Archive for the ‘Inflation’ Category

There is a combination of worry and hope about the coming wave of mortgage resets.  First came the subprime.  Next will be the Alt-As and Option ARMs.  And then, in 2013 or so, it appears that we may be out of the woods.  Housing will stabilize.  Rates will be set. Foreclosures will level off and decline.

Will they?  ARM resets lock in a particular rate and then float.  They’re a good mortgage product for people that expect rising income, or expect to sell their house in a few years, or have good credit and equity to allow conversion to a 30 year fixed at the reset point.  And low rates–caused in part by the 2008-2009 flight to treasuries and deflation–have made resets a boon to homeowners that led (for now) lower rates.  But times are changing.  Banks are stingier with their credit, and even those with ARMs (especially Alt-A ARMs) are being buffeted by unemployment, reduced assets, the inability to refinance their homes based on their nonexistent equity, and all the other tales of woe unleashed by the recession.

The reset is not a one-time event.  It’s periodic.  It means that the ARMs will now be floating based on the LIBOR (i.e., an overnight rate that is pretty much the lowest market rate) plus some marginal rate.  LIBOR plus 2-3%, let’s say.  But the LIBOR floats, as will the new floating rates.  As government spending goes up, defaults of various loans continue apace, and inflation risk gets priced into borrowing, interest rates across the board will rise.  This rising cost of borrowing will be reflected in both the floating rates and the available 30 year fixed rates in the years ahead.  And these rates by design adjust periodically, either every six months, once a year, or monthly (according to The Handbook of Mortgage Backed Securities).

Far from being relieved of danger after the “Alt-A reset bomb,” the reset bomb will be a continuous threat to housing, made more permanent by the inability of upside down ARM holders to refinance.  Every year, as interest rates rise, their monthly payments will go up.  Borrowers will get the double whammy from inflation that the old-fashioned fixed rate provided protection against.  The ARM, which made a great deal of sense in the go go years of the mid 2000s, may become a permanent albatross on homeowners, and, in turn, a continued source of new insolvency, reduced consumer demand, and declining wealth nationwide.

The rough ride is only beginning, I fear, and the loose money policies of the Federal Reserve and the Federal Government are only going to make things worse by pushing up interest rates and inflation.  Those who did the historically responsible thing by buying a home in the last ten years will get whacked by the combination of inflation, rising interest rates, and wages that lag behind this wealth-destroying pincer movement.

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Obama and his supporters are fond of blaming George Bush and the deficit spending of 2002-2008 on our  government’s various fiscal problems.  As Obama put it, “”Number one, we inherited a $1.3 trillion deficit. … That wasn’t me.”  This is that trademark Obama straight-talk we’ve come to expect. It’s a false alibi that has the additional demerit of making the President appear remarkably weak and incapable of leadership.

Bush truly did a lot of deficit spending, as much as four hundred billion per year in 2008.  But notice the chart above.  This spending was dwarfed by the total scale of government spending in any given year and the high receipts (i.e., taxes) raised compared to deficit spending.  Now look at 2009, year of Obama and the major stimulus coupled with the continuation of Bush’s half-spent TARP funds.  The budget appears to be half deficit spending.  And the deficit is an order of magnitude larger than it has been in previous years, nearly $2,000,000,000,000.  The government is not taking money in and spending like it always did, but instead is borrowing on a heroic scale to maintain an unrealistic scale of legacy spending and unworthy causes like propping up GM and financing broke state and municipal governments.

This level of spending is dangerous and unsustainable. Judging by Gold’s recent spike to $1,190/ounce, it appears people interested in maintaining their wealth are starting to realize what’s going on with out devalued currency.

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Gold hits $1,190/ounce. Got Stimulus?

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Right up there with the idea that you can’t go wrong with real estate is the investing folk wisdom that equities are the place to be, especially long-term.  Is this true?  Most of that folk wisdom comes from the happy experiences of the baby boomers who started investing in the late 70s and early 80s and have had a huge rally ever since.  The last 30 years have been, by any measure, a time of extraordinary growth fueled by a combination of emerging economies, cheap energy, a relatively stable U.S. financial and legal system, and U.S. comparative advantages in education and innovation.  These advantages seem to be dissipating for reasons both too obvious and too complicated to mention.

If you look at other periods, particularly periods of macroeconomic turmoil, equities did not perform so well, often for a decade or more.  Look at the chart below:

It took until the 1950s for the market to reach its 1929 high.  The 1970s saw almost no DJIA growth.  And this chart does not even correct from the mirage growth caused by artificial inflation, a phenomenon which has only gotten worse since the introduction of a fiat U.S. currency in 1971.

In principle, some variant on diversification is the best way to invest long-term.  But diversification does not just mean diversification in equities. By way of analogy, bundled mortgage instruments were diversified only superficially:  they depended on the housing market as a whole. Bundled equities, such as index funds, are also somewhat sector-dependent: they ultimately depend upon the growth of both the US economy and the world economy.  But how do you invest in a shrinking economy where a great number of malinvestments must be liquidated?  After all, it seems reasonable to conclude, we’re heading into a period of stagnation and decline that will last quite some time. 

It is simply fool-hardy to tie up a great portion of one’s cash in equities based on models of long-run equity performance that conveniently cut themselves off at 1980 or thereabouts.  As in all statistics, look at the scale and size of the X and Y axes.  Most models promoting the long-run benefits of equities discard data showing 10 and 20 year cycles of equity stagnation during earlier periods of decline. 

Real diversification should include real estate, bonds, cash, commodities and should be adjusted, especially during troubled times, to include the wealth-preserving insurance of tangible gold bullion.

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This is a useful analysis of the dual pressures on the economy: the massive decline in spending and housing prices, which is counterbalanced by inflationary activities such as the Federal Reserves’ expansion of lending and its increase of balance sheet assets. In other words, the only reason we won’t have hyperinflation (yet) is because of an impending economic contraction. Some prices might rise, but overall economic activity will decline dramatically dampening the immediate inflationary effects of government spending through another round of cheap credit. Commodities valued for use value will decline–oil, copper, etc. Gold will likely stay elevated above other commodities because of its “safe haven” reputation when bank guarantees are viewed suspiciously and the spectre of debt monetization is always waiting in the wings.

This WSJ article describes how the government blew its wad on Bear Stearns, could not respond in the same way to Lehman Brothers, and that this evidence of government impotence freaked the market out.

While there are obvious political reasons Bush and Paulson and Bernanke want to kick the can down the road, government cannot do much to resolve this crisis. Paulson and company’s frantic maneuvers, three or four steps behind the market, reveal this in dramatic fashion. Obviously, going forward, some changes to CDS markets, tying the dollar more closely to commodity prices, revisions to executive compensation on Wall Street (more salary and fewer bonuses, as well as clawbacks for failures), reducing incentives to “expand home ownership,” and an industrial policy that drives harder bargains with exporters to assist domestic exporters would be sensible. In the meantime, we just have to let all kinds of businesses fail, shrink, reduce sales and salaries, and otherwise adjust.

Loose money bailouts will solve nothing. You cannot patch a leaking dam with more water.

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In March of this year, wrote that the credit crisis is not an issue of liquidity but of malinvestment enabled by central banking’s penchant for inflation.  This was also the chief cause of the Great Depression, and many economists’ misreading of the Depression as a liquidity problem has led the supposed free-market oriented Monetarists into the weeds ever since.

There is a good article over at the Von Mises website about why the bailout will delay recovery by continuing to prop up these bad investments, whether they are derivatives secured by worthless housing or anything else that is tanking. To proponents of the bailouts, Frank Shostak writes:

They argue that were it not for the Fed’s injecting $105 billion and the subsequent announcement of the rescue package, the stock market would have had a massive fall. They also believe that the massive monetary injection prevented a run on money-market mutual funds and prevented a major disaster.

They further believe that if people had taken the money out of their money-market mutual funds, banks wouldn’t be able to secure money to fund credit cards and various consumer and business loans. This in turn would have paralyzed the economy.

So let us think about this. Say that people take their money from the money-market mutual funds. What happens then? They will have placed it somewhere else, mostly likely with commercial banks. Hence money wouldn’t disappear and banks could continue to fund activities as before.

If large money-market funds were to go under, some of their assets would be sold and the shareholders would suffer losses; this however, cannot provide justification for the Fed to pump money and to introduce a rescue package. Monetary expansion and a rescue package do not undo the bad investment decisions of the money-market-mutual-fund managers. Why should people who didn’t risk investments in the fund pick up the tab?

A fall in asset prices, including stocks, and a run on financial institutions are just symptoms and not the cause of anything. The key factor behind the current difficulty in the credit markets is the lagged effect coming from the Fed’s tighter stance between June 2004 and August 2007, when the federal-funds-rate target was raised from 1% to 5.25%.

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