Borrowing Chaos

Expansion of credit isn’t the same as expansion of money. A bank might loan the village idiot $10,000, but the bank doesn’t reserve $10,000 to back the loan. While heady booms spark expansive loan policies, says Fred Sheehan, like: "Here, idiot – go start a fiber optic company"…bad times raise caution.

America is broke.

Please excuse this redundancy. We could really stop right here. For an investor, a helpful rule of thumb is to own real money (cash, gold, a company trading at its cash value) and squeeze debt-dependent conglomerations until they gag and choke.

Rules of thumb are only general approximations, however. And the unlimited credit and Fed-led money expansion of the past half-decade does what free money always does – it chases the rising asset class.

Doug Noland, author of the weekly "Credit Bubble Bulletin" for the Prudent Bear website (, reports that, "Since the beginning of 1998, total mortgage credit has surged almost $2.8 trillion." That’s a 53% rise. "To put the second quarter’s [2002] $817 billion annualized growth into perspective, total mortgage credit grew at an average of $207 billion from 1992 through 1997." (The $2.8 trillion boom reaps a paper appreciation of $35,000 a household – one reason why "trading up" is so attractive.)

Despite Alan Greenspan’s newfound aversion to reading anything other than his own publicity releases, he might like to skim through Charles Kindleberger’s "Manias, Panics, and Crashes". The book covers several examples of stock market bubbles moving to the real estate market. It was true in the U.S., Britain, and Japan a decade ago.

How did we get here? In the spring of 2000, credit that had been spinning outward in centrifugal fury started to contract, in centripetal penance. Anyone who recognized and understood this reversal saved a bundle of money.

The procession from then until now looked like dominoes in a television commercial: in rough order, the first to lose funding were the dot.coms, then the IPO market, private equity, the telecoms, then went high-yield bonds, investment-grade bond trading dried up, as did the commercial paper market, then the companies on tremendous but fraudulent buying sprees got trampled (Enron, WorldCom, Global Crossing) along with their stock, bond, and bank loan creditors.

One might wonder, with all of this capital liquidation, how come the economy isn’t worse? How come the home market is still booming? Because the economy and housing are bosom buddies. The stock market boom was an appendage to the credit boom. Indebtedness patterns are illuminating. According to Paul Kasriel at Northern Trust, U.S. debt as a portion of GDP was around 160% in 1980 and rose to 280% in 2002. Over the same period, debt divided by total U.S. capital stock has risen from less than 50% to over 90%.

Expansion of credit isn’t the same as expansion of money. A bank might loan the village idiot $10,000, but the bank doesn’t reserve $10,000 to back the loan. The bank will hold capital against that loan in proportion to the level of confidence that it has of being repaid. Heady booms spark expansive loan policies: "Here, idiot – go start a fiber optic company." Bad times raise caution. "What, Mr. Rockefeller, you think I’d loan you money?!"

One might expect we would be a nation lying in the gutter, tin cups raised in hope of receiving a few pellets of couscous. The very opposite is true, and we should probably first thank the Asians. The U.S. imports $500 billion more than it exports each year. Either that gap is filled by a people of opposite propensities, or the dollar finds a discounted level that the rest of the world sees fit.

As a schematic: Asians save far more than they spend, and we spend far more than we save. To the extent that Asians are willing to forego the conveniences we find necessary, the U.S. will enjoy the fruits of their labor. At this point in the cycle, consumption mostly takes the form of bigger houses, cars, and stomachs.

This is quite a simplification, and one must acknowledge the generosity of Alan Greenspan. The former gold bug has desperately kept the bubble in the air to avoid a massive liquidation. To give him his due, he has successfully forestalled our national denouement. We’re financing the binge with free money. Loans and credit lines are still easy to come by, at very affordable rates. Three years ago, it could be said that anybody with a idea of sufficient implausibility (the more hair-brained the better) could get the money, in some market.

It can be said today that practically anyone can find a willing financier for a new house and a new car splurge. That’s true of credit card lines, too. The Financial Times reports that the outstanding credit card debt of the average U.S. household is $8,000. Home equity loans are up 40% over the past year. Gaping and growing government debt at the federal, state, and municipal level, plus corporate cash flow crises, deserve their own treatise. They are gasping for air, too.

Ergo, the binge rolls on. There never has been a time, since the Second World War, when home-owners have held less equity in their residences than they do today (about 55%). Is ‘home-owner’ a dated description?

There is an incredibly well-tuned mechanism at work here. The savings rate of individuals fell to zero a couple of years back. The ready reason was the stock market – who needed to save? That money lost, the Average Joe tapped his home equity line. This is unfortunate; a chance to regain his financial solvency is lost. As Nicholas Retsinas of the Center of Housing Studies at Harvard noted, "With real-estate prices up, you would think that Americans would be rolling in home equity. But as fast as they lay hands on it, they are borrowing it out."

Not only is this a source of credit, but also the interest rate structure is so low and the borrowing terms so aggressively profligate (loans of 120% of appraised value are hot; Fannie Mae and Wells Fargo have restrained themselves to 107%, interest-only loans for the first 15 years, which are also a big hit) and so flagrantly unscrupulous (The Philadelphia Inquirer reported of brokers tracking down more aggressive appraisers) that the village idiot is living a very princely existence. (Need it be said that buying on infinite margin, house prices have risen according to a structure that might be called the home carry-trade.)

One reason for this profligacy is the low-hurdle rate for getting into the home, car, boat, luxury cruise loan market. Banks are in a pickle. They are regulated and constantly examined but compete with freelance financial institutions such as mortgage companies, credit unions, sub-prime lenders, Fannie Mae, Freddie Mac, the Federal Home Loan Bank, and the Boston municipal transportation system, called the "T."

An ad in the subway cars read: "Take the T home mortgage, if you are a regular rider, you may qualify…" A card I received in the mail, from something called the Direct Federal Credit Union, offers a 2.75% home mortgage with no fees or closing costs. "And you get same day approval on your application."

An offer not to be passed up, especially for those who miss the very fine type – DFCU’s mortgage is reset every six months to match that of the prime lending rate, 4.75% at the time of this mailing. Merrill Lynch is offering 3.75% adjustable-rate mortgages. From Merrill Lynch? Who isn’t in the mortgage business?

In other words, chaotic lending and borrowing reigns, although few see it as such. We have it on the authority of David Seiders, Chief Economist of the National Association of Home Builders, whose stentorian late-July blast comforted the wary: "The time has come to put this issue to rest. The nation’s home builders have said it, the [r]ealtors have said it, and Alan Greenspan has said it once again, in no uncertain terms: there is no such thing as a current or impending house price bubble."

Since that oration, foreclosure rates have risen to a 30- year high, delinquency rates have climbed, the median house price is now 5.4% lower than a year ago, housing starts fell 2.2% in August, Fannie Mae is getting battered by the rising number of refinancings, and bootleg lenders, some on the verge of bankruptcy, may soon liquidate their saleable assets. In the case of Conseco, 16,700 foreclosed houses would hit the market.

As to the question of what will precipitate a bear market, who knows? It is the weight of such things as those above that will drag the market down. As to the question of what might prevent a downturn, well, an enormously successful business recovery might do it…

Notice I said: might.


Fred Sheehan,
for The Daily Reckoning
October 30, 2002

P.S. In Massachusetts, the average home sales price is $367,678 and the average income of households is $63,362. Mortgage payments as a percentage of income top 44%. If the average income leaps to $95,000 (without inflation), we could probably service the debt.

Editor’s note: Fred Sheehan is the director of John Hancock Financial Services. The previous essay represents his opinion and not that of John Hancock. Shareholders will be relieved his job does not include time spent reading Joseph Conrad and John Ruskin, or critiquing the wonders of Installation Art. You can contact Mr. Sheehan by writing to P.O. Box 111, Boston, MA 02117.

Fred Sheehan is an occasional contributor to Strategic Investment.

All that money! Where does it go?

We refer to the $1.4 trillion that is expected to come from home refinancings this year alone. If that doesn’t cause a boom, what would?

Good question.

"If refinancings were going to provide a boost," asks Martin Bukold of Northern Trust, "why haven’t we seen it?" Instead, chain stores report lower sales and mall walkers are said to be able to do an entire mile without knocking down a single shopper.

The chip stocks have risen 40% since October 9th, but almost all the news from the silicon sector is bad.

Other industries aren’t much better. Car sales are declining and experts are warning that it may be a blue, blue Christmas for retailers nationwide.

Alan Greenspan may decide it is time for another rate cut. (More below…) And the mortgage-peddlers may find even more clever ways to entice poor schmucks toward insolvency. But if $1.4 trillion has not done the trick this year, why would another trillion or so do any better the next?



Eric Fry, from the Big Apple…

– Consumers are human, after all…They do, in fact, bleed when pricked; ice does not course through their veins; and, contrary to legend, they will – eventually – stop spending money that does not belong to them. Yesterday morning we learned that consumer confidence plunged sharply in October. Immediately after the news hit the wires, stocks tumbled and bonds soared.

– The report seemed to shake the confidence of stock investors as well, as the market continued tumbling until the Dow had fallen 170 points. That’s when investors dusted themselves off, took a deep breath and started buying stocks again. By the closing bell, the blue chips had recouped all of their losses to finish with a meager 1-point gain at 8,369. The Nasdaq also recovered from its lowest levels of the day, but still ended the session with a 1% loss at 1,301.

– Meanwhile, the prospect of slowing economic activity suggested by the dismal confidence report caused bond investors to become downright giddy. They snapped up Treasuries with both hands, causing the 10-year yield to dive through 4% to 3.93%…And voilà! Old man Deflation awakens from his slumber.

– Consumer confidence has now fallen for five straight months and sits at a nine-year low. Clearly, confidence has been badly shaken, not merely stirred. The current conditions sub-index dropped to 77.5 in October from 88.5 in September, while the future expectations reading tumbled to 80.7 from 97.2. And yet, the stock market has been rallying all month…Go figure. What is the stock market if not a very elaborate "future expectations" index? Somebody’s got it wrong. We think it’s the stock market.

– The prospect that anxious consumers might stop spending and start saving is enough to strike terror into the heart of any American investor. Sure, it may be prudent to save money, but saving money is no way to help the economy grow…or at least, that’s the prevailing "pop economic" theory. If consumers don’t consume, who’s going to do it? And where will corporate profits come from?

– Here’s another question: are corporate profits lower than most folks assume? Standard and Poor says, "Yes…much lower." That’s because most companies don’t include hidden costs like pension-plan liabilities and employee-option grants in their reported profits.

– As we noted last week, corporate pension liabilities are rapidly becoming very serious hazards for investors – all the more serious because they are somewhat hidden from view. (See: "Pension Plan Poison", last Friday’s Daily Reckoning essay). Employee-option grants are also a very large "hidden" cost. Just how large have these expenses become? Standard & Poor’s just-released ‘core earnings’ calculations for the S&P 500 provide a rough idea.

– After deducting pension expenses, employee-option expenses and the various other expenses that most companies prefer not to deduct from their cosmetically enhanced reported earnings, Standard & Poor’s calculates that ‘core earnings’ for the S&P 500 were only $18.48 a share for the 12 months ended June 30, 2002. That’s well shy of the REPORTED earnings number of $26.74.

– "The big difference in the reported and core numbers are due to option and pension fund expenses," Comstock Partners points out. "S&P calculates that employee option grants for the index amounts to $5.21 a share…S&P also makes adjustments in pension fund accounting that reduces income by $6.54 a share."

– In other words, in the harsh light of real-world accounting, the S&P 500’s honest-to-goodness earnings shrivel like raisins in the sun. "Figures, as used in financial statements, seemed to have the bad habit of expressing a small part of the truth forcibly, and neglecting the other part," financial author Fred Schwed observed some sixty years ago.

– Even so, Wall Street strategists persist in presenting a ‘small part of the truth’ by basing their rose-hued forecasts on ‘operating earnings,’ which most strategists predict will be higher than $50 in 2003. Based on this flattering portrayal of earnings, the S&P 500 is selling for "only" about 17 times 2003 earnings. That valuation, while still high by historic standards, sounds a lot more enticing than 47 times "core" earnings.

– Unfortunately for investors, core earnings are a much closer approximation of underlying economic realities than are the fluffy confections called operating earnings. And that means that the folks hoping that the stock market has bottomed may be disappointed.

– The odds of a new bull market starting from 17 times earnings are slim. A new bull market starting from 33 times earnings (based upon the reported earnings number) is even more improbable. But the prospect of a new bull market heading out the gate from 47 times earnings is simply ludicrous…but Mr. Market may have a different opinion, of course.


Back in Ouzilly…

*** The price of gold rose again yesterday. December contracts closed at $318.50. Richard Russell points out that in August 1999, the Dow equaled 42.1 ounces of gold. Now, it brings only 26. We hope we didn’t forget to tell you, dear reader, but we thought exchanging stocks for gold would be the Trade of the Decade. We still think so: sell the Dow, buy gold.

*** Not that we know what will happen, far from it. Inflation? Deflation? We don’t know. But we like the feel of real gold coins in our pockets. Even if the global economy falls apart, we figure, we’ll still be able to buy a loaf of bread and a bottle of wine.

*** ‘Fall apart’ is just what Stephen Roach thinks the global economy is about to do. Two things, he says, make worldwide recession and deflation almost inevitable. First, globalization has dramatically increased the supply of cheap goods. While real investment in the means of production may have been negligible over the last 10 years in America, in China, factories have been springing up like bamboo shoots. With very cheap labor, and access to huge amounts of foreign capital, China is able to drive down the prices on manufactured goods throughout the world.

The second major factor, according to Roach, is the collapse of the demand side of the equation. In the present bear market, Western consumer nations have lost trillions in supposed wealth. People in all the developed countries are getting older and poorer at a rapid rate. In Japan, domestic demand increased at only 1.3% per year from ’94 to 2000. America will follow, he believes, because "an increased preference for saving, ultimately, seems like the only way out for an overly indebted, aging and saving-short American consumer."

After every house in America has been refinanced…and the world’s consumer of last resort stops consuming…what then?

"Global recession and deflation," is our answer. "And the end of the world as we have known it."

*** It is another miserably wonderful day out here in the country. The trees are beautifully turned out in their fall colors. The sky is clear and blue. The gardener is happily raking leaves. Out in the shop, Pierre is cheerfully pounding on steel rods to make a sort of fish trap for when he drains the pond. Henry is having fun brushing down the horses. And Edward is running around the yard with a wooden rifle, shooting imaginary enemies behind every tree and every wall. Even my mother seems to be enjoying herself in the kitchen…for we smell the aroma of today’s desert, already baking in the oven.

But a writer’s life is a wretched one. Day after day, he is trapped inside with his words and pathetic intellectual pretenses…wishing it would rain.