The
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March 8, 2008
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Lessons
From the Mortgage Mess
The
Slow Death of Consumption
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Q-Calls
Lessons
From the Mortgage Mess
JOHN: Well, there’s nothing like 20-20 hindsight. But sometimes hindsight applied in a proper, constructive manner is worthwhile. Loeffler’s Rule of Thumb #54 –I think I should get this copyrighted, Jim – is: If they didn’t see it coming, they won’t know what to do when it gets here. Which is a corollary to Rule #55: Never appoint the same people to get you out of a problem that got you into it in the first place. I guess if they knew what they were doing you wouldn't be here.
So what are the lessons that we can learn from this whole subprime mortgage issue. Obviously, there are things that can be drawn from this for future financial investing etc. etc. etc.
In this segment we’re going to examine the mortgage mess; we’re going to try to put this in perspective relating it to the economy, its impact and how this will actually impact the markets. And a lot of information that we’re going to discuss is actually a compilation from several reports which have been released recently that frame the issue.
JIM: The one surprising issue about the mortgage mess – and you remember when the bubble was being created, when the Fed slashed interest rates they kept them artificially low and that’s what caused the real estate boom and the mortgage mess. And remember all the politicians who were praising the fact that homeownership in this country had gone to the highest records in history. And they were praising the government agencies that were making the loans. And when we were going through the boom everything was okay, but we knew that this boom was artificial. What has been surprising when the Fed began to raise interest rates in 2004 at the same time they were urging people to get variable rate mortgages – you remember the Greenspan speech?
JOHN: Yup.
JIM: Is the delayed effects of the credit crisis on the markets. In fact, it was right about this time last year, remember February of last year when we had some of the first intermediary financial lenders go bankrupt? We had a crisis in the month of February, the market went down and then it was over and everybody said, “all right, that’s it.” Bernanke said: “uh, maybe we’ll lose 50 billion to 75 billion in the mortgage mess.” But it was not until the last half of last year and then the beginning of this year that it has become a concern. Now it’s front page headlines almost every single day. [2:32]
JOHN: You wrote about this problem though in a four-part fictional piece if you recall back in 2005 when we were talking about this a lot. It was called The Day after Tomorrow and you talked about the issue again in December 2006 in another piece called The Next Rogue Wave, so if you could see this there were reasons why you drew these conclusions long before they became the center of talking piece everywhere. What was that?
JIM: Well, there were a number of things and it began in 2000. We saw a recession coming at the end of 99 and 2000 and we sold all of our technology stocks at the end of December of 2000 and began positioning for what we saw coming. I was in a house at the time and I remember we saw a recession coming, and typically in a recession real estate leads the downturn just like it did in 91– just as it has done in the last year or two. But in 2000, I saw my next door neighbor – I was pulling out of my driveway one day – and all of a sudden a for-sale sign went up with a sold sign. In other words, he listed his house and sold it before the real estate agent could even order a sign to put in his front yard. And when I talked to him about the price that he got on the house, which was almost 2 ½ times what he paid for it in three years I said this is nuts. And so we put our house up for sale – at that time I was going to build a custom house out in the country; I had a ranch that I had bought. And it was just kind of nuts.
But, John, what we saw during that period of time is during the recession instead of real estate going down, real estate began to go up and that was because the Fed was slashing interest rates bringing them down to levels we hadn’t seen in half a century, and this whole boom cycle in real estate - in other words, we had a deflating bubble in technology and the Fed was creating another bubble in real estate to take its place. And consumers were going out and doing nutty things; unlike the recession of 91 where Greenspan brought interest rates down, the average consumer refinanced their home and started paying down debt. During the recession of 2001, the opposite happened. Yes, they refinanced their home as interest rates came down but then they began to spend more. And so there was something different during that period of time.
In 1993, there was a development here near our office that they began clearing and it was a huge development. I gave it a fictitious name and I called it the Big Sky Ranch. And when I saw how nutty things were going because there were ten homebuilders in the development area and I would talk to them. I would go on weekends and I was just kind of curious and it was amazing to see the prices of homes. I’m talking about homes on postage stamp lots that were starting at ¾ million dollars. And it was rather interesting when I began to write my piece on The Day after Tomorrow it was actually based on characters that I had met, interviewing salesmen like I think one of the people I used I came up with Erica Barry; she was actually a salesperson for one of the builders and I had long conversations with her on several occasions over a six month period of time.
I also interviewed the lenders at that time, I called them Citywide; it was actually Countrywide. And I can remember talking to the Countrywide lender and Countrywide was pushing variable rate mortgages, interest rate only, and negative rate amortization loans. And I can remember the Countrywide guy telling me, “look, in California most people only keep their homes three to five years. Why would you want a fixed rate mortgage? Why would you want a 30 year mortgage and pay almost twice as much in interest rates when you can a variable rate mortgage for half the interest rate which would enable you to buy a bigger home and add more options.” And that’s why I began to write about this and then I came up with a hedge fund character. But I had never seen anything as crazy.
I mean this was crazier than the real estate boom that we had at the end of the 80s that led to the S&L crisis. At least back in the late 80s and the early 90s lenders were still requiring down payments. I have a friend who is in the mortgage business, he works for one of the nation’s largest banks, and the stuff he was telling me about…in fact I came up with this fictitious couple I called the Wheelers who were actually based on a compilation of a couple of couples that had refinanced their home several times with my friend and the things that they were doing. And it was just absolutely amazing and you just knew that when you started making loans requiring no money down, requiring no documentation, interest only or negative amortization loans, you knew that sooner or later –and especially when the Fed began raising interest rates – this wasn’t going to end well. And now we’re starting to see the consequences of all this nonsense. [7:48]
JOHN: So basically what you were writing about there was really a real world analysis because these were real people that you were writing about. You simply changed the names to protect the guilty, I guess, in this case. All right.
Let’s look at the situation of how this all came about. What were the dynamics of it and it’s really fictitious to have people say they really didn’t see this coming. They knew what they were doing.
JIM: Yeah, the first thing to understand about the current problem is it’s mainly concentrated in a sector of the market, mainly financial institutions with exposure to mortgage securities. That’s why, for example, there are elements in the economy that are still doing well, in other words, exports. But if you take the current estimates I’ve seen in several reports they’re putting the losses in this mortgage market somewhere around $400 billion with half of that amount being born by leveraged financial institutions. The result will mean a substantial reduction in credit to businesses and to households. And this has a lot of variations and themes that are going to play over in the investment markets which we’ll get into in the next hour. [8:59]
JOHN: Okay, if the losses are going to be ranking somewhere around 400 billion, somebody is going to be holding this hot potato when everything settles. Who’s that going to be?
JIM: The brunt of the losses are going to occur in the financial intermediary sector, mainly banks, broker-dealers and hedge funds because remember banks changed their investment model from making a loan (sitting across the desk looking at the homeowner and keeping the loan on the books) to just basically repackaging the loan and selling the loan; Wall Street would come in, securitize it and slice it and dice it.
And this whole structure of finance is mainly contained at the present time between banks, broker-dealers and hedge funds. And as a result, these entities are going to deleverage over the next few years and that’s why you’ve been seeing some of this play out in the market in the next hour as they face large capital losses. I mean I think the figure has been somewhere around 100… we’re almost close to 200 billion that we’ve written off so far. So these institutions are going to be forced to scale back their leverage and try to rebuild their balance sheets; and what that will mean is they will be reducing leverage on their balance sheets to the tune of somewhere around two trillion dollars of which roughly 900 billion would represent a decline in lending to households. So the net effect is going to be a reduction of credit to businesses and consumers resulting probably in a reduction – I’ve seen figures that depending on whose study you’re looking at, but a reduction of GDP growth in approximately the 1 to 1 ½ percent range. [10:43]
JOHN: So number one, we really haven’t seen the ultimate impact on the economy; and number two, couldn’t we actually say that this is the multiplier effect in reverse. Would that be a fair statement?
JIM: Oh, very much so and we’re going to talk about how this deleveraging takes place, how the debt-to-equity ratios are almost like a constant. In fact, there was a report released on Friday which we’ll get into here in just a moment…
JOHN: But you know, Jim, when these things go over the edge so to speak. It’s amazing how you can actually see this coming. It’s almost like the collapse of the bridge. If you go up and look at the joists and where everything goes together and you check them out and you see them rotting, you can predict what’s going to happen. But when it does happen it happens quickly – that’s the funny part. And it’s always some unusual little thing that triggers it that nobody expected. So what was the trigger point for this?
JIM: It basically gets down to real estate. I mean real estate prices had gotten so expensive that they were using these creative mechanisms to allow the subprime borrowers to get in because people couldn’t afford to buy homes. So it gets down to real estate. You had the Fed raising interest rates which meant mortgage rates went up, which means mortgage resets went up, and real estate –the higher interest rates go, the lower the price of real estate has to counterbalance that, otherwise people can’t afford to buy. So the drop in prices as the boom turned into bust was a result of Fed rate hikes which turned the problem as it spilled over into the mortgage market.
And we had a harbinger of things to come last February, but the real crisis began on August 9th of last year when a large European bank announced it would close three investment funds because it was nearly impossible to evaluate the underlying assets. That was what triggered it, and a couple of days later the Fed reversed its policy within almost a couple of days of an FOMC meeting and they slashed the discount rate by half a point. This event triggered an intense examination of investor exposure to risk. In other words, up until this time investors were very complacent, risk was not being priced in the market place and the problem spread because the loans under scrutiny were embedded in a wide variety of securities from SIVs to commercial paper to CDOs to Auction Rate Securities. So the problem began to spread from subprime to jumbo loans to Alt-A mortgages to asset-backed commercial paper, SIVs, CDOs, Auction Rate Securities – one domino after another.
In fact, in the case of jumbo loans, roughly 50% of jumbo loans were tied to homes in the state of California. And we talked about this for years on this program, the prices of real estate in southern California and elsewhere: It was just nuts! Imagine a starting middle class home for ¾ million dollars. How do you expect people to afford to make payments on a home like that. [13:46]
JOHN: Yeah, especially a young family trying to get started or something like that. It seems like the American dream in that category just began drifting further and further back. But it also sounds like with the inability to really properly evaluate assets what started to happen there is the credit market just began to seize up at some point.
JIM: That’s exactly what began to happen last August. It hit the commercial paper market hard even though the majority of paper in the market was highly rated. The problem here was investors were having difficulty in evaluating the credit quality of the underlying assets. And remember, they’ve been so sliced and diced and redistributed which also brings up a problem in terms of the latest Fed move to ask banks to forgive mortgages. So the issuers were confronted with the inability to roll over maturing paper. This is what happened in the commercial paper market. This led to either 1) forced liquidation of assets or 2) the triggering of backstop credit agreements with the banks.
And we’re going to get in this in a second because normally when you go through a bust what happens is financial institutions begin to deleverage their balance sheet; that did not happen this time around because of all of these backstop credit agreements with leverage buyout companies, with commercial paper, with SIVs. In other words, instead of contracting the balance sheet, banks expanded their balance sheet because they began to take on credit. They did it reluctantly because they had made these agreements and they had to honor them, but at a time when banks would typically contract their lending and their balance sheets, bank balance sheets expanded. And as these assets came back on to the banks’ balance sheet, banks began to tighten lending standards which is what you’ve seen in Fed loan surveys of banks. Everywhere you look – whether it’s commercial lending or residential lending or even in the credit card market banks are tightening lending standards all across the board. [15:45]
JOHN: Explain backstop for people who may not understand that.
JIM: Backstop might be something where let’s say you’ve got commercial paper that is being financed and if it can’t be rolled over there is a sort of like an emergency credit agreement with the bank that if you can’t roll it over the bank will step in and lend the money. Or you might have the deal going with a leveraged buy out, if you guarantee the leveraged buy out firm of your credit commitments, so even though the bank which would typically raise the money in a bond issue and sell it to investors, if they can’t sell the bond to an investors then the bank has to take the loan onto their balance sheet. So it’s kind of like an emergency credit line. You might call it like a home equity line. It’s there in case of emergency but once it’s put in place and agreed upon the banks have to follow through whether they like it or not. [16:36]
JOHN: It’s almost like an insurance type policy that guarantees and provides some cushion in there it would seem like.
If we look at the last crisis that we ran into in real estate, this was back in 1991. Here we are 15 years plus later, what makes this crisis different?
JIM: I think there are a number of issues but I think probably the major difference this time around is that the securities market was a dominant source of intermediation as a result of this securitization of these mortgages. Remember, we moved from the days when the bank would sit across a desk, you would look at a loan applicant, you would look at their personality, judge their character, you would make the loan and the bank would keep that loan on the balance sheet. This time – and especially with structured finance – banks basically went into an underwrite-and-distribute mode. In other words, they would make the loans but as soon as they made them they would sell them to Wall Street and they were repackaged into various kinds of mortgage securities. So I would say securitization of mortgages is probably what makes this crisis different than the one back in 1991.
JOHN: Does the person who is paying on the loan, do they know that the loan has been sold or securitized or is it the bank still processing the paperwork every month?
JIM: Most people will see that their loan has been sold to somebody. You’ll get a notice of that, but the banks quite honestly didn’t care. They were making the loans. It was like a manufacturing mill: You made the widget and the widget went out the door and it was sold.
JOHN: That was all they cared about because the process just kept on going okay.
JIM: Yeah, because the more loans that they made the more fees they would make.
JOHN: This would seem to be sort of an unsustainable type of situation so why did it take so long for this thing to really unravel?
JIM: I think if you take a look at how this whole structured market is set up, once again the bulk of the damage so far has been confined and concentrated in financial institutions. Who do you see in the news writing the big write-offs? It’s the banks, it’s the brokerage firms, it’s hedge funds, it’s the bond insurers that got involved in this. And here’s the other thing too, as a result of securitization because the assets were so dispersed it took longer to unfold as problems in one area spilled over into another area. In other words, there wasn’t some large bank or institution that held all the loans because when you securitize something you sell it to pension funds, you sell it to investors, you sell it to mutual funds, you sell it to insurance companies. And it was global, it just wasn’t our financial institutions buying this. Foreign financial institutions were buying it. And it wasn’t until something called the TED spread began to rise dramatically that things began to get worse. And just to explain: the Ted spread measures the difference between an unsecured deposit like at a bank rate and a rate on government-backed obligations. And the rise in the TED spread, in the second half of last year rivaled and surpassed the crises that we’ve seen over the last couple of decades, including Long Term Capital Management, the Peso crisis, the Y2K crisis, the crisis of 9/11 or even the 90 and 91 S&L crisis. Then the other thing that you had is a lot of these mortgages were priced according to an index, the ABX indices, which began to plunge. And all of this led to various knock on effects. [20:06]
JOHN: Well, it sounds like far from being contained right now it has really turned into almost spreading disease-like contagion. It’s spilling over into the real economy; you can see credit tightening. Weird things are going on. I mean people who are trying to make loans are trying to figure out why prime is going down but the loan rates are going up. And it’s becoming harder for businesses and consumers to get credit, so now the economy of course starts to contract on the basis of that if they can’t get the credit, if they can’t get what they need to do on their jobs etc.; and we’re now into really a recession. So, where are the big losses? And ultimately somebody’s got to be stuck with this when the music grinds to a dead halt. Where’s that going to be?
JIM: You know, as best as we can guess right now, it’s mainly the leveraged financial community. Most of the mortgages originated before 2004 should be okay because things didn’t get goofy when interest rates were low. Prior to 2004 banks were asking for down payments, they weren’t going to the negative amortization loans, the interest only loans, the exotic mortgages, no-doc loans – they came in during the Fed rate cycle. In other words, the Fed began to raise interest rates in 2004 and as real estate prices continued to go up that’s when these exotic mortgages came in to allow the boom to continue so that people could get in to homes even though they were going up and interest rates were going up. So the problem is contained primarily in the mortgages that were issued between the years 2004 and 2007. There’s where the problems are. And when the Fed raised interest rates in 2004, banks shifted to exotic loans, they lowered their lending standards and the basic issue is that as home prices decline it’s created large amounts of negative equity. You heard about Bernanke this week that in order to create positive equity he wants banks to forgive mortgage debt so that homeowners can get some equity:
When the mortgage is under water, a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure.
Homeowners, as you know, with negative equity can’t draw upon their capital gains to buffer or cushion against adverse financial effects such as a homeowner losing a job or, for example, a variable rate mortgage is reset. How are you going to finance when you have no cushion in your house? In other words, you don’t have any equity because the house is worth less than your mortgage on your property. And it estimated that a 15 to 20 percent decline in housing which we’ve seen certainly here in California is going to put somewhere in the neighborhood of 2.5 to 2.6 trillion in mortgage debt under water. So what you’re seeing are default rates set to escalate over the next three to four years. It’s probably not going to be until housing finally stabilizes that this trend reverses itself.
We saw this very same thing play out in the early 90s; from 91 to almost 96 here in California you had housing prices declining and mortgage default rates going up. So real estate plays out over a much longer cycle. In fact, there was a report that came out this week, last year mortgage foreclosures rose to an all-time high, new foreclosures jumped to nearly one percent of all home loans in the fourth quarter from a half percent a year earlier, and 40% of these foreclosures were subprime, another 23% were loan modification mortgages. So all of this exotic stuff that was used between 2004 and 2007 to extend the boom is now starting to unravel. And that’s where the problems are. [24:00]
JOHN: Isn’t the real problem that the lenders really pushed the limit by overstretching buyers to get into homes which they really couldn’t afford; or we had property flippers, remember that? That was one of the big things driving this. And the banks were generous and they overextended the credit because the property flippers assumed we’re going to move into this property for six months even if they don’t physically move in, and we’re going to move out and we’ll make 100,000 or 200,000 on the flip; and that was it. And then of course the whole thing came sort of crunching down at some point.
JIM: Basically what happened is as property prices rose the financial community – banks, lenders – came up with creative loans and looser lending practices that were used to qualify buyers. That was the only way you could do it. “We’re not going to ask for three years worth of tax returns to verify what you said you earned last year.” Can you imagine making loans on a home and not asking for tax returns to verify income. And that’s what’s starting to backfire. So assuming politicians don’t make matters worse –and then of course in an election year that’s a big, big ‘if’ – it looks like total losses in the mortgage arena should come in or around 400 billion. And most of that is going to be concentrated with leveraged US financial institutions which hold approximately 50% of that debt. [25:22]
JOHN: If we say that 50% of this is being held by financial institutions what are they?
JIM: And these are just rough guesses from various people that looked at this: banks are sitting on roughly about 5.6 trillion, you’ve got savings and thrift institutions at 1.2 billions; credit unions roughly about 400 billion; broker-dealers a little over 200 billion; and government GSEs are sitting on almost one trillion. [25:53]
JOHN: Wow, that’s quite a bit.
JIM: A trillion here and a trillion there, pretty soon you’re talking about real money. Wasn’t that Everett Dirksen that once said that. “A billion here and a billion there.” It just goes to show you with inflation now we talk about trillions.
JOHN: Yeah, it’s like what’s his face, John Maynard Keynes: “In the long run, we’re all dead anyway.” I guess that’s it.
Well, where is this all taking us?
JIM: Well, I think it’s very important to understand here if you want to look at what’s happening in the market is that there is a cyclical nature to leverage. In good times, balance sheets expand within the financial sector; leverage increases when balance sheets expand and conversely in bad times leverage decreases as balance sheets contract. The problem we face is that balance sheets have not contracted this time around. And the reason behind that is the lending crisis evident in the interbank market. In the fourth quarter of last year, banks – as I mentioned earlier – banks did not contract their balance sheets and that’s because they were taking a lot of these credit instruments back on to their balance sheets, whether it was SIVs, commitments on leveraged buy outs, commercial paper credit backstopped. So banks had to honor these loan commitments with back up credit on everything from LBOs, SIVs and more debt was added to the balance sheets instead of contracting the balance sheets. And that is what has yet to unwind and is in the process of unwinding. [27:30]
JOHN: Yeah, if this is a cyclical type of process then what are the stages in it? How does it look when we go around it?
JIM: Let’s just take a look at a simple cycle. When you’re in a bull market, in other words, assets are going up –whether it’s the stock market or real estate. Let’s confine this to real estate. In a bull market assets appreciate in value and the financial sector is a very heavily leveraged sector, whether you’re talking about banks, broker-dealers, hedge funds, financial intermediaries, credit unions, savings & loans, they are leveraged. And a very simple example is – and these are just some benchmark statistics I’m going to give out but banks are leveraged typically 10 to 1, meaning for every dollar of equity they have about 10 dollars of debt supporting their balance sheet.
And let me give you an example. We’re just going to keep this mathematically simple. Let’s say a bank has $100 worth of assets and those assets include securities, loans etc.. Now, on those $100 worth of assets, the bank has a leverage factor of 10 to 1, so they have $10 of equity and $90 of debt. Now, let’s suppose those assets of $100 go up in value because of appreciation in a bull market – let’s say real estate markets go up, security values go up, etc. Now let’s say the security value goes up to $101. Now the back has $90 of debt against $101 of assets, so bank equity has gone up $10 to $11. Now if a bank wants to maintain that leverage ratio of 10 to 1, if their equity increases by one dollar, then what they do is go out and buy another $9 worth of assets. So now the bank has $109 worth of assets and $11 worth of equity. And this keeps compounding. If equity increases to $12 then they would add even more debt on the balance sheet because they keep this constant ratio of 10 to 1.
The problem is: what happens if the assets start to contract? In the example I gave of $100 worth of assets rising to $101, if the value of the assets dropped back to $100 then what the bank would do is shed the $9 of assets they expanded on the balance sheet when their equity was rising. So just as balance sheets and leverage go up when assets are appreciating, conversely in bear market, or a bust, bank balance sheets must contract if they want to maintain that same leverage ratio. Because banks are so highly leveraged that’s why when you saw these huge write offs announced by the brokerage firms and Citibank they immediately went out and raised equity so they could maintain that equity balance and that leverage ratio. [30:45]
JOHN: So if they need to deleverage what does this mean for the financial markets and the economy and how is it going to get resolved?
JIM: Well, there are a number of ways that this can get resolved – there’s actually three ways: 1) banks and brokers can track their balance sheets sufficiently that their capital cushion is once again large enough to support their balance sheet - in order to they deleverage, they get rid of the amount of debt and the amount of assets; 2) banks or brokers raise sufficient new equity capital to restore the capital cushion and a large enough size to support existing balance sheets – and that’s what we’ve seen. Every time, whether it was Bear Stearns or Merrill Lynch, it was Citigroup, any time they were ready to announce huge write offs you notice that before they even announced the write off and the size of it, they said, “oh, we went to Dubai and we got $7 ½ billion from the Saudis” or Dubai, or some sovereign wealth fund. No. 1 and No. 2 is basically what has been happening.
3) The third method is the perceptions of risk in the market place change and in other words, people say, “okay, the crisis is over, real estate is stabilizing. I guess a lot of these mortgages that we thought were going to go bankrupt aren’t…you know, a lot of these people aren’t able to refinance or something comes in and the level of leverage can once again be supported with existing capital. However, I just don’t see the third option happening until maybe mid-year when some kind of bailout or some kind of guarantee comes in, and all of a sudden the emotional tenor of the market changes dramatically to one of fear, to one of relief.
But right now, the primary way that this is being taken of is option 1) which is deleveraging the balance sheet; that accounts for a lot of the selling that you’ve seen in the markets and 2) reliquefying or raising new equity capital which in my opinion is the best way to do this. [32:47]
JOHN: So then there are going to be spill over effects to this – that’s the cycle. What happens when it occurs?
JIM: Because when banks have to contract their balance sheets because they’re losing money – their equity – and remember, banks are highly leveraged as are brokerage firms and hedge funds – we’ll get to that in a minute. So far what has happened is the majority of all of this has been contained in the financial sector. Most of the damage that you’re seeing is in banks and broker-dealers, financial intermediaries, the bond insurers, insurance companies that bought a lot of this mortgage debt.
But here’s the problem: If leverage ratios remain constant then we’re talking about a shrinking of the balance sheet as equity shrinks. In other words, as banks lose money their equity shrinks along with that. So it’s been estimated – and there’s been a couple of people that have looked at this but the bank balance sheets of the financial sector needs to reduce their balance sheet by nearly two trillion dollars. And what you’re seeing – this will explain part of the sell off that you’ve seen in the stock market since the beginning of the year because if you have to dump assets one of the problems that you’ve seen a lot of the blue chip stocks and stocks that have sold off that are relatively cheap is that when you need to get liquid and reduce your balance sheet you’re selling anything you can get your hands on in a rush to liquidity. And that explains some of the market selloff that we’ve seen here since the beginning of the year.
However, eventually this spills over into the consumer sector because banks are not loaning, they’re being tougher on their lending standards both to business and consumers and it’s estimated that lending to the consumer sector is going to contract roughly 900 billion and I don’t need to tell consumers it’s tougher to get a loan today. Whether it’s a home equity loan or a refinancing, banks are taking a tougher standard in terms of before they make a loan because the reason is they’re losing money. So that is why I believe economic growth is going to weaken and inflation is going to remain high as the government and the Fed inflate their way out of this mess.
This Bloomberg story out on Friday, the Federal Reserve announced Friday they’re going to increase their Term Auction Facility next month by 100 billion dollars. So they’re injecting massive amounts of money in to the system; they’re going to be lowering interest rates. The speculation is now that at the next FOMC meeting that it’s all but said that they’re going to be reducing interest rates by another 75 basis points, so the federal funds rate will drop down to 2 ¼. So what the Fed is trying to do is trying to fight housing deflation because remember as prices houses go down, equity disappears both on the bank balance sheet and the homeowners balance sheet. And if we get a serious recession the $400 billion loss number gets much worse, so the Fed by lowering short term interest rates is trying to steepen the yield curve. And over time as the yield curve steepens – meaning the difference between short term interest rates and long term rates gets wider – this improves the profitability that banks can make in lending and thereby it allows them to rebuild their balance sheets and equity capital. And the best course would be for banks to raise new capital, cut their dividends – in fact, probably eliminate them to conserve cash flow to strengthen the system. And the government should also enact incentives to encourage savings. However, it isn’t just the financial sector that needs to deleverage. Consumers also need to deleverage and start saving – and that will be another theme that we’ll take up here in just a moment. [36:46]
JOHN: Well, when you look at it, all of this doesn’t really sound too good for the financial sector in the short term, and for other sectors I would think in the longer term.
JIM: No, it really doesn’t. And what’s really surprising every time we get some announcement that the Fed’s going to inject more liquidity, I mean here we are Friday, the markets down 200 points, people are rushing into the financial sector and they’re selling off gold! And we’ll get to that in the second hour.
But if you take a look at the financial sector over the last 2 ½ decades, the financial sector in this economy has grown at almost twice the rate of GDP. The industry that creates, trades and manages this whole artifice of debt is now going to contract. Banks have shifted we’ve seen over the last couple of decades their business model to an originate-and-distribute model. The security firms repackage this debt and it was redistributed and it has contributed to huge profits in the sector. This whole model is now in the process of contracting. The whole industry is going to downsize. You’re going to see layoffs of brokers, layoffs of analysts, layoffs of real estate agents and you’re going to see large scale layoffs; in fact we’re seeing a part of that right now. The banking sector is going to have to rebuild and that is going to take years to repair the damage. The brokers are going to be shrinking in size.
The stock market returns I believe are going to be mean reverting. I mean just look at the five and six percent returns we’ve seen in the market last year. And this is the reason why I believe strongly in dividends if you’re investing in the market because they are going to account for a greater part of investor returns. It’s also why believe large cap multinational companies that earn enough money that are self-financing and that have access to credit are going to be doing much better. In fact they have because the credit markets are going to be tight for years to come as the financial sector deleverages its balance sheet.
Let me just get to this Bloomberg story that was on Friday. There was a report out by Friedman, Billings and Ramsey and they were saying that the $11 trillion US mortgage market needs about one trillion dollars of new investment to halt the slide in real estate crisis. And as the amount of leverage or borrowed money used to boost investment returns decreases – this deleveraging I’m talking about – the yield and extra yields over borrowing costs on mortgage assets need to increase to allow buyers to earn the 15% returns that are typically targeted in the industry. And here was a story getting to exactly what we’re talking about. Non-banks are being hit. This is from Bloomberg I’m reading:
Non-banks are ``being hit'' the worst by the reduction in allowable or desirable leverage, the analysts [at Friedman, Billings, Ramsey & Co] wrote. The amount of leverage employed ``appears'' to have fallen to 10-to-1 from 20-to-1 for agency securities and to 2-to-1 from 10-to-1 for non- agency securities.
They also talked about some of the mortgage players have dropped their leverage from 20-to-1 to 15-to-1, and people just don’t realize how large this leveraged sector is and the meaning of this. [40:12]
JOHN: We can talk about this on a theoretical level but the real eye-opener is when you realize how badly leveraged a lot of financial institutions are here in this country. And you hear the numbers and then you begin to go, oh my gosh, we’re in trouble. Can you throw some of those out?
JIM: This is just a broad generalization within each category. You may find some institutions more or less leveraged, but generally commercial banks are leveraged 10-to-1, meaning for every dollar of equity they have about $10 of debt. Savings institutions like thrifts are leveraged 8.5-to-1; credit unions are leveraged 8.5-to-1.
Now here’s one that’ll scare the heck out of you – brokerage firms and hedge funds are leveraged 32-to-1, meaning for every dollar of equity they have $32 of debt. GSEs like Fannie and Freddie are leveraged 25-to-1.
And if you average all of these together because obviously commercial banks and savings institutions and credit unions are larger than the broker-dealer/hedge-fund group, but the leveraged sector on almost 20 ½ trillion dollars worth of assets are leveraged 12.2-to-1. So meaning that you take a look at the balance sheet of 20 ½ trillion, there’s only 1.7 trillion of equity behind that $20 ½ trillion worth of assets, meaning that liabilities are almost 19 trillion. [41:52]
JOHN: Could we say this is sort of phantom money. I mean is that a good way of if you were to paint that to people.
JIM: It’s like a fractional reserve system. When the Fed creates high-powered money that’s exactly what this high-powered money goes into. And that’s why, for example, we’ve had John Williams – in fact, he issued a flash estimate: M3 money supply is now growing at almost 17% a year. So when you create this high-powered money that’s where it goes into. I mean when money is created at that level it doesn’t go into a mattress, or people or institutions are burying this money in their backyards. And so what they’re doing is creating as much assets to replenish the assets that are disappearing or vaporizing because of asset writedowns. [42:38]
JOHN: But it would seem like some instability could throw this thing into a crisis.
JIM: That’s why we’re basically in the bunker mode right now. And what the temptation is – and here’s where my depression theory may come in depending on who wins the election – the government creates this mess; the Fed created the real estate mortgage boom by artificially lowering interest rates to fight off the technology bust, so Greenspan bring interest rates from 6 to 1%, they pump the money supply and they kept them artificially low for years. And what this did is encouraged people to go out and make improper decisions, leverage their balance sheets, spend money and drive asset prices up and then you get the crack-up boom which is what we’re getting now. And then what happens is the government comes in and they want to bail out everybody as a result. So the more the government tinkers, whether it’s Bernanke asking banks to forgive mortgage loans, I mean think about that for a moment. Number one, a lot of these mortgages are embedded in some kind of security. So think if you owned a mortgage bond that was worth a dollar and Bernanke told the financial institution to forgive 30% of that debt; that impacts you on the money that you made when you made that mortgage investment. So I mean you’ve got things like many unconstitutional issues that are coming forward here; but this is what government does. This is what we did during the Great Depression that made a recession a depression. [44:16]
JOHN: This sort of comes back to my little theorem that I started out with, and that is don’t put the people who got you into the mess in charge of getting you out of the mess. You know, if they didn’t see it coming they won’t know what to do when it gets here. In reality, they did see it coming but I think they were between a rock and a hard place; and more increasingly so as time goes on. Is there anything I should ask here that we could expect to trigger in the near future.
JIM: You know, there could be all kinds of things that are happening here but I would say, given what I’ve seen coming from the Fed, given what I’ve seen coming from Washington, John, I would invest in chainsaws because they’re going to be cutting every tree down in the forest.
JOHN: Chainsaws!
JIM: Yeah, I mean look at Friday. $100 billion of Term Auction Facility next month and the Fed will be cutting interest rates by another 75 basis points when the FOMC meets this month. And we’re going to get into why the markets don’t understand what all of this means: what a falling dollar means; what cutting interest rates and printing money means; what it means when the government is doing helicopter drops with this rebate which everybody knows will do nothing to cure the economy, this is just buying votes in an election year. [45:31]
JOHN: They’re going to buy chainsaws to roll down Wall Street like the peasants storming the Bastille a few hundred years ago, going after everyone with chainsaws. It’s going to be wild times.
But this is also why your investment portfolio differs from Wall Street which is a topic we’re going to get into in the next hour. Given that this is the climate and the environment and is going to remain that way for some time, how do you invest your money in this type of market?
And you’re listening to the Financial Sense Newshour at www.financialsense.com online all the time.
I’m Andy Looney. I went to the gas station yesterday to gas up Big Blue. You know, my 4x4. Wow! It cost me the price of a Lexus to fill up. $80 doesn’t seem fair, especially when my tank wasn’t completely empty. It only took a few minutes to spend what it had taken me hours to earn. My friend Charles says that oil is at record highs and that Hugo Chapstick, or something like that, wouldn’t sell to US oil companies. Didn’t they name a hurricane after him? I think they did. I don’t think I like him very much because he’s messing with Big Blue, and I can’t afford to drive her very far with such prices. Charles also says that the demand is up globally. What’s with demand? I mean my wife Sandy never gave into my demands, so why should that make a difference? Can’t President Bush stand up to this Hugo Chapstick. Come to think of it, President Bush couldn’t stand up to Sandy either. Could you? I can’t. Sorry, Honey. I wonder if Sandy would let me get a bicycle built for two, that way we could get around town without going through the gas station. We tried one of those bikes once but Sandy got to laughing so hard she couldn’t pedal, and I couldn’t make it pedaling on my own. I guess I should think of something else. What do you think? I think so. So if you happen to see a couple on a tandem bike, wave as you drive by, it just might be Sandy and me. Sorry, Big Blue. I’m Andy Looney for Financial Sense. [47:44]
JOHN:
Well, here we are back again. This segment follows the lead
with which we left – I don’t know if it’s a lead. I
don’t know, maybe it’s a trail. I guess we’ll call it a
trailer. It’s not a movie trailer, it’s a radio trailer
from the last segment.
We ended the first part of the Big Picture talking about a contraction in bank balance sheets and lending. What that means is that credit conditions are going to get much tighter which is going to affect the general economy because there’s going to be less money to spend.
In this part of the Big Picture we’re going to talk about what that means for you the consumer.
JIM: you know what was absolutely amazing is I have seen all of this playing out. I started in this business in 1977, well over 30 years ago.
JOHN: More than you’d care to admit.
JIM: Yeah. I do have gray hair now. But when I got into the business I started out in…well, I started out in corporate life with a Big 8 accounting firm – at least there were eight of them back then. But in 1979 I got into the financial industry, I left corporate life and I became a certified financial planner. And the two issues that we were talking about in guiding people were taxes and inflation. Remember, the tax rates were 70%, the tax rates on estate planning were 70%; they taxed your estate when you died. When the first spouse died the exemption was like only 175,000. The inflation rate was at 14%. People’s taxes were going up each year as bracket creep…in other words, as you got a cost of living increase it pushed you into a higher tax bracket. And those were the two problems facing Americans.
And here we are 30 years later and we’re making the very same mistakes. And most Americans are facing those very same things: higher taxes and inflation. People are seeing inflation in their day-to-day living and next year when they repeal Bush’s tax cuts everybody is going to see their tax cuts – we already did a show on that showing that it’s going to affect everybody more so on the bottom and the middle class than it is the upper class. And the more the Fed lowers interest rates and devalues the dollar the higher inflation we’re going to face. And the more the government intervenes with bailouts and rebates, the more taxes are going to go up and the higher the inflation rate will be.
Also, as the government spends more money than it gets in revenues they will tax and inflate more to pay for this largesse. I thought it ironic on Friday you had Congress interviewing the CEOs of some of these financial firms; they got big bonuses and here is Congress getting in and thinking of regulating CEO pay and they’re saying these guys shouldn’t get this because they lost money. Well, I hate to tell these Congressmen but these Congressmen have lost money for taxpayers for every single year since 1971. We’ve been running continuous budget deficits and are now talking about almost $10 trillion of debt and almost $55 trillion of unfunded liabilities for Medicare and Social Security. These criminals have spent the Social Security trust fund. I see nothing here that tells me that inflation and taxes…we’re almost going to get to the point where most people will be serfs working for the government to pay their taxes. It used to be May and I think we’re into June now, and by the time they get done with the programs they’re proposing for next year we maybe will be working till July or August to pay our taxes. [51:39]
JOHN: You know, it’s interesting that that is the stretch on that because you have to realize that the baby boom issue – the unfunded liability – is separate from all of the financial issues we’re talking about right now. So these are two parallel running but converging trends, maybe it’s important to view like that way which is also converging with the oil crisis as well at the same time. So these are different issues all coming together at one point.
You know what makes it even scarier is that some of the candidates are talking about trillions of dollars of new government programs. At the Institute for Policy Innovation they’ve been trying to put together all of the proposals that the candidates have for new tax proposals. And the funny thing is they finally managed to compile a list and they said: “Look at the list. Everybody is going to get tax credits and tax deductions.” But they can’t figure out who is going to make the tax payments to pay for all of this stuff. We have new government programs, the UN tax. We don’t have the money to pay for the programs already promised; it’s simply not there. So this is going to leave our government here in this country with very, very few options. They either raise taxes as high as politically possible –and frankly, Jim, I think they’re almost there – and print money to pay for the rest which means higher inflation rates which as Congressman Ron Paul would say is the “invisible tax.” So basically you have the tax brackets coming down on the top and the inflation rate nipping at their heels from the bottom shoving them upward. It’s an impossible sandwich for the middle class.
JIM: And we’re on a one way path. Last week we talked about price revolutions in history and I mentioned David Hackett Fischer’s book The Great Wave and all of these big inflationary waves are preceded and begin with higher energy and food costs. Exactly what we’re seeing now. So higher taxes and inflation are going to be the result. And so what that means very simply is people are going to have less money to spend. If they repeal the Bush tax cuts that means that most people – 99% of taxpayers – are going to see what they make will be less because if the government takes more of what you make then you have less money left over to spend. [53:51]
JOHN: And with the inflation chewing you up when you need more money to spend, taxes take more of that money that you need to spend because inflation is shoving you upwards.
JIM: Yeah, because if inflation rises it also means that the things you need to live will cost more, so there will be fewer goods bought because they will cost more money and you will have less money to pay for them. [54:13]
JOHN: Which means then we see a slowdown in the economy. If people are buying fewer things then companies can’t make products and therefore they lay off people because that’s the first place they cut, and you can see this thing as a big giant downward spiral.
JIM: But you know, bringing this back to the economy…
JOHN: Unlike the housing boom say, for example, Americans could use the equity in their homes sort of like ATMs to get cash out of them, banks are reluctant to lend so this contraction of bank lending doesn’t really bode well for the consumer. And I really want to point out it follows the same pattern of the past. You can go back to Weimar Germany, you can go back to all of these inflationary waves we’ve been talking about. We are going lockstep, literally step by step, into this pattern.
JIM: You know, it’s not only that the supply of credit is going to diminish but it also means that demand for credit will also decline as consumers move to reduce their record debt levels. The level of household debt right now absorbs over 50% more of after tax personal income. Just think how bad it could get next year when Congress raises taxes and inflation levels rise. It’s going to take at least in my opinion a very, very long time here before household balance sheets improve.
And here’s another key factor demographically with baby boomer getting closer to retirement there is going to be a dramatic shift in consumption and a move towards saving. The next trend that you’re going to see I’m predicting is consumer downsizing. And what does that mean, it means smaller homes, smaller cars, less spending. Just as in the last recession in 2001 where you saw this big leveraged boom in the corporate sector the 2001 recession was a corporate business-led recession. Businesses contracted. Everybody remembers the front page layoffs and what happened is in this recovery businesses rebuilt their balance sheet, they trimmed personnel, they cut cost, they improved the financial soundness of the cp, and that’s what consumers are going to have to do. So in the end the good news assuming that politicians don’t mess it up this is going to be healthy. But for the next decade the consumer trend that you’re going to see is downsizing. You’ll see this become headlines a year from now, they’ll be talking about consumer downsizing, the trend of downsizing homes, of downsizing cars; and it’s going to be driven too demographically. And this has tremendous broad investment implications in terms of how people are going to make money. [57:05]
JOHN: Remember a couple of weeks ago when we were talking about the fact when you’ve been on a roaring drunk all night there’s sort of a repentance period in there; there’s a period where you have to detoxify and that’s not fun. But the downsizing, the contraction, everything you’re talking about is precisely that. That’s exactly what you’re looking at. And there’s no way to avoid it – have you notice that? No matter how hard politicians try to tell you we can avoid this, it never works. What they do is they actually make the headache worse.
JIM: That’s because what they’re urging is they want to see more consumption when the problem was too much consumption and debt. You can’t build prosperity – if you just think about this logically – by going into debt and consuming. You build prosperity by saving your income, investing it, producing things and building capital structure in an economy. And we’ve gone on this debt and consumption binge for 25 years under Keynesian economic assumptions as a means of trying to build prosperity and it’s not working, John, and we’ve reached the limits of this. And unfortunately it’s going to be forced on us one way or another and it doesn’t matter what the Fed does or what politicians do, it’s going to happen. [58:20]
JOHN: And it’s going to cause a revolution at the polls like we said. I think we’ll see this process of throwing one group of rascals out just to put another group in, hoping that somehow we’ll get some relief each time. But unless they really derascalize Congress that’s not going to happen. All right. That’s the situation that we’re facing.
Any other headwinds or issues that consumers really need to know about that they’re facing in addition to taxes and inflation. I should point out that regulation is crushing a lot of small businesses right now, something that you didn’t talk about today. So TIR – taxes, inflation, regulation and less credit availability.
JIM: Yeah, it’s amazing. You can see it. Even in our own industry now we’ve got two or three personnel just to do paperwork – compliance paperwork. One of my doctors has three people dealing with Medicare and two nurses. So there’s three people on the staff that are just dealing with government paperwork.
JOHN: But Jim, it’s really important to recognize socialized medicine is going to eliminate that. Don’t you understand that? As soon as we get government in charge of all of our healthcare, that will eliminate all of that paperwork.
JIM: Yeah, instead of three people on paperwork you’re going to have ten people on paperwork and two people that are actually doing things related medically. [59:35]
JOHN: And that is after they jettison all of the patients. They’ll just be doing the paperwork.
JIM: Yeah. But two other headwinds come to mind and they’re kind of related as the economy goes into recession more people are going to lose their jobs. Also, as we approach peak oil energy costs are going to escalate. I couldn’t believe I saw one anchor go on TV the other day and say, “I wouldn’t invest in energy companies with oil prices at $100, they’re too high.” It’s like: Hello! [1:00:05]
JOHN: You need to address that though because I get…I’ve talked to people and I think people are already getting panicked. They’re looking at their portfolios bobbing up and down. One family member said, “well, we’re thinking about completely jumping out of that and getting into real estate because my gosh, we’ve lost $10,000 here” and blah, blah, blah. And you can hear the panic in these people’s voices. And of course, this is not a time to panic.
JIM: No, and actually I think there’s a great opportunity that’s unfolding here. But anyway, if we get back to where we’re going with this segment which we’re calling “the slow death of consumption” as energy costs go up it’s going to make driving your car, heating and cooling your home more expensive. Energy is also going to make goods produced more expensive, from food to minerals to production goods. And so this is just another factor…if you have to spend more of what you earn on food and groceries or utility bill, that means there is going to be less money left over for the discretionary things you like to do whether it’s entertainment, going out to eat at the restaurant or you know, going shopping for things. But that’s what’s happening. You’re going to see…it was interesting to look at some of the retail statistics; of the retailers doing well they’re the giant discount chains; they’re the Walmarts, they’re the Costcos, they’re the Sam’s Clubs because how do you make your dollar go further as the cost of food and everything else goes up. [1:01:35]
JOHN: I’m predicting we’ll see… I don’t know if they ever went away but we’ll see the rise a lot more in the way of co-ops like church groups form, you know, where you buy food in bulk and everybody gets together. They all agree what they need and they buy it in large bulk and then meet together on a Saturday and all divide it up.
JIM: People haven’t thought through with this what deleveraging of financial balance sheets is going to mean to the financial sector because every time you have like on Friday the Fed’s going to pump another 100 billion into the sector and you know, people rush in to the homebuilders and the financial stocks and then they sell gold. Or they go into Treasuries. You know, on the day that you and I are talking you had the two year Treasury note at 1 ½%; you’ve got headline inflation at 4.4%. And the Fed just told you they’re going to inject another $100 billion through TAF and repos next month. And what do people do? They sell off gold, they sell off oil, they go out and buy Treasury bonds at one third the inflation rate. I mean this is just absolutely insanity. People have no idea what causes inflation. When you watch these dialogues on the financial cable channels it’s like I’m thinking: what has happened to economic understanding or monetary understanding? I mean we have basically become a nation of monetary illiterates. [1:02:56]
JOHN: But isn’t that due to 50 years of Keynesian training in colleges?
JIM: Yeah, sure. Even the dictionary definitions of inflation have changed to rising prices and deflation as falling prices rather than an expansion or a contraction of the supply of money and credit. [1:03:13]
JOHN: Let’s follow this model down the road then now. Consumers are obviously going to cut back, they don’t have any choice. They’re going to have to do that. Now, that will affect the economy. Are there any offsets that we could have coming from the business sector which might offset weaknesses from consumer spending because, you know, you’re an Austrian economist, you believe that production and investment are more important to economic growth than consumption which is the Keynesian side of the issue.
JIM: You know, if there is one bright spot here it has been from the business sector. American manufacturers are becoming more competitive, but most business clients that I have personally – these are entrepreneurs, people who have their own businesses – they don’t know what is going to happen with taxes both on income taxes and estate taxes.
Most people don’t realize that the estate tax rates go up. Many people may not recall this but prior to Reagan becoming president the exemption was like 175 so any asset over 175,000 was taxed for estate taxes and the estate taxes went all the way up to 70%. Also, they would tax you on capital gains. So let’s say that…And the estate taxes were due on the death of the first spouse and so what would happen is the surviving spouse would have to sell off assets to pay off the estate tax. But what if those assets appreciated. Well, then you would not only have to pay the estate taxes but then you would get hit with capital gains taxes. And the idea that they passed with Bush was they lowered the estate tax rates, they increased the exemption on estates (it’s somewhere over two million; I think it’s going to rise to three million); in the year 2010 you have one year where you have no estate taxes and the step up in basis goes away. And then in 2011 we go back to the old pre-Reagan rules – the exemption drops to 600,000, the tax rates go up to 55% and you no longer have step up basis in cost when one spouse dies. So for a businessman who owns his own business who may not be liquid because it’s a privately held business there’s huge estate taxes.
So a lot of the business clients that I have they’re becoming more cautious. I mean there’s a lot of talk about more government relations, more interference in the market place. And John, this is creating an environment of uncertainty because how can you plan a business when you don’t know what interest rates are going to be, you don’t know what tax rates are going to be, you don’t what estate taxes or regulations. Most businesses are beginning to hold back in the CEO surveys because they simply don’t know what Washington DC will look like next year. Is it going to be a hostile environment or is it going to be a friendly one. And right now, it doesn’t look good for the markets or the economy next year. [1:06:17]
JOHN: I’m not sure why but the more you talk the more horrified I’m getting because you realize that people are going to work and work and work and in the end trade it all away. That’s what’s going to happen. They’re going to be trading this into government at some point or another. You won’t be able to pass on to you’re kids; you’ll be lucky to hang on to what you have and I keep wanting to hear what all the pundits are going to say in the midst of all of this as to what’s responsible for all of this.
Getting back to the consumer, I’m thinking of the consumer because the consumer is the little guy. If the consumer pulls back on spending how does this change the investment picture, what sectors of the economy will be hit the hardest and I should probably say on the counter side, what do you think is going to do well during this time?
JIM: I want to get back to the first segment that we talked about and that’s the contraction of bank and financial balance sheets. This debt liquidation phase that we’re going through is going to translate into spending restraints on the part of consumers and also on the part of business. Also, higher taxes and inflation means there’s going to be less money to spend; and money because it is depreciating – just look at the value of the dollar – that means money is going to buy less. What this means is discretionary spending is going to decline. So this impacts a whole broad segment of the economy; with the falling real estate market you’re going to see less money spent on household furniture, appliances, home improvement sales – those sectors are going down. You can see it in the stock charts. Home sales and auto sales are going to fall, and households are going to begin this downsizing that I predicted. It’s going to be driven both financially and demographically. This is also going to impact entertainment and leisure.
(You know, we normally don’t go to the movies anymore and somebody please explain to me what has happened to restaurants. We went to the movies Sunday night with my youngest son and his fiancé and, John, I noticed my parking indicator – we usually go Sunday matinees – and most of the time I have to spend 15 to 20 minutes driving around the parking lot to find a space to park. So I’ve noticed less attendance at movies. And then we went in the restaurant and not only was it to walk in, where before if you’d get there you’d have a half an hour wait, sometimes 45 or 50 minute wait. But then on top of that, in the restaurant we were in we had four TV sets going and then music at the same time. When did this come into vogue that we’re going to blow your ear drums out? We actually walked out it was so loud. I said I can’t even hear what you’re saying. And this was when we were seated immediately and I said, “could you turn the music down.” And the guy just looked at me like, Dude, this is the way we run this. And so we just got up and walked up and we walked down the street to a another restaurant and they had like a side room where you didn’t have to compete with all of that noise. But anyway…)
As consumers downsize this is also going to impact the entertainment and leisure market. There is going to be less money for restaurants, less money for spas, hotels, movies and instead you’re going to see instead of people going to the theater where it costs 15 bucks for just a popcorn and a coke and 11 or 12 bucks for a movie ticket people are going to use Netflix and Blockbuster at 5 bucks instead of 12 bucks and 20 bucks. And instead of eating out I think you’re going to see people eating at home. I mean we entertain a lot and we like to entertain at home because number one, it’s quieter; I can buy high quality food and it’s much more enjoyable not having to compete in conversation with four TV sets and 10 speakers blaring out music. [1:10:09]
JOHN: I know you like to cook. I do too, so does Carol. This is a total sidebar. A couple of weeks ago we got a brand new Mexican food recipe book and we came home one day on Sunday and said, “okay, what are we going to make here today?” And we all split up the task load and created a whole new exotic dinner.
JIM: Some of the things we like, like I’ve got a whole series from Williams Sonoma on Mediterranean cooking, cooking beef and stuff like that, and that’s what I try to do on weekends I try to find a recipe and go to the store and get the ingredients and then a lot of times our dinner guests we invite over we have them participate. Last week I had like five different dishes going on and so it was kind of fun. You know, it was a lot less expensive than going to a restaurant where we would probably have walked out with a couple of hundred dollar bill. [1:10:56]
JOHN: And if you don’t have to call 911 for your guests then you know that the recipe is probably worthwhile, and if you do, you just don’t make it again.
So if consumers are retrenching that’s going to affect business, that’s going to affect their dividend etc. etc., so where will the investment placements be?
JIM: I think and we’ve been talking about this. I think it gets down to the simple things. The things that people have to have. What do people have to have. You have to have energy. You have to have food. You have to have water. And with the dollar depreciating and government and the Fed inflating you’ve got to have precious metals; and I think also because of decaying infrastructure in the United States and Western countries – I mean look at our bridges, our roads, our power plants, our refineries, our airports, our rail system – infrastructure is going to be a theme. And it’s interesting for the first time in a hundred years railroads are going to invest billions of dollars to rebuild their tracks and their freight because as energy prices go up over $100 for a barrel of oil it’s going to be much cheaper to put those containers on a railroad which can operate at a third of the cost of a truck. So infrastructure investing.
Even during recessions, people still have to eat. They need to take a shower, they need to drink water to quench their thirst, they need to put gas in their cars and they need heating and air-conditioning depending on where they live in the country. [1:12:24]
JOHN: Is that why Warren Buffett recently bought into Kraft? I mean here you have the world’s richest man seeing the same thing – also makes Oreo cookies by the way. Buffett has bought into energy, he’s bought infrastructure, railroads. He didn’t get to be worth $62 billion and become the world’s richest person by making silly investments.
JIM: You know you’re right, John. I think he sees the implications of the contracting economy. He definitely understands higher energy prices. He just made a fortune in his investment in PetroChina and he still owns Williams Energy. And I think he also sees the sad shape of the country’s infrastructure. The one thing about all of this is that these trends are long lasting. Bridges, levees, airports, power structures, refineries – I mean these aren’t things that you can fix overnight. I mean right now we have nothing to replace oil and natural gas and there’s also a problem with excess power capacity to generate electricity: It’s diminishing. When the nuclear power plants went out in Florida there was no excess power in the grid system to pick it up. I know here every single summer when we get a heat wave we get power outages. I mean you just plan on it in California because the idiots that run this state don’t want to build power plants. I think we are going into more of this in our next segment in terms of these long trends and what is working in this kind of environment. [1:13:55]
JOHN: So basically what you’re saying is taxes and inflation are going to go up, discretionary spending will go down in proportion as people need to live within a budget. So you’re basically back-to-basic necessity areas – the things that people need. That would probably mean that retail sales of things you don’t need go right off a cliff. What is this, the death of the American consumer?
JIM: No, I don’t think so. That’s not what we’re saying here. You know, retail sales are not going to fall of a cliff, I think they’re going to die a slow death. In other words, as taxes and inflation go up corresponding with that increase will be a decrease in discretionary spending so you’ll see lower levels of consumer spending especially in real terms after you adjust retail prices for inflation. So it’s going to be a gradual rollover as more people get closer to retirement, as they get older, as they begin to downsize. So this is going to be a very long lasting trend and we’re going to get into that in the next hour. [1:14:56]
JIM: That’s going to destroy people riding their pickups on old abandoned rail lines which was going on here in Montana and Idaho about 10 years ago – and driving the rail companies crazy. People would, you know, all these little hookups like the railroad companies have to put pickups on the rails when they want to do maintenance. Well, cowboy types were doing that on the weekend for some fun here but if they start to use rails again…not going to be able to do that.
You’re listening to the Financial Sense Newshour at www.financialsense.com. More to come, we are not done I assure you. We’ll be back.
JOHN: Here we are looking at some practical applications about the things we spoke of in the last hour. But here we go: consumer spending is on the way down; credit constraints are going to become more and more prevalent. What will work in this market?
JIM: The very same things we’ve been talking about on this program, gosh, John, for the last seven or eight years. And I’m trying to think of the author we had on recently, it was on value investing and he talked about markets are range bound after they’ve had a tremendous bull market as we saw between 1982 and 2000. If you look at markets become range bound - in other words, the high double digit returns that we saw in the markets for almost 18 years become mean reverting. And that’s what we’re seeing in the stock market. But, while this cycle and paper assets is returning to mean reverting (in other words, you’re going to see lower returns) there is another bull market that has begun in another sector.
And what drives all bull markets fundamentally is supply and demand. Forget the charts. The charts will pick up on this but what drives, what is at the basis of all bull markets are supply and demand imbalances. And for gosh, nearly two decades we saw a bear market in commodities, whether you were looking at mining, whether you were looking at energy, whether you were looking at agriculture. We did not invest in new supply, we did not go out and explore as much as we should have; we did not go out and open new mines. In fact, mining companies went out of business, they got consolidated which is one of the reasons why you see these big behemoths that we have in the gold sector like the Barrick and the Newmonts and the Gold Fields and some of the large companies as a result of consolidation.
And in the meantime, during that 20 year bear market we saw in commodities we’ve added over three billion people on this planet since the 70s in the last bull market in commodities. So as Jim Rogers has talked about, as Marc Faber has written about, and as a lot of the great thinkers in this area have talked about, these cycles are anywhere from 15 to 18 years. And so we’re just in the beginning stages this cycle. We don’t have surplus energy; they’re not finding enough energy each year to replace what it is we consume and what I found rather interesting and it goes to show you, it doesn’t matter whether you’re looking at energy, whether you’re looking at base metals, or even commodities – I mean the president of Potash recently said, “We’re are going to have to have record harvests every single year for the balance of this decade to avoid a famine.” And we’ve had 17 years of record harvests, but our grain inventories are the lowest that they’ve been since 1960.
So the point I’m making here...or even more recently you can talk about the example last week, you had a nuclear power plant in Florida and their wasn’t any excess power capacity in the grid system to resupply it. Our excess capacity in generating electricity has diminished tremendously. And that’s what people don’t understand. And what we are going through, as we go from this consumption-oriented economy which is what has driven the US economy over the last 25 years, we are going to now go back to basics. We’re going to have to rebuild infrastructure; we’re going to have to rework our water systems because water is a diminishing asset too because we’re using too much of it and we’re not upgrading our water systems in cities – they’re falling apart. Just pick up the headlines. It’s almost like every week there is some evidence that we see in the news of declining of infrastructure in this country.
And the more important thing that you have to understand – and I think Jeff Christian and I talked about this in the first hour – is you can’t just look at “oh, the US is going in to recession therefore we’re going to consume less copper because we’re not building as many homes,” or we’re going to consume less energy the economy is slowing down. You have to think of the world today in a global sense. And the United States is not the main economy engine. It’s one of them but it is no longer the only one. And it’s not just the fact that we have three billion more people on the planet, it is the fact that China, India are industrializing; their economies are more commodity intensive. And so one thing I wrote about in my Storm series, going back to 2000, and then another piece I wrote in The Next Big Thing in 2003: If you wanted to make money this decade the very basic necessities of life. At the top of my list were precious metals because when I wrote The Perfect Storm back in 2000 and 2001 the Fed was reinflating so you were going to need that and the dollar was going down in value, so you need too precious metals.
That still applies today: on the day you we’re talking the Fed is talking about $200 billion of injection into the TAF program; they’re talking about repos; they’re talking about cutting interest rates and the dollar continues to lose its value. We’ve talked about water. Water is a segment that I think is being ignored in the market place right now. Greater demand on the agricultural system means greater demands for oil; also, by the way, greater demands for natural gas which is associated with a lot of the fertilizers farmers use. So precious metals, we talked about water, food – gosh, we could do a whole segment on food and we’ll probably do more on that – and then energy.
I am absolutely amazed, we’re sitting at $105 a barrel and people are saying there’s plenty of oil in the world. If there was we wouldn't be sitting at $105 a barrel. Now, part of this price differential is investment demand that’s coming into the commodity complex which always happens. And I dismiss the bearish argument that the only reason it’s this high is because the hedge funds are buying. When a bull market begins, as prices begin to go up, as the fundamentals drive the case for higher prices, money begins to move into the sector. It’s no different from what we saw in the bull market in stocks in the 80s and 90s; by the late 80s, institutions were coming back in to the stock market; by the mid-90s, individuals were coming back into the stock market in the final stages of the bull market. So any time a bull market begins, it begins with the smart money going in first and then secondly institutions follow and then thirdly the individuals will be the last to come in. But by the time the individual gets in on this market we’ll be talking about 3 or