June 11, 2012
The Heart of the Matter
Over the past 13 years, the S&P 500 has underperformed even the depressed return on risk-free Treasury bills. Real U.S. gross domestic investment has not grown at all since 1999, and even as a share of GDP, real investment remains weak.
The ongoing debate about the economy continues along largely partisan lines, with conservatives arguing that taxes just aren't low enough, and the economy should be freed of regulations, while liberals argue that the economy needs larger government programs and grand stimulus initiatives.
Lost in this debate is any recognition of the problem that lies at the heart of the matter: a warped financial system, both in the U.S. and globally, that directs scarce capital to speculative and unproductive uses, and refuses to restructure debt once that debt has gone bad.
Specifically, over the past 15 years, the global financial system - encouraged by misguided policy and short-sighted monetary interventions - has lost its function of directing scarce capital toward projects that enhance the world's standard of living. Instead, the financial system has been transformed into a self-serving, grotesque casino that misallocates scarce savings, begs for and encourages speculative bubbles, refuses to restructure bad debt, and demands that the most reckless stewards of capital should be rewarded through bailouts that transfer bad debt from private balance sheets to the public balance sheet.
What is central here is that the government policy environment has encouraged this result. This environment includes financial sector deregulation that was coupled with a government backstop, repeated monetary distortions, refusal to restructure bad debt, and a preference for policy cowardice that included bailouts and opaque accounting. Deregulation and lower taxes will not fix this problem, nor will larger "stimulus packages." The right solutions are to encourage debt restructuring (and to impose it when necessary), to strengthen capital requirements and regulation of risk taken by traditional lending institutions that benefit from fiscal and monetary backstops, to remove fiscal and monetary backstops and ensure resolution authority over institutions engaging in more speculative financial activities, and to discontinue reckless monetary interventions that encourage financial speculation and transitory "wealth" effects without any meaningful link to lending or economic activity.
By our analysis, the U.S. economy is presently entering a recession. Not next year; not later this year; but now. We expect this to become increasingly evident in the coming months, but through a constant process of denial in which every deterioration is dismissed as transitory, and every positive outlier is celebrated as a resumption of growth. To a large extent, this downturn is a "boomerang" from the credit crisis we experienced several years ago. The chain of events is as follows:
Financial deregulation and monetary negligence -> Housing bubble -> Credit crisis marked by failure to restructure bad debt -> Global recession -> Government deficits in U.S. and globally -> Conflict between single currency and disparate fiscal policies in Europe -> Austerity -> European recession and credit strains -> Global recession.
In effect, we're going into another recession because we never effectively addressed the problems that produced the first one, leaving us unusually vulnerable to aftershocks. Our economic malaise is the result of a whole chain of bad decisions that have distorted the financial markets in ways that make recurring crisis inevitable.
Once we abandoned Glass-Steagall, removing the firewall between traditional banking and more speculative activities, and allowing those activities to have the effective protection of the U.S. government, it was only a matter of time until a credit crisis would unfold. My 2003 piece Freight Trains and Steep Curves detailed the problem: "So the real question is this: why is anybody willing to hold this low interest rate paper if the borrowers issuing it are so vulnerable to default risk? That's the secret. The borrowers don't actually issue it directly. Instead, much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government. These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam."
The ability to use the Federal government as a backstop for risk-taking was the central element in creating the housing bubble. As long as a borrower was physically breathing, you could make a mortgage loan without really worrying about whether the loan could be paid back. By the time it was packaged up, tranched out, and securitized either by a bank or by Fannie and Freddie, all of which had the government backstop, the loan was somebody else's problem. When the bubble crashed, our policy makers made their crucial mistake - first through the Bush Administration, and then continued by the Obama Administration - they failed to require bondholders to take losses on bad loans.
Every major bank is funded partially by depositors, but those deposits typically represent only about 60% of the funding. The rest is debt to the bank's own bondholders, and equity of its stockholders. When a country like Spain goes in to save a failing bank like Bankia - and does so by buying stock in the bank - the government is putting its citizens in a "first loss" position that protects the bondholders at public expense. This has been called "nationalization" because Spain now owns most of the stock, but the rescue has no element of restructuring at all. All of the bank's liabilities - even to its own bondholders - are protected at public expense. So in order to defend bank bondholders, Spain is increasing the public debt burden of its own citizens. This approach is madness, because Spain's citizens will ultimately suffer the consequences by eventual budget austerity or risk of government debt default.
The way to restructure a bank is to take it into receivership, write down the bad assets, wipe out the stockholders and much of the subordinated debt, and then recapitalize the remaining entity by selling it back into the private market. Depositors don't lose a dime. While the U.S. appropriately restructured General Motors - wiping out stock, renegotiating contracts, and subjecting bondholders to haircuts - the banking system was largely untouched.
The failure of our policy makers to restructure debt resulted in the worst of both worlds - an economy where banks were relieved of the need for transparency (thanks to accounting changes by the FASB), and yet homeowners strapped with bubble-sized mortgage obligations saw very little in terms of debt restructuring. The reason we never got any economic traction in this "recovery" is that these debt burdens remain in place. While we certainly don't advocate "freebie" principal writedowns - which would almost surely result in a tsunami of strategic defaults, we've long proposed what we've called Property Appreciation Rights as a way to partially substitute mortgage principal for a marketable claim on future appreciation. Failing any meaningful debt restructuring, however, we've got a financial system that continues to operate with a confident government backstop for risk taking, while aggregate demand remains suppressed by a burden of existing debt.
Economists define a standard of living as the amount of goods and services that people in the economy can consume as a result of the work they do. They define productivity as the amount of goods and services that people in the economy can produce as the result of the work they do. In the long run, a rising standard of living requires rising productivity, which in turn requires the economy to accumulate a stock of productive investments - factories, machines, inventions, education, and so forth. In the short run, the benefits of productivity growth can be retained through profits in a way that prevents those benefits from being enjoyed by workers, but even then, redistributing wealth can only achieve limited improvements in living standards. Over time, an economy that squanders its scarce savings will predictably suffer for it.
Tragically, nobody seems to have learned a thing from the dot-com crash, or the tech crash, or the housing crash. Wall Street continues to beg for monetary interventions to reward speculative trading, even though these rewards have repeatedly proved to be short-lived. What investors don't seem to appreciate is how much of our nation's scarce savings have been burned to ashes as a result.
I really don't mean to pick on Facebook. It's a neat company, a neat platform, and I respect Mark Zuckerberg's charitable initiatives. But the example is too instructive to miss, so let's think about it as a business and as a major recipient of investment capital. If you go on Amazon or Ebay, you want to stay in order to buy something. That's a fine business model, and network effects work in your favor because there are a lot of sellers on the other side. If you go on Google, you want to find what you're looking for and then leave, which is a situation where advertising is welcome, and has also worked as a business model (though with a surprising lack of competition given that the business is based largely on a single eigenvector calculation). But consider Facebook. If you go on Facebook, your whole intention is to stay on Facebook for a while, but not to buy something. Here, network effects work against advertising because responding to the ad pulls you away from the network. On that platform, advertising is a nuisance, and if you're forced to tolerate advertising, you'll eventually migrate to a platform without it, so retention will be challenging. And yet, somehow the investment bankers were able to price the company at $100 billion on offering day. Perhaps the IPO proceeds will bring us more games, more photo apps, and more ways our kids can pass their time online, instead of developing some useful knowledge or skill. I'm all for down-time and social networks in moderation, but it's discouraging when this is the stuff that historic IPOs are made of - that this is where massive amounts of savings are allocated on the basis of a "wait and see" business model. Thanks to speculative hype, coupled with intentionally suppressed returns on less speculative but better understood investment choices, we continue to allocate the nation's scarce savings in ways that are ultimately unproductive, and that error will return to bite us over time.
How do we change course? To restore the economy to the path of long-term growth, we need to allocate capital better. This requires the willingness to allow bad investments to work out badly, without being bailed out or otherwise rescued. It would also help to detach the global economy from the burden of bad loans that can't be serviced. The first order of business is to restructure debt burdens. This requires lenders and bondholders to take partial losses (rather than transferring those losses to the public through bailouts) and requires debt repayments to be restructured - ideally swapping part of the principal for some form of equity claim. A return to growth will require regulatory structures that protect depositors but fully remove government protection from investment banking and trading activities. A return to growth will require monetary policy that stops distorting financial markets by simultaneously suppressing the incentive to save and encouraging speculative investment.
Over the long run, economic growth really means the introduction of new products and services, new methods and technologies, and indeed whole new industries. These aren't the result of stimulus programs, but are instead the result of productive investment, education, creativity, and frankly time. Of course, stimulus programs can have important short-term effects, but even here, we can't talk meaningfully about "stimulating aggregate demand" unless we also restructure the debt burdens on individuals, primarily on the mortgage side. Next to nothing has been done in on this front in recent years. A sharp "fiscal cliff" would be very disruptive here, but we shouldn't overestimate the ability of deficit spending to produce meaningful or sustained economic progress, however "enlightened" a given stimulus package seems to be.
Meanwhile, we can't imagine that the European crisis can be addressed by piling up excessive government debt to bail out troubled banks, and then relying on troubled banks to buy the excessive government debt. Unless we want a world where public services are cut to the bone in order to make bank bondholders whole, and where recession (or in some countries depression) is forced onto citizens in order to make government bondholders whole, the world's leaders will eventually have to wake up and recognize that bad debt requires bondholders who willingly took the risk to also take the loss.
The latest item in the ongoing European crisis is the news that Spain has been promised loans from the EU in order to bail out its banking system. The promise to bail out Spain may provide a burst of positive market sentiment, though I suspect there are some wrinkles ahead before any of that funding will actually be forthcoming. It's a little depressing to reflect on the fact that Spain is one of the four largest European nations, so it's effectively being called on to lend to itself. Somehow, this is seen as Europe "doing the right thing." But what is really happening is that a continent that is already excessively in debt is promising funds so that Spain can increase its government debt, and then needlessly protect the bondholders of Spanish banks, who should be subject to orderly restructuring instead. This is interesting because the new debt will be senior to existing Spanish bonds, much to the chagrin of existing Spanish bondholders, and the bailouts will put the claims of Spanish bank bondholders ahead of the claims of the Spanish citizens who are funding the "recapitalizations." The only way Spain could make a more explicit gift to bank bondholders would be to include wrapping paper and a bow.
If it seems as if the global economy has learned nothing, it is because evidently the global economy has learned nothing. The right thing to do, again, is to take receivership of insolvent banks and wipe out the stock and subordinated debt, using the borrowed funds to protect depositors in the event that the losses run deep enough to eat through the intervening layers of liabilities (which is doubtful), and otherwise using the borrowed funds to stimulate the economy after the restructuring occurs. We're going to keep having crises until global leaders recognize that short of creating hyperinflation (which also subordinates the public, in this case by destroying the value of currency), there is no substitute for debt restructuring.
Finally, on the subject of a Greek exit, bank runs, and general Euro-area stress, the always observant guys at ZeroHedge noted the following news item last week:
VANCOUVER, BRITISH COLUMBIA--(Marketwire - June 7, 2012) - Fortress Paper Ltd. ("Fortress Paper" or the "Corporation") (TSX:FTP), announces that its wholly-owned subsidiary, Landqart AG, a leading manufacturer of banknote and security papers, has had a material banknote order reinstated. This order was unexpectedly suspended in the fourth quarter of 2011 which negatively impacted the financial results of Landqart's operations in the first half of 2012. The Company operates its security paper products business at the Landqart Mill located in Switzerland, where it produces banknote, passport, visa and other brand protection and security papers, and at its Fortress Optical Facility located in Canada, where it manufacturers optically variable thin film material.
We'll add that De La Rue PLC, a British company involved in the design and production of over 150 national currencies, registered a new 52-week high last week, despite steep recent losses elsewhere in foreign stock markets.
As of last week, we continue to estimate a prospective return/risk profile for stocks that is among the most negative 0.5% of historical instances. The primary window here is about 2 weeks to 6 months, but extends as far as 18 months. On a longer-term basis, we estimate 10-year S&P 500 total returns of about 5.1% annually (nominal), based on our standard methodology. Strategic Growth and Strategic International remain tightly hedged. Strategic Dividend Value is about 50% hedged, which is its most defensive position. Strategic Total Return continues to carry a duration of just under 1 year, with a bit less than 14% of assets in precious metals shares, and a few percent in utility shares and foreign currencies.
Overall, we remain strongly defensive. Our return/risk estimates are averages of course, and any particular instance may deviate from that average. And even here, market conditions could change in a way that shifts our return/risk estimates. But here and now we are defensive. Based on present conditions, the risk of a deep and extended market decline remains high. Investors who are committed to a buy-and-hold posture, in consideration of the depth of prior cyclical downturns over the past 12 years, should ignore my views and adhere to their own investment discipline. In my view, investors who would be unable to tolerate a downturn similar to the 2000-2002 and 2007-2009 declines should pare their equity exposure to a level that they could comfortably maintain through a similar completion of the present bull-bear cycle. The day-to-day ebb and flow of news will periodically create the perception that things are suddenly "fixed" thanks to some intervention, bailout, or agreement. Be skeptical - the headwinds here remain enormous.
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