Tuesday, May 22, 2007

The Coming Economic Depression

In my first blog entry http://ponziworld.blogspot.com/2006/12/it-was-good-for-some-while-it-lasted.html, I made the case that the world economy has become one giant Ponzi Scheme (pyramid scheme) in which a fortunate few at the top are reaping the vast majority of the rewards while those further down the pyramid are left to eat the bread crumbs falling off the table. Like all Ponzi schemes however, this one will eventually collapse, and I now believe that we are at or very near the breaking point.

With this post, I will now delve more deeply into what I see as the greatest risk factors facing the U.S. economy (and by extension world economy), and also explain why these risk factors, many of which are well publicized (not well understood), are highly correlated and likely to cause a chain reaction economic collapse of historic proportions.

1) Unprecedented Debt: Much has been posted about the debt problem, but few know the total magnitude of private and public debt outstanding. Current estimates put this total at $48 trillion, or 460% of U.S. GDP. By any measure, absolute or relative, the current level of debt is unprecedented. Yet, the vast majority of economists, politicians and financial "experts" are sanguine about debt levels, rationalizing these high levels of debt as sustainable and even desirable. Likewise, most observers see the current melt-down in the sub-prime lending market as an isolated event, not acknowledging the reality that the same foolish lending practices now causing the unravelling of the the sub-prime market ("no doc loans", zero down payments, optional payments/non-amortizing loans etc.) were also commonly employed throughout the "higher quality" segments of the mortgage market as well. In hindsight, we will come to realize that the sub-prime debacle is only the canary in the coal mine, and that the problems related to lax lending standards will eventually move up the food chain to the "Alt-A" (medium risk) and finally the prime quality segment. In the government and corporate sectors, thanks to similarly lax lending policies, we will see a concomitant avalanche of escalating defaults there as well. In addition, consider that for the first time since the 1930s (The Great Depression), the U.S. savings rate has gone negative - for several years in a row (i.e. in aggregate we now spend more than we earn). However, unlike during the 1930s, today's savings deficit is occurring while the economy is actually in expansion! Therefore, the economic "growth" of the past four years was an enormous (well orchestrated) illusion, propagated with massive amounts of debt. Which also tells us that long-term we cannot maintain anywhere near our current standard of living because THE U.S. ECONOMY IS NO LONGER SELF-SUSTAINING. Once this current business cycle stalls and we are unable to support additional debt, the economy will collapse like a cheap tent.

2) Real Estate Melt-down: The problem with real estate is directly related to the consumer debt issue. Housing is the consumer's primary collateralized asset. When housing prices go up, more debt can be assumed by the borrower; however, when housing prices go down, the process goes in reverse, and the borrower faces fewer financing options. This is what is happening now to those consumers who used their homes as virtual ATM machines - using cash out refis and home equity lines of credit to liquidate their home equity. Today, these same consumers face lower home prices (less collateral), higher interest rates, tighter lending standards and high levels of long-term debt. The other negative impact of the housing downturn is via the construction industry, which had been a major driver of economic growth in recent years, but is now starting to cause a drag on the economy as new housing starts collapse. So far, the decline in home prices has been contained, as the economy has been growing. Again, one can only imagine the negative chain reaction via debt and housing that will occur once the economy really starts to tank.

3) China Trade Policy: The Chinese government is pursuing an aggressive classic mercantilist ("beggar thy neighbour") policy. They are actively subsidizing and promoting export-based industries in order to shift manufacturing employment and production from the U.S. to China. This orchestrated, massive trade imbalance between China and the U.S. is being abetted by the Chinese using their balance of payments surpluses to bid up the dollar (vis-a-vis the Yuan), thus keeping the terms of trade in their favor. Ultimately, this policy has caused a massive shift of R&D and manufacturing investment from the U.S. to China and a corresponding dependence on China as a sole manufacturer of consumer products to the U.S. (i.e. risky from a national security standpoint). Ultimately, this strategy will end badly for all parties, including the Chinese. For the U.S., the downside is obvious: lost manufacturing capability, lost jobs, massive foreign debt, and a debt-inflated economy that will ultimately prove ephemeral. For their part, the Chinese will come to realize it's not a good long-term business strategy to first bankroll and then bankrupt your largest customer, as having thousands of (idle) factories will be a hollow consolation. Furthermore, all of the Chinese' U.S. dollar holdings will likely end up being massively devalued when the Fed panics and gets the dollar printing press cranking.

4) Energy Crisis: The world's fossil fuel supply is massively depleted and at risk of major disruption. Apologists for the oil industry continue to pump time and effort into the disinformation campaign against peak oil theory, despite the facts, history, and common sense that all indicate we will soon, if we haven't already, reach the point of maximum daily oil production. In addition, once peak oil production is reached, no one knows for sure how quickly the remaining supply of economically attainable oil will be depleted. Considering the decades of exploration that have already taken place and the relative old age of the largest producing fields, it's more than likely that total world oil output will drop precipitously after the peak is reached. Therefore, past the peak, expect the remaining supply of oil to be vastly more expensive, thus placing the supply/demand balance squarely in favor of the suppliers. Which brings us to the next point. Currently, ranking among the top 15 world producers of oil are: Saudi Arabia, Iran, Iraq, Venezuela, Nigeria, Mexico and Russia. This list is the who's who of totalitarian, corrupt and unstable regimes, to say nothing of being overtly or subversively hostile to the United States. Even the most optimistic among us has to wonder how dependable and affordable will our energy supply be over the next couple of decades.

5) Financial Derivatives Risk: The past several years has seen an explosion of new financial products and derivatives become available to both institutional and retail investors. We've been told not to be concerned by this vast array of new "products", as these devices will have the overall effect of spreading risk more broadly in the markets. In reality, no one knows for sure what the net sum impact of all these new derivatives will be and/or how they will perform under adverse market conditions. What we do know is that the decoupling of risk that has taken place in the mortgage underwriting process via mortgage securitization (packaging and selling of loans), has had the unintended consequence of actually increasing risk. What happened is that local banks quickly morphed into origination factories, more concerned with quantity of loans originated than with the quality of loans originated - go figure. The potential risks around derivatives also ties into a broader issue around "liquidity". Excess global liquidity, has been the primary driver behind the relentless levitation of world financial markets over the past several years, as market after market has become seemingly decoupled from the underlying economic fundamentals. Unfortunately, history has proven that liquidity is just a proxy for confidence and willingness to take risk, which means that trading vehicles that work great in a highly liquid bull market, will likely not trade quite as orderly or predictably when everyone is panicking out the same door at the same time.

6) Hedge Fund Mania: The topic of hedge funds is very much related to the topic around financial derivates. The past several years has seen a coincident proliferation of hedge funds, which are also unproven under adverse market conditions. No one knows what net sum impact all of these new hedge funds will have in a down market. What we do know, is that the collapse of just one major hedge fund in 1998 (Long Term Capital Management) almost triggered a worldwide financial meltdown. In that situation, the Federal Reserve had to step in and arrange a private bail-out for the fund AND aggressively lower interest rates to support the market. One can only wonder what tools the Fed would require in the event of having dozens of LTCM-like funds all blowing up simultaneously. Compounding the risk is the complacency resulting from the past 4 years having been one of the least volatile market periods in market history -not one 10% correction in any of the senior indices. This means that for a long time (long by market standards) we've been in an environment that has disproportionally rewarded the dumbest and most aggressive ideas, giving rise to the oft-quoted phrase "the dumber the money, the bigger the return". Another risk derives from the way that hedge fund managers' bonuses are calculated - based entirely on one year performance, making no adjustment for portfolio risk or even intra-year volatility. As a result, as many in the industry have admitted, hedge fund managers as a whole have been trending towards ever-riskier, more leveraged strategies in order to maximize their short-term returns (and bonuses). After all, if they don't take enough risk and garner enough return, they could lose their jobs anyway. On the other hand, if they take too much risk and blow up, they can just walk away, leaving their investors holding the bag. Another way of looking at it, is that many hedge funds have basically become big call options on the U.S. economy - the liquidation of which could have substantial negative impact on the markets.

7) Fiscal and Monetary Policy Fiasco: After 9/11, the Bush Administration took the opportunity to bulldoze it's campaign-promised high income tax cut through Congress under the auspices of patriotic "fiscal stimulus". Had they really been concerned about the economy and/or the majority of Americans, they would have passed a tax cut that primarily benefited the middle-class and working poor. But in the event, the tax cut that was passed provided only moderate fiscal stimulus - however it did manage to provide a very healthy boost to already ultra-wealthy bank accounts. This tax cut was not only a failure in how it was targeted, but worse yet, it was a failure in the fact that the country was already running a massive spending deficit. Basically, it was one generation saying to another, we are not only going to spend your inheritance, but we are also going to run up a ton of debt, and let you young folk deal with the consequences. On the monetary side of the house, owing to the punk tax cut, (punk in terms of fiscal stimulus, not in terms of deficit impact), it was left to the Federal Reserve to do the heavy lifting and ensure that the American consumer was duly resuscitated. The Fed did its part and eventually lowered interest rates to 1%, setting loose a massive borrowing spree which re-inflated the economy - via the housing ATM effect described above. Around that same time, with rates at multi-generational lows, Federal Reserve Chairman Alan Greenspan went off the reservation and publicly endorsed all of the new and exotic financial "products" coming to market. He was especially enamored of subprime loan vehicles, which he reasoned would spread debt accumulation opportunities heretofore not afforded to the working poor and financially unstable. Heretofore not offered for good reason, no? Basically he was saying, let's give a blind man a horse, a rope and a tree, and marvel at the possibilities. Worse yet, with interest rates at generational lows, he also publicly advocated Adjustable Rate Mortgages as the superior alternative over fixed rate mortgages. Of course, no sooner had he uttered such ludicrous advice, that he then proceeded to embark on a multi-year, non-stop rate hiking campaign, increasing rates no less than 17 times, and financially decimating anyone who had been trusting enough to have taken his mind-bogglingly bad advice. How the leader of the largest central bank in the world could have endorsed using a short-term loan to finance a long-term asset, when interest rates were at generation lows, is beyond all comprehension.

8) Complacency and Mass Delusion ("How did we not see this coming...?"): There is an extremely dangerous belief among the financial community that the more people know about a particular problem ahead of time, the less effect there will be on the market when the problem/crisis actual occurs. This belief derives from the Efficient Market Hypothesis which in its strictest form states that all information is already priced into the market. Unfortunately, in reality there are two major issues preventing the real-world realization of Efficient Markets: 1) Greed and 2) Fear. The major side effect of greed is that it leads to a biased form of judgement known as "wishful thinking" - or on Wall Street they refer to it as "Talking your own book". Conversely, extreme fear leads to negative extrapolation, which is another mental bias limiting one's willingness to accept risk. Looking back at past market manias that rose vertically and then collapsed vertically (Nasdaq, Nikkei, Nifty Fifty, 192os etc.), we see that these were not driven by a radical change in the underlying fundamentals, instead these were driven by the sheer power of the prevailing mass psychology - greed or fear. This untimely decoupling of rational pricing from fundamentals inevitably has catastrophic consequences. In other words, most people either load up on risk and/or sell risk at exactly the wrong possible moments. Right now we find ourselves precisely in one of these historically critical, greed-fogged moments, where the prevailing major risks are in fact NOT discounted in the market and where virtually every piece of bad news is quickly rationalized away. Therefore, the market will soon be in the relatively rare and yet uniquely devastating position of following the fundamentals lower, rather than leading the fundamentals lower. As I have also made clear, the ensuing unwinding of exotic derivatives and leveraged positions will cause a relentless bear market and economic collapse, the severity and duration of which will catch almost everyone by surprise.

Friday, May 18, 2007

Humpty Dumpty

A seven year round-trip!

All it took was $48 trillion in total debt (460% of national income).

"Just a wafer-thin mint, Sir..."

Thursday, May 3, 2007

What a Top Looks Like

Well it's official, I am definitely the last "bear" standing and the only person left who thinks that this insanity will end soon (and badly). Recently, even the Elliot Wave perma-bears (bearish since 1998) have turned bullish with their claim that this bull market could last at least another year (See their April issue of Elliot Wave Theorist). Talk about throwing in the towel in the last round...

Meanwhile, ironically, the two articles I clipped below both appeared in today's WSJ, which to me about sums it all up. The first article indicates that recently issued mortgage bonds are being downgraded at a faster rate than expected. It appears that the rating agencies (S&P/Moody's) who helped rate and price these deals, have been aggressively downgrading the very same bond products that they recently helped bring to market. This reminds me of the GO GO .dot com days when newly issued IPOs were downgraded soon after the first day of trading, by the same brokerage firms that brought them public.

The second article indicates that the big banks are now looking for new customers by offering mortgages to illegal immigrants - I kid you not. It makes me wonder how many nanoseconds will pass before these new "Illegal Alien Mortgage Bonds" are downgraded...

Bond Investors' Lament
Fallout as Moody's, S&P Cut Ratings on IssuesTied to Subprime Loans
By SERENA NG May 3, 2007; Page C1

More challenges are hitting bond investors who own securities backed by risky mortgages.
Over the past two weeks, Moody's Investors Service cut credit ratings on more than 30 bonds that were issued in 2006 and backed by pools of "subprime" mortgages, home loans made to consumers with troubled or sketchy credit histories. The downgrades came as more borrowers defaulted on their mortgages and caused losses to spike among the pools.
"It's embarrassing for a ratings company to downgrade bonds so quickly" after the bonds were issued, said Paul Ullman, chief executive of HFH Group, a New York hedge fund active in the mortgage market. "It reflects poorly on all parties in the underwriting process and their judgment of the credit-worthiness of the bonds."
Big Banks' Loan Push: Illegal Immigrants
Mortgages Get PitchedTo Underserved Market;Critics Find Some Risks
By ROBIN SIDELMay 3, 2007; Page C1

The nation's big banks, scrambling for customers, are pitching mortgages to illegal immigrants.
"Whoever hits the street first with these loans will be the winner," says Timothy Sandos, president of the National Association of Hispanic Real Estate Professionals"

[My Comment: Winner of what? The dumbest idea in history award?]
In Maricopa County, which includes the city of Phoenix, the sheriff, whose office has arrested hundreds of illegal immigrants, said banks providing these loans are taking on a risky proposition.
"If I catch these people, they are going back to Mexico and the banks will have a tough time collecting on their loans," said Sheriff Joseph Arpaio.

[My Comment: I am sure the Mexican Government will help get the lenders' money back]