King Derwin's Magicians -- and Ours

Waiting on Economists'
"Chants and Charms?"

"A mighty good chant," said the King, looking very pleased. Are you sure it will work?"

All the magicians nodded together.

"But," said the King, looking puzzled, "How long will it take?"

"Be calm, oh, Sire, and have no fears," chanted the magicians.

"Our charm will work in ten short years."

--"The 500 Hats of Bartholomew Cubbins," by Dr. Seuss

Watching an inspired production of the famous Dr. Seuss story by The Children's Theatre yesterday, I couldn't help noting the parallels between King Derwin's magicians, and Barack Obama's economic magicians.

Just like Dr. Seuss' magicians, our government magicians profess confidence that their "spell" -- TARP, zero percent interest rates, quantitative easing, etc. -- will have the desired effect.

King Derwin pronounces the magicians "fools," and promptly dismisses them.

Meanwhile, in the real world, we are giving our latter-day magicians more power, and waiting for their chants and charms to work.

P.S.: How do you say "economist" in Japanese?

Profiting from Bubbles: 'Grab Marshmallows'

What's an Investor to Do?

[But] as long as the music is playing, you've got to get up and dance.

--Former Citigroup CEO Chuck Prince

Perplexed by a stock market that (inexplicably?) is once again on the rise -- along with all manner of commodities (oil, gold, silver, etc.)?

That, despite at best conflicting economic signals (continuing weak employment numbers, constricted lending, soft housing, etc.).

You shouldn't be.

Behind the scenes, the Federal Reserve has signalled its ongoing commitment to print money as a way to stimulate the economy, via a mechanism euphemistically labelled "quantitative easing."

"Grabbing Marshmallows"

So how should investors play such an environment?

If you have the stomach, take Barry Ritholtz's advice (my paraphrase):

When the Fed adds even more gasoline to the conflagration, [investors] should grab some some marshmallows and sticks and head over to the boy scout jamboree campfire.

--Barry Ritholtz, "Do You Wanna Be Right, or Do You Wanna Make Money?"

Note to the intrepid: the trick is not waiting around for the embers.

The Wall Street Journal Whiffs on Warren

Protecting Consumers From Banks

It turns out that Harvard Professor Elizabeth Warren will head the new Consumer Protection Financial Bureau, after all.

The Bureau, which Warren proposed creating, is charged with ensuring that "consumers are protected from unfair, deceptive, or abusive acts and practices and from discrimination."

Seeing as how millions of consumers are routinely deceived, abused, and dealt with unfairly by the nation's biggest banks, that would seem to be a good start.

So, what exactly is the Wall Street Journal up in arms about ("Elizabeth III")?

Here is their case against her, followed by my rebuttals in italics:

WSJ: [Senate leaders] have warned the White House that Warren probably isn't confirmable. A President with more political and Constitutional scruple would have nominated someone else.

Ross Kaplan: Most of the Senate's senior leaders depend on Wall Street cash to fund their election campaigns. The surprise would be if someone hostile to Wall Street's interests was confirmable.

WSJ: Ms. Warren was a vociferous opponent of allowing regulators charged with maintaining the safety and soundness of banks to control this new bureau.

Ross Kaplan: Regulators just presided over the biggest financial debacle since The Great Depression, and did nothing to stop it -- in fact, they facilitated it. Why should Warren answer to them??

WSJ: The new bureau [is] destined to be a bureaucratic rogue, inside an agency (the Fed) that it doesn't report to, with a budget not subject to Congressional control.

Ross Kaplan: And exactly who are the too-big-to-fail banks accountable to? Yes, there are "rogues" running amok and threatening the Republic . . . but it's not Warren and her tiny, new federal agency.

In truth, installing Warren by Presidential appointment instead of Senate confirmation -- what the Journal is putatively upset about -- could very well be a tactical blunder.

That's because a Senate confirmation hearing would shine a huge, public spotlight on a dysfunctional U.S. Senate, and the interests it truly serves.

No, Not THAT QE II!!

First, the Trial Balloons

What is all this fuss I hear about the Supreme Court decision on a "deaf" penalty? It's terrible! Deaf people have enough problems as it is!

--Befuddled spinster Emily Litella, one of Gilda Radner's several characters on the original Saturday Night Live.

Emily Litella comes to mind as the murmuring about QE II is getting louder.

No, not that QE II (pictured above).

Rather, they're talking about another round of quantitative easing by The Federal Reserve.

Because the Fed has already lowered interest rates to zero, its remaining weapon to stimulate an apparently flagging economy is to simply print more money (the fancy name for this is "quantitative easing").

In practice, that's accomplished by buying up new U. S. debt -- debt which the government has been more than happy to issue lately.

First broached on the blogosphere perhaps a month ago, the drumbeat in the MSM (main stream media) is growing discernibly louder the last 10 days or so.

P.S.: Growing up in the Twin Cities, I was confused by why everyone was making such a commotion over the West Bank. By age 8 or so, I finally figured out they were referring to the one in the Middle East.

I thought they were referring to the one across the Mississippi from the East Bank of the University of Minnesota.

Housing Market Hindsight

Low Interest Rates -- Then & Now

Three (four?) years into the housing market downturn, what conclusion is it possible to draw?

In retrospect, it seems obvious (at least to me) that it was a liquidity-driven phenomenon.

Add a tsunami of cash, subtract any vestige of underwriting standards, and real estate will go up.

Subtract liquidity, and tighten lending standards . . . and it goes down.

No Pop from Low Rates

Astute market watchers will point out that, if cheap money drives real estate upwards, it should be positively flying now, because mortgage rates are at record lows.

What that analysis ignores is: 1) the cheap money is itself a symptom of the downturn, as the Fed is using cheap money (free to the banks) as its weapon of choice to support housing (the so-called "hair of the dog" cure); and 2) to qualify for a cheap mortgage, you must have good credit and a job.

If you're a move-up Buyer, you also need some equity for a downpayment.

Needed: Glass-Steagall . . . for the Housing Market

Life after Life Support

There are no atheists in foxholes.

--Famous aphorism

There are no free market Republicans in today's housing industry.

--Real estate version

When it comes to the housing industry today, even the Republicans sound a lot like Democrats.

For now, at least, people of all philosophical stripes understand that the housing market is functioning in large part due to governmental support.

That includes providing the capital for mortgages; insuring mortgages once they're created; and providing the credit for investors to buy the resulting securities that the mortgages are bundled into.

No one is eager to see what happens if that support is scaled back precipitously.

The focus of the upcoming debate, then, is how much support to withdraw, how fast.

Reason(s) for Hope

One overlooked possibility, however, is that the housing market might actually need less help than is commonly believed.

Take, for example, the Federal Reserve's now-concluded purchase of $1.25 trillion in mortgage-backed securities -- undertaken to assure continued low interest rates, and thereby support the fragile housing market.

What happened to mortgage rates in the almost two months since the program was discontinued?

They've gone down.

Thanks, Eurozone (in point of fact, they were declining before that).

Producing "Financial Foie Gras"

Obscured by the "recent unpleasantness" is the fact that the U.S. housing market functioned successfully for more than half a century.

What changed?

Two things:

One. From 2003-2004, the Federal Reserve dropped nominal interest rates to near-zero (negative, in real terms), unleashing a tidal wave of demand for securities that paid a respectable return.

Two. Wall Street got a hold of the housing market.

If the demand was created by the Federal Reserve, the supply was provided -- on a truly breathtaking scale -- by Wall Street.

In effect, Wall Street stuffed the housing market "goose" with capital to be turned into financial foie gras.

Or at least what the ratings agencies promised was foie gras.

Glass-Steagall for the Housing Market

Which catches us up to today.

Used and abused by Wall Street, the housing market is temporarily a ward of the state.

Fortunately (unfortunately), something like this has already happened.

Before Wall Street got a hold of the housing market, it got a hold of the banking system

The direct result of that was something called The Great Depression.

But note society's response then.

Wisely, it wasn't to socialize the banking system in perpetuity.

Rather, it was to throw Wall Street out of the banking system for a long, long time, by separating "investment" from "bank."

In fact, the Glass-Steagall Act served the banking system -- and U.S. -- well for over 60 years, until its repeal in 1999.

What the housing industry needs now is a real estate version of the Glass-Steagall Act.

There's no reason the U.S. housing market of 2010-2070 cannot be as stable, functional, and largely independent as the housing market that prevailed from the 1930's to the 1990's.

Federal Reserve & Low Mortgage Rates

No Change in Mortgage Rates (Yet)

I have just received the following telegram from my generous daddy. It says, 'Dear Jack: Don't buy a single vote more than necessary. I'll be damned if I'm going to pay for a landslide.

--John F. Kennedy

Almost a month after The Federal Reserve completed its massive, $1.2 trillion purchase of mortgage securities, 30-year mortgage rates are about 5%.

What were they prior to March 31?

About 5%.

Which begs the question: did The Fed really need to spend all that money?

Commit Fraud, Get Free Money

Borrow at 0%, Lend at 3%, Make Billions

Is it customary, when someone is charged with fraud and awaiting trial, to leave them in possession of the victim's credit cards, and, indeed, to continue to allow them to spend and gamble the victim's money?

In the corporate arena, apparently the answer is "yes."

U.S. vs. Goldman Sachs

While the putative victims in the SEC's fraud case against Goldman Sachs are two institutional investors, the real victims are the millions of Americans who've lost their homes and jobs due to Wall Street's role in causing The Great Recession.

Yet Goldman Sachs, by virtue of its status as a "bank holding company," continues to have direct access to the Federal Reserve's discount window, where the cost of money is . . . . nothing (not coincidentally, what millions of thrifty Americans are currently earning on their hard-earned savings).

Goldman Sachs and other too big to fail banks can then take that free money and turn around and lend it back to the government -- taxpayers -- for a risk-free 3% (more if you add leverage).

How much of Goldman Sachs' just announced $3.5 billion quarterly profit was made in such a fashion?

How about, just for the sake of decorum, suspending Goldman Sachs' access to free Fed money, until it's cleared of the charges pending against it?

Post-March 31 Mortgage Rates Flat

The Dog That Didn't Bark?

So, the Federal Reserve finished its massive, $1.25 trillion purchase of mortgage securities almost three weeks ago.

Have mortgage rates spiked upwards since then?

Nope, they're basically unchanged.

What could that mean?

Other investors -- supplying fresh capital -- have taken their place (the "supply explanation"); a weak economy is keeping demand for mortgages -- and therefore rates -- low (the "demand explanation"); and/or the Fed's exit was so loudly pre-announced that the bond market already anticipated it ("other").

As they say, "buy the rumor, sell the news."

Any other "Other" plausible explanations, anyone?

Benjamin Franklin, Strategic Default, and Economic Recovery

Strategic Defaults Driving Retail Sales?

A penny saved is a penny earned.

--Benjamin Franklin, circa 1780

A penny defaulted on is a penny earned.

--Benjamin Franklin, 2010??

No, I have no way of knowing whether a modern-day Benjamin Franklin would have uttered the second quote. In fact, he didn't even say the first one (that hasn't stopped him getting credit for it, though!).

But the sentiment is well-placed.

More and more economists now see a connection between rising strategic defaults -- the term for owners who walk away from their underwater homes to preserve their cash flow -- and recovering retail sales.

That link helps explain a conundrum -- namely, why are retail sales improving when hiring is anemic and unemployment is still high?

Strategic Default Economics

The (partial) answer appears to be that people who've ditched their expensive mortgages have more disposable income to spend at Target, Bed Bath & Beyond, restaurants, etc.

Sometimes, A LOT more.

So, somebody who bought a home at the peak in Las Vegas (or Southern Florida, or Phoenix) for, say, $600k and has seen prices subsequently drop 40% could easily rent for $2,500 a month, instead of paying their $4,500 monthly mortgage. And live in just as nice a place.

Voila! An extra $2,000 in monthly disposable income.

Multiply that phenomenon by a couple hundred thousand people, and suddenly it's no surprise to see retail sales pick up.

Here's what David Rosenberg, former chief economist at Merrill Lynch and now playing the same role at Canadian firm Gluskin Sheff, says in today's edition of his daily market analysis ("Breakfast with Dave"):

Speaking of the U.S. housing market, we are convinced that strategic defaults by various homeowners, along with double-digit growth in tax refunds, have spurred the jump in retail sales (Easter timing helped too) of late. The economy is growing, the bulls are in a great mood, apparently we are into a new phase of job creation, and yet somehow 320,000 mortgage loans that were current when 2010 began were at least 60 days past due in March. Interesting.

--David Rosenberg, "Breakfast with Dave" (4/19/2010)

Of course, more borrower defaults ultimately means more foreclosures, which translates into more housing market supply -- and more bank write-off's.

But thanks to the Federal Reserve's policy of zero percent interest rates, banks are now booking huge profits to help offset their mortgage and housing-related losses ("Citigroup Posts $4.4 Billion Profit" -- WSJ).

They also continue to benefit from the government's unofficial policy of "too big to fail," with the implicit promise of future bailouts, if and when needed.

It all sort of recalls the chorus from a classic rock 'n roll song:

Take a load off Annie, take a load for free;
Take a load off Annie, And (and) (and) you put the load right on me

--The Band; lyrics, "The Weight"

The (financial) weight, indeed.

Is the Fed Really Done?

Testing "the Bernanke Put"

So, the Federal Reserve’s $1.25 trillion program to buy mortgage-backed securities officially ended yesterday.

Next up: home buyer tax credits, scheduled to expire at the end of the month.

But are the Fed -- and U.S. Treasury -- really done?

In an era of too-big-too-fail, "the Bernanke put" (preceded by "the Greenspan put"), and continued federal stimulus, it certainly seems more like an interlude than the end of an era.

If the housing market reacts badly, it's not to hard imagine further aid efforts materializing (no doubt in different guises).

Counting Down to "The Deadline"

Mortgage Rates: Moving Up

Everyone in the housing business seems to be counting down to the approaching deadline with baited breath.

No, not April 30, when the home buyer tax credits expire.

March 31, when the Federal Reserve stops buying mortgages and mortgage-backed securities -- reportedly, anywhere from $10 to $25 billion, per week, since at least last Fall.

Those purchases act like a huge subsidy, keeping rates down and the mortgage securities market liquid.

The Fed Exits

How big a subsidy?

We're about to find out.

No doubt anticipating the Fed's exit, interest rates have been rising this week; just this Wednesday, according to Edina Mortgage's Lala Brosz, rates on jumbo mortgage re-set four times, from around 5.25% at the beginning of the day, to 5.5% at the end.

The potential updraft in mortgage rates makes it more imperative that prospective Buyers lock in good rates while they're still low (vs. float, in the hopes that they'll drift down).

It may also be a good time to inquire about whether your lender offers a re-lock option, which can be cheap insurance in an environment of rising rates.

Bubble Dynamics

Here We Go Again?

While early investors savor their gains and see their money multiply, those still on the sidelines must consign themselves to earning less than nothing on their savings.

At first, it's easy for prudent savers and investors to tune out the "siren call" of the hot market du jour, and "just say no."

But eventually, you feel like a chump sitting on the sidelines while everyone else is partying.

And if you're someone who actually needs to earn a return on your money -- like a retiree -- you really have no choice but to take more risk.

So, you hold your nose and join in.

Today's stock market?

Well, yes.

But it also describes the dynamics underlying the housing bubble, and the last stock market bubble in the '90's.

Who's ultimately responsible for creating a (promiscuously) easy money environment that creates such perverse incentives?

The Federal Reserve.

Who benefits? Banks and wanton risk-takers.

Who loses? Everyone else.

Exit Strategies

"Surge" or "Stay the Course?"

Depleted and demoralized by the huge sums it has already spent (and arguably squandered) trying to stabilize a still-hostile environment, the U.S. must decide its next move.

The three choices are to: 1) double down ("surge"); 2) "stay the course"; or 3) declare victory and get out.

U.S. forces in Afghanistan?

Try, the federal government and the U.S. housing market.

A partial list of all the direct and indirect financial support provided to the housing market to date includes:

--Record low mortgage rates, courtesy of the Fed's $1.25 trillion purchase of mortgages.
--Zero percent short-term interest rates, intended(?) to resuscitate the banks and promote private sector lending.
--Hundreds of billions shoveled into Fannie Mae, Freddie Mac -- and prospectively, FHA --to enable them to (continue to) fund and guarantee a huge chunk of all U.S. mortgages.
--Tax credits and incentives to home buyers, expanded and extended through April 30, 2010.
--A combination of financial incentives and political muscle designed to induce banks to modify non-performing mortgages in their portfolios.

In light of all the foregoing, the two, $64 billion (times 10) questions looming over the 2010 U.S. housing market -- indeed, economy -- are: 1) how much financial support will the government provide to housing going forward?; and 2) how long can it afford that amount?

Oh, yeah -- one last question: isn't "limited surge" an oxymoron (like "jumbo shrimp?").

Ripple-Free Mortgage Markets

The Fed and Interest Rates

If you follow markets -- stocks, housing, you name it -- two things catch your attention: too volatile, and too calm.

The former is usually associated with rapidly changing, "macro" events that the markets are struggling to make sense of; the latter, somebody's got their "hand on the scale" (at an extreme, you get government wage and price controls).

So, how do you explain the almost ripple-free calm in the mortgage markets that last six weeks or so?

The Fed has clearly targeted a 30-year rate in the low 5's, and has been spending hundreds of billions to keep it there . .

New Consumer "Payment Hierarchy"

Credit Card Bills Trump Mortgage Payments

I attended a private dinner this week where the featured speaker, a senior executive at FICO, offered a wide range of comments. Since the talk was off-the-record, I won't mention the individual's name, but the insights were fascinating.

In a nutshell, FICO is observing a sea change in how consumers prioritize their debts.

Twenty years ago, here's how it looked:

1. Mortgage
2. Car payment
3. Utilities
4. Credit Cards

Today, that hierarchy has literally been turned upside down:

1. Credit Cards
2. Car payment
3. Utilities
4. Mortgage

To say the least, this change has huge implications for housing, and the economy generally.

Two conclusions seem inescapable:

--The risk of continued mortgage defaults is quite high, especially in locations where homeowners are deeply underwater (i.e., their home is worth less than their mortgage). According to the executive, the % of underwater mortgages nationally is now 40%(!).

--The U.S. consumer is tapped out, and especially vulnerable to anything that makes installment debt (credit cards) less available and/or more expensive. Which is pretty much what's happening now.

When you're living off your credit cards, it's safe to say that any financial "cushion" you once had is already gone.

The executive was optimistic that the Federal Reserve was on top of things, and reacting appropriately to the economic crisis; less so that Congress would surmount politics, and spend and tax appropriately.

Silver Linings (Kind of)

Silver linings? The executive cited three (kind of):

--Per above, solving today's economic challenges isn't a question of knowing what to do -- there's actually a surprising consensus amongst policymakers about what's needed (I've noted this on previous posts). Rather, it's having the political resolve to do it (the ball's in Congress' court, not the Federal Reserve's).

--While the ranks of consumers with low FICO scores is swelling, so is the number of people with high FICO scores. The executive called this phenomenon a "flattening out of the bell curve"; the explanation is that many consumers are spending more conservatively, paring their debt, etc. as a result of the financial crisis.

--Everyone's mailbox is a lot emptier these days without all the junk mail, credit card solicitations (have you noticed?).

P.S.: It's too off-color for this blog, but Tom Wolfe has a hilarious, updated version of the "first base, second base" vernacular that every high school boy knows. FYI, "first base" is still kissing -- everything else is different. You'll have to read his novel, "I am Charlotte Simmons" to find out the rest.

Taking Away the U.S.'s Punch Bowl

In Jeopardy: U.S.' "Punch Bowl" Privileges

The job of the Fed is to take away the punchbowl just as the party gets going.

--former Federal Reserve Chairman William McChesney Martin

What if the Fed won't take the punch bowl away? Or can't? Indeed, what if official U.S. policy is to keep replenishing the punch bowl way past the point that all the guests -- not to mention the host -- are inebriated?

What happens then feels a lot of like what's happening now:

--Key U.S. trading partners become increasingly reluctant to accept U.S. dollars for their exports;
--Key U.S. creditors, such as China, Japan, and Germany, telegraph that their willingness to keep buying -- indeed, holding-- U.S. debt is finite;
--As a result of both of the foregoing, the dollar weakens and the cost of servicing the U.S. debt rises; which in turn . . .
--Accelerates a concerted, multi-lateral push to replace the dollar as the world's de facto reserve currency with a basket of world currencies.

It's as though, after more than a half century of relative calm, the world financial system is waking up to the realization that the status quo has a major loophole: it rests on the discipline of U.S. monetary authorities to parcel out credit judiciously.

Like any privilege, if it's misused, it can be revoked.

By whom, and how, is what's now on the table.

Seed the Bottom of the "Food Chain"

Scorning the Financial Gods --
And Paying the Price

After the tech bubble, the healthy and natural progression dictated we enter recession. Alan Greenspan never allowed us to take that medicine, opting instead to inject the economy full of fiscal and monetary drugs. The resulting imbalances steadily built through the years and arrived at our doorstep with a thud. It’s not wise to mess with Mother Nature. We’re now witnessing the other side of risk gone awry and the cumulative comeuppance of a scorned business cycle.

--Todd Harrison, "The Future of Wall Street"; Minyanville (2/11/09)

If Harrison's take is right -- and I believe it is -- a couple conclusions and observations logically follow:

--Beware of cures that are worse than the disease (anyone else have deja vu right now?). Or, if you want a "folksier", Upper Midwest analogy: don't drive your car into the ditch -- or oncoming traffic! -- just to avoid a deer.

--The stage we're in now could be called "financial de-tox." It's perfectly appropriate -- and maybe even life-saving -- to use "financial methadone" ("hair of the dog," etc.) to help an acutely addicted patient wean themselves from their addiction (I put tax credits for home buyers, stimulus spending, federal aid to states, etc. in that category). Just be clear that that's what you're doing, and that such a strategy is temporary.

--There's something deeply ironic (if not foolhardy) about relying on an institution, The Fed, that helped cause today's financial melt-down to oversee its rescue. Ditto for too-big-to-fail financial institutions, GSE's ("government-sponsored enterprises") such as Fannie Mae and Freddie Mac, etc.

--Instead of breaking with past financial blunders -- and sequestering flawed institutions -- we appear to be doubling (if not quadrupling) down. In that vein, you'd speculate that, once the financial dust settles, there will be calls to strip the Fed of some of the vast new powers it now wields (and to unwind what now very well may be the world's scariest balance sheet -- ever).

"Financial Food Chain"

Life does go on after the meterorite kills off the dinosaurs, the forest fire clears away the old giants, etc.

However, we would do well to *mimic how nature regenerates herself after such cataclysms: not by resurrecting the species at the top of the old, collapsed food chain but by seeding -- literally -- those at the bottom.

The meek may not inherit the earth, but birds and all types of microscopic plants sure seem better adapted to -- indeed, capable of adapting to -- a new and dramatically leaner environment.

*Manufacturers are just now beginning to exploit the secrets of what's called "biomimicry" -- for example, studying how a spider makes silk that is stronger, ounce for ounce, than tensile steel, while using vastly less energy and creating none of the waste or pollution.