Inflation Hedges

In early August, a major storm swept across Wall Street credit markets, leaving hedge fund implosions and fear of undisclosed losses in its wake.

Bloomberg warns that “The worst U.S. housing slump in 16 years may lead mortgage companies to eliminate almost 100,000 jobs, more than double the number already cut this year.”

Countrywide got the ball rolling on September 7 by announcing its intention to eliminate 10,000-12,000 jobs — a complete reversal of what the company had been saying just a month or two ago. At that time, CEO Angelo Mozilo could hardly contain his enthusiasm about poaching top mortgage brokers from busted outfits like American Home Mortgage and New Century. Countrywide’s survivability is now being called into question.

At the very least, if Wall Street’s mortgage securitization machine remains stuck in neutral, Countrywide’s business plan will have to be completely overhauled. The ability to maintain operations depends on Wall Street funding that can dry up in an instant.

This huge layoff is a crystal-clear signal from Countrywide that Wall Street’s credit “indigestion” is likely to continue for an uncomfortably long period of time.

Another notable September 7 announcement: IndyMac Bank CEO Michael Perry published a letter to shareholders announcing his intention to cut 1,000 jobs, or 10% of the thrift’s work force. He also proposes to cut to the thrift’s quarterly dividend by 50%.

Aside from emphasizing their reputations for stellar underwriting practices, several of the banks I’ve looked at recently are reminding a panicky stock market about the strength of their underwriting discipline.

Call me skeptical. Just as surveys indicate that most Americans consider themselves to be “above average” drivers — despite the mathematical impossibility — it seems that most banks believe they are “above average” mortgage underwriters. A handful of banks resisted the temptation to underwrite irresponsible mortgages, and they should be lauded for their integrity and foresight.

But focusing on quality underwriting standards misses a key point about collateralized lending: Once collateral is fully overinflated by irresponsible lending, all collateral-based lenders suffer during the inevitable post-bubble fallout.

A good analogy is what we see in depressed neighborhoods where once a few mortgage foreclosures occur, the entire neighborhood’s house values suffer — even the houses of those who remain current on their mortgage payments.

During the bubble, you’ll recall that house value appraisals were based almost entirely on “comps.”

Bankers’ Lost Confidence

As I explained to my Strategic Investment readers in August 2006, too many people read far too much into the price signals of the 2003-2005 housing market — a market in which about 9-10% of the entire housing stock turned over annually (compared with 150% annualized turnover on the typical stock). Now it looks like this 9-10% annual turnover is headed for a few years of 6-8% annual turnover, and this depressed volume of housing transactions will occur at discounted prices.

Should the mortgages written in the coming years reflect depressed housing values? Perhaps not, but they will anyway, because lenders will be fearful about lending against weak collateral.

But there’ll eventually be another bubble as long as the current paper money system remains in place. Why? Because it’s a good bet that over the long term, the volume of government liabilities (federal debt and currency) will grow at a much faster rate than housing supply. The way the political and monetary system is set up, we’re almost guaranteed to see some sort of massive bailout.

While central bankers will gradually intensify their inflation campaign, we can’t expect them to ride to the rescue immediately. They’ve pumped hundreds of billions of dollars into the system in recent weeks, without fully realizing or acknowledging the core problem: a crisis of confidence among banks. Banks are fearful to lend to each other, because they are worried about each other’s unknown, undisclosed exposure to toxic waste instruments like subprime CDOs.

This crisis will not enter its final stages until it becomes reasonably clear who’s holding the bag and they take their losses, even if it includes bankruptcy. Right now, the market is not hungry for liquidity — it’s hungry for information.

Is what I’m describing a prescription for “deflation”? I think it’s not rational to expect that the supply of money and credit will be allowed to contract very long on its own without massive government intervention. Sure, some asset prices can deflate in nominal terms over long periods of time, but as I wrote earlier, it’s a good bet that over the long term, the volume of government liabilities (federal debt and currency) will grow at a much faster rate than tangible assets, including housing.

And dollar-denominated assets are already in huge oversupply. It will be difficult to convince everyone, including the Chinese, to stuff Treasury bills and dollars into mattresses (i.e., a permanent increase in the “demand for money”) when you consider the long-term history of paper money systems.

Financial crises always prompt the general public to demand the “socialization” of both losses and risk. And the only way for the government to do that is to expand its debt, its paper money supply, and the charter of the Federal Reserve (to include the unconventional policy actions outlined by Ben Bernanke in his famous 2002 “helicopter” speech).

To protect yourself, I advise adding “inflation hedges” to your portfolio. These hedges include precious metals, energy, and natural resource stocks.

Then, you should hedge these positions against a general market decline by holding short positions in vulnerable stocks and sectors.

Best regards,
Dan Amoss, CFA

October 11, 2007