Sunday, May 30, 2010

The US Real Estate Recovery: Prices and Quantities


Market analysts, pondering when the US real estate market will revive, usually conflate two distinct aspects of the market: a recovery in demand (for homes, offices and retail space) and a recovery in the price of buildings from their currently depressed level.

There is no doubt that price and demand are related. A recovery in demand will put upward pressure on price. As existing vacant building space is used up, the price must rise, at a minimum, to a level at which new buildings can be erected and an investment return commensurate with the risk undertaken earned. But to determine how high prices will rise (in relation to its prior peak) we need to examine underlying factors affecting cost and demand.

Two Factors Exerting Upward Price Pressure

There are two factors that will continue to exert upward pressure on price. On the demand side, trend US population is growing at about 1% per year (with a recent dip due to the damping impact of a soft labor market on immigration). That is the highest rate of population growth for a developed country in the world and it ensures ongoing demand for new homes, places of work, recreation and shopping. The quantity of real estate demanded and used will rise significantly over time. On the supply side, the movement towards ever more restrictive land use regulations and environmental constraints on development have broad public support and are likely to continue into the future. This will limit the availability of land on which the new buildings can be built and increase the price of land.

Three Factors Exerting Downward Price Pressure

There are three factors that will exert downward pressure on price. One is the reduction in leverage in real estate lending, which will be instituted by regulatory directive – higher capital provisioning for real estate loans, reduced leverage in the banking sector, lower LTV limits - and by markets in reaction to the massive losses on real estate lending that has occurred during the crisis. As the cost of equity is normally greater than the cost of debt, the increase in required equity will raise the required real estate investment return and, for a given level of rental income, will depress the price of buildings and the land upon which they locate. This reasoning applies to housing, where the rent is an implicit stream of services the home renders to its occupant and where the increased equity must come from households who are less wealthy and more liquidity constrained than they were before the financial crisis.

The second negative price impact comes from the likelihood that real interest rates will eventually rise above the levels of the past two decades. This is a consequence of the simultaneous reduction in private wealth – which reduces the pool of investible funds – and the explosive increase in public sector debt worldwide over the past two years, which will ‘crowd out’ private investment. A higher interest rate increases the rate at which future rental income is discounted, and this will reduce the price of the asset. A monetization of US government debt may damp real interest rates (while increasing nominal rates) but real rental income would decline as wealth is transferred from the private sector to the government, which will reduce the value of the asset. Likewise, a tax increase to pay for a portion of government debt may reduce the government borrowing requirement, but it will increase the required after tax rate of return on investment.

The third negative price impact arises from the requirement that the US eventually reduce its trade deficit. The US cannot indefinitely become more indebted to the rest of the world.; US net exports must increase. For this to occur, the US must eventually reduce consumption (relative to GDP) and shift spending away from the production of non-tradables (like real estate) towards tradable goods for export (and import substitution). The reduction in the proportion of GDP spent on real estate will exert downward pressure on price. As the required adjustment in trade flows is large as a proportion of the US economy –5% or more - the negative impact on price will be large.

My Verdict- Real Estate Price will not Recover to Anywhere near its Previous Peak

I believe that when the adjustment in the US trade balance occurs - and it must happen some time - the resultant reduction in the share of GDP devoted to domestic non-tradables like real estate will be the dominant influence on the price of real estate. A reduction in resources flowing into the sector has to depress the price, I don’t see any way around it.

Thursday, May 27, 2010

What a Bailout is Really About!



"It's a slow day in some little town. The sun is hot ... The streets are deserted ...

"Times are tough, everybody is in debt, and everybody lives on credit.

"On this particular day, a rich tourist from back west is driving through town. He stops at the motel and lays a $100 bill on the desk saying he wants to inspect the rooms upstairs in order to pick one to spend the night.

"As soon as the man walks upstairs, the owner grabs the bill and runs next door to pay his debt to the butcher. The butcher takes the $100 and runs down the street to retire his debt to the pig farmer. The pig farmer takes the $100 and heads off to pay his bill at the feed store. The guy at the Farmer's Co-op takes the $100 and runs to pay his debt to the local prostitute, who has also been facing hard times and has had to offer her services on credit. She, in a flash rushes to the motel and pays off her room bill with the motel owner.

"The motel proprietor now places the $100 back on the counter so the rich traveler will not suspect anything.

"At that moment the traveler comes down the stairs, picks up the $100 bill, states that the rooms are not satisfactory, pockets the money and leaves.

"Now, no one produced anything ... and no one earned anything ... However the whole town is out of debt and is looking to the future with much optimism!

"And that, ladies and gentlemen is precisely how our governments are conducting business today!"

Unknown author (thanks to Sheldon Reich for the e-mail)

In a similar vein, you can watch this video.

Wednesday, May 26, 2010

My Big Fat Greek Debt



It's funny how things happen! Once upon a time it was thought that the financial crisis would be "contained". It was supposedly a liquidity crisis and the pundits were claiming that by adding liquidity, everything would be fine. It was soon discovered that the crisis had a solvency component to it. This added a dimension to the crisis in that, without restructuring, the insolvency would not go away just by adding liquidity into the system. Liquidity was there to buy us time to restructure. We knew that if we didn't restructure, the liquidity needs would become permanent like for a patient on permanent life support. Yet we did not do much about it! And interest rates are still at close to 0%. But not for much longer says Bernanke. Well, maybe just until after the Greek crisis is over says the market. OK! replies Bernanke.

You can extinguish a fire with water but if the source of the fire is an oil well, it may require more than water. It may require that you cut off the source of energy, the combustible that is keeping that fire alive. Given enough water you may drown the fire but the collateral damage will be a flood. The same is true with this crisis: you may be able to drawn the problem in excess and permanent liquidity but you will have inflation down the road.

So far the liquidity that was poored over the economy was meant to give it room to breath - temporary life support - while it was supposed to recover from its liquidity crisis and then its solvency problems. The problem is that, while liquidity shortages don't last if there are no underlying solvency problems, they tend to be pepetual until solvency issues are dealth with. But who has the political will to deal with those?

No wonder that the economy is not creating jobs and that it is stalled in third gear. The solvency problem of banks has not been addressed. They still carry the toxic waste on their books and are unwilling to lend. In the meantime, the fllod of liquidity keeps a veil on the problem and lax fiscal policies are creating the illusion of growth. But remove government stimulus and we would have no growth. Turn off the money spigot on top of this and the patient would die. Already SMEs which traditionally are responsible for over half of job creation in our economy are suffocating. It seems obvious that the patient would not be able to survive on his own but that we refuse to acknowledge it. Everything will be fine.

Now Greece. It's the same story. Yet this time it's obvious. The problem is structural in nature. It is not a liquidity crisis. The economy is in need of restructuring simply because it has too much debt and because it wants to continue borrowing more. Any bail-out from other European nations is only postponing the day of reckoning; it is good money thrown after bad.

I don't know if the Greeks are in denial or if they are holding out to be saved by the Europeans but anyone with a clear mind is realising that a once in a life time bail-out is possible but it is not credible. If you give in now, Greeks will not have not any incentives to behave optimally and the signal will also have been clear for others. Except that the others are bigger and that the source of the problem won't be extinguished by throwing money at the problem. That is because the amount of money needed is already huge and will grow with each bail-out; and it will soon become unsustainble. The only source of money that will eventually be infinite will be coming from the magical printing press. If we get there, the temptation will be great to use it. Just a little at first. Then a little more ... until it is too late. It's the same with gambling and torture. You start with good intentions but can't get it under control. It's never been done. Why would we be any different than our ancestors?

That day is coming. How do I know? We have already place our first bet and we lost. Now we are placing our second. Just a small second bet on Greece. And then it's over, I promise. You bet!

Monday, May 24, 2010

A Few Words of Wisdom from Seth Klarman



He must be the most discreet investor on Wall Street. We never hear about him and he rarely appears in public. Yet, Seth Klarman is another Warren Buffett pocketing a 20% annual return performance over several decades.

He appeared at the CFA Institute annual meeting in Boston last week. It is thus worth reporting what he actually said. Because I was not there, I bring you two articles somewhat complementing each other about the event: The first one by Jason Zweig Write (intelligentinvestor@wsj.com) who writes the Intelligent Investor column in the Wall Street Journal. Mr Zweig also had the privilege to be the interviewer de service at the CFA gathering. His article is entitled Legendary Investor Is More Worried Than Ever and was published on May 22nd. The second piece, Seth Klarman: Stocks Will Have Zero Return For A Decade, was written by Henry Blodget. I found it at the Business Insider, The Money Game on May 19th.

Article 1:

“Seth Klarman is worth listening to, especially when markets go mad.

“Mr. Klarman is president of the Baupost Group, an investment firm in Boston that manages $22 billion. His three private partnerships have returned an annual average of around 19% since inception in 1983—and nearly 17% annually over the past decade, as stocks went nowhere.

“To measure Mr. Klarman's importance as an investor, you need only see the value his rivals place upon his words. You could have earned at least a 20% average annual return since 1991—better than twice the performance of the market—merely by buying and holding Mr. Klarman's book, "Margin of Safety": Published that year at a cover price of $25, hard copies now fetch up to $2,400.

“But the professorial Mr. Klarman speaks in public about as often as the Himalayan yeti. He made an exception last Tuesday, when I interviewed him in front of a standing-room-only crowd of 1,600 financial analysts at the CFA Institute annual meeting in Boston. He then made another exception, speaking with me over the phone later to clarify points that he feared had been misconstrued.

“Mr. Klarman specializes in buying securities that nauseate other investors. As the credit crisis exploded, he put more than a third of his assets into high-yield bonds and mortgage-related securities. I asked him what he had meant, in a recent letter to his clients, when he compared the financial markets to a Hostess Twinkie. "There is no nutritional value," he said. "There is nothing natural in the markets. Everything is being manipulated by the government." He added, "I'm skeptical that the European bailout will work."

“Some members of the audience gasped audibly when Mr. Klarman said, "The government is now in the business of giving bad advice." Later, he got more specific: "By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can't stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate."

"We didn't get the value out of this crisis that we should have," Mr. Klarman told the audience. "For our parents or grandparents, it was awful to have had a Great Depression. But it was in some ways helpful to carry a Depression mentality throughout their later lives, because it meant they were thrifty with their money and prudent in their investment decisions." He added: "All we got out of this crisis was a Really Bad Couple of Weeks mentality."

“You could have heard a pin drop as Mr. Klarman proclaimed, "I am more worried about the world, more broadly, than I ever have been in my career." That's because you can make good investing decisions and still end up with bad results if you reap your profits in currencies that do not hold their purchasing power, he explained.

"Will money be worth anything," asked Mr. Klarman, "if governments keep intervening anytime there's a crisis to prop things up?"

“To protect against that "tail risk," said Mr. Klarman, Baupost is buying "way out-of-the-money puts on bonds"—options that have no value unless Treasury bonds plummet. "It's cheap disaster insurance for five years out," he said.

“Later, I asked Mr. Klarman what he would suggest for smaller investors who share his worries.

"All the obvious hedges"—commodities and foreign currencies, for example—"are already extremely expensive," he warned.Especially gold. "Near its all-time high, it's a very hard moment to recommend gold," said Mr. Klarman.

“Mr. Klarman pointed out that his own ideas "on bottom-up opportunities in undervalued securities are more likely to be accurate than my top-down views on what's going to happen in the world at large." In other words, while you might want to insure against a disaster scenario, you shouldn't bet the ranch on it.

“And, said Mr. Klarman, one of the best ways to protect against a decline in purchasing power is to buy whatever is "out of favor, loathed and despised." So forget about gold or other trendy hedges. Instead, wait patiently for markets—European stocks, perhaps—to get so cheap that they turn most investors' stomachs. Then you can pounce.

“As Mr. Klarman put it, "Sometimes, when you can't figure out a good defense, the best thing to do is to go on offense."”


Article 2:

“Legendary fund manager Seth Klarman of the Baupost Group made some rare public comments recently at the CFA Institute in Boston. Suffice it to say that he does not have a bright and sunny view of the world.

“Some choice quotes relayed by Aaron Pressman at Reuters:

* "Given the recent run-up [in stocks], I'd be worried that we'll have another 10 years of zero returns."

* "I'm more worried about the world broadly than I've ever been in my whole career."

* Current market conditions remind Klarman of a Hostess Twinkie snack cake because "everything is being manipulated by the government" and appears "artificial."

* Publicly traded real estate investment trusts...have "rallied enormously" and are "quite unattractive."

* Inflation is a risk that Klarman said he is particularly concerned with given the government's high rate of borrowing to bail out the financial system. Baupost has purchased far out-of-the-money puts on bonds to hedge the risk, he said.

“Baupost has 30% of its assets in cash.”

Here is a link to an interview Seth Klarman gave last year.

Here is another one to a site that follows pretty much everything that is written about the investor.

Sunday, May 23, 2010

British Pound?

Exactly 5 months ago we recommended on this blog (Can the Bank of England save the Pound- Dec. 20, 2009) to short the Pound versus the US$. It turned out to be a good call as the Pound went from 1.60 to 1.44 currently. Is it time to buy it back?

Yes. The Pound will rebound to 1.50 versus the US$. Even though the Conservative party of David Cameron managed to barely form a government and the UK is not an example of fiscal policy 'fitness'- the fiscal deficit is 11% of GDP- the fact that Britain is part of the European Union but not part of the Euro area is short term positive for its currency. Elections uncertainties have been lifted. Already the new government has announced austerity measures that should make Britain a role model in Europe.

The Pound is now trading around 8% below its 200- day moving average, sign that it is oversold.

Thursday, May 20, 2010

An Antitode for Bond Market Vigilantes



Alan Blinder, professor of economics and public affairs at Princeton University and vice chairman of the Promontory Interfinancial Network recently wrote Return of the Bond Market Vigilantes. Mr. Blinder fears the return of the speculators who wreak havoc on the bond markets a few decades ago during the Clinton era. The vigilantes are not here yet but they are at our door step, in Europe. "Their beachhead is Greece" and surely we are on their path. According to the former vice chairman of the Fed "One way for Washington to reassure markets is to tackle Social Security reform." The argument makes sense and politicians could convince the public of its soundness, it could be a major coup with very positive benefits for our economy. The article was published in the Wall Street Journal yesterday. Thank god for Vigilantes!

"Remember the bond market vigilantes, that frightening band of financial marauders who once roamed the earth like a fearsome herd of Tyrannosaurus rex? They were so scary that in February 1993, as President Bill Clinton struggled to reduce the federal budget deficit, James Carville quipped that he wanted to be reincarnated as the bond market so he could intimidate everybody.

"Well, they're baaack! Not in the United States, though. Here, the Treasury Department continues to borrow brobdingnagian sums of money at extremely low interest rates—about 3.5% for 10-year Treasurys and under 1% for two-years lately—even though everybody knows that the federal budget deficit is on an unsustainable path toward the stratosphere. (Could it be that not everybody knows?)

"But the bond market vigilantes have landed in force in Europe. Their beachhead, of course, is Greece, which all but invited them in with—how shall we put it?—a certain lack of fiscal probity. The ensuing roller-coaster ride of ups and downs that have roiled stock, bond and currency markets around the world is apparently not over. As you read this, the markets may be either sinking or soaring on the latest news out of Europe.

"Greece recently signed up for an International Monetary Fund program—the sort of treatment once reserved for supplicant developing countries. It also now has the European Central Bank (ECB) buying its bonds, access to the European Union's new €60 billion bailout fund, and potential access to bond guarantees via a €440 billion "special purpose vehicle" that euro-zone countries promise to cobble together if necessary. But all this has only partly calmed the Aegean waters.

"Here's the problem: Bond market vigilantes can be a force for good or ill, often both at the same time. The bond market is certainly powerful, as Mr. Carville saw—but it's not always wise and it's rarely subtle. Once the vigilantes get riled up about, say, budget deficits, they can turn into an electronic mob that circles the globe faster than Hermes. Unfortunately, the basic economic message about deficit spending today requires some subtlety: Most countries need fiscal stimulus today but a large dose of deficit reduction in the long run.

"To fight the 2008-2009 recession, many countries deliberately increased their spending and/or reduced taxes, thereby swelling their budget deficits. That was the right thing to do under the circumstances, because private spending was drying up and unemployment was on the rise. (Ask the oracle: John Maynard Keynes.) Or, more correctly, it was the right thing to do as long as the higher spending and lower taxes were temporary—as was typically, but not always, the case.

"The trick was to promulgate major short-run fiscal stimulus programs without spooking investors about the long-run fiscal outlook. And it worked—for a while. But now the bond market vigilantes have been awakened and are spoiling for a fight. I worry that they may force many European (and other) countries into premature fiscal contractions.

"Sadly, it is already too late for Greece, where sizable tax hikes and expenditure cuts are coming to a land where gross domestic product has already declined for five consecutive quarters. It is hard to imagine how Greece can avoid a nasty slump. If we look for historical examples of countries that have lived through major fiscal retrenchments without recessions, we find three principal ways out. But two of these options—easing monetary policy and depreciating the currency to boost exports—are unavailable to euro-using Greece.

"The third way is to ignite a bond market rally by convincing traders that you've got religion on fiscal responsibility—which is what happened here during the Clinton years. (Full disclosure: I was part of President Clinton's original economic team.) Could the Greeks have accomplished that by themselves? It looked unlikely without intervention from Mount Olympus, which is why the EU rode to the rescue.

"The more important question now is whether the rest of Europe is under a similar threat. Greece accounts for less than 2% of European GDP, so a sharp recession there—if it's only there—should have only minor demand spillovers to other countries. But with most of the other 98% of Europe growing very slowly, large fiscal contractions are not exactly what the macroeconomic doctor ordered. (Ask the oracles: Herbert Hoover or former Prime Minister Ryutaro Hashimoto, the "Herbert Hoover of Japan.") The ECB seems unlikely to help by cutting interest rates further. But the value of the euro has fallen, which should give exports a boost.

"From a long-run perspective, the bond market vigilantes have it right. Greece, Europe, the U.S. and other countries must take serious steps to get their budget deficits under better control. And the long-run budget problems of many nations are too large to be solved exclusively on either the tax side or the expenditure side.

"The U.S. is a case in point. Under continuation of current policies, our budget deficit and national debt would soar to impossible heights. (Ask the oracle: the Congressional Budget Office.) The amount of deficit reduction needed to stop this incipient explosion is so large that no serious person should believe we can do it without both spending cuts and higher taxes.

"But not yet, please. And therein lies the difficult-but-essential subtlety.

"St. Augustine urged the Lord to make him chaste, but not yet. Now budget and finance ministers around the world, including our own Peter Orszag and Tim Geithner, must make an analogous plea to the bond market vigilantes—and back up their words with deeds. The problem is that the vigilantes are an impatient lot and Greece has set their clocks ticking faster."

"What needs to be done varies enormously by country. Here in the U.S. Social Security reform, once considered the third rail of American politics, is now the low-hanging fruit of deficit reduction. Fixing Social Security's finances is easy, technically. And the timing is perfect because promising deficit reduction now but delivering it later is exactly the right thing to do. After all, no one wants to raise payroll taxes now or reduce retirement benefits without giving people many years of advance notice.

"When the Greenspan Commission "fixed" Social Security's finances (for a while) in 1983, it delayed much of the pain for decades. Its proposals not only passed Congress in a flash but have raised barely a whimper of objection since.

"Pulling off something like that today might be a good way for the U.S. to steer a middle course between the Scylla of the bond market's wrath and the Charybdis of premature belt tightening that damages the recovery. Hey, Odysseus managed it.

Tuesday, May 18, 2010

Dealing with complex financial transactions

Analyzing a complex financial transaction can be difficult – even a very sophisticated investor can be fooled. However, there is a simple, fool-proof method that was successfully used by some people to see through the Enron, Madoff, and asset-backed securities fiascos.

The method is based on the observation that true financial innovations are rare. When they do occur, most of the benefits – if not all – actually flow to those that developed the new strategy – at least until the structure is well enough understood by others. Interest rate swaps are a good example. In one early swap, a French investment bank was able to pocket annual fees of 50 basis points. Today, swap fees are only a few basis points.

Most innovations, the me-too products that are not really all that innovative, extract their performance from four sources: investors, issuers, investment bankers, or government.

For example, many complex financial structures have been devised to generate performance by reducing taxes. This can be achieved by delaying when a tax is due, by moving income to a lower tax region, or by exploiting the inconsistencies of the taxation rules of different countries.

Or the performance can be at the expense of the investor, either because the investor can be convinced to accept a lower return or the investments are actually riskier than they appear. For example, many investors purchased higher yielding, apparently safe, triple “A” rated bank paper, only to learn later the full meaning of “structured asset backed securities.” The rest is history.

Issuers can also be misled. Even relatively sophisticated issuers sometimes do not fully understand all the risks of a particular structure. Complex option structures are often a source of the problem. For example, Orange County lost $1.6 billion through interest rate derivatives.

Sometimes, though more rarely, it is the investment bankers that get it wrong. Lehman Brothers and Bear Stearns are recent, notorious examples.

How should one deal with a complex financial transaction? First, it’s important to realize that these structures are expensive to put in place. Someone is going through a lot of trouble to do it. A lot of money is surely at stake.

Second, how is the money going to be shuffled around? Don’t assume that the investment bankers have charitably mispriced the product. Ask the question: at whose expense will the structure’s performance be derived? If it comes out of the issuer, then why is the offered yield higher than expected? Is the default risk actually higher than it looks? If the performance is supposed to come out of the investor, is he really so unsophisticated as to accept a lower rate of return for no reason? What has been missed? Or if the performance is supposed to come out of a tax angle, be careful. Tax loopholes that are too lucrative can be closely quickly.

Third, accept the implications and be blunt. If you can’t figure out at whose expense the structure’s performance is derived, then it is undoubtedly at your expense. Walk away. Somebody – on purpose – is not explaining some crucial details. Walking away takes courage. There will be repercussions. At the very least, your intelligence and professional competence will be questioned. A team of analysts working for the Treasury department of a Canadian telecommunications company was pitched a complex structure that promised high returns. Since the source of the benefits was not obvious, the team spent many hours modeling scenarios and found that the promised returns were attractive only over a narrow range of assumptions. When the team refused the deal – politely – the investment bankers were somewhat miffed. They went directly to senior management, complaining that the analysts lacked the sophistication required to understand the deal. Okay, replied the team, if it’s such an attractive deal, can the investment bankers sign a formal, written recommendation of the deal, with a copy to senior management? Checkmate – they refused to sign – and vanished.

The method works, though it can take real courage to say, in effect, “ I don’t understand the deal, because you’re not telling me the whole story – I won’t invest.” Finance professionals that practice this method can save themselves, their firms, and their clients a lot.

Robert Morgan CFA – Blake Sutherland CFA

Friday, May 14, 2010

Two New Breakthroughts about Life on Other Planets




Two newspaper articles were published last week about scientific attempts at proving that there might be life on other planets. There are not about observing UFOs. They are about rigorous efforts at testing a scientific hypothesis. They are not going to move the market this week, like Greece or Goldman, but they are a reminder that with knowledge, creativity and efforts there are always ways to see the world with an insightful perspective. In analysing the markets, the biggest rewards often go to those who can think in such a way.

What is most surprising is that both independent initiatives are looking for clues on our own planet:


The first article, Glacier may hold key to life on other worlds, Satellite detection of stain opens way for space probes by Randy Boswell from Canwest News Service, was published in The Gazette on May 7.

The second article is The Aliens Among Us by Paul Davies. It was published in the New York Times on May 13. Paul Davies is the director of the Beyond Center for Fundamental Concepts in Science at Arizona State University and the author of “The Eerie Silence: Renewing Our Search for Alien Intelligence.” The article contains a link to an excerpt of Paul Davies' new book.

I am still stunned by the possibility "that there could be upward of a billion Earth-like planets in our galaxy alone". A billion! And there are tons of galaxies in our universe! True, the universe has had time to expand: Our galaxy is around 5 billion years old. Yet, another fascinating "fact".

And, as fascinating, men's ancestors appeared only a few hundreds of thousands of years ago. If you interested by the link between us and Neanderthals (and you have access to The Economist on line) also read "A cave man blinking in the light".

Tuesday, May 11, 2010

Drifting to the Left without Noticing the Storm Ahead



As we are suffering from private sector greed backlash, we are slowly drifting, almost seamlessly, to the left and entering into a renewed era of big government. Bush even started it with his new Homeland Security, bigger involvement in fighting terrorism abroad and the return to massive deficits to finance all kinds of initiatives. Within a few more years, government everywhere will have bought hundreds of billion dollars of private sector debt, own banks and other too-big-to-fail companies, tightly police the segments of the financial sector it does not already own, reign in excessive executive compensation, attempt to control GHG through taxes and cap-and-trade mechanisms, tax the rich and try to redistribute money to the poor, get further into the business of healthcare, education, social security and pension, get involve deeper in trade to protect jobs, tax everything and everybody through the roof to finance itself, etc.

All of these things appear necessary today. After all, the private sector cannot to be trusted, it cannot access the capital needed to ensure that economic growth reaches its potential, banks are afraid of lending money, car companies and other large private entities are in a mess which they cannot get out on their own and the financial sector and executives are indeed in need of tighter oversight. Moreover, although we should remain opened about what science has to say and what technology can bring to resolve the risks associated with climate change, who wants to take the risks of the potential consequences of global warming?

More broadly, the distribution of income in the US and many emerging countries at least, appears to have been tilted in favour of the very rich at the expenses of everyone else in the last few decades. Also, most pension funds are underfunded and people who don't have one do not, and will not, have enough money for retirement. Social security and pension problems will then only be solved by the government which will be injecting more money, reducing benefits for the wealthy and raising the retirement age for instance.

Moreover, although the percentage of the uninsured remained the same in the US for the last two decades (even if popular opinion has it that this percentage grew because of Georges W. Bush), the aging of the population calls for more government resources to deal with a growing share of health expenditures in total GDP. Finally, pressure will grow to protect jobs and resources from failing in the hands of foreign governments refusing to play by our “fair rules”.

Well, if you believe this, good luck! You are soon going to be deeply disappointed by what your government is going to do for you. That is because your government is soon to be bankrupt and we let it happen.

What has really changed during the last two years is that we collectively believe, and maybe rightly, that government is in a better position than the private sector to tackle all kinds of issues and problems. In other words, we are less and less trusting of entrepreneurial initiatives. Take the case of the massive government bail-out of banks. We overwhelmingly believed that it was infinitely more desirable than to have let the economy the chance to restructure itself. We wanted to avoid at all cost a fall into another Great Depression.

We are, however, not very concerned today about the long term consequences of that bail out; and maybe rightly so. Depressions have long term negative consequences as well. Weren’t we then just trying to avoid both the short and the long term consequences of a protracted depression? We were. However, the bottom line is that given the choice between a private solution (restructuring) and a public solution (bailing out the banks), we overwhelmingly preferred the public solution. We deemed it both less risky and more likely to succeed. Given the economic and ethic recent record of the “unregulated” private sector (and chief among them the banks), who would trust it with anything? Tempting thoughts but is it the right approach? Didn’t the government also have a role to play in the recent debacle? The record of regulators is not that much better than that of bankers.

The idea, I thought, was to establish fair rules and let incentives do the rest. But it seems that the rules failed; at least for bankers. Incentives, on the other hand, seemed to have worked just fine; maybe a little too well sometimes, given the flawed rules. But who makes the rules? Isn’t it the government? Maybe the government got influenced by some special interests that succeeded in making officials tweak the rules in their favour and that blinded regulators to certain devious behaviours. Again, the problem seems to have been with governance. And if this is truly the case, who would trust such a government to re-establish a levelled playing field? I don’t understand who would but it seems that we collectively do. And if the recent bail-out proves anything is that it favoured bankers at the expense of all of us, the taxpayers. Shouldn’t that make us a little suspicious of what is happening now?

The new collective belief or consensus that public interventions are superior to “regulated laissez-faire” was an omen to both governments (Bush then Obama) as it made it easier to implement the bail-out. It should also make it easier to engineer the needed changes that were so difficult to implement in the financial sector when things were apparently going so well. We suffered from complacency a few years ago and were thus not able to realize that the rules of the games were leading to perverse behaviours. Moreover, political discord encouraged the status quo. The crisis finally broke the status quo, put an end to our complacency and brought us back to our senses and in the "right" direction. But don’t count on this to happen. I will come back to this later.

Yet, more importantly with every new social consensus also immediately comes collective blindness. Think of the promises of the Reagan revolution. They had unintended consequences which the majority of us were blind to and which are partly responsible for the mess we are in today. The reality is obviously more subtle and more complex. On the one hand, we have Google and e-bay and Apple which are the positive side of the revolution that unleashed productive incentives in America and around the world. On the other hand, some institutional giant survivors from the post-WWII era, such as Fanny Mae and Freddie Mac, are also greatly responsible for making the current crisis much worse than it could have been. Had we pushed the revolution further and destroyed these institutions, maybe we would not be in this situation. Look no further than Canada where such institutions never existed to be convinced that the US crisis would not have been as painful had these monsters been reigned in earlier in the eighties and the nineties when they started raising alarm among many pundits.

History is littered with the ruined of bankrupted social consensus. The Reagan revolution was itself the result of a public consensus gone astray after several decades of success: The New Deal, following the Great Depression (itself deemed to be caused by the excesses of liberalism, the prevailing consensus in the 1920s) was originally designed to restrain the vile consequences of excess capitalism. Yet, the reality of what happened in the early thirties was much more complex: Failed government policies (both monetary and trade protectionism), not the behaviour of the private sector alone, were responsible for what happened and for greatly turning a bad situation into a nightmare.

The short of it is that, as always, success breathes contempt and contempt eventually leads to failure which in turn leads to another consensus with the same dynamics. We find ourselves today at the beginning of a new cycle with a new consensus emerging, that of government intervention. The social engineering that will take place - that is already taking place - in the next few years will essentially be build on rejecting the old consensus, trying to improve upon it but often forgetting the lessons that had brought about the old consensus in the first place. Oblivious to the negative consequences of the new consensus, it will contain the seeds of its own eventual destruction in a few decades.

Yet, I am more worried this time that things won’t work out. Usually, the honesty of the players through which a new consensus emerges, gives it a few decades of grace (i.e. success) until it self-destructs. In other words, a revolution is usually carried in earnest to defend a cause until it falls victim to its internal flaws; but not before it has delivered some benefits. Maybe I am being naive in reading history or paranoid in looking at current events, but this time it seems that the “revolutionaries” are phonies. I genuinely feel that a Trojan horse full of corrupt bankers has had enough influence on government to convince it to save the “cast of villains” and then to bankrupt itself without any consideration towards the disastrous consequences that this may have on all of us.

In other words, if a new paradigm is going to prevail for several years in which the public is going to call on its government to deal with a lot of problems (either because it looks like they are intractable for the private sector or because the public has lost faith in the private sector), it appears that we will end up like Greece. Not so much because the public is unreasonable (some of that might be true) but because we let the government save the banks instead of demanding that they save themselves. We were presented with a policy that appeared to be in our interest. And, it could have been had we decided to implement it otherwise but we failed to follow suit after we handed out the money. We now have cut our margin to act swiftly on many issues that will matter greatly in the future (security, climate, social policies). And the way it is shaping up to be, in spite of the health care bill, there is only more pain ahead.

Saturday, May 8, 2010

The Magnetar Trade or the China Trade? What Everyone is Missing

Every day new revelations of Wall Street greed, over-leveraging and irresponsible lending are divined that, as the zeitgeist has it, caused the erection and meltdown of our housing and financial markets.

Something of a pinnacle has recently been reached, a sort of dialectical synthesis. It has been sleuthed that some major investors who shorted the housing market – an activity that normally slows speculative excesses – devised a diabolical trading strategy to mint lucre from an acceleration of predatory lending. The so-called ‘Magnetar trade’ is the realization of a millennial dream of creating gold from base material. It was a classic bait and switch; lure borrowers and investors into an alluring, irresistible proposition – housing for the indigent and legalized usury for the investors – and then, unbeknown to anyone except Goldman Sachs- place a huge bet against the whole house of CDO’s. The odds of collapse improved with every new loan. The poor were made poorer, the innocent were fleeced and the hedge funds raked it in. Sharpies and smart-alecks have inherited the earth.

Or maybe not. Neophyte would-be Grand Inquisitors are closing in on the brigands and forcing them to circle their wagons. Senator Carl Levin, Chairman of the Senate sub committee on Investigations – the very same outfit that used to be ruled by Senator Joe McCarthy – spent millions of taxpayer money to unearth the smoking gun; an email in which one mid-level Goldman employee opined to another that a certain trade – not the Abacus deal that has attracted the attention of the SEC – was ‘shitty’. It was quite a sight to see. Senator Levin, defender of the public trust, perched on the podium leering down at the former Masters of the Universe, demanding from them a confession of guilt for having been involved in a shitty deal. And since a deal by definition cannot be a solipsistic affair, Goldman spread the shit on its clients. Not since the General of the Normandy invasion was President has a grandee of the US Senate pronounced ‘j’accuse’ with such vitriol and to such affect.

But I am here to tell you there is another game going on. Blankfein and Paulsen are beards. They mask the real power. It is a trick as old as magicians have been doing children’s parties. Divert the juvenile attention in one direction and switcheroo, right out in the open. The lemmings miss what is in plain sight.

James Carville famously wished to be reincarnated as the bond market ‘because then [he] could intimidate everybody”. But that was in the nineties. In the naughties it was the trade deficit that possessed the Archimedean lever. Nobody other than Martin Wolf noticed it.

Say you’ve got a housing boom. Mortgage money is being lent as freely as women throw themselves at Warren Beatty. Banks and borrowers are leveraging to the hilt. Investors are pouring money into mortgage securities, encouraging banks to douse yet more gasoline on the fire. What happens?

More people buy houses, so housing prices go up, right? More homes get built because there are more suckers who can buy a home, right? More investors make money and spend it, right? More money gets spent all over the place, right? More borrowers compete to borrow money, right?

So, what happens if spending shoots up out of control? Prices go up, right? What happens if prices and borrowing demand shoot up out of control? Interest rates go up, right? And when that happens the party is over. Carville was right after all; the rocket scientists can only push it so far before the bond market brings us back down to earth. But this time the dog did not bark and that, Holmes, is the key to understating the nature of our financial crisis.

When the crash cameth, neither interest rates nor goods prices had spiked. It was as if there was an endless supply of money pouring into the bond market, fueling ever more lending while pushing down rates. So much money, in fact, that an unscrupulous astronomy buff could conspire in the creation of ever riskier bets with the promise of higher yields for yield hungry investors in search of yield. And there were goods supplied at ever cheaper prices to slake the avaricious thirst of borrowers for ever more stuff.

Wherefrom did this limitless money tree and manna from heaven issue? From heaven? Heavens no! It came from China.

You see it now? We buy our stuff from China and China invests the money we pay them in our bond market. Now here’s the key; China doesn’t want our stuff. They want to sell and save whilst we borrow and spend. There’s nothing apparently wrong with these behaviors, we each get what we want. Sometimes, it’s better not to get what you want, however, because our deal with China removed the natural brakes that would have snuffed the boom before the really big damage was inflicted.

The old idea –from last month- was that it was the Fed’s fault because it failed to take away the punch bowl. But the Fed had lost control of the bond market. The recycled dollars formed a tidal wave more powerful than any device known to central bankers. Even if the Fed could have raised rates and slowed the boom, doing so would have caused unemployment. The ‘China Trade’ gave rise to a new trade-off. In the closed economy it was inflation verses unemployment; now it is asset bubble or unemployment.

What is to be done? Is it a Faustian bargain; feast on trade and inevitably face financial ruin? It need not be, but trade flows, as the great Keynes understood and warned, must be balanced. That is the lesson everyone is missing.

Thursday, May 6, 2010

MIT Economist Esther Duflo



Listen to the latest John Bates Clark Medal winner, Esther Duflo. I found the video on Greg Mankiw's blog. Fascinating. More info about Esther.

Wednesday, May 5, 2010

Why Home Ownership is Bad for the Economy



In a recent blog, I argued that it will take jobs to get the real estate market pumping again. Yet in an interesting article, Richard Florida looks at the opposite relationship, from home ownership to job creation, and he convincingly demonstrates that the relationship could be negative. In other words, the higher the proportion of home owners, the lower economic growth which, in turn, is directly related to job growth. Florida also offers some empirical evidence to back his claim. The article was published in the Globe and Mail this week-end and is also available here where you can read other thought provoking contributions by the University of Toronto professor.

One more thing with deep implications for the economy: According to Florida "the U.S. has shown an uncanny ability to use crisis to remake its economy ... Because of the economic crisis, fewer Americans are buying houses, a decline likely to continue as young people choose to save money and guard their options by renting." This is obviously only a hypothesis about how young households will behave in the future. However, if it proves to be correct, job creation (which I expect to remain weak for at least a year) might not be sufficient to kick start the housing market.

That is because a drop in the rate of home ownership (let's say back to its historical level of about 65%) over the next few years would continue putting deep downward pressures on home prices for a while. Moreover, it would damage banks' balance sheets, at least beyond today's current rosy expectations that "banks are over the hump". It is useful to remember that at the height of the housing boom, the U.S. home ownership rate only reached about 68%. If going from a 65% to a 68% homeownership rate over the course of a few years created a housing bubble, going back to a rate of 65% could indeed be a significant headwind for the economy.

Monday, May 3, 2010

Africa: unprecedented Chinese investments


China is the largest investor in Africa while bilateral trade has just past US$100bn annually. The May 2010 issue of The Atlantic Monthly carried a detailed article on this topic aptly named "The Next Empire" by Howard French. The article analyzes various Chinese investments on the continent which could pave the way for major economic transformation.

In order to satisfy its enormous need for commodities, Chinese companies - often government backed- have signed deals to obtain supply of oil, iron ore, metals and agribusiness. In order to facilitate the transfer of these resources to the market, China is also investing in infrastructure projects such as railways, highways and ports.
Its current footprint in Africa looks like a bit like this:

- Libya, Algeria (Oil and Wheat)
- Sierra Leone, Guinea (Iron Ore and Rice)
- Ghana (Oil and Gold)
- Gabon and Angola (Oil and Coffee)
- Niger (Uranium)
- Sudan (Oil and Iron Ore)
- Congo (Copper, Zinc, Cobalt)
- Zambia (Grains and Copper)
- South Africa (Platinum and Gold)

Note that Chinese have been in Africa for a long time but the scale now is of another magnitude. This writer remembers well seeing Chinese workers building roads in Central Africa in the mid 1970s.

There are two significant areas of investments in commodities- agriculture and metals. In agriculture, Africa has seen a large influx of Chinese farmers who have for years been buying land and harvesting it using their own techniques. Disruption from the Three Gorge Dam has forced many farmers from Chongqing to Africa. Their farming skills combined with plenty of available, non productive land in Africa is a win-win situation. The focus is generally on rice and cash crop production. In Zambia for example there are millions of hectares of available farmland lying fallow due to a lack of infrastructure investment since the independence in 1964.

Copper-rich areas have attracted Chinese investments such as in Congo where so far US$6bn has flown in to improve infrastructure in the large province of Katanga. Construction of highways, railroads and hospitals is taking place on a scale Congolese have never seen before. China has also been busy developing iron ore deposits in Guinea and Sierra Leone in order to reduce its dependency on the Western companies such as Rio Tinto and BHP. Again here the scale of investments dwarf what has taken place before in these countries.


By 2050 Africa will have a population of 1.8bn, according to the UN, 25% more than China. In one century the population would have been multiplied by ten, never seen in the history of humanity. While the old colonialists powers such as France and England have slowly withdrawn form the continent, China has understood that Africa is changing. The trade and returns approach of Chinese investments might prove beneficial to African economies by creating a consumer/ middle class. Something that Europeans were never able, or never intended to do.