Tag Archives: consumerism

Reconsider the Stimulus

I am fed up with the structure of the stimulus plan.  Bailing out failed banks is foolish when tax credits for mortgage payments would cut the foreclosure rate and fix the toxic debt.  Why ignore this easy and super-efficient tactic?

If I could recommend a specific plan, it would be to provide tax credits for up to $30k/year in mortgage payments for primary residences for the next 2 years. This relatively cheap solution maintains free market capitalism with all the good incentives, and would dramatically reduce the foreclosure rate — particularly for those paying less than $30k/year for their mortgages. The plan could be extended or expanded if necessary, of course.

The result would be a reduction in mortgage defaults, an increase in the value of mortgage backed securities (MBSs), and a recovery of the financial strength of the lending institutions and pensions that hold MBSs. Essentially, this would repair the cause of the credit crisis rather than throwing money away at the symptoms and rewarding failure.

As soon as it is announced, assumptions about foreclosure rates would fall, raising the value of MBSs the same day.

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The Credit Crunch and the Market

[Download the complete article in PDF format, with charts and better formatting]

The past month has been a roller-coaster in the financial markets.

At the first hints of falling prices in the mortgage backed securities markets, Bear Sterns announced the bankruptcy of two large hedge funds, and 90% losses in a third fund which had $850 million invested in highly rated mortgage-backed securities. In the following weeks, other major funds also announced losses. Goldman Sachs’ Global Alpha hedge fund fell 27% this year through Aug. 13, prompting clients to ask for $1.6 billion in redemptions, investors told Bloomberg. DE Shaw, a pioneer of quantitative investing based on complex mathematical and computer techniques, has been hit hard in August. DE Shaw’s Valence fund is down more than 20% through August 24th, according to a fund of hedge fund manager.

These high-profile losses are prompting redemptions, and as cash flows out of hedge funds, managers must sell. Around the world, leveraged funds anticipate redemptions and are deleveraging (selling).

“When you can’t sell what you want, you sell what you can.”

Because the markets for mortgage-backed securities dried up so completely and so quickly, managers began selling positions that remained liquid and well-priced. In a sense, they had to sell good investments because they couldn’t sell the bad ones. What started as a series of collapsing mortgage strategies has spread into just about every other market that hedge funds touch. Prices fell in investments ranging from emerging market bonds to the price of hogs. In all, more than $1 trillion in value has been lost in US stock markets, alone. Many foreign markets and alternative asset classes suffered worse declines.

The trigger event is a credit tightening: mortgage issuers extended too much credit, were too loose with their lending standards, and may not have adequately communicated their loan terms. In response, lending standards have been increased and credit is tighter. US consumers might slow their spending, which might trigger a broader slowdown in the US economy, which might have implications for global growth. Uncertainty and fear prevail.

We view this fear as primarily psychological, wildly overestimated, and only loosely related to market fundamentals (See Figure 1). But that may not matter.

Contagion

The pricing of risk is driven by psychology. Investors require compensation for the possibility of loss and also for the inconvenience of uncertainty. So rising risk can cause capital to become scarce, lending rates to go up, and spending to slow. In this sense, the psychology can impact the fundamentals in what is sometimes called a “contagion”.

The “Greenspan put” was like a safety net, providing the comfort that credit would be made available on those occasions when it was needed. Bernanke has reiterated this strategy, but it remains to be seen if he has the same appreciation for what Keynes called the “animal spirits” of the market. Contagion is a real phenomenon, generally starting with a crisis in one market or a large fund, then spreading to other asset classes as volatility rises and investors require higher premiums for risky investments.

In our view, the excessive lending in the mortgage industry could trigger a contagion in a variety of ways, such as:

  • Rising rates and tightening lending standards leads to a contraction in home prices, reducing consumer spending and slowing economic growth.
  • A new awareness for the risk of debt investments causes borrowing costs for corporations and governments to rise, reducing investment and slowing economic growth.

These risks can be self-reinforcing, and could change the fundamental characteristics of the economy. These are the type of events that could change our investment strategies if they appear to develop out of control.

So far, these contagions have not caused a significant slowdown in economic activity. Volatility triggered by major hedge fund failures is different; it generally causes sharp declines in recently popular asset classes followed by recovery. These declines can proceed in unexpected ways, and can continue for some time because each price shock runs the risk of triggering another failure. It is surprising how many hedge funds use leverage sufficient to make them incompatible with price shocks. As months pass, however, these shocks can be a blessing because they offer rare value opportunities.

We should all hope that a full-fledged contagion does not develop, and be thankful that the world’s central banks are standing guard.

The Federal Reserve

It is important for the government to intervene if a contagion might damage the economy in fundamental ways, but also important for the government to avoid interfering otherwise. The Federal Reserve and foreign central banks play an important role in managing the stability of economic growth by changing the availability of capital at money-center banks, but interventions can also cause distortions in currency exchange rates, changes in the money supply affect inflation expectations, and reliance upon government intervention can lead investors take excessive risks.

On the 17th, the Federal Reserve followed several foreign central banks (European Central Bank, Australia, Japan, and others) by pumping capital into their nations’ banking systems in response to the recent volatility. This intervention increases the monetary supply, but the psychology of selling is still driving down many market prices as global investors reduce their exposure to risk and shift their portfolios to hold more cash and US Treasury Bonds.

Credit tightening is a reasonable response to excessive lending, but the signal from global central banks is that they are ready to smooth the volatility, even if it means increasing the money supply. This indicates that they may intend to inflate their way out of potential economic pain. As a result, we are less concerned about a recession, but our long-term expectations for inflation have risen. This combination makes stocks and real assets more attractive because they are better hedges against inflation, and reduces the value of fixed income instruments (such as US Treasury Bonds). Meanwhile, the global investor crowd has been doing the opposite. If higher inflation will be the ultimate outcome of this recent roller coaster, then the massive global shift toward cash and fixed income may ultimately be reversed.

20th Century Sociological Trends – Political and Commercial

“The Century of the Self” is a documentary from the BBC which discusses how groups behave, and why. The psychology of individuals has implications when studying populations. Understanding the dynamics of groups has been used to engineer demand and consent for products and political views. This is a very interesting documentary, with detailed historical references.

“Consumerism was a way of giving people the illusion of control, while allowing a responsible elite to continue managing society”

  1. The Century of the Self (1 of 4)
  2. The Century of the Self (2 of 4)
  3. The Century of the Self (3 of 4)
  4. The Century of the Self (4 of 4)

America’s addiction to oil

PDF VERSION WITH GRAPHICS

Every time oil prices pull back, the financial press repeats the misguided mantra that crude inventories are too high. The fact is, inventories are far from excessive. Rather, they reflect the strategic importance of oil and America’s increasing dependence on foreign sources. Indeed, we believe that investors should expect crude oil inventories to continue rising along with prices. The higher inventories shield the economy from unexpected and uncontrollable disruptions in crude oil supply.

Oil inventories are strategic

As the chart below indicates, following the 1973 oil embargo, US crude oil inventories began rising steadily. Companies and the US Government correctly understood that maintaining larger inventories would help to avoid risks from further supply disruptions caused by OPEC. The increase in inventories continued for more than 16 years before stabilizing.

The attacks on September 11, 2001, triggered a similar change in perception – this time, the widespread recognition that inventories should be maintained to protect against supply disruptions resulting from terrorism or other political volatility. It is impossible to predict whether the current increasing trend of inventories will last as long or push as high as the previous one, but the increase appears ongoing.

CHART

Crude inventories in terms of months of supply

The slow-moving trends shown above may give false confidence in US crude oil inventory management. A more important measure of inventories is how long inventories would last during a supply disruption. Inventories would provide about two months’ supply at the current pace of consumption. This two-month period is up only slightly since September 11, 2001.

CHART

The US is increasingly dependent on foreign sources of oil

US oil production peaked in 1971. Since that time, growing demand for crude oil in the US has been satisfied by rapidly increasing imports. In 1991, imports surpassed domestic production, and since that time imports have grown to two-thirds of the total US crude oil supply.

CHART

In today’s world, the disruption of imports is a distinct risk. In the event of a war, embargo, or terrorist act, imports could be interrupted while domestic production might continue. Current US crude oil inventories would replace about 100 days of imports. This 100-day period has essentially remained the same since September 11, 2001.

If inventories do not grow in pace with demand, the period of protection against import disruptions will decline. As inventories shrink relative to imports, the US becomes increasingly vulnerable to import disruptions that could adversely affect the labor and lifestyles of Americans. By this measure, inventories have rarely been lower.

CHART

It is probably no coincidence that the|1973 oil embargo was triggered by OPEC when US inventories had fallen to less than three months of imports. A period of low inventories causes prices to respond dramatically to disruption. The oil crisis of 1979 resulted in long lines for scarce gasoline. Solar panels were actually installed on the roof of the White House.

In order to provide for the equivalent of six months of imports, inventories would have to rise by 79% over their current level.

Almost every aspect of modern living is tied to consumption of crude oil, directly or indirectly. The economy relies on the oil industry for gasoline, diesel, jet fuel, heating oil, natural gas, propane, asphalt, lubricants, fertilizers, antifreeze, pesticides, synthetic rubber, pharmaceuticals, and plastics. It is hard to imagine a functioning economy without these products.

Even the most optimistic experts anticipate that world crude oil production can only grow for a few more decades. After that time, production would decline as remaining sources became more difficult to recover from depleting reserves. Most prominent experts anticipate that global production will peak sooner; some even believe it peaked in 2005.

Already, energy efficiency is on the rise. We are increasingly using crude oil for applications that are best served specifically by crude oil. Other sources of energy are being exploited whenever possible and whenever the cost can be justified. The US economy has been growing faster than its rate of consumption of oil, but it is still highly dependent on crude.

CHART

In sum, America began coping with its dangerous dependency on oil after the Arab oil embargo of 1973. But management of this dependency is ongoing. War and terrorism, increasingly scarce supplies, and changing standards in the transportation industries are likely to lead to rising energy prices as America continues to struggle with its addiction to oil.

PDF VERSION WITH GRAPHICS

Buffet: "I don’t see how the dollar avoids going down"

Forbes reports on Warren Buffet’s currency perspective:

Heed the Sage of Omaha. Warren Buffett, whose investment acumen seems unerring, had a caveat for America: Barring “a major change” in policies, the trade deficit will further undermine the U.S. dollar.

The billionaire spoke in a Wednesday interview with CNBC, the cable TV news channel owned by General Electric (nyse: GEnewspeople).

Without shifting current trade policy, “I don’t see how the dollar avoids going down,” he mused, warning of inflation risks posed by an anemic Yankee currency.

The prairie-born genius also confessed he’s having a “hard time” identifying stocks to buy, and isn’t purchasing commodities. His cash swelled to $43 billion in the third quarter, by one account, because he couldn’t find many investment opportunities.

Buffett, 74, is chairman of Berkshire Hathaway (nyse: BRKa
news
people), the immensely successful investment vehicle that acquired a new–and immensely successful–board member in December: Microsoft (nasdaq: MSFTnewspeople) Chairman Bill Gates.

The latter also enjoys a personal friendship with Buffett, and takes part in his bridge games. (see: “Gates: Buffett’s Pal Bill Elected To Berkshire’s Board“)

Is Global Free Trade Always Good?

As long as trade is at will by both parties, it is good, right?

Not necessarily.

Innovation has led to great developments in goods and services, and led to amazing increases in productivity and capacity utilization. International trade is distributing value more efficiently than ever.

Peter Weiss raises an important counterpoint:

“[clip] The dislocation is often painful and some people cannot make the transition for any number of reasons – I don’t minimize or ignore their pain, or loss. As people living in a community, however we define it, we should consider how we respond to them [clip]”

Throughout history, the waves of displaced workers have ranged from negligible to crisis levels. Displaced workers are typically older workers who are highly skilled in a shrinking industry, or people of all ages who do not have economically rewarding skills. The first set of people is generally easier to define because they had and lost their jobs, while the second set may be far more difficult to quantify.

In the transition to the industrial age, displaced farmers, craftsmen, and tradespeople went through fairly desperate poverty, but there was a large industrial complex forming, ready to hire people with a wide range of skills. In the information age, and with a far larger and more anonymous society, we are dealing with new dynamics. Automation is increasingly replacing labor in production, putting a greater emphasis on capital. The economically rewarding skill set is becoming more cognitive, scalable, and competitive. The highly scaled production of the globally efficient producers displaces less efficient producers throughout the rest of the world.

Why would this be a problem? Clearly, we already acknowledge that some trade should be illegal: monopolistic mergers are restricted by the Federal Trade Commission. Even overly concentrated industries may have restrictions on further consolidation. With information services and assets, marginal costs fall to about zero, and this economy of scale is a strong force for monopolies within each product or service class. Innovation can be stifled if monopolists prevail. However, this dynamic cannot be controlled globally by the US Federal Trade Commission.

But it goes further than that: whenever productivity rises faster than production, fewer workers are required in aggregate. Production may still be growing, but the non-working population and increasing concentration of wealth means that the median utility may shrink. Recent drops in interest rates has promoted refinancing and debt, enabling continuation of consumer spending, but factoring out this externality implies a scary economic reality.

I’m afraid I can’t offer a comprehensive solution, but as policy makers (or simple commentators), the goal should be maximizing the growth rate of the median utility, right? The Fed and international trade policy are currently influenced by an optimization problem that maximizes total GDP growth. Changing the nature of the optimization has the potential to imply that free trade might not always be good. Similar to the measures put in place to avoid the downsides of monopolistic trade in the US, legal and financial policy reform may be due in the next decades to enforce rules as a Global Trade Commission, and also to target disadvantages from productivity growth overwhelming production growth.

Renminbi Valuation

The renminbi is pegged to the US Dollar, and has been for a long time, so what would a revaluation of the Chinese currency mean? Without an exchange rate determined by the marketplace, how can we anticipate the magnitude of the difference between the pegged rate and the appropriate market rate?

It is clear that the yuan is cheap relative to the dollar, but by how much? Our economies are different, and these differences lead to different relative pricing, but looking at a variety of prices can give us some sense of purchasing price parity.

Unskilled Labor:

Textile workers in China are paid about 1/30 of the amount paid for equivalent work in the United States. If this ratio were to equalize through currency revaluation, the yuan would increase by 3000%. However this is almost certainly too high, as China has an oversupply of unskilled labor. This number provides the high-end boundary on the scope of the question.

Gold:

Gold can be purchased in yuan At the time of this writing, $442 worth of gold costs 3670 yuan, implying an exchange rate of about 8.303 Yuan/$. If this ratio were reflected in the currency echange rate, the yuan would increase a negligible amount (Because the exchange rate peg is currently 8.27 Yuan/$). However this is almost certainly too low, as it is illegal for chinese citizens to invest in Gold. This number provides an low-end boundary on the scope of the question.

Basket of goods:

Depending on the basket you select, purchasing price parity implies different undervaluation of Yuan. I estimate approximately 40% undervaluation, clearly with different classes of goods and services.

Trading:

Under a fair and open market, I envision a 40% inflation on Cinese imports would greatly imporove the stature of US companies that have been drowning under Chinese import competition. Similarly, Chinese companies that earn their revenues from Chinese will see a US Dollar denominated revenue increase of 40%.

[UPDATE 1/25/2005]

Senator Lindsey Graham, (R) Judiary Committee and

Senator Charles (Chuck) Schumer, (D) Finance Committee

are announcing bill to impose a 27.5% tarif on Chinese imports, implying their view that the Renminbi is near 27.5% discounted against the Dollar.

[END UPDATE]

Let’s speculate that Chinese currency will reflect market forces within 2 years. In this speculative possible environment, investors might benefit from:

underweight Chinese companies with revenues largely based on exports

overweight Chinese companies with revenues largely based in China

underweight US companies who import from China

overweight US companies who compete with Chinese imports

Now let’s speculate that Chinese currency will remain pegged to the US Dollar. In this speculative possible environment, investors might benefit from exactly the opposite positions.

How can the US exploit a currency peg that is clearly an unfair trade practice?

Cut taxes and issue more debt.

This increases the Federal deficit, diminishing the value of the US Dollar, and also increases the after-tax pay rates for US workers.