CALPERS, the California Public Retirement Pension fund is about to learn that lesson the hard way. Formed in the 30′s, but built on the back of the 50s through the 80′s, it’s investment options expanded from solely bonds to real estate, to equities.  During this time, America experienced the greatest growth of real estate, equity, and bond values.  But most of all, of leverage.  Sadly, most of the value “growth” in the US over the past 20 or so years has been attributed directly to monetary growth.  Indeed, as yields on lower risk returns shrink, perception of higher risk equity values go up.  Unfortunately, for many, this mirage has much more power, and this perception that trees grow to the sky and all charts go up and to the right meant that there was little risk in promising free healthcare and pensions to the moon for all who worked for the grand state of California.

Except that it can’t.  The high profile failure of CALPERS has been nothing short of stunning.  Having lost more than 30% of its total value in 2008, it is unclear how the future promises made to state employees can be filled.  Especially when those promises are built on expectations that returns are 7.75% over the long run.

SFGate recently reported that they are considering lowering their benchmark rate above.  As reported:

Larry Fink, CEO of the giant money management firm, BlackRock Inc., with which CalPERS has invested, told its board in July, “You’ll be lucky to get 6 percent on your portfolios, maybe 5 percent.”

Even that might be optimistic.  When mortgages were returning 10% and you could expect a 1% chargeoff ratio and a 1% management fee, you could maybe meet the goal with a moderate amount of leverage.  When mortgages are yielding sub 5% and chargeoffs and management fees eat up most of that, you’d have to create an insane amount of leverage, which only increases your risk, to make it even rationally feasible, if even possible.

Why is this important?  Well, the benchmark rate determines the contribution rates, both of members and the State Government.  This is only one of many elephants in the room in California that noone wants to talk about it.  At precisely the time when the state can least afford to spend even more money, it may be required to.  Which only makes the situation more dire.  State and local government employees in California (in many, but not all cases) already enjoy higher pay than their private enterprise counterparts.  In addition to that, they are afforded better health benefits, vacation packages, and generous pay packages and benefits upon retirement.  When the world has all but forgotten pensions, many state employees enjoy the grandaddy of them all, a defined benefit pension plan.

It even seems quaint to talk about it since few still understand the difference between the defined benefit and defined contribution pensions.  It will suffice to say that the defined benefit is almost always much, much better, and much, much more expensive.  It’s quaint because most people who are not state employees in California do not even have a significant 401K, much less a crappy pension.  This is nothing compared to the Cadillac pension plan that virtually ALL state employees get.

So, to sum it up, California faces a budget shortfall of epic proportions.  It has parlayed every non-GAAP accounting trick in the book to delay the day of reckoning, hoping that pink ponies save them, but they have not.  The bill is quickly coming due, and indeed, the state may have even more troubles.  There is no way out.  Without serious pension reform (hand their asses back to them), taxes will have to be raised.  Given that the state already recalled one governor over licensing fees, I see this one going over like a lead balloon.  Meg Whitman has been campaigning that she can fix this mess.  I’m sorry, but there is nothing that will fix that mess except for a miracle or much higher taxes.  This still will need to invent something seriously out of this world to make that happen, or bite down on the bullet of austerity to balance the budget and maybe put something away for a rainy day (if it gets any rainier, this place is going to figuratively float away).

We need another investment bubble.  Luckily, the goldrush of 1849 proves that there is significant gold in them thar hills.  Perhaps we can put a tax on pickaxes and heavy machinery that will help us cover some of the shortfall.  With the bubbly prices that gold is now fetching, it might just do the trick.  However, I wouldn’t expect the Marijuana tax proposed earlier to make a big dent.  We’d need some serious potheads to move here to make it work (and they’d have to be stinkin’ rich to boot).

No, perhaps we we all need to collectively do as Californian’s is to do what CALPERS will in the end be forced to do.  Lower our expectations.  But, when have you ever known Californians to do that?

Houston, we’ve got a disconnect.

Housing to the moon!

I would remind readers, though, that predicting is a difficult art to perfect.  As Elizabeth herself states, she would have herself been surprised by the outcome of the pressures.  In the same way, “collapse” is probably a misnomer.  We will adjust, but with a quite different set of priorities.  Technology has improved many parts of our lives; but has contributed little to our happiness.  Our ancestors would probably be surprised how little we do with our large amount of spare time, but surprised at how hard much stress our daily lives entail; which is probably the biggest toll that the housing bubble has had on America; the human cost is much greater than the monetary cost, especially considering that our children and grandchildren will pay dearly for our stupidity over the past 5 years.

Much of the last 4-5 months has seen a veritable frenzy of activity in the housing market throughout Southern California and throughout the rest of the US.  What does this mean?  Have we hit a bottom?  Is it a dead cat bounce?  Or, was the last year a bump across the bottom before an explosion upwards?

Well, if you’re looking for easy answers, I don’t have a crystal ball, any better than anyone else, so it’s nearly impossible to tell you where its going.  But, I can tell you the basics of the Long, Medium, and Short term.  Much of this is common sense, but must be repeated constantly to remain tethered.

Long Term Prediction

Eventually, though, it’s an argument about inflation or deflation.  Housing prices relative to incomes, rents, and inflation have moderated, but at a much higher level than historically, as pointed out by Dr. Shiller above.  If this is indeed a bottom, the ramifications of higher home prices are profound.  Consider for a moment, the beginning of this thought expounded in the WAPO yesterday regarding the housing stimulus:

Putting cash in pockets does have a stimulative effect because some of that cash will turn into consumption. But as far as stimulus measures go, it has a low multiplier (the ratio of new economic activity to stimulus spending). By contrast, we could take the same cash and hire more teachers, police officers or soldiers to fight in Afghanistan. We would get more economic activity, and the government would get something for its money.

But the tax credit stabilizes the housing market, people say. What does this mean? It means that the credit keeps housing prices artificially high. But housing is something that all people need. Why do we want it to be expensive? Would we want government policies that artificially push up the price of food?

To take it a step further, is there anything in this world that we consume that we would cheer when it goes up in price?  Nevertheless, even knowing how wasteful, inefficient, and stupid the measure is, our congress seems intent on passing an extension of the home buyer credit.  Even worse, it appears to be expanding to existing homeowners, completely negating the originally intended purpose of clearing inventory.  Of course that could be in large part because inventory in many areas has dramatically decreased, and it’s simply a matter of pork and pork products for the housing industry.

Currently, housing prices receive the largest subsidy of any asset class, and for what?  To make our neighborhoods better in some way?

But isn’t it just better for more people to own their homes? The conventional wisdom is that homeownership has positive externalities: Homeowners are more likely to invest in their communities, and it is the best way to build household wealth. But the evidence for this is mixed. In “Our Lot,” Alyssa Katz cites three academic studies and concludes: “Scholars found that once they set aside the various traits that tend to determine whether someone chooses to own or rent one’s home, homeowners and tenants really aren’t that different. . . . Often the new homebuyers were purchasing the worst housing in the worst neighborhoods with the worst schools — hardly a solid investment.”

So, to recap, we’re giving money to people to do what they were going to do anyway, and thereby increasing our own costs and driving malinvestment into residential housing instead of manufacturing capacity or research and development reducing our country’s competitiveness.  We’re taking money away from firefighters, teachers, and policemen so that your neighbor can afford a larger SUV or better furniture, and this entire premise is built on the disproved theory that won’t improve our neighborhoods in any way?

As I mentioned earlier, the real fight is about inflation or deflation.  There is no doubt that inflation is a monetary phenomenon.  At the present time, the deflationary forces of deleveraging are stronger than the inflationary forces of the stimulus packages and absurd monetary policy.

Make no mistake about it, in the long run, our currency will be devalued through inflation to nothing.  This is the fate of every fiat currency, and given the political stupidity that occurs when large numbers of people vote conmen and shamsters into political office.  This is the state of the US, and there is no indication that this will ever change.  Just look at the last 30 years.  In this environment, you will want to hold assets, not cash in the long run.

Medium Term Prediction

However, in the long run, we’re all dead, so we need to know what’s going to happen in the next 3-5 years.  What we can expect are the following in the medium term.

1.  Higher taxes.  This is true of both state and federal taxes.  We are on an unsustainable path.  While most Americans would rather make do with smaller government, the fox guarding the henhouses will never allow themselves to be kicked out.  This means less money to be spent on food, housing, healthcare, education, etc.

2.  Low interest rates.  Financing will stay very loose as long as interest rates are held down.  This is the latest salvo on the war against savers.  Banks, governments, and every company is doing everything it can to separate you from your money.  Most Americans will simply give up because they know nothing else.  Saving will come from outside the US, and not inside.  American’s balance sheets are beyond repair.  Nothing can save the average consumer now.

3.  Commodities Bubble.  Expect the next bubble to be in hard assets.  Perhaps this is oil, gold, natural gas, copper, lumber, corn, porkbellies, wheat, etc, etc, etc.  The government DOES want prices to go up, and will do anything to make it.  It would rather destroy Americans in its quest to save them than to admit that they don’t know and just let the world sort it out.  Most commonly, those who think they understand economics are far more dangerous than those who study it.

To be sure, there are no easy answers, even in the medium term.  And, beware that many of the above issues work against each other, so it will all be relative.  For example, low interest rates will drive a weaker dollar, rising prices on products which will improve export industries that may end up increasing jobs and demand and moderate the decline of the dollar.  Such paradoxes routinely exist, and help prevent the currency of a diversified economy such as the USD from declining too quickly too fast.  But make no mistake, the endgame of the fiat currency is to fall to zero value.  Eventually, houses will hold their value, even if prices are still too high.  This just means that they will endure long periods of poor returns relative to other assets.

If housing prices stabilize here, there will be no free lunch that returns us to high returns. That can only come if they fall below intrinsic value, something I feel supremely assured in saying has not happened in Coastal California (not true of deep inland Cali such as the Victor Valley or Palm Springs).  Orange County, San Diego Coastal, Los Angeles Coastal, and Ventura and Santa Barbara Counties are still painfully overvalued in relation to their alternatives.

The medium term case to own a home in Coastal California is uncertain.  I predict that we will have a clearer picture in the short-term predictions, but there are no certainties with this much malinvestment.

Short Term Prediction

There has been a significant shift from foreclosures.  Various reasons abound as to the cause, but there is no clear reason that the Notice of Defaults has continued to rise to record astronomical levels while foreclosures have remained relatively low.

The Big Picture takes up part of that story with “Strategic Non-Foreclosure” and the Piggington site details some of the statistics in the recent past for SoCal.

Do not be misled, there is a serious imbalance that has grown between defaults and foreclosures.  Foreclosures are dramatically lower than they should be given the incidence of defaults.  There are 2 possible reasons for this imbalance:

1.  Banks are having difficulty foreclosing.  Numerous possiblities exist for this reason such as poorly equipped staff, moratoriums, trepidation of foreclosure while on government dole, stated contradictory policies, and many more.  The general perception is that this will eventually result in higher foreclosures once the problems are dealt with.  Noone knows when that historical balance will return.

2.  Banks are actually working out modifications and they are sticking.  This could mean that a dramatically higher number of modifications are being approved and they are having the intended effect of reducing the market’s fall.  This would be difficult to explain.  Never in history has this happened, but never in history have we been this indebted before either.

While it’s entirely possible that #2 is happening, the risk is much higher that #1 is the actual case.  The table is clearly tilted on a risk/reward basis that #1 is happening. Smart money should hold out at this time until the trend is clear.  While the past 4 months is the first indication of stabilization, an unbroken 1 year trend will be the clear signal.  The soonest that could happen is next spring.  That is the earliest BUY signal that the housing bubble could  give us since Summer 2005.  We will simply have to see if that buy signal is confirmed for early entrants.  Purchasing now is highly speculative and likely to result in knife-catching.

According to Occam’s Razor, it is beter to attribute the latest moves to #1.  I cannot stress this enough that the risk/reward ratio still favors waiting for much of Southern California.  The exceptions to this are areas where buying is at a significant discount to renting (some exist).  It doesn’t preclude the possibility of failure, but it does give options for medium term and longer term trends to mitigate the risks of buying a home now.  For coastal california, any purchase now can only be seen as speculative and imprudent.

The Final Wrap

The basis of any bubble is a speculative frenzy.  Recognizing the attributes of a speculative frenzy and the stages bubbles go through is critical to timing any asset purchase.

Remember, there is nothing more fundamental to investing than timing.  Anyone who tells you otherwise is a fool.  Timing your purchases of stocks, bonds, commodities, housing, or any other asset is critical to success.

My hope was that this country and its leaders could see the value of letting housing prices fall to their intrinsic demand value, but leadership is nearly absent in US politics today.  There does not appear to be an opportunity for this to happen any time soon.

If you waited to buy a house because it was too expensive, ask yourself, is it too expensive now?  This is the easiest concern to get over.  In the throes of the housing bubble, you would have been told by your agent that you should just lower your expectations.  Buy a smaller place.  Buy a place further out.  Buy a place you don’t want, but can afford.  I’ll dispel any myths, there is no such thing as a crystal ball.  Just as I tell you that scamsters like Gary Watts didn’t know was going to happen, we also only operated on verifiable information.  All information is telling us that while a bit of affordability has returned, the underlying problems with the housing market still exist.  Let’s outline those quickly:

1.  Housing exceeds healthy income limits for much of Southern California (inland areas are back to a healthy level, so this really only refers to coastal areas, and some pockets throughout.

2.  Interest rates are low, masking the affordability problems mentioned above.  Rates are low because the Federal Reserve is intentionally targeting mortgage rates by purchasing up to 50% of all issued mortgage paper.  This is only intended to be temporary, and at some point, not only will this be removed, the current leverage must be unwound.  It is likely that interest rates will proceed higher.  While noone can know for sure when this will be done, it is likely to have an impact in the 2nd half of 2010 and into 2011.

3.  Unemployment in Southern California is increasing.  This is a known fact, and is expected to peak sometime in 2010 if things immediately improve.  However, it is expected that the decline will be less than steep, and high unemployment could persist for up to 5  more years after the recession ends.  Add in that California has become a very difficult place for many businesses to continue due to high taxes and infrastructure problems, and many companies are looking at alternatives if they upstaff.  Only lower wages will attract them back.  Lower wages do not increase home prices.

4.  The option-arm Tsunami has not come yet.  With an expected default rate that is much higher than subprime, and a concentration in coastal California, much of pain that inland areas sufferend is expected to occur in the more expensive areas.  If this materializes, buyers today are “catching the falling knife”.  The option arm recasts are expected to peak starting this quarter and cresting late 2010 and not declining until 2011 or 2012.

5.  The move-up market is dead.  The most starkly different part of this bust versus prior busts is that many, many people over-leveraged their houses even more than their increase in value.  Indeed, so many people are underwater at prices that locals can afford that it’s impossible for the majority of home buyers to move up at all.  This is one of the reasons that the low end is the most active areas.  Higher areas are simply over-priced for locals who fear for their jobs and have suffered a calamitous stock market setback.

6.  The banking system is unhealthy.  Leverage, and indeed money supply is decreasing.  This is the backside of a debt-fueled overcapacity bubble.  First, it was businesses that were overleveraged.  Then it was households.  Soon, it will be government, and there won’t be enough income to support the levels of debt and still account for imperfections in the system.  Someday, we’ll worry about

So, if you’re still interested in buying after knowing all of that, don’t say nobody warned you.  I understand, sometimes the social peer pressures push us to do irrational things.  Just look back at the bubble.  And, with the seemingly invincible Federal Government pulling out all stops to stimulate housing sales and ownership, it might seem that you just want to throw in the towel and give it up.  I know, I’ve wondered if it’s worth the wait.  I won’t think bad of anybody who buys now.

However, if you’re waiting for prices to come down more, I believe they will, but don’t fool yourself, no one will intentionally catch the bottom.  I don’t believe we’ll see the bottom until noone cares anymore, that’s how bubbles work historically.  We are, however, still pulling demand from the future.  We’ll overshoot by that much, at some point.  It can be fast and painful, or it can be slow and painful.  Either way, we haven’t had pain in the coastal areas yet.

Besides, if you’re wanting people to think you’re a genius, you might be surprised to find that no one likes the smartest guy in the room.  I know a lot of Goldman Sachs employees are finding that out.

It’s no surprise to most readers, but banks are finally figuring out that which was already extensively investigated and reported on by SoCal bubble bloggers; that the primary determinant of foreclosure is not the point at which the buyer purchased the home, but rather all of the “wealth harvesting” that was done via refinancings and second mortgages.  Nowhere is this more prevalent than in Orange County, it seems.  Most of the area’s extravagent showings of wealth were actually extracted from home equity.

A recent study by CSU Fullerton with assistance from Fannie Mae has linked the correlation of cash-out refinancings with foreclosure.  The main takeaway:  Homedebtors who are now in foreclosure are not victims of circumstance (the prevalent thinking in Washington), but rather victims of their own selfish and greedy tastes.

The Wall Street Journal has some a great summary up by Nick Timiraos.

Michael LaCour-Little, a finance professor at California State University at Fullerton, looked at 4,000 foreclosures in Southern California from 2006-08. He found that, at least in Southern California, borrowers who defaulted on their mortgages didn’t purchase their homes at the top of the market. Instead, the average acquisition was made in 2002 and many homes lost to foreclosure were bought in the 1990s. More than half of all borrowers who lost their homes had already refinanced at least once, and four out of five had a second mortgage.

The original loan-to-value ratio for these borrowers stood at a reasonable 84%, but second and third liens left homeowners with a combined loan-to-value ratio of about 150% by the time of the foreclosure sale date.

Borrowers, meanwhile, took out around $2 billion in equity from their homes, or nearly eight times the $262 million that they put into their homes. Lenders lost around four times as much as borrowers, seeing $1 billion in losses.

“[W]hile house price declines were important in explaining the incidence of negative equity, its magnitude was more strongly influenced by increased debt usage,” writes Mr. LaCour-Little. “Hence, borrower behavior, rather than housing market forces, is the predominant factor affecting outcomes.”

What happened in SoCal over the past few years has been tragic, not only because of what happened to families, but rather that it was a tragic waste of human abilities; a misallocation of our skills into a non-productive asset.  Rather than investing time and capital into a productive enterprise, it was wastefully fed into a giant Ponzi scheme.

Unfortunately, old speculative habits die hard, as is evidenced by the dearth of investment-worthy housing in the midst of a sea of WTF asking prices.

Now that the goose that laid the golden egg is killed, cooked, and finding its way through the proverbial lower intestine of our financial system, wealth will need to be made from something other than housing.  Here’s to hoping it’s something that actually produces value for our company.  However, considering the loose monetary and regulatory policies that are still written in stone, I wouldn’t hold my breath.

California has staved off the day of reckoning for a few more months.  The can has been kicked further down the road with everything from taking from municipalities to pushing out payroll days to the next fiscal year (good thing they don’t have to conform to GAAP, or that wouldn’t have worked).

However, Jack Kyser is telling us that it’s not going to get much prettier.

Personal income will drop 2% in the state this year, the report said, the first annual decline since 1938.

“Most people haven’t experienced anything like this in their lifetimes,” said Jack Kyser, founding economist of the Kyser Center.

California’s jobless rate, which was 11.6% in June, will average 12.6% next year, according to Kyser, who also projected that Los Angeles County’s unemployment rate will be even higher, averaging 12.8% in 2010. The county’s jobless rate was 11.3% last month.

It’s going to be a doozy, and the economics aren’t getting any better.  Ever wonder why?  Well, the state and its municipalities are very generous to some people.  Take fire chiefs for example (I have nothing against them), but as the following story illuminates that a recent police chief retired at 51 with a $241,000/year pension plus still works as a “consultant” in the same job he just retired from getting paid $176,400/year.  Folks, that’s $417,400/year.  Retired.

The Wall Street Journal gives us the report on the outrage.

Still wonder why California is having budget problems?  Really?

Kyser says:

Kyser did not agree that the budget fix would help matters. Losses in revenue will continue to dog municipalities throughout the state, he said, potentially even pushing some into bankruptcy. Budget cuts will make it even more difficult to create jobs.

“The news from Sacramento is going to create more problems next year,” he said. “It could even get worse.”

It’s not getting better soon, though Kyser’s detractors say that the unemployment picture won’t go as high as the 12.6% he predicts next year.  I would only believe that with  mass exodus to nearby states/countries.

I love it when a plan comes together – A-Team’s Hannibal

Arnold Schwarzenegger has fired off his assessment of where California is today.  In short, we’re screwed.

Declaring that “California’s day of reckoning is here,” Gov. Arnold Schwarzenegger said today the state should turn its dire budget straits into an opportunity to make government more efficient.

Speaking to a rare mid-year joint session of the Legislature and other constitutional officers, Schwarzenegger acknowledged the billions of dollars in spending cuts he has proposed to close a $24.3 billion hole in the budget will be devastating to millions of Californians.

“People come up to me all the time, pleading ‘governor, please don’t cut my program,’” he said. “They tell me how the cuts will affect them and their loved ones. I see the pain in their eyes and hear the fear in their voice. It’s an awful feeling. But we have no choice.

“Our wallet is empty. Our bank is closed. Our credit is dried up.”

There’s still some hope:  Here’s where the cuts are coming from:

Schwarzenegger has proposed a plan that relies partially on accounting maneuvers and borrowing funds from coming fiscal years, but mainly on deep cuts in nearly every program funded by state government.

Those range from cutting spending on K-12 schools, community colleges, the University of California; releasing some non-violent prisoners a year early; cutting pay for most state workers and laying off others; closing 80 percent of the state’s parks, and wiping out or paring back on health and social service programs for California’s neediest residents.

California is broken and needs to be fixed to keep people here.  Maybe that’s not what we want.  Growth for growth’s sake has proven to be an untenable solution for us.  While we mourn the loss of programs, let us be happy for the new found frugality and self-sufficiency.  Maybe some day we can save up in the fat years to prepare for the lean years.

Foreclosures in April exceeded even March’s blistering pace with a record 342,000 homes receiving notices of default, auction notices or undergoing bank repossessions, according to a regular industry report.

One of every 374 U.S. homes received a filing during the month, the highest monthly rate that RealtyTrac, an online marketer of foreclosed properties, has recorded in four-plus years of record keeping.

“April was a shocker,” said Rick Sharga, a spokesman for RealtyTrac. “I would have bet on a dip because March foreclosures were so high.

Instead, filings inched up 1% from March and rose 32% compared with April 2008.

Indeed, for those who do not keep up with the lingo, you may want to google what a shocker is.

For those wondering, I’ll give a visual:

Shocker!

If this is in bad taste, let me know, but the foreclosure numbers are definitely a surprise.  Sometimes, I’m not sure if living in SoCal has warped my sense of humor.

And, for those seeing green shoots in the economy, I doubt you”ll be seeing a corresponding positive report out of housing.  We may very well be in a strong dead cat bounce this year (much like California experienced in 1993) as housing prices realign themselves.

There were 63,900 bank repossessions, the last stop in the foreclosure process. More than 1.3 million homes have now been lost to foreclosure since the market meltdown began in August 2007.

The increasing foreclosures will force RealtyTrac to rethink its forecasts, according to Sharga. “We had been predicting 3.4 million filings for the year,” he said, “but we’ll blow those numbers out of the water.”

With so much uncertainty, I can only stand by my predictions for 2009.  There will be some up and some down areas.  Overall, the direction is down.

California recently took the steps to reduce government deficits by raising taxes:  1% on sale tax , and raising income taxes.

It doesn’t seem that this worked out too well.

From the information that came out, California is pretty much KlusterF*(ked. With a kapital K.

From the May 09 Summary from the state controller’s office.

Compared to April 2008, General Fund revenue in April 2009 was down $6.3 billion (-39%). The total for the three largest taxes was below 2008 levels by $6.3 billion (-40.3%). Sales taxes were $452 million lower (-50.9%) than last April, and personal income taxes were down $5.7 billion (-43.6%).

That’s gotta hurt.  This recession is going to make things even more difficult.  California is wanting to start talking about legalizing pot.  Some ideas have been floated of putting a $50/oz tax on recreational use.  Nice.  At this point, California needs to do something big.  Look to have even higher taxes and even more people leave if they do.

As part of my 2009 forecast, I saw California unemployment rising to 11.5% by year’s end.  That single tidbit is likely to be proven wrong, as it is obviously too optimistic in the light of what the BLS has offered today.  Their estimate of regional and state unemployment weighed in at 11.2% for California. At the rate we are bleeding jobs, that’ s not likely to be the end of it.  Besides, employment typically lags tops and bottoms of business cycles, so even if the recession were over tomorrow, we’d likely blow through the 11.5% rate.  Though, to be fair, 11.2% is already a record, so it’s hard to predict what will happen next.

Over the last year, Caliofornia has lost some 637,400 (est) jobs.  In Feb 2009, the rate of unemployment stood at 10.6%.  There is no pricing pressure (except downward) on houses with job losses like this.  We have now left the barn of bubble-delfation driven price decreases, and have now entered into the economic eqilibrium impacts that job loss creates.  The number of jobs in California now stands at 14,474,700.  March of last year the state reported 15,112,100 jobs.

Due to the relationship of jobs to inflation, it is unlikely that absent even more massive money creation, business or homes will have any pricing power in 2009.

At present course and speed, and assuming some moderation of the the the rate of increase, I’d say it’s likely that we exceed 13% unemployment in 2009, and that California is still receeding economically until 2nd half 2010 or so.  (The national recession, I believe, will end sooner than that at the end of this year or early next year.

THE fundamental causes of this recession, unique in the experience of the United States, were mortgage defaults and the consequent insolvency of major financial firms. These insolvencies, and especially fear of them, damaged normal credit mechanisms.

The self-correcting nature of markets will ultimately prevail. We should not underestimate the power of monetary policy; with the sharp increase in the nation’s money stock starting in September, monetary policy is now extraordinarily expansionary. I believe, though without great confidence, that the recession will end in the second half of this year.

Federal policy is damaging the economy’s prospects. It fails to provide the needed tax incentives for investment in factories and equipment, incentives that were central to efforts to revive the economy during the Kennedy-Johnson era and under Ronald Reagan. But government spending can’t lead the way to sustained recovery, because its stimulating effect will be offset by anticipated higher taxes and the need to finance the deficit.

I, of course, agree with this assessment (although I believe the recession could linger quite a bit longer due to the current political response). There are 2 fundamental problems with the current administration’s approach:

1. Changing the rules of the game only makes sure players will wait until they are clear on what the new rules are before they begin playing again.

2. History has told us (even though we have deflation now) that a strong increase in the money supply is inflationary. The lag time between the money creation and the effects to rising prices is measured in years, not months.

In the end, a more moderate monetary approach, with the INCREASE in foreclosures, and expedition of foreclosures and bankruptcy will speed the recovery that much faster. It’s the difference between ripping the bandaid off (which is what free markets do to minimize pain) and slowly pulling it off.

We can’t forget that FORECLOSURE AND BANKRUPTCY ARE THE SOLUTIONS, NOT THE PROBLEM.  The problem is too much debt, and the only way it can be resolved is the legal resolution as quickly as possible.  All attempts to forestall the solution are forestalling the recovery in our economy.  Once people are no longer held captive to bad bets, their discretionary income can once again be released and well-run businesses can capitalize on the demand.

Magical thinking comes in many flavors, but isn’t entirely unuseful.  It helps when systems are so complex that it would take so much time to simply understand the system of events required that it would be impractical to act before a rational decision could no longer be effective.  Much of what we see today in public economic forums is massive amounts of magical thinking.  That somehow, if we meet certain conditions of yesteryear, we will “put a floor” in on home prices, the stock market, and the economy as a whole.  Unfortunately, we are in some cases only delaying the inevitable, and in many cases worsening the outcome of the housing bubble.

In a rational, efficient market, participants act in a personally beneficial way.  Often, when participants act in a personally beneficial way, this benefits society as a whole.  However, because the system of decisions needed is inherently complex, a bit of the system sometimes needs to be mentally “fudged” to make the whole issue work.  This is often what people mean when they refer to the “50,000 foot view”.  In centralized organizations, a leader with this type of view depend on their underlings being able to translate this kind of vision with on-the-ground experience to execute the plan.

Some examples that have recently come to the forefront:
1.    Provide a tax credit to homebuyers

2.    Banks failures cause more hardship than paying to save them

3.    Large industrial producers cannot be reduced because they will crash our economy

Tax Credit to Homebuyers:

Unfortunately, it appears that we have more turned into a Cargo Cult that focuses not on the productive activities, but to somehow hearken back the golden days of yore through repeating the same stupid rituals that brought the original cargo planes and our former riches.  This is a complete erosion of the American fabric; a lie to western peoples that economists know the way out better than prudent business people.

Many in the government have noted that in the last 20 years, rising home prices produced a large benefit to homeowners.  They were able to borrow against their houses to fund growth in the economy.  The solution to our ailing consumption, it must mean, that houses are undervalued and need to be propped up.  Never mind that the last 20 years has been an historical aberration, a flyspeck on the overvalued of all overvalues.  In our current policy, “reversion to trend” means an upward reversion of the home price appreciation to +10% per year.  No matter that in many locales in the US, our incomes have not kept pace with the cost of homes and therefore we are already dedicating too much of our income to housing.  We all need a REDUCTION in home prices for consumer spending to increase.  Anything else (such as increased incomes) would put us as a country even further behind in competitiveness with respect to global wage arbitrage.  I’m not a purist in the sense that I feel that we need to have a large manufacturing base, but our economy has got to consist of more than trading houses and debt amongst ourselves.  The longer we wait to realize this and return incentives to work, risk, and honest reward, the more we as a country suffer.  There should never be a return to leisurely earning above the rest of the world because there is no such thing as barriers to entry in the long run.  Eventually, our wealth will be eroded if we do not continue to maintain a global competitive advantage (and I don’t mean in financial engineering).

People are currently rational.  They’d love nothing more than to return the heady days of 2007 where they spent willy-nilly on consumer goods.  They really would, but they also realize that the only way to do that is to reduce their consumption of something else.  Something that doesn’t produce much satisfaction in their lives: housing.

Bank Failures

This is perhaps one of the most prevalent of magical thinking.  In the participants mind, the bank failures of the 1930’s created a fear of banks when they failed.  At that time, this had 2 effects:  1.  People would have rather stuffed the money in their mattresses, collapsing monetary velocity and trade.  2.  This collapse of bank deposits put otherwise healthy banks in a more precarious positions since they could not maintain adequate reserve ratios and were then insolvent.  I believe that we do not have this type of environment, partially because of the lessons learned over the past 80 years.  The FDIC creates a kind of buffer that assures accountholders that their money is safe (within limits)  Most can ensure all of their money is safe by maintaining multiple accounts at multiple banks.  People do not want money stuffed in their mattresses, and will only do so if they believe the government will begin to confiscate it.  Harebrained ideas such as an asset tax or cash taxes will assuredly collapse velocity and many banks along with it as depositors choose to stuff Ben Franklins in their pillow cases.

Today’s problem has little to do with the same problems as the 1930s.  Today, the mark-to-market accounting rules have substantially decreased the value of assets that depositors’ money was attached to while bank deposits have not done much.  However, most of those assets should never have been purchased because they were junk to begin with.  Most were a Ponzi Scheme where the greater fool needed to come along before their next balance sheet review or FDIC stress test.  In the past, the FDIC would sieze the bank and sell off the parts, making the secured creditors partially whole and making the equity holders eat dirt.  The shortcomings on depositors would be made whole by the FDIC before anyone else.

Circumventing normal market clearing practices for these liabilities and assets will ensure that the required write-downs necessary to produce never happen and that the remaining “Zombie Banks” will continue in perpetuity with damaged assets; unable to lend due to the need to recapitalize.  More importantly, (or at least as important), the current leadership fails to be deposed; ensuring the problems of yesteryear are never allowed to become discovered and the organization can never move on from prior mistakes.  The leadership is every bit as damaged as the assets the banks hold.  To keep them in place is to reward bad behavior and ensure that we do not have a return to long-term profitable business practices.

Our current populace is engaging in magical thinking to believe that if we just keep the banks alive for a little while longer that they will be able to return from the dead.  The only result will inevitably be zombies; having the appearance of life, but dead and hungry for brains.

Large Industrial Producers

This one is about GM.  I believe this one to be a very different animal than banks and requires a more sophisticated resolution; but let’s be clear: allowing GM to continue to operate without destroying the unions as they now exist is in effect transferring taxpayer money directly to GM union workers.

At the present time, bankruptcy for GM holds 2 major obstacles that are not related to the above
1.    No sufficient Debtor In Posession (DIP) financing exists in the private sector.  Without government intervention, GM could only progress directly to Ch7, which would be a shock to the economy.
2.    Even progressing to a Ch11 bankruptcy protection shows that consumers would likely boycott GM products as a safety measure.

Therefore, you can see that a traditional bankruptcy for GM is not an option if we do not want to add several hundred thousand directly to the dole and probably reach several million before all is said and done.

In the 80’s Chrysler was bailed out with a loan from the government.  It is simply magical thinking to believe that we can make a loan with attractive terms and the whole problem will go away.  The issue is that with each infusion, the company becomes more dependent on the donor.  We are raising a vegetable company.  Therefore, the problem must be attacked with swiftness and exactness.  Most importantly, the 30 and done has to be removed and made retroactive.  Sorry, you shouldn’t be able to retire until 70, and if that sucks, it sucks; get a job lowlife.  None of the rest of America has a cush job with secure retirement; you won’t be getting it either.  Sorry.

However, doing nothing while making large loans that go directly to pension beneficiaries is inherently unfair to workers everywhere and distorts normal competitive markets.  With the kind of money that GM is getting, many skilled could come forward and rebuild a competitive auto company.  The failed leadership that has complained about the problem yet done thing for the last 30 years while foreign competitors ate our lunch cannot be rewarded, nor should bondholders who are essentially being treated like Treasury holders be either.

In conclusion:

I believe our country’s leadership is unable to see how the magical thinking of today will translate into actionable items of tomorrow either because they fail to see personal motivations of participants, or because they have failed to see the solution and worked their way back putting into place contingency plans.  Until we have a workable solution, we will continue to pour money down the drain and extend the recover further.

The systemic risk is that since credit = debt = money, we can pretend that there is more of it than is possible. That is because debt cannot exceed some fraction of the potential future amount of work. When it approaches that point, confidence collapses and the debt is destroyed. We have gone through this over and over and over in history. The hot fad now is to think government can alter this cycle by creating even more debt. The answer to that is : ha ha ha ha. Think it over: by preventing the destruction and extending the time frame of debt (by financing with future deficits) the government lengthens the process, as it did in the 1930s, rather than decreases it.
We are in for a loooonnnnnnnng one this time.

That is why we are just fiddling while Rome burns.  Twist from Housing Doom had it right: what we need right now to fix the housing market is MORE Foreclosures, not LESS.

I’ll start at the beginning. Adam Smith wrote a book called “Wealth of Nations”. At the heart of this book was the concept that individuals attempt to maximize their own personal profit. A lengthy discussion of capital, labor, and revenue conceded that individuals seek to minimize the cost of production and maximize their own personal intakes. This is the reason that we stand today at the brink of quick and painful deflation. (Unless our leaders force us to long, deep, and painful deflation.) However, it is important to remember that Smith was not concerned with money or the use of money. His analysis was only ex post facto considered the defining text for a field of study, economics. Up until that point, trade was only infrequently international and the costs of trade were quite excessive and time-consuming. Modern economists have become so entrenched in the day-to-day predictions of economic output that they often forget to look at the big picture of economics and what it means. Even the most popular “economist” bloggers of today largely ignore basic economic theory and tend to focus more on policy and politics (Paul Krugman comes to mind as a perfect example of this dichotomy as an “economist” but opining almost singularly on political rants and ignoring the motivations of individuals and how the present environment changes them). The only blogger or writer I have found that engages in a realistic discussion of economics is Mish (Mike Shedlock) of Global Economic Analysis. His insights have largely influenced my ideas of the last few years and its application in investing. I applaud his most recent discussion of how Peter Schiff got his hyperinflation call all wrong.

Adam Smith wrote:

What is the species of domestic industry which his capital can employ, and of which the produce is likely to be of the greatest value, every individual, it is evident, can, in his local situation, judge much better than any statesman or lawgiver can do for him. The statesman who should attempt to direct private people in what manner they ought to employ their capitals would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.

This predisposition leads us down the road of what competitive advantage each country has at its disposal.  In the natural progression of industries, whatever component of production is in greatest shortage will grow in cost.  This is considered a shortage.  Everything has a point at which it becomes the bottleneck of production and therefore to employ more of it in production, the price of it will rise to bring additional resources that were engaged in lower-value activities.  In the most recent past, labor within established economies was the choking point and wages increased strongly for many years.  It seemed that these gains were not only here to stay, but would increase in infinity.  Under normal circumstances, these pressures are offset by automation.  By investing capital into additional production machinery, the cost of production can held in check.  In Adam Smith’s world, the “invisible hand” of profit maximization motivation means that this transition is seamless.  In periods of major labor dislocations, investment is “lumpy” meaning that spurts and stops of investment cause labor to be temporarily in shortage or in tight supply.

For the decade of the 90′s, despite a recession, labor demand grew quite steadily.  At the same time, an entirely new labor force for America was being trained on the other side of the world.  Several types of labor were created in India and China; production and information workers.  With India’s long history of British influence and control, they were largely positioned as an alternative to information workers in the United States.  Until the infrastructure was created in the 1990′s to provide real-time support and analysis, the use of place-shifted information workers was largely unheard of.  After the late 90′s, it was a matter of general business in the US.  While the Tech bubble drove up IT costs to insane levels, most companies were planning to offshore as much of the information workers world as they could.  India had done an incredible job of attacking this part of Corporate America, both here (through H1B lobbying) and abroad(through direct outsourcing).  Meanwhile, China was feeding off of the wealth of the West by siphoning off manufacturing jobs.  First, it was manual menial labor, and later, skilled labor of all kinds from jewelry manufacturing to circuit boards.  American’s often now lament that nearly nothing is produced in America.  We, it seems, have priced ourselves out of the labor market.

Which leads us to the outcome.   America has lost the orignal source of its wealth: innovation and manufacturing.  Luckily for us, we own some quite valuable assets; Intellectual Property and real estate. (okay, we’ve got more, but that’s not really what this is about)

While the cost of labor was rapidly declining, and in an environment of tight labor supply (much of the 90′s and this decade), most Americans found high paying jobs such as consulting, sales, and management.  While these are often high paying jobs, they can be quite transitory. Meanwhile, the cost of everything was getting relatively cheaper compared to incomes; food, housing, computers, cars, etc.  Indeed, the loose monetary policies were in a sense combatting this dramatically increased productivity and lower cost labor.  We were digesting it quite well; however right around the corner was indigestion.  This indigestion was where monetary policy was letting us go.  We overheated and the engine of growth stalled.  There was nothing more to milk out when our housing bubble hit.  When  prices of the #1 asset owned by most Americans began to defy logic, reason, and prudence, most took it in stride.  To make up for diminishing household income in real terms, most just extracted the equity of their homes.  Because lending on real assets had proven so effective in the past, investors, cheered on by a FED determined to keep money flowing freely accepted lower and lower restriction on limit, chasing yield.  This chase of yield ended in multiples of leverage beyond human comprehension.  Meanwhile, average Americans could get a piece of their own leverage with low-down or even zero down (and frighteningly negative down 120% loans in some cases).  When prices were normal, this worked as there was little stress on incomes and savings could account for some losses.  Once prices began rising, consumers found little need for savings when their homes were provding them for us.

Which is what led us to the housing bubble popping when noone could afford their own home and noone could continue to pay their mortgage (more or less nearly everyone who “owned a home fit into one of these, if not both in Southern California in 2006-2007).

While we are deleveraging, deflation is setting in.  There is no way to combat this without creating massive amounts of money.  Where that money ends up is no matter when you’re in the storm of deflation.  Right now, 0 interest rates are all that are keeping us from a deflationary depression.  We’ll see what wins out.  Adam Smith’s invisible hand dragged jobs out of America.  Perhaps one of our own “economists” can provide us a way to bring them back.

Which brings me back to a statement I made back in November of 2006:

Historically, strongly inverted yield curves have historically preceded economic depressions… and normal inversions have preceded recessions.

I also agree that we have a “normal inversion” signalling a potential economic recession.

One of the questions that is somewhat debateable is still what makes this time different:
1. There is a lot of liquidity still in the system. China, for instance, has waaaaay too much currency reserves, and heavily weighted towards USD… depressing our rates in treasuries, likely setting off our really low mortgage rates as well. Mortgage rates could snap back due to a variety of situations, not the least of which would be higher defaults. Of course, the cows have already left the barn, the question only remains how fast will lenders close the gates?
2. Lending standards in the mortgage area are likely the lowest they have been in history. Lenders are offering neg-am option-arm, no-doc, teaser rate loans to people one day out of bankruptcy. Best Funding here in L.A. even advertises to this kind of people. I don’t know how you can get any lower than that.
3. Bank reserves are frighteningly low. Why the FED has not yet stepped in to raise reserve rq’s is beyond me. It’s like a drunk asleep at the wheel. I just don’t know when it crashes, but it’s going to. I wonder how much the FDIC designation is going to mean then… I wouldn’t recommend to anyone to exceed those amounts… open more accounts at more banks if you have to, but you dont’ want to take a haircut on cash.
4. The stock market is surprisingly bullish (might be a sucker rally, but I can’t say for sure). Either way, I can sense the tenseness on Wall Street. I am tempted to liquidate everything and hold cash for a while, just because spooked investors can pack the exits at any time.

Some time ago, someone was mentioning stagflation… something which is absolutely garbage. There is no comparison of now to the late 70’s. Still, i might be led to see the uncanny similarities to the ‘72-’73 market.

By your statement, you and I are both asset deflationists, however, the FED can (under pressure) jam the ZIRP pedal and go to infinity with debt monetization to stimulate the economy. It would tank the dollar, but we might actually start producing stuff again. If that doesn’t save us from price deflation, then there is no hope for Keynsian monetary policy in the future.

We’ll see if Keynsian Monetary policy can rescue us here.

Platinum 5 year

Silver 5 Year

Palladium 5 Year

Gold 5 Year

What do you think? Is gold going to fall to meet it’s historical relationship to other metals, or will the other metals rise?

Can you believe that platinum is priced on parity with Gold?

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.

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.

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:

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?

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.“

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.