Adverse Selection

“Why will DaimlerChrysler want to add significant new manufacturing capacity in 2001 – no matter how low rates go,” asks Christopher Byron in an MSNBC article, “in the face of having just announced that the company plans to cut auto production by 25% in the year ahead?”

Byron wonders, along with many others, how a rate cut from the Fed stimulates demand. After a man has stuffed himself with foie gras and canard a l’orange, for example, a restaurant is not likely to entice him to spend more by lowering its price on poulette fermiere. All it might do is to draw in new customers – those who could not afford the previous prices – who are still hungry: that is, customers it may not really want.

“Adverse selection” it is called – when policies designed to encourage one group end up stimulating another, unintended – and perhaps less suitable – group. It is just one part of a whole group of perverse phenomena – all of which seem to find expression in Greenspan’s rate cut. In an attempt to avoid the consequences of too much credit over too long a period, the Fed chairman is offering the market what it needs least: more credit.

Lower interest rates are intended to induce qualified borrowers to take up loans and use them to good purpose. But who would borrow when asset prices are falling, shelves are clogged with inventory, and borrowers already have borrowed too much? Any sane man knows what to do when he has over-eaten…it is time to push back from the table, light up a cigar, and have a drink!

But the latest figures show that people are still borrowing – despite the most ravenous gorging on debt in all history. Consumer debt rose $12.9 billion in November – a 10.29% rate, annualized. This follows an increase of $17.3 billion in October.

Countrywide Home Loans, a California lender, says refinancing requests rose 30% since the Fed’s rate cut announcement. And credit card debt rose $4.8 billion in November, after going up 7.9% in October.

Who are these borrowers? And why are they borrowing?

Greenspan made a critical mistake on Jan. 3. He lowered rates – between FOMC meetings… and by 50 basis points. These two features signaled to the markets that the problem was large…and urgent. Large problems are not solved by a single rate cut. In every case, it has taken a series of rate cuts over many months to cure a declining economy. Thus, more rate cuts are almost guaranteed.

“Anyone who had been planning to make a discretionary purchase expensive enough to require a loan or mortgage,” continues Byron, “now has a powerful reason to stop, lean back and simply wait, secure in the knowledge that loan rates will be lower 6 or 9 months from now.”

This is the law of perverse outcomes at work. Greenspan’s action has the effect of discouraging borrowing – at least by those who are creditworthy.

But it may accelerate borrowing by those who are not – and make the resulting credit collapse worse. Xerox borrowed $7 billion from banks before its lines of credit were exhausted. Now it is forced to sell assets under the worst conditions – when it has to do so to raise operating cash.

A similar phenomenon of adverse selection may be occurring among retail borrowers. Caught in a squeeze of lower stock values, higher debt servicing costs, and stagnant incomes – they may need the money to meet operating expenses.

This is a problem that could get much worse. The total of outstanding credit card debt is less than $500 billion. But, thanks to aggressive credit card marketing, there is $2.4 trillion of unused lines of credit available to credit card customers. How much of that will get used up – like the loans to Xerox – just to meet cash-flow obligations?

If only Alan Greenspan were really at the controls of some vast machine! He might twist a knob…he might push a lever…and the machine would do as he wanted.

Instead, Greenspan’s lever sends the machine going in an unexpected direction: “History shows us,” writes Charles Peabody optimistically, “that such injections of liquidity (while they can arrest the deflation process of a particular asset) rarely seek out the devaluing asset, but instead seek out the inflating assets.”

Rate cuts do not restore things to the way they were before the downturn, in other words, they create a new bubble somewhere else! Alas, life is such a tangle….such a jungle of mixed and contradictory motivations…with such dense underbrush that you can scarcely see where you are going.

In every respect, Greenspan’s rate cut seems doomed. It causes qualified borrowers to hesitate…while inviting unqualified ones to go more deeply into debt. And it produces a new round of inflation in an unintended sector.

Or, it does nothing at all!

“Today’s economy is far more responsive to movements in stock prices than it is to short term interest rates,” says Ray Dalio of Bridgewater Associates. As long as stock prices are going down, rate cuts are not likely to have much effect. In Japan, the central bank reduced rates following its bubble deflation of 1990. Rates went all the way to zero – with no effect on either the Japanese economy or Japanese stock prices. Instead…the liquidity in Japan flowed all the way across the Pacific…and lifted the yachts of tech entrepreneurs on Puget Sound and stockbrokers and analysts on Long Island.

Your correspondent….

Bill Bonner Paris, France January 10, 2001

*** The big news today is that Europe is now growing faster than the U.S. European growth is estimated to be about 3% in 2001. Even with the flattering light of hedonic measures, and the extensive cosmetic surgery done on American income statements, the U.S. doesn’t look so good. Byron Wien, chief economic strategist at Morgan Stanley believes the U.S. economy will shrink 1.25% annualized in the first half of the year.

*** And Barron’s reports that consensus earnings for U.S. corporations for this year are below those of the year just past.

*** Is it any wonder the euro has gained 12% against the dollar since the end of November? The European currency fell back a little yesterday, but still closed just below $.95 – way above the 83 cents of last autumn.

*** All of a sudden, it looks like the dollar has competition. And so does America. Unemployment in Euroland is coming down. It dropped 2.35% last year – the biggest decline in 35 years. Incomes are up. Savings are strong. Debt levels are low.

*** Nor is Europe particularly concerned about a slowdown in the U.S. Despite the massive trade deficit in the U.S., exports to the U.S. make up only between 2% and 3% of Europe’s GDP.

*** America led the most recent phase of the world’s technological evolution. Thanks to companies such as Microsoft and Intel, almost every desk in the world has a computer on it. But now it appears that the world is ‘spent out’ on computers. And profit margins are falling too – as the whole industry becomes more competitive and components become commoditized.

*** What will be the next stage? Will America dominate it too? Not necessarily, says Bloomberg columnist Matthew Lynn. The next big boom could be in pharmaceuticals or genetics – where the Europeans are as strong as anyone. Europe is leading the way on the next generation of mobile phones, too. And the European manufacturer, Airbus, not Boeing, is developing the huge new Airbus 380 plane – capable of making up to 500 passengers miserable on a single flight.

*** The Dow dropped 48 points yesterday. The Nasdaq gained 45. Again, breadth was good. 1622 stocks rose on the NYSE; 1285 declined. There were 165 new highs; but only 14 new lows.

*** Why the good breadth? Leading techs disappoint investors and get marked down. But people – especially new investors with no experience of bear markets – still believe in ‘stocks for the long run.’ So they move their money to other stocks. A headline in the Atlanta JC tells the story: “401(k) Investors Still Aggressive.”

*** “The greater fool market is still working feebly,” writes the Fleet Street Letter’s Lynn Carpenter. “There are still hopefuls out there who will buy a good story and don’t know how to pick stocks. If you want to make money on your riskier stocks, do it now. Sell your growth stocks unless they are very high-quality, profitable businesses. Unload your doubtful techs if you have any. Take profits on stocks that have grown overvalued. Today there are buyers, maybe. Tomorrow there won’t be.”

*** Internets were the big winners yesterday – with TheStreet’s index up 8.6%. Amazon was a winner too – plus 10%. But diving into the murky waters of the Amazon.com’s income and balance sheet statement, a researcher from Grant’s found that the company was taking longer to pay its bills.

*** The rise of the euro is a much under-appreciated event. It means, for example, that the Fed will pay a heavy price for lowering interest rates. Foreign investors look first and foremost at currency trends before making an investment. How could it make sense to buy a T-bond with a yield below 5% – when you lose 12% on the falling dollar?

*** And how does it make sense to buy dollar-based stocks that are losing 10% – 50% of their value in the course of the year? It doesn’t. And a few basis points won’t change the logic.

*** When foreign investors lose money on their U.S. investments, they can be expected to do the logical thing – sell. This selling pressure drives down asset prices even further.

*** “Analysts Wonder,” says a headline from the Kansas City Star, “Whether Fed’s Rate Cut Will Be Enough To Loosen Tight Lending Market” Well, they might wonder. But the current malaise is a product of rates that have been too low for too long – not that have been too high. More below…

*** GE fell another 2% yesterday. The company has big exposure to derivative positions…plus it owns so many different companies in so many different industries – it can’t help but be hurt by a business slowdown.

*** FDIC said that net charge-offs are up 16% from the 3rd quarter of 1999. A third of these bad loans were made to business borrowers.

*** And this from a DR reader who has found a star (or two) to steer by:

As a business astrologer, I looked at Pacific Gas and Electric’s astrological cycles today (Friday, Jan. 5th). If they have a zillion fairy godmothers, maybe they could prevent bankruptcy, and I’m not even sure that would help their situation. It looks like they will be sold off in pieces shortly after they go bankrupt VERY soon (days).

Bank of America is also in trouble (stopped trading!), but astrologically it looks like they will manage to escape bankruptcy.”

*** My source then offers an interesting reflection: “I only know that a year ago I read an article about the mega- banks, of which Bank of America is one. It used to be the big banks were considered to be ‘too big to fail’, so they were merged with other larger banks whenever this occurred. Now the mega-banks are so big, they can’t be saved…”

*** Securitization, Derivatization, Globalization. Remember these words. You will be able to use them to pass an American history test in the year 2100.