Chuck Ponzi November 20th, 2008

Yahoo’s finance headlines always provide a good look at the panic of the last few weeks. Virtually buried in the “Oil at 3-year lows; gas below $2 in 23 states” was this hardly startling revelation:

Also Goldman Sachs, which earlier this year predicted oil would reach $200 a barrel, said Wednesday that it was discontinuing its oil trading recommendations. Goldman said Wednesday in its weekly energy report said while continued weak demand and constrained credit would keep prices under pressure, it hoped that high volatility would provide a better exit point for trading.

“The volatility in the past few weeks has mostly been to the downside and the pressure on the oil complex has increased,” the report said. “In the near term, we do not expect significant upside potential and as a consequence we are closing all of our oil trading recommendations.”

Of course, the surprise isn’t always to the downside:

Light, sweet crude for December delivery fell 7 percent, or $4, to settle at $49.62 in Nymex trading.

Oil prices have fallen 66 percent since reaching a record $147.27 a barrel in mid-July.

Oil analyst Stephen Schork wondered if $50 would even hold.

“Maybe $50 is too conservative given the putrid, putrid look at the economy,” he said.

“If we’re not out of these doldrums nine months from now we’re looking at $30 oil.”

Did I say that deflation sucks for pretty much everyone?  If you owe money, it becomes more ominous.  If you own something, it falls in value.  If you derive everything from income, you’re likely to lose your job.

Here’s to hoping I don’t lose my job.  On the cheerful side, this last weekend, we went out of state… at one point paying $1.87 for a gallon of unleaded.  Seems downright cheap now.

• Deflation
• Comments(1)

Chuck Ponzi October 9th, 2008

Sorry that I have been out of pocket for the past week.  Chuck has been in Mexico this week getting some much needed vacation time.

Meanwhile, the world financial system is in meltdown.  The worldwide housing bubble and deflation is finally being priced into the stock market.  It is complete and utter housing panic.  There is no safe haven at this time.

Personally, I cannot believe some of the deals out there in the stock market!  Armageddon is priced in.  Many stocks yielding more than 5%.  If yields stay at this level, sheer and utter panic is the only reason.  I’ll be getting some sun and water for all of you there.  Good luck to everyone.

• Deflation , Housing Crash
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Chuck Ponzi September 29th, 2008

Thank god we have some sane representatives in Congress.

I have a lot of money invested in the stock market, but I have a lot more invested in mine and my children’s future.

See how the 228 voted against the bailout from the New York Times.

We’ve got a full-blown taxpayer revolt on Congress’ hands.  There has been enormous amounts of scaremongering going on today with everything from ranting congresspersons to talking head reporters, and man-on-the-street info from traders on the NYSE floor.

The stock market took one on the chin, and could erode further if bailout proposals are blocked.  My hope is that until some seriously different legislation gets proposed, I will personally oppose this on the SCREBC blog.

And, for today’s reflection, we’ve got to give kudos to Dr. Ron Paul for opposing the bailout:

• Bailout , Deflation , Housing Crash , Panic
• Comments(4)

Chuck Ponzi June 30th, 2008

I recently had a reader pose a question to me via email and I’d like to take some time from our normal programming to see what is on his mind

Our friend, let’s call him Boomer for short, had this to ask of me:

Moved my family to La Costa area (renting) and own a house in AZ which I owe $159k at 6.5% (it adjusted and will again in 8 months) The home was at peak worth $750k now $550k I had it rented last yr for $2200 and just signed a 3 yr lease w/ new tennant for $2,400 . I have $600k in cash..Should I pay this house off?? or should I just refi it and hold on to my cash to buy here in S cal in a yr or two?

First off, I have a couple of thoughts:

1. Whoever Boomer is, he’s in a pretty good position, relatively speaking

2. Without knowing his age, I’d say Boomer is likely Early Xer or Late Boomer.

3. The most important point of all (where he wants or needs to live) is missing from the question. Don’t feel bad, many people forget this little factoid. We’ll assume that he wants to stay in SoCal.

I’ll deal with some important points:

1. What is that house in Arizona really worth long-term?

2. What should Boomer do with the cash?

3. What kind of financing makes the most sense?

What is that house in AZ really worth?

This is the question that wasn’t really asked, but needs to be answered, what is the house in Arizona worth, so we can understand what to do with the money.

Well, Arizona is a big place. It has a varied geography with beautiful vistas, scorching deserts, and some bone chilling mountains. You may not like what I have to say, but I’ll say it anyway. Your perception of the world and finances is the boiled frog syndrome. Not that I blame you. You’ve been raised in a world of ever decreasing interest rates and increasing asset values. The world has been kind to you.

You see, the success of many of the past 30 years (primarily the boomer cohort) is a demographic abnormality. Asset values have increased simply because of the organic demand of the Baby Boomer generation and ever increasing ability to finance that demand. In addition to this, an extremely relaxed monetary policy has increased the value of assets consistently since inflation was trounced back in the late 70s.

Unfortunately for many, that time is over.

In the short run, houses are worth what someone else is willing to pay for it, but in the long run, they are subject to the value of the next best alternative, or substitute pricing. The best substitute for owning a house is renting one. In some cases (such as short-term living), renting is almost always the clear alternative.

There are many formulas for determining the value, but one of the simplest mechanisms is the GRM (Gross Rental Multiplier). Basically, this number is used to multiply the monthly rent to arrive at a fair estimate of rental value. However, this is only a rule of thumb and is not to be taken as gospel; lower interest rates (like I expect we will see for the forseeable future) will increase the GRM, while substitutes (buildable land, locus to employment centers) will decrease it. In certain premium places like Orange County, the upper stretch might be 220 or so, while in places like Las Vegas or Arizona, a more reasonable 120 to 160 is more in line with reality. If we err on the side of optimism (150 GRM), this places the current value based on long-term fundamentals at about $360,000, leaving Boomer with a $190,000 premium over its fair value. If I were evaluating a stock, I’d say SELL! SELL! SELL! Doubly more so if Boomer had lived in the house for more than 2 of the last 5 years since he can walk away with pretty much all of the money tax free. It doesn’t matter what the market is selling at, if there is really that much of a disparity, sell that house and get your money! (of course, it doesn’t help that it was just rented, but there are always ways to let a renter go, if the price is right). At a 229 GRM, his house is badly overpriced. When it was $750K, I haven’t a clue how someone could justify that, since it would have been a GRM of 340. Holy smokes!

The future good in some ways, but bleak in other. The Southwest is largely overbuilt in nearly every city with a real dearth of extensive employment opportunities (unless WalMart is your target), and if energy prices remain elevated (not a given in my mind), the ability to pay will deteriorate along with the economy. Boomer may end up with late (or no) payments from his rental. Rentals are generally difficult to manage from a long distance and I would only advise it if you were planning on returning back to the home at some date. However, that would be hard after living in LaCosta for a few years.

In addition, a house can be valued at the cost of money to purchase it. This is a bit more detailed, but an easy rule of thumb is to take the rental equivalent, figure in future increases in rent, and discount the cash flows based on current borrowing rates. It accomplishes about the same thing as GRM, but removes the variability of borrowing rates (especially if it is held as a long-term investment). Using the inverse calculation, you could figure what the “money rent” on the current place would be given a few variables such as the “current value” and current interest rates. Given a current value of $550,000, the money rent valuation using 7% says that Boomer should be collecting about $3,700 in rent on that money. This leaves out taxes, repairs, rental expenses, vacancy, and many other options, so it is by far the most optimistic. By this reckoning, the house would have an imputed value of $357K, pretty darn close to our above $360K value. Sounds like time to sell this puppy no matter how you look at it.

As another way of thinking of it, as interest rates go down, this increases the ability to pay, but that can only increase so much since the risk of buying on low interest rates and being unable to sell into a similar situation will weigh heavily on others’ minds and prices will need to adjust to handle this uncertainty. Since demand for housing is waning as the boomer generation ages in place or downsizes (or simply dies), it is unlikely that houses will be able to continue their rich valuation long into the future without a substantial demographic to replace them with the ability to purchase.

Any way you look at it, the house is currently valued at more than it is “worth”. I can show houses in Orange County that currently have better GRMs than what this house is showing, and Orange County is one of the most overpriced locales in the US.

Tomorrow, I’ll deal with the question of what Boomer should do with his cash. Any thoughts before then?

• Boomers , Bubble , Deflation , Denial , Investing
• Comments(3)

Chuck Ponzi March 24th, 2008

The following is a copy of a post I made back in November 2005 (nearly 2 1/2 years ago).  Pay close attention to what is supposed to happen next:

from Interest Only - Creative Financing or Harbinger of Deflation?

>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>

The economists over at Elliott Wave have a great write up about deflation and what causes deflation in a piece titled “What is Deflation and What Causes it to Occur?”

All deflationary periods were marked with the following conditions:
(a) All were set off by a deflation of excess credit. This was the one factor in common.
(b) Sometimes the excess-of-credit situation seemed to last years before the bubble broke.
(c) Some outside event, such as a major failure, brought the thing to a head, but the signs were visible many months, and in some cases years, in advance.
(d) None was ever quite like the last, so that the public was always fooled thereby.
(e) Some panics occurred under great government surpluses of revenue (1837, for instance) and some under great government deficits.
(f) Credit is credit, whether non-self-liquidating or self-liquidating.
(g) Deflation of non-self-liquidating credit usually produces the greater slumps.

From the article: “Self-liquidating credit is a loan that is paid back, with interest, in a moderately short time from production. Production facilitated by the loan - for business start-up or expansion, for example - generates the financial return that makes repayment possible. The full transaction adds value to the economy.”

Credit lent against homes are most definitely non-self-liquidating credit. Unless, you count the opportunity cost of renting as a form of liquidation - however this requires there to be some relationship of rents to monthly payments; something that can’t be said of current market. The relationship of these nonproductive asset backed loans to productive asset backed loans, it would seem is at its peak historically.

Reading this type of semi doom-and-gloom scholarly article makes me think about the many types of financing recently available to the public masses and what impact they might have.

It takes a bit of economic sense to understand a risk premium. A risk premium is an additional amount that a lender expects to compensate them for additional risk. If risk is considered great either a high risk premium is attached or sometimes a transaction cannot take place. We currently have some of the lowest risk premiums in history; interest rates on non-productive assets are at historical lows.

Typically, a lender requires that at some point, principal on the note must be paid back. Interest only loans are an exception to this. Why? And, why have they become popular now?

It’s easy to see why a borrower would want to take on one of these loans; why pay for something now if I can pay later. But, what’s more interesting is why are they so popular for lenders?

Human beings are a fickle bunch. Each one wanting to do something different than the other. Like watching an ant, it runs to and fro, sometimes lost, sometimes productive, but always unpredictable. But, take a step back, and the anthill is an extremely efficient, coordinated jumble of activity. A very predictable bunch. Human financial systems are similar. Each borrower is very unpredictable, but bundle a few thousand together and they suddenly become more predictable; hence the popularity of Mortgage Backed Security Bonds (MBS’s).

BUT… and you knew this was coming… you need to take even a step back to see what is going on in the macro environment. Who has all of this money, and why are they lending it at such low rates. A flat yield curve would signal that lenders see little reason require a larger risk premium for longer-term loans because they expect long-term rates to be about where they are far into the future. How often is the bond market right? Well, that’s for you to decide. Greenspan has even named it a conundrum.

So, this brings me to the title of my post. How could interest only loans signal possible deflation in the future? We already know that low-interest rates can be a signal, but what about creative financing?

Interest only loans cannot be self-liquidating in the short run. When they switch to a liquidating (fully amortized) loan, the payments jump substantially because they do 2 things at once: 1, they begin fully amortizing 2, they adjust to prevailing interest rates. One would expect that people faced with these issues would simply replace the shorter amortizing period with a longer amortizing period at the same rate. Or, they would attempt to liquidate the loan by selling. Since interest-only loans are not self-liquidating in the short run, the bond market is signalling that for the medium-term, interest rates and returns will be low, or that investors are extremely risk-averse to the stock market. The investors feel justified that any possible deflation is offset by the Fed’s moderate inflationary policy, or at least an attempt to prevent deflation. So, MBS investors have signalled that for the medium term (3 to 10 years), that they would rather take their chances with low interest rates AND non-liquidating debt.

Will this truly end as Greenspan has put it? I will leave you with one of his most famous statements on the subject:
“But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.“

• Debt , Deflation , Mean Reversion , Speculation
• Comments(5)

Chuck Ponzi March 11th, 2008

Despite all that you hear and see in the headlines about rising oil and gold prices, we are about to experience the worst deflation in the history of the United States, or at least the 2nd worst after the Great Depression.

I have to write this entry because of the amount of absolute rubbish that I see printed throughout the media and repeated ad nauseum in the blogosphere regarding the money supply and how the recent fed actions are inflationary.

Even with the dramatic action today in the stock market (the last time we saw a 400 point day in the dow was mid 2002, near the depth of the last bear market), the general trend is that the market is quickly siphoning off the dollars put out via the central bank the past 8 years.

Noone now doubts that Greenspan made 2 fatal mistakes that caused the largest bubble in history. First, he brought interest rates too low and held them too long, and secondly and more importantly oversaw the most complete and utter breakdown of lending standards in history. Put together, it pumped too much debt into the system.

This debt became non-servicable from income during a time when debt should have been waning, not peaking since the largest demographic baby boomer bulge is passing into its retirement age. The sad state of affairs of most baby boomers is only a testament to the incredibly poor management of their finances until this point. Several decades of declining interest rates and ever-increasing credit has created a new age of debt serfdom where most can only hope to ever service the debt and hope it never gets called, the serf ever sickens, or misfortune visits a single household.

Put succinctly, increasing the money supply is inflation, deflation is decreasing the money supply. The accomplished blogger Mike Shedlock has made this case quite well, and the facts speak for themselves.

In the deluded minds of those pumping housing, they are hoping that actions by the FED will rescue housing. It won’t. Housing was in a bubble that was reinforced by the increase in money supply, and as long as the money supply is contracting and remaining contracted, we not see a return to the insane days of lending we have seen the past 7 years. This is deflation. Assets going down in value. Housing, stocks… even commodities should be declining. Which brings us to the next bubble… commodities. It was only a matter of time; and frankly I haven’t a clue as to how long it will last. But it’s not ready to pop yet. We are just now getting the first whiff of a bubble; and there will be plenty of time for commodities apologists to scoff it off and disprove recent price action, but let’s not forget the fundamentals… commodities are priced between the cost of production plus normal profits and the cost of alternatives. Gold, corn, rice, sugar, even oil has alternatives, and let’s be honest… we have departed from these fundamentals. It costs approximately $400 to produce an ounce of gold. It costs approximately $4 to produce an ounce of silver. We have all gone mad in the search for the next place to put our dollars. We are living in an inflated world where stocks and housing are no longer considered safe havens after the last 2 bubbles have popped, yet commodities are just warming up.

But, let’s not forget that even with the bubble forming in commodities, it does not yet have a complicit Federal Reserve bank… borrowing for precious metals is much more difficult than leveraging equity in a house or margining stocks; and there are few takers to lend the money in that kind of speculation.

I predict this next commodities bubble will be much shorter than the last 2 and more violent to the participants.

Disagree below.

• Bubble , Deflation , Inflation
• Comments(43)