

"Risky though the trading may be, it's the forays into private equity that keep many risk managers awake at night. Fully formed companies are the hardest assets for banks to get off their books if things go wrong; just try selling a pipeline in the middle of a financial panic."

Risky in the real world, yes, but easiest to fudge in the fantasy land of financial reports. And that's the world that matters when bonus time comes around at the end of the year.

"Wall Street moves in cycles of excess. Before the current cycle turns, the odds are good that at least one bank will take things too far. That's what happened in the '80s, when banks churned out an array of new products like junk bonds and created whole new markets for them, then abused those markets for their own ends. It happened again in the '90s as bankers cashed in on the Internet bubble. "There's always someone who doesn't see that the turning point has been reached," says Frank Fernandez of the Securities Industry Assn."

Ummm... "one" bank?

One thing the article doesn't mention is how market volatility decreased dramatically from 2002 to 2005. Meanwhile, Wall Street ran up great profits by selling derivative protection against volatility. Fed policy of letting banks create almost unlimited liquidity amidst a backdrop of very slowly rising interest rates has been extremely helpful to the firms absorbing risk through the derivatives markets. Consequently many firms have taken on tremendous amounts of risk, jeopardizing the stability of the entire system.

I don't care for the VIX or other wall street measures of volatility, opting instead to calculate my own measures based on daily highs and lows. Here's a chart giving an indication of what I've seen volatility do in recent years:

Volatility began a significant uptrend about the time Japan began reducing its treasury holdings. The market appears to be getting away from the tight control of the Fed and its main constituents. Volatility will continue to be a major indicator for me of how much trouble is brewing in the financial system.

2006-07-21T11:47:00.000-07:00

And Now For Some Good News

The good news is that the economy is creating lots of jobs. If we are going to make it through the rebalancing process without going into a depression, keeping the number of jobs up will be important. Some sectors (housing, mortgage lending, retail) will likely suffer, while others are likely to grow.

Many blogs and websites in the Economics Underground downplay the strong growth in the job market. There is a deep rooted and justified mistrust of government statistics, which are often manipulated for political purposes. Nevertheless, I believe that the numbers of jobs being created are more or less legitimate. The change in methodology to add the Birth/Death Model gave W some artificial job gains to boast about in the 2004 presidential campaign, as a previously uncounted category of hypothetical jobs was added to the totals. But now the model is just a seasonally based guess at the number of new jobs that won't be reported to the goverment until the next July or January. People who try to claim that the economy is actually losing jobs because of the B/D adjustment don't understand how the number is derived.

What is more important to me than the total number of jobs is which sectors are seeing the job growth:

The Oakland Police Department is hiring. They have a huge banner on their headquarters facing highway 880. With the murder rate up 80% in Oakland over last year there is definitely a need for more cops. The San Francisco Police Department is running ads on local buses looking for new cops. An SFPD dispatcher I know says the most calls they receive are for relocating homeless people from people's doorsteps and for suspected terrorism tips (i.e. 4 Arabs in a car together). The prison population in the United States rose by about 1000 inmates per week from 6/30/04 to 6/30/05 to reach a total of 2,186,230. Sounds like law enforcement is a growth industry.

Other sectors are growing too. Mining jobs increased by 9.6% from 6/05 to 6/06, which isn't surprising given the huge demand for raw materials coming from China. "Rip it and ship it" should be a growth theme as the rebalancing process continues.

Then there's real estate, which added 52,300 jobs in that same time period. Good thing there are now over 1.5 million people working in real estate because selling a home is becoming very hard work. Whether anyone can actually make a living selling real estate will be the interesting thing to see.

Retail jobs are down, year over year, and that situation is probably going to get much uglier. One way or another, US consumption of imports is going to have to decrease relative to exports.

In spite of the strong job market, many (I believe most) workers are losing ground to inflation. Official government statistics show compensation rising as fast as inflation, but I believe actual inflation for working people is understated and compensation is overstated when you factor in stealth cuts like higher insurance co-payments and the elimination of some retirement benefits. At the same time, debt service is on the rise, so consumers aren't able to consume as much as before.

I'd get all worked up about this if I didn't think it was necessary. Working people may be bearing the brunt of the rebalancing effort for now, but soon enough everyone will be feeling it. Having the pain felt most by the masses will get them to consume less, while getting more of them to recognize how the political establishment is working against them. Hopefully a future administration can figure out how to make sure more wealthy people feel their share of the pain.

If the job market heads south then it will hurt the housing and financial sectors the hardest. I've heard executives from more than one mortgage based company say that job losses are the big factor that leads to rising defaults. Most people can survive a squeeze by cutting back on consumption. They usually can't survive a prolonged job loss with their mortgages intact.

In my mind, the key to a successful transition will the the rebuilding of our manufacturing base, which has been largely dismantled after years of increased outsourcing and importing. After a long, steady decline, manufacturing jobs have recently picked up a little. When the dollar finally does start declining, and we begin unwinding the trade gap, we will hopefully be able to create enough manufacturing jobs to keep people occupied and make up for lob losses in other areas.

I continue watching weekly employment numbers to get an early indication of what's going on in the total job market. Ignoring the large blips from Katrina and the Puerto Rican shutdown, initial claims were trending down in 2005 and have began trending up in 2006. I'm expecting the trend to continue upwards, given the way things have been heading in housing and retail:

2006-07-20T13:09:00.000-07:00

The Housing Bubble and the Global Rebalancing Process

Mike Shedlock ran a letter from Florida realtor Mike Morgan in his blog today that does a great job of summing up much of what is wrong with the housing market these days. Please go check it out.

The bursting of the housing bubble is old news compared to the rebalancing process, but the two are inextricably intertwined. Excess foreign investment capital flowing into the mortgage market helped spawn the biggest housing bubble of all time. At the same time, the imagined wealth created by the housing bubble and the ease of cash out refinancing allowed consumers to live far beyond their means. As the rebalancing process unfolds, the damage will be especially great in the housing sector.

The first chart below adjusts 5-year annualized appreciation for inflation to show how much bigger this housing bubble has been on a national scale than any other housing bubble in recent history. (I did it a year and a half ago, so it doesn't include the last 6 quarters):

In inflation adjusted terms the nation has seen significant declines in housing values over multi-year periods, and certain areas have seen severe declines. The next chart is not adjusted for inflation, and if you fail to do that mentally you might be misled into thinking this bubble isn't as bad as the bubble of the late 1970s. Two main things it does demonstrate are how the bubble has been a national phenomenon and that we hit a final national peak of 9.44% for 5-year annualized appreciation. There is a very long way for prices to fall from here.

Because so much easy money was flowing into the housing sector, and because they are incredibly greedy, homebuilders went on a land acquisition and building binge that has been producing about 500,000 more new homes than the country has needed per year. Inventory is the biggest problem in the housing market, and we haven't come close to the inventory peak yet:

The severity of the housing bubble was obvious a year and a half ago, as was the unsustainability of the trade gap. All you had to do was look at the right data with a critical eye. The national press is gradually waking up to the reality of the housing bubble, although the news will get much worse. Global rebalancing isn't even on the radar of the major media yet, but I believe the overall impact will be even greater.