Elephant In America's Living Room

In the second half of 2009, we witnessed a dramatic increase in investor risk appetites and the reduction in risk premiums relative to US treasuries. Speculative interest in riskier assets rose further over the balance of December.  Yields on 5 and 10 year treasuries increased about 9% and gold prices decreased 6% while the VIX rose 2% due to a sharp 8% advance on the last trading day. The VIX is often referred to as the "fear index" and represents the market's expectations of volatility over the next 30 day period. Since 1990, the VIX has typically traded at 20 or above, except during the periods of highly stable economic activity from 1992 to 1997 and 2004 to mid-2007.  The decline of the VIX below 20 is highly unusual given the consensus view of the Federal Open Market Committee that higher than normal economic uncertainty lies ahead.  In this context, portfolio insurance is now very cheap from a historical perspective.

 

This rise in investor complacency appears to reflect wide market acceptance that the U.S. economy and financial system has returned to "normal" based in part on recent self-congratulatory commentary by Fed and treasury policymakers.  Hazy suggestions have been made that the recent financial crisis has been resolved "profitably" simply because most of the TARP money has been repaid by too-big-to-fail financial institutions.  The government's mission accomplished banner is once again prematurely on display.    But the "open secret" is that things are far from "normal."  How can they be with an elephant in America's living room?

 

 

 

The expression "elephant in the room" refers to a situation where something hugely dysfunctional is going on.  It's on everyone's mind and impossible to ignore -- like an elephant in the room.  Yet nobody talks about the "elephant" because nobody knows what to do about it. For example, Uncle Barleycorn is busily getting intoxicated at the family Thanksgiving dinner. There's ultimately going to be a drunken scene with pink elephants on parade. But everyone feels powerless and chooses to ignore his behavior and pretend everything is normal.

 

The elephant in America's living room is the Federal Reserve and U.S. government's pervasive support of the housing and mortgage market.  Fed holdings of mortgage securities is substantial and growing as the following chart depicts.   In the chart, MBS is mortgage backed securities.  Agencies represent holdings of Fannie Mae and Freddie Mac paper.  Maiden Lane and other assets represent the bailouts of Bear Stearns and American International Group (AIG)). 

 

 

 

Lest someone think the ubiquitous government's role supporting the economy and financial system is diminishing please note that late last year GMAC Financial Services received a third round of TARP bailout funds from the U.S. Treasury Department, and the government took a controlling stake in the company.  The troubled auto and mortgage lender received $3.8 billion of additional aid on top of the nearly $13.5 billion already received since December 2008.  The fresh lifeline is intended to avoid placing its home lending unit, Residential Capital (ResCap), into bankruptcy. ResCap was one of the largest subprime mortgage underwriters.  With this capital infusion, our government retains yet another prop for the mortgage and financial systems to go along with its fiscal backing of money losing Fannie Mae and Freddie Mac and the Federal Reserve's massive mortgage securities purchases.  The NY Fed has estimated that its purchases lowered mortgage interest rates by 1.5%.  In other words, free market mortgage rates would be substantially higher absent Fed intervention.  Last but not least while we were busy with family gatherings, the U.S. Treasury made a Christmas eve announcement that it would be providing Fannie Mae and Freddie Mac with unlimited financial support for the next three years. Release available at http://treasury.gov/press/releases/2009122415345924543.htm

 

Like an elephant in your living room, these government actions do not reflect normalcy and order, but rather dysfunction and chaos.   Much like Uncle Barleycorn's holiday folly, the government and Fed's behavior will likely have costly, unintended consequences. But there will also be opportunities in the aftermath.

 

During my transition period from public company CFO in 2003-2004, I recall telling my pre-teens while at the Ringling Brothers & Barnum and Bailey's Greatest Show On Earth that if I couldn't find employment in finance, I was certain there was a job for me in the circus (or government).

 

 

Green Shoots and the Sower

There appears to be growing conviction that what we've been witnessing the past eight weeks in the stock market is something more than a bear-market rally. Unfortunately, this is not the beginning of a secular bull market.  Bear market conditions will likely resume.  Buying the S&P 500 at these valuations is very risky given the awful economic fundamentals and considerable work required to repair the damage to the financial and economic system caused by the excesses of the past two decades. The massive monetary and fiscal policy responses to this crisis alone would suggest that this will not be a typical recession and recovery in severity or duration. 

 

Grant's Interest Rate Observer estimates that the government has currently provided combined monetary and fiscal stimulus of approximately 30% of U. S. gross domestic product (GDP) of $14.2 trillion.  This level of stimulus is unprecedented.  For example, monetary and fiscal stimulus applied in The Great Depression period of August 1929 to March 1933 totalled 8% of GDP.  The combined stimulus in the 2001 recession totalled 7% of GDP.  The central issue for the U.S. economic system is that we have too much debt - personal, corporate and governmental.  Total debt to GDP approximates 360%, up dramatically from 230% in the early 1990s.  This debt needs to be paid off through savings, restructured (debt for equity exchanges), destroyed through defaults or otherwise inflated away. This is likely the beginning of a major generational economic adjustment with prudent savings for retirement replacing profligate spending of the massive baby boomer generation.  Consumer spending represents approximately 70% of U.S. GDP and will be adjusting downward toward 63% level as the consumer savings rate rises to 5% to 10%.

 

U.S. economic issues of this size and scope will not be resolved quickly.  Ever since Ben Bernanke, chairman of the Federal Reserve Board, told 60 Minutes in mid-March that he detected "green shoots" of economic recovery, the phrase "green shoots" has become an often used propaganda message.  Desperate for any sign of hope, the political establishment, Wall Street strategists, and media experts have taken to repeating the phrase "green shoots" as a soothing mantra.  The Administration, Congress and the Fed continue to throw manure on these economic "green shoots."  Please do not let this beautiful farming imagery mask the truth. In reality, the U.S. economy has only shown signs that it was deteriorating more slowly.  This passes for improvement and economic "green shoots."  Like life, there are no shortcuts to economic nirvana. There is a lot of hoeing still required to get our economy back on a sustainable growth path.  As Dwight Eisenhower once said  "Farming looks mighty easy when your plow is a pencil and you're a thousand miles from the corn field."  In short, Ben Bernanke is an academic, pencil pushing bureaucrat, not a green thumbed farmer.  Some of Ben's monetary actions and related Federal policy responses will undoubtedly fail to produce the intended results and may also have major unintended consequences.

 

This is reminiscent of the parable of the sower. The parable tells of seeds that were erratically scattered by a sower, some falling on the road and consequently eaten by birds, some falling on rock and consequently unable to take root, and some falling on thorns which choked the seed. According to the parable, it was only the seeds that fell on good soil and were able to germinate, producing a crop thirty, sixty, or even a hundredfold.  Like the sower in the parable, the U. S. government has crudely distributed massive amounts of monetary and fiscal stimulus (seeds). Unfortunately, many financial experts believe that only a limited number of these economic seeds have been targeted to the "good soil" of infrastructure projects or other fertile commercial areas that will ultimately enhance the long term productive capacity of our nation.  The rest of the seed has fallen on road, rock or near thorns.

It's the Consumer Stupid!

Many investors took comfort last week when initial US gross domestic product (GDP) for the first quarter of 2008 was reported at 0.6% compared to consensus of 0.3% and initial unemployment for April came in at 5.0% versus consensus of 5.2%. We believe these initial reports are suspect and subject to negative revisions in the future.  Furthermore, since the consumer represents more than 70% of US GDP as the US consumer goes so goes the US economy. 

As we wrote last fall in "This Ain't My American Dream" about the subprime mess and credit excesses,  "Many of these young Americans will wake up some morning to find that their irresponsibly financed excesses of recent years have left them with no equity in their homes, no liquidity and limited access to credit.  How these young Americans and other citizens in similar situations respond will likely be a key determinant of the future direction of the United States economy and government leadership."

One of the best sources of information on current consumer sentiment is the University of Michigan/Reuter's Consumer Confidence Survey.  The headline of their April press release says it all, but here are some additional stats that paint a more complete picture of the American consumer's psyche.

• Headline "Confidence Sinks to Quarter Century Low"
• The Index of Consumer Sentiment was 62.6 in the April 2008 survey, down from 69.5 in March, and significantly below the 87.1 recorded last April and the recent peak of 96.9 recorded in January of 2007.
• The Index of Consumer Expectations, a closely watched component of the Index of Leading Economic Indicators, was 53.3 in the April 2008 survey, down from 60.1 in March, and well below the 75.9 recorded in April 2007 and the recent peak of 87.6 in January 2007.
• From the January 2007 peak, the Expectations Index has fallen 39%; the Expectations Index fell by 24% prior to the 1990 recession and by 30% prior to the 2001 recession.
• Just three-in-ten consumers plan to spend the tax rebate in 2008, with most consumers preferring to repay debt and add to savings.
• Smaller gains in inflation-adjusted incomes were expected in April than at any time in the past quarter century.
• Consumers expect the unemployment rate to steadily increase during the year ahead, rising to 6.0% by the start of 2009.
• Nearly nine-in-ten consumers thought the economy was already in recession, and three-in-four anticipated that bad financial times would persist for at least another year. This was the worst assessment of overall economic health since the early 1980's.
• Uncertainty about future income and job prospects has had a devastating impact on buying plans, with consumers citing these uncertainties three times as frequently as they did a year ago.

Although the Fed arguably prevented a systemic shock to the financial system with its rescue of Bear Stearns, as it relates to the broader economy the Fed can simply hope to promote a monetary environment conducive to stable prices, employment and growth and hope that the public and economy respond appropriately.  Naturally, we can expect to hear government propaganda statements about the health and resiliency of the US economy with increasing frequency (think reverse psychology, political agendas and legacies), but by no means do Ben Bernanke, Hank Paulson and the Federal Reserve control the direction of US economy.  Rather, the answer to the question of who controls the future direction of the US and global economy is "It's the consumer stupid!" (according to an oft used campaign quote from President Clinton).

This Ain't My American Dream!

The title for this article comes from a line from the song American Dream by Switchfoot.  The song tells a story about a young American who has a wake up call about living excessively.  The song lyrics are an excellent metaphor for the state of the United States financial system and economy brought on by the subprime mortgage mess and credit excesses of the past decade.

When success is equated with excess
The ambition for excess wrecks us
As the top of the mind there becomes a bottom line
Where success is equated with excess

Despite early Federal Reserve assurances that the subprime mortgage troubles would be contained and not cause significant spillover into the financial system and economy, it has occurred.  A comprehensive summary of the subprime crisis mess is available here on Wikipedia. 

As a result of this spillover, the risks of continued market adjustments and adverse economic fallout have increased significantly as past excesses are removed from the housing, credit and equity markets.  The contraction of credit in the subprime and prime mortgage markets has already led to downward pricing pressure in housing in certain real estate markets and the dramatic repricing of mortgage backed securities.  Similar debt deflation may also continue to play out in the debt and equity markets.

Like a puppet on a monetary string
Maybe we've been caught singing
Red white blue and green

But the Federal Reserve does not control the United States economy or its citizens as if they were puppets on a string. At most, the Fed can promote a monetary environment conducive to stable prices, employment and growth and hope that the public responds appropriately. 

The following considerations signal the great difficulty of the subprime financial crisis facing Federal Reserve Chairman Bernanke:

·      The Federal Reserve Chairman’s view of severity of the subprime troubles and its potential impact on the financial system and the economy has deteriorated rapidly.

·       Federal Reserve regulatory framework places considerable emphasis on market discipline. Therefore, the stability of the financial system depends on adequate risk measurement and management by market participants. Recent events raise questions about the adequacy of the risk controls by several market participants. This was particularly evident in financial industries that experienced rapid growth such as non-bank mortgage lenders (several have filed for bankruptcy) and hedge funds (bankruptcy of two Bear Stearns hedge funds and a large capital infusion to one Goldman Sachs hedge fund). In addition to their rapid growth, these industries are characterized by the use of sophisticated financial instruments such as asset securitizations, leverage and derivatives.

·       Note that unlike their bank and mutual fund/investment company brethren, non-bank lenders and hedge funds are lightly regulated.

When success is equated with excess
When you're fighting for the beamer, the lexus
As the heart and soul breathe in the company goals
Where success is equated with excess

We have witnessed an out-of-control credit expansion with company profits of the financial innovators - non-bank lenders and their financiers - taking precedence over the public good.  These financial innovators created new financial products (eg. subprime mortgages and consumer loans, asset backed securities and related securitizations, credit derivatives, interest-only mortgages, negative-amortization mortgages) whose risks were not well understood by consumers and investors.  The long term nature of these instruments makes the estimation of expected profits/losses and their valuation subject to considerable judgment since the economic outcome is contingent on future events.  These valuation difficulties are usually accompanied by enormous incentives to cheat in accounting because employee compensation is tied to reported company profits. Such features may allow profits to be initially reported when the actual underlying transactions will be unprofitable at the end of the day as occurred in the underwriting of subprime mortgages.

This quote from Warren Buffett in Berkshire Hathaway's 2004 annual report appropriately summarizes the situation of the financial innovators.

Investors should understand that in all types of financial institutions, rapid growth sometimes masks major underlying problems (and occasionally fraud). The real test of a derivatives operation is what it achieves after operating for an extended period in a no-growth mode. You only learn who has been swimming naked when the tide goes out.

With the tide receding, our economic tale arrives at the consumer - the linchpin to the United States economy. 

·       Most American consumers are tapped out after a credit financed spending boom. Many do not know it yet, but their sources of credit have dried up.

·       70% of US GDP is tied to consumer spending. Arguably the boom in real estate and credit resulted in an increase in consumer spending, which has fueled economic growth. Now that the United States real estate and credit markets have cooled off and are contracting, one might reasonably expect a decline in consumer spending and hence a decline in economic growth.

·       According to a Beacon Economics study entitled "Savings and Asset Accumulation Among Americans 25 – 34"

Savings rates in the United States began to drop in early 1980s, from 11 percent of disposable income to 2 percent in 2000. Savings rates dipped into negative territory in 2005 and the first half of 2006. People are literally spending more than they are earning after taxes for the first time since the Great Depression.

·       The net worth of most Americans has declined from 1985 to 2004, particularly among 25 – 34 year olds.  This latter group likely represents a good cohort for the subprime and non-prime mortgage borrowers.

The mean net worth for all American households 25 to 34 increased from $25,000 in 1985 to $26,000 in 2004. However, the median of all households declined from $7,000 in 1985 to $4,000 in 2004. While the median for married households declined from $13,000 in 1985 to $9,000 in 2004.

Many of these young Americans will wake up some morning to find that their irresponsibly financed excesses of recent years have left them with no equity in their homes, no liquidity and limited access to credit.  How these young Americans and other citizens in similar situations respond will likely be a key determinant of the future direction of the United States economy and government leadership. 

I want out of this machine
It doesn't feel like freedom
This ain't my American dream!

Fuel up the helicopter Ben!

(Refers to a 2002 speech in which Bernanke referred to a statement made by famed economist Milton Friedman about using a "helicopter drop" of money into the economy to fight deflation. Bernanke's critics have since referred to him as "Helicopter Ben.")