Seth Klarman: The Forgotten Lessons of 2008

Friday, March 5th, 2010

In this excerpt from his annual letter, investing great Seth Klarman describes 20 lessons from the financial crisis which, he says, “were either never learned or else were immediately forgotten by most market participants.”

One might have expected that the near-death experience of most investors in 2008 would generate valuable lessons for the future. We all know about the “depression mentality” of our parents and grandparents who lived through the Great Depression. Memories of tough times colored their behavior for more than a generation, leading to limited risk taking and a sustainable base for healthy growth. Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior. One state investment board recently adopted a plan to leverage its portfolio – specifically its government and high-grade bond holdings – in an amount that could grow to 20% of its assets over the next three years. No one who was paying attention in 2008 would possibly think this is a good idea.

Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt- down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.

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Twenty Investment Lessons of 2008

1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.
7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.
9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.
11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.
12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.
13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.
16. Financial stocks are particularly risky. Banking, in particular, is a highly leveraged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.
17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
18. When a government official says a problem has been “contained,” pay no attention.
19. The government – the ultimate short-term-oriented player – cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.
20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.

False Lessons

1. There are no long-term lessons – ever.
2. Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.
3. There is no amount of bad news that the markets cannot see past.
4. If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.
5. Excess capacity in people, machines, or property will be quickly absorbed.
6. Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.
7. In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.
8. The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.
9. The government can indefinitely control both short-term and long-term interest rates.
10. The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost. (Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”)

Source: ValueInvestingInsights via My Investing Notebook.

Tags: Bond Holdings, Collapse, Dangerous Situation, Excesses, False Sense Of Security, Financial Crisis, Great Depression, Investment Board, Investment Lessons, Market Observation, Market Participants, Near Death Experience, Parents And Grandparents, Paying Attention, Regularity, Sense Of Security, Seth Klarman, State Investment, Sustainable Base, Tough Times
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The Cycle of Deflation: Impediments to Debt Relief

Friday, February 26th, 2010

The post below is a guest contribution by Marty Weiner of Comstock Partners, the highly regarded investment manager run by Charles Minter.

We have been strong believers in the deflation theme since we have been writing these reports beginning in early 2000 (and even before).  We are attaching a chart depicting the “Cycle of Deflation” which you should print out and refer to as you read this comment.

As you can see by the chart, the typical deflation starts with savings and investment which produces strong sustainable growth in the economy.  However, when “greed” gets added into the equation, things sometimes change into non-sustainable growth.  This is what happened in the late 1900’s when the dot com bubble mania convinced every man woman and adult child to believe that they were all supposed to be multi millionaires.  They became so jealous of their neighbors who boasted about all the money they made in the market, that they also jumped into the market by buying such things as Internet Capital Group, CMGI, Iomega, JDS Uniphase, and many others of the same ilk which are now worthless.

The unraveling started taking place in 2000 and it looked to us like the American public came to their senses.  We expected to have a significant recession where Americans could rebuild their balance sheets as the cycle of deflation took hold.  But,  instead the Fed lowered interest rates to 1% and kept them there for a year causing the public to again become jealous of their neighbors making thousands and millions of dollars on their homes. And also, believe it or not, the housing bubble brought about another bubble in the stock market. We couldn’t believe our eyes!!!

After the housing bubble burst, the stock market also collapsed causing a financial crisis “heard ’round the world”.  Then, we were sure the markets and economy would fall to levels that would repair balance sheets of the household sector and allow the economy to get back to the tried and true savings and productive investment that built this great country.  We still need to repair the household balance sheets that were, and still are, in the worst shape since than the Great Depression.  What will it take to get to the debt repayments and debt defaults (see the last stage of The Cycle of Deflation) that has to take place before a sustained recovery can be accomplished?

We understood that the stock market was extremely oversold in March of 2009 and that there had to be a rally.  But we found the 70% to 80% rally which occurred to be incredulous.  The market is up so far from the lows in March now that they have discounted a V shaped recovery.  We have to wonder if the public and financial institutions will ever learn.

We are now in the “competitive devaluation” part of the cycle of deflation and we should be getting close to repairing the balance sheets that are so out of line with history.  But, there is a stumbling block to the normal competitive devaluations that typically take place. In the past, a country that incurred too much debt just did what they could to devalue their currency in order to export their way out of the dilemma by exporting their goods and services to their trading partners.

Now, however, it is not so simple.  The Chinese have linked their currency to ours, so as we debase our currency, one of our major trading partner’s currency is also declining and China becomes the major beneficiary of the debasement of our dollar. Because of this peg (and the Euro tied to 22 countries) the typical method of debasing the currency of debt laden countries (or countries that just want to get even) have swung down in “The Cycle of Deflation” past competitive devaluations to “beggar thy neighbor” policies.  We explained many times that “beggar-thy-neighbor” policies essentially go much further than just currency debasement, but actually do whatever a country has to do to protect its jobs and its economy.  This means “dumping” goods and services on their trading partners (selling  goods and services below cost and subsidized by the government), increasing tariffs, and anything else in its power to help the economy at their trading partners’ expense.

A perfect example of this lies in the recent accusations from China that the U.S. has been “dumping” chicken products into the Chinese market.  It at first threatened imposing heavy trade duties on U.S. chicken companies, and just recently China did impose the heavy duties.  They imposed duties of 64.5% on Sanderson Farms, 80.5% on Pilgrim’s Pride, and 43% on Tyson Foods which just happens to be an active investor in China.   These types of “beggar-thy-neighbor” policies are an extension of the past policies they have used to support exports. But now they feel that they have to go further since China now accounts for 9% of global exports.  Earlier this month China filed a compliant to the World Trade Organization against the European Union tariffs on imports of Chinese shoes.  “The dollar peg of the rinminbi has put additional pressure on lower end Asian exporters.  This has led to charges of unfair trade from across Asia,” said Jamie Mezl, executive vice president of the Asia Society.  Even nations in Africa and the Middle East are complaining.  “When we look at the reality on the ground we find that there is something akin to a Chinese invasion of the African continent,” Libyan Foreign Minister Musa Kusa said in November.

China’s exports were helped enormously by repegging their renminbi to the dollar in mid 2008.  Their exports got a further boost once the dollar started falling from March of 2009 by about 10%.  Now that the dollar has started up they could be close to reversing that decision.  Despite all the hoopla of China trying to slow down their growth, the above policies don’t support that at all.  The Chinese total debt to GDP is very difficult to quantify, but with the enormous stimulus undertaken last year ($550 billion) and government supported bank lending ($1.3 trillion), we know they are not in great shape.

America has retaliated by imposing punitive tariffs (as much as 99%) on Chinese tires and tubular steel (used in oil and gas wells).  The Chinese government weighed in by condemning the U.S. tariffs as an “abuse of protectionism”.

These examples of Chinese actions illustrate how difficult it is now for debt ridden countries to simply devalue their currency in order to export their way out of the dilemma. And just think about the situation in Europe, where this problem is exacerbated by 22 fold, since they now have 22 countries tied to one currency.

The problem is not confined to America, Asia, and Africa-Look at what is taking place in Greece presently.  In the past, a country like Greece that over indulged and got caught with their “hands in the cookie jar,” would just debase their currency in order to export their way out of the problem.  But, now that their currency is tied to the Euro like 22 other of its trading partners, they don’t have the same option as they did in the past to bail themselves out.

In summary, due to the debt related problems many countries worldwide are struggling to help their own economies at the expense of their trading partners.  In the past this has been accomplished by debasing their currencies in order to export their goods and services.  Because of currency pegs and one currency used by 22 countries (Euro Zone), this means of debt relief is not as easily accomplished.  The next stage of the Cycle of Deflation is the much more onerous “beggar-thy-neighbor” policies in order to support the economies of debt burdened countries.  This is not good news and could have the same effect for the global economies as Smoot Hawley did (a bill in 1929 that became law in 1930 which raised the tariffs on the U.S’s. major trading partners).   Therefore, the main problem of reducing the debt of major economies throughout the world is even more complicated and makes us even more convinced that the secular bear market that started in 2000 is still intact.

Source: Comstock Partners, February 25, 2010.

Tags: Adult Child, Balance Sheets, Bubble Mania, Cmgi, Debt Relief, Financial Crisis, Household Sector, Housing Bubble, Ilk, Impediments, Internet Capital Group, Investment Manager, Iomega, Jds Uniphase, Man Woman, Millionaires, Minter, Stock Market, Sustainable Growth, Weiner
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Canada Moral Hazard Corporation?

Monday, February 15th, 2010

As the world’s spotlight turns to the Vancouver Olympics, all eyes will be on Canada. Our nation suffered comparatively less than other G7 economies during the last recession, and our banking system has received praises for being good and boring (read the Sceptical Market Observer’s comment on this).

To be sure, our economy is adding jobs, our stock market has rallied sharply, our currency is close to reaching parity with the USD, commodity exports are up, everything looks great. A buddy of mine even told me that our currency is being bought by central banks around the world. Canada seems to be on a tear.

But things are far from perfect. For one, there is a housing bubble in the making that could last a lot longer than people think. Stephen Jarislowsky, one of Canada’s best known investors, says he believes government measures aimed at juicing the housing market has put the sector in a bubble:

“I am convinced there is a housing bubble in Canada,” Mr. Jarislowsky told Bloomberg News. “… I conclude that the prices of housing today in the U.S. are cheaper than they should be, and that the prices in Canada are far more expensive than they should be.”

Mr. Jarislowsky is not alone. Other economists have also fretted about a bubble given the stunning rebound in real estate after the slump, and projections for record sales and prices this year. Ottawa is now considering tightening some rules. Said Mr. Jarislowsky: “They have basically encouraged people to buy houses based on cheap mortgages. That has created the opposite effect of what was desirable.”

Then, there is what Peter Foster of the National Post calls the Canada Moral Hazard Corporation:

There has been much official chest swelling over Canada’s relatively strong performance during the financial crisis, but perhaps Canadians shouldn’t — if you’ll excuse the mixing of metaphors — be counting their chickens until they are sure that there are no black swans present. And in fact there does seem to be one dark, plump, bird looming around the back of economic barnyard: the Canada Mortgage and Housing Corporation. Or is that a turkey that should be renamed the Canada Moral Hazard Corporation?

The CMHC was never given a cutesy acronym like its U.S. equivalents, Fannie Mae and Freddie Mac. But why not “Morrie Haz,” acknowledging that it has always been an instrument of moral hazard, the situation where insurance makes the insured-against event more likely?

As we know, Fannie and Freddie — which were privately-owned but “government-sponsored,” which meant they inevitably got bailed out — were front and centre in the U.S. housing market meltdown, which in turn precipitated the global financial crisis.

There are increasing concerns that the Canadian housing market is headed the same way as that of the U.S., stoked by the same factors: artificially low central bank interest rates, and the government insurance/promotion of risky mortgages.

This policy double whammy explains the growing calls for somebody — banks? CMHC? Carney? Flaherty? Anybody else? — to tighten mortgage regulations. These requests appear puzzling until we realize the role of the CMHC in encouraging perverse behaviour.

In a free market, if banks felt a housing bubble building, they would simply tighten standards themselves, either by demanding higher credit qualifications, hoisting rates, or shortening amortization periods. Hoisting rates is out of the question, since rock bottom mortgage rates are now considered by the Bank of Canada to be essential to national economic recovery and protection of our export industries. That leaves Morrie Haz waiting there to insure mortgages, and gives the banks every incentive to hand out any loan that can get insurance. However, they obviously grasp that such cosmic policy fecklessness will ultimately come back to haunt them.

A couple of weeks ago, Peter Routledge of credit analyst Moody’s pointed out that the overheating of the housing market was goosing an unsustainable increase in household borrowing more generally. “As witnessed in the United States,” he wrote, “this movie does not end well.” Specifically, once the punchbowl of low interest rates disappears, households find themselves in trouble, and so do their bankers.

Mr. Routledge noted that Canadian banks likely wouldn’t wind up in the same depths as their U.S. counterparts, but that is only because their riskiest mortgages are backstopped by CMHC. But this makes the systemic threat to the Canadian economy greater.

The U.S. crisis was massive but did not fall entirely on Fannie and Freddie. It was shared with other financial institutions. Nevertheless Fannie and Freddie both failed and had to be taken into government “conservatorship.” Mr. Routledge suggests that the situation is more “secure” in Canada, but as a recent report from the Fraser Institute points out, what this really means that the Canadian system features “massive taxpayer exposure.”

Mr. Routledge suggested that CMHC should tighten its insurance criteria, and this week he was seconded by former Governor of the Bank of Canada David Dodge.

The Fraser study, by Neil Mohindra, confirms that the taxpayer risk from a housing collapse is greater in Canada than elsewhere. He notes that a stunning 90% of all insured residential mortgages in Canada are covered by the CMHC. This amounts to an estimated $480-billion for which Canadian taxpayers would be on the hook if the housing market tanked (although any loss would obviously only be a fraction of this amount).

The study suggests that the CMHC’s activities should be privatized, but that possibility appears a long way down the road, both for practical and political reasons. The biggest problem is that nobody is going to want to privatize a property which harbours a potential time bomb.

The whole thrust of CMHC insurance is to encourage banks to make riskier loans. Normal insurance provisions are based on actuarial principles. CMHC insurance is based — like the activities of Fannie and Freddie — on promoting home ownership. Mixing social and economic objectives usually ends in taxpayer tears.

There is no indication that the Canadian mortgage market has been subject to the lunacies of the U.S., where — for a while — anybody with a pulse could get a home loan. Still, high ratio mortgages — that is, ones with down payments as low as 5% — inevitably carry a hefty risk of default when a bubble bursts. That default then becomes the CMHC’s problem.

As such, notes Mr. Mohindra, Canada is not a model for anybody. Morrie Haz has always been an accident waiting to happen.

According to Moody’s Mr. Routledge, “If policymakers deploy the appropriate tools early rather than late in this period of household credit expansion, perhaps the Canadian movie will end differently.”

But Finance Minister Jim Flaherty knows that ending the party is not going to be popular, which is where inevitable political self-interest compounds those practical problems. Meanwhile CMHC isn’t just a provider of potentially reckless insurance and the depository of last resort for mortgage assets the banks don’t want. Yesterday a representative of Diane Finley, Minister of Human Resources and Skills Development, who is also responsible for CMHC (go figure), was in Montreal handing out stimulus slush under Canada’s Economic Action Plan.

Mr. Flaherty doesn’t want to see a bubble, much less a bomb. But when it comes to which movie we’re coming to the end of, maybe he should check out The Hurt Locker. Just in case.

Of course, lenders like ING, oppose any clampdown to rein in mortgage borrowing. Sound familiar? I agree with Stephen Jarislowsky and I also fear that this movie isn’t going to end well. Enjoy the Vancouver games, because I feel a post-Olympics winter chill headed our way.

Tags: Banking System, Black Swans, Canada, Central Banks, Cheap Mortgages, Chickens, Commodity Exports, Financial Crisis, Government Measures, Housing Bubble, Housing Market, Jarislowsky, Metaphors, Moral Hazard, Parity, Praises, Recession, Record Sales, Slump, Swans, World Canada
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A Magic Bullet for Inflation and Deflation?

Wednesday, February 3rd, 2010

During the better part of the last 18 months, since the financial crisis erupted, the debate over whether we are in store for inflation or deflation has dominated the investment decision making thoughts of all market participants, from retail investors to hedge fund managers.

The burning question – “Are we heading for inflation or deflation?” – is the toughest one to hurdle. Since there is no way of knowing, you have to make a decision based on what you know about each, then, make a decision about how to invest, based on your decision. Its precarious at best. Many investors, however, unable to settle on an outlook, will choose the option that requires the least amount of thought – cash, GICs, and short term bonds – and wait for things to be clarified.

That’s why something hedge fund manager David Einhorn, of Greenlight Capital wrote last year has got my attention again.

Read the whole article here.

Pierre Daillie (AdvisorAnalyst.com), GlobeAdvisor.com, February 1, 2010.
http://www.globeadvisor.com/advisoranalyst/aa20100201.html

Tags: Burning Question, David Einhorn, Financial Crisis, Fund Managers, Gics, Globeadvisor, Greenlight Capital, Hedge Fund Manager, Inflation And Deflation, Investment Decision, Magic Bullet, Market Participants, Retail Investors, Term Bonds
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The Deleveraging Has Begun

Wednesday, January 27th, 2010

The post below is a guest contribution by Comstock Partners, the highly regarded investment manager run by Charles Minter.

Barron’s magazine printed the first part of its annual Roundtable discussion of 2010 this past week.  We noticed that many of the participants were very concerned about the debt (mostly government debt while we think total debt is a much more useful metric).  Marc Faber, in fact, talked about a 7,000 word New York Times article by Professor Paul Krugman.  He stated that the article “How Did Economists Get It So Wrong?” never mentioned that excessive credit growth or leverage was the cause of monetary instability and brought about the financial crisis.  Bill Gross stated that by lowering interest rates we promote consumption instead of manufacturing.  Central bankers were forced to respond with liquidity to a problem that developed over the past 25 years.  There was more discussion of credit growth (another way to say debt growth) in the macro analysis that is always presented in the first part of the three Barron’s articles of the Roundtable.  The amazing thing to us is that most of the roundtable participants understand the same problems we talk about almost every single week, yet are mostly very positive on the market for 2010.

It seems that most of the roundtable participants understand the debt problem we have been talking about for the past 14 years. The worst period of the debt explosion started with the outrageous internet bubble in the late 1990s, continuing through the correction in the internet bubble, then the housing bubble which should have been obvious to everyone (even the Fed) and then the financial crisis of 2008.  We are astounded that we have the potential for another bubble in the stock market now.  We expected the rebound from a much oversold market in March of 2009, but not a 70% rebound from the lows.  We don’t believe it is possible to fool the investors in the U.S. stock market one more time. Especially this close to the 2003-2007 and 1996-2000 bubbles.

Hopefully, all of our regular viewers know that we have been, and still are, very concerned about the debt situation in this country– and many others.  Until balance sheets are repaired we don’t think the stock market will do well and expect the secular bear market to continue.  We really don’t know why the roundtable participants, or virtually anyone else for that matter, do not bring up the fact that the total debt in this country doubled from 2000 to present (from $26 trillion to $53 trillion).  This drove the debt (both public and private) to 375% of GDP in this country before recently declining to 370%.  This 370-375% number is the highest since the Great Depression when it reached 260% at the peak, even with a collapsing GDP. Even more incredible is that the present debt level does not include the entitlement and pension obligations that would just about double the total debt from where it is now.

This U.S. debt to GDP started accelerating in the 1960s (with the Vietnam War, Space Race and continuation of the Cold War) when it took $1.53 to generate an additional $1 of GDP.  Then during the 1970s, with the continuation of the Vietnam War, it took $1.68 to generate $1 of GDP.  In the 1980s (including Leveraged Buyouts and Star Wars) it took $2.93.  In the 1990s (with the internet bubble) the debt it took to generate $1 of GDP climbed to $3.12.  However, the most incredible of all was the first decade of this century when it took over $6 to generate an additional $1 of GDP.  That decade included the war on terror, two wars, private equity firms (new name for leveraged buyouts) and housing and another stock market bubble, as well as promises of entitlements that we have no possibility of being able to keep.  Clearly, needing over $6 to generate $1 of GDP is unsustainable.

We have been trying to compare the U.S. total debt to GDP to other countries for some time and have some figures that were just corroborated with a recent McKinsey report.  As high as our U.S. debt to GDP number is, believe it or not, it is not as bad as many other countries according to a recent report by McKinsey Global Institute (the research arm of McKinsey & Co.).  The UK debt to GDP is about 470%, Japan 460%, Spain 340%, South Korea 340%, Switzerland 315%, France and Italy about 300%, Germany 275%, and Canada 245% (all are records of debt to GDP).  The BRIC countries (Brazil, Russia, India, and China) all have debt to GDP under 160%.  We have been warning our viewers about the pain of deleveraging for some time (Special Reports-’Deleveraging the U.S. Economy” 8/09-comparing our deleveraging to Japan, and “Debt Dynamics Will Hold Back Economy” 11/09).  The McKinsey report agrees that the deleveraging will be painful and take years to resolve.

You may think that since China and the other BRIC countries are not as leveraged as the more developed countries that they could grow enough to pull up the global economy. But you have to remember the McKinsey report was as of 2008.  China had a stimulus package that was three times the size of the U.S. stimulus package relative to GDP.  This means the U.S. stimulus package of $787 billion would have been over $2 trillion if we had a package as large as China.  Also, the Chinese government encouraged bank lending, and banks loaned out $1.3 trillion during 2009.  They could now be more leveraged than the United States.  China also could be the next bubble as they are building up their economy to sell products to a world that is deleveraging.

As we stated in many commentaries and “special reports” in the past we expect the deleveraging of America, as well as many other countries, to be the primary focus of central banks worldwide-not the escape from the financial crisis, not the earnings that are supported by cost cutting, and not the economic rebound supported by the stimulus and inventory rebuild.  The deleveraging of America and much of the global economy will trump everything else.

In the past when a nation’s total debt rose to unsustainable levels it would just debase its currency enough to try to export its way to prosperity, and even this didn’t always work.  However, when all its major trading partners also need to debase their currencies, it becomes an impossible task.  This takes us to the “Cycle of Deflation” chart (attached) which we authored and point to in almost every discussion of our debt problem.  We are still in the competitive devaluation part of the cycle; however, you can only devalue or debase your currency relative to other countries in order to gain a competitive advantage. And when all of your trading partners are in the same boat as you, then you are forced to take more drastic measures, and that brings you down the “Cycle of Deflation” to “Beggar-thy-Neighbor policies.  This essentially means that the country in trouble will do whatever it takes to sell its products abroad.  When a country needs to keep its plants open it might have to sell its products at less than cost, or put restrictive tariffs on imports and/or subsidize exports.

Essentially, we believe we are still in a continuation of the financial crisis we entered in 2008.  We have been headed for this crisis for a few decades but are just now realizing the consequences of the debt build up over the years. Before this is over we expect the private debt in the U.S. to drop substantially (from $40 trillion now towards $30 trillion or even as low as $20 trillion) while the government debt explodes to at least double the $15 trillion presently.  And since most of our trading partners are in the same boat as we are, they will also be forced to become more protectionists.  This does not bode well for the global economy.

In conclusion, we cannot emphasize enough that the total debt to GDP is so onerous for the economies of most mature countries as well as China, that the global economy will suffer tremendously over the next few years.  We have discussed this over and over again and, in fact, with a little “tongue in cheek” stated in many comments and “special reports” that when Obama realizes what he inherited he will “demand a recount” of the 2008 election.  The masses don’t trust the liberals and they don’t trust the conservatives -they don’t like Democrats and they don’t like Republicans-they don’t like any institution be it government, journalism, or anything else-they just want things to CHANGE.  The regulation of the banking industry, the tea parties, the populist demands, the election in Massachusetts, the healthcare reform, even the employment situation all take a back seat to the enormous amount of debt relative to GDP.  The masses want a change because of the pain they are going through presently and just don’t understand the invisible hand of the interest on the debt absorbing so many dollars that could have been used to support the economy.

This invisible hand is causing the masses to want change even though they don’t understand why they feel so uncomfortable and don’t know who is to blame.  They are just “mad as hell and can’t take it anymore” (from the movie, “Network”).  All of this causes the deleveraging as shown in our Cycle of Deflation as the private sector pays down debt or defaults. This process is very painful while taking many years to resolve.  The process has already started as business loans and consumer credit are shrinking at record rates while the government debt is expanding at record rates.  This deleveraging we expect will take place on a global scale and will take many years to resolve.  Japan has already suffered two “lost decades” and has still not solved its problem.   We expect this to take place globally and will continue to be painful.  We honestly don’t want to be correct in this assessment for the global economy, but we can’t see how this deleveraging process and the consequences of the process be avoided.

Tags: Barron, Barron S Magazine, Bill Gross, BRIC, Canada, Charles Barron, China, Debt Growth, Debt Problem, Emerging Markets, Financial Crisis, Government Debt, Housing Bubble, India, Internet Bubble, Investment Manager, Lows, Macro Analysis, Marc Faber, Minter, Monetary Instability, New York Times, Paul Krugman, Professor Paul, Roundtable Participants, U S Stock Market, York Times Article
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Inflation expectations approach pre-crisis range

Tuesday, January 12th, 2010

On the burning issue of inflationary pressures, Asha Bangalore (Northern Trust) yesterday remarked as follows: “Inflation expectations as measured by the difference between yields of the nominal US 10-year Treasury note and the 10-year inflation protected security are now at levels seen prior to the onset of the financial crisis in August 2007. As of January 8, the difference between the nominal yield and yield on the inflation protected 10-year US Treasury securities was 245 bps. Inflation expectations have climbed 28 bps during the last 20 trading days.

“The movements of inflation expectations will be watched closely in the near term.  The Fed’s ability to influence the course of economic growth will be prevented if inflation expectations become unhinged,” she said.

The minutes of the December 2009 FOMC meeting indicate that the staff did a special presentation on inflation and inflation expectations. The highlights of this discussion were reported as follows: “Evidence suggested that sizable shifts in the longer-run inflation expectations of households and firms had influenced the evolution of inflation over previous decades; in contrast, the anchoring of inflation expectations in recent years likely had damped somewhat the response of actual inflation to the recent economic downturn and to fluctuations in the prices of energy and other commodities. In discussing these issues, participants noted that they bear in mind the shocks hitting the economy and regularly monitor more than one measure of resource slack as they assess the outlook for economic activity and inflation. They also noted the importance of formulating monetary policy in ways that would work well across a range of possible economic structures rather than relying on any one analytical framework. Finally, they underscored the importance of keeping longer-run inflation expectations firmly anchored to help achieve the Federal Reserve’s dual mandate for maximum employment and price stability.”

Meanwile Peter Boockvar reported on The Big Picture blog as follows: “The 10 yr TIPS auction was good as the yield was about in line with expectations but the bid to cover at 2.65 is above the ‘09 average of 2.59 and the average over the past 2 yrs of 2.30. It’s the 2nd highest going back to 2000. Ahead of the auction, the implied inflation rate in the 10 yr TIPS was 2.45% which means if one believes inflation will run above that over the next 10 yrs on average then buy inflation protection and vice versa.”

“Bullish economic reports are most likely to lead to pressure on long-term interest rates and push inflation expectations into a new range. Having said that, a caveat is necessary, final demand in the US economy is significantly weak and it is unlikely to post robust growth until the final three months of the year. Therefore, it is reasonable to expect that inflation expectations will remain anchored in the months ahead,” concluded Bangalore.

Perhaps, but I am in no hurry to see my gold holdings protecting my portfolio against the biggest monetary reflation in human history.

Tags: Bps, Commodities, Dual Mandate, Economic Activity, Economic Downturn, Economic Growth, Economic Structures, Federal Reserve, Financial Crisis, Fluctuations, Fomc, Gold, Households, Inflation Expectations, Inflationary Pressures, Monetary Policy, Nominal Yield, Northern Trust, Shocks, Slack, Treasury Securities, Us Treasury, Year Treasury Note
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Bill Gross: Investment Outlook (January 2010)

Thursday, January 7th, 2010

Bill Gross, co-Chief, PIMCO, has just released his latest instalment of his newsletter, titled, “Let’s Get Fisical.”

In it, Gross discusses the theme, that 2010 will be a year of “exit strategies,” of breaking free of government assistance. As usual, Gross’ outlook is captivating, and like others requires some interpretation as well as look-through.

Here is an excerpt:

“If 2008 was the year of financial crisis and 2009 the year of healing via monetary and fiscal stimulus packages, then 2010 appears likely to be the year of “exit strategies,” during which investors should consider economic fundamentals and asset markets that will soon be priced in a world less dominated by the government sector. If, in 2009, PIMCO recommended shaking hands with the government, we now ponder “which” government, and caution that the days of carefree check writing leading to debt issuance without limit or interest rate consequences may be numbered for all countries.”

and,

Additionally, if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009. It seems no coincidence that stocks, high yield bonds, and other risk assets have thrived since early March, just as this “juice” was being squeezed into financial markets. If so, then most “carry” trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their “sugar daddy.” There’s no tellin’ where the money went? Not exactly, but it’s left a suspicious trail. Market returns may not be “so fine” in 2010.

I find it unusual that the discussion of carry trades is seldom discussed in depth, especially when it is such an integral, and functional, moving part of both the credit and equity markets. There has been a noticeable amount of press on the dollar carry trade ending, and the threat that poses, but very little on the subsequent presence and resumption in the yen carry trade, our Japanese “sugar-daddy.” As Hosein Askari recently asked, “Whose paying for the beer?”

Gross doesn’t mention it. There has been a reversal of the inverse relationship between the U.S. dollar and equity markets, emerging markets, commodities,  and the Canadian dollar, et al., since the U.S. dollar recovered off its late November lows. Where is the mysterious support coming from? Perhaps its too early to tell, OR, those who do know about it, are exploiting the opportunity, and keeping their lips tightly sealed.

Read the whole newsletter here.

Tags: Asset Markets, Bill Gross, Canada, Check Writing, China, Commodities, Debt Issuance, Economic Fundamentals, Emerging Markets, Exit Strategies, Financial Crisis, Financial Markets, Fiscal Stimulus, Government Assistance, Government Checks, Government Sector, Gross Co, Gross Investment, High Yield Bonds, Instalment, Investment Outlook, PIMCO, Shaking Hands, Sugar Daddy
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Chart of the Day: Subpar recoveries follow financial recessions

Thursday, January 7th, 2010

“Economic cycles associated with financial traumas such as banking crises or asset price collapses tend to have deeper downturns and weaker upturns. The current uptrend in US economic growth should be sustained, but the rebound will remain subdued compared to recent recoveries,” said BCA Research.

The chart below illustrates the typical recovery patterns following financial and non-financial recessions respectively. As they say, a picture paints a thousand words … Should the after-effects of the financial crisis indeed remain a serious headwind to economic growth, policy conditions should remain favorable for risky assets.

Source: BCA Research - Daily Insights, January 6, 2010.

Tags: Asset Price, Collapses, Crises, Current, Economic Cycles, Economic Growth, Financial Crisis, Headwind, Insights, January 6, Rebound, Recessions, Risky Assets, Traumas, Typical Recovery, Uptrend
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Investing in Range-bound Markets

Tuesday, December 15th, 2009

This article is a guest contribution by Vitaliy Katsenelson*, Portfolio Manager and Director at Investment Management Associates in Denver, CO.

December 15, 2009

In the bull market that preceded the collapse of Lehman Brothers and the financial crisis, equity valuations reached some very frothy levels.

The correction that followed lasted only until March, and since then the S&P 500 index and the FTSE Eurofirst 3000 have risen more than 60%. Even in spite of the post-Lehman correction, equity markets have been in a secular range-bound phase since 2000.

Investors must understand the dynamics of range-bound markets and the best ways of investing in such an environment.

Secular market cycles

Let me lay out my thesis for secular (long-term, longer than five years) market cycles.

Ask an investor what the stock market will do over the next decade, and he’ll tell you his expectations for the economy and earnings growth, and that will turn into his projection for the market. However, this kind of thinking looks at the half of the equation that explains stock market (and individual stock) returns, while completely ignoring a very important variable that is responsible for a significant part of stock returns: valuation.

Mathematically, stock prices in the long run (not minutes or days, but years) are driven by two factors: earnings growth and (it’s a very important and) changes in valuation (P/E ratios). Once you add a return from dividends, you’ve captured all the variables responsible for total return from stocks.

During the last two centuries, every time we had a long-lasting bull market the market what followed was not a bear but a range-bound, sideways market. (The only notable exception was the decline during the Great Depression.) This happened not because of some hidden, embedded magical pattern. No, there is no practical joke being played on gullible humans; it happens because our emotions get the best of us. Yes, emotions! Secular bull markets start at low, below-average P/Es. A combination of earnings growth and P/E expansion (which is a simple reversion towards the mean) bring spectacular returns to now jubilant investors.

Then the investors get overexcited about stocks and drive valuations (P/Es) to above- average levels.

P/E expansion is a powerful tailwind and a significant source of the returns during secular bull markets, but high P/Es can create a headwinds. When they start to fall, they curtail returns during secular range-bound markets. As P/Es stop expanding at the very late stages of a secular bull market, investors who were accustomed to above- average returns grow less than thrilled with lower rates of return. The higher the P/Es, the more difficult it is for stocks to continue to climb, as earnings growth alone cannot keep the secular bull market going. Returns from stocks decelerate to below the levels investors have learned to expect, and investors gradually migrate from stocks to other asset classes.

Welcome to a range-bound market!

Emotions now shift into reverse. P/E compression is like gravity pulling stocks down, where earnings growth is the force that counteracts its effects. All the benefits from earnings growth are gradually offset by constant P/E compression (the staple of range- bound markets). P/Es mean-revert from above to average to below-average levels. Stocks go nowhere for a long, long time in the process.

I discuss this topic in great detail with plenty of charts and tables on my Contrarian Edge website.

US equity markets remain locked in a range-bound state

In the US, economic performance has not been significantly different during range- bound and bull markets. That is, as long economic performance was not far from its average state we had either range-bound or bull markets. However, when you coupled high (above-average) valuations with long-term economic contraction, you had a secular bear market. This is exactly what took place during the Great Depression (and has taken place in Japan from the late 1980s until today).

In secular bear markets, economic growth does not offset a price/earnings (P/E) mean reversion; declining earnings add fuel to the fire and supersize the decline in P/E, thus causing stock prices to decline over a protracted period of time.

In the last (1982-2000) secular bull market P/Es reached their highest level ever. Today, nine years into a range-bound market, US stocks are still at above-average valuations. If over the next few years the US economy doesn’t achieve positive nominal earnings growth, we may slide into a secular bear market.\

The Fed is throwing an enormous amount of liquidity into the economy, yet it has very few tools to deal with deflation (you can make borrowing virtually costless, but borrowers may still choose not to borrow or to spend). The Fed is much better equipped to fight inflation: it can make money very expensive, and expensive money curbs spending. Thus, historically the Fed was willing to err on the side on inflation - be it in consumer prices, housing, commodities, or the stock market (”Bubbles-R-Us”). (In part we are paying today for the Fed’s handling of the 2001 recession: Alan Greenspan took interest rates to a very low level and kept them there for too long, starting a bubble in real estate.)

Current Fed actions may have the unintended consequence of promoting another bubble in stocks. I believe it will be harder to achieve a broad market bubble, since the more you stimulate the less effective stimulus becomes, over time; but I can see how a few sectors may (and already have) bubbled up.

The Fed and politicians will likely err on the side of overstimulating the economy, as the career risk for taking the economy back into recession through constrictive monetary policy is too great.

The exit strategy from a range-bound market

Will my observations continue to play out in the future?

In my book Active Value Investing: Making Money in Range-Bound Markets (Wiley, 2007), I inadvertently created a framework that explains the mechanism behind stock market cycles. As things change over time one thing remains the same: our emotions will make us overexcited about stocks, and this will drive stocks to above-average levels, giving us cause to be underexcited (I think I just made up a new word), which will result in treacherous periods of range-bound markets.

If it were not for our emotions, stocks would always hew very close to their value levels (a normalized P/E of 15) and secular market cycles would not occur. I am oversimplifying; but if it were not for emotions, returns from stocks during short, intermediate, and long-term periods would be identical to their earnings growth.

Human emotions don’t let valuations (P/Es) remain in their average state of 15, and so they are driven to extremes, on both sides of the mean. Returns from stocks over short (one year) and intermediate terms (5, 10, or 15 years) may have a significant disconnect from their earnings growth. And the disconnect between earnings growth and stock market returns may persist for decades, or even longer.

Over, say, thirty years in the US (it takes that long for bull and range-bound markets to cancel out each other), returns from stocks will be in line with economic growth.

The role of technical analysis and market timing

About a month after my book came out I regretted its subtitle, “Making money in range- bound markets.”. People assumed that I knew what the range was, and the name also implied that I use technical analysis. “Sideways markets” would have been a more accurate description, but what’s done is done.

Secular market cycles are full of many cyclical bull and bear markets; the last range- bound market, which started in 1966 and ended 1982, had five cyclical bull and five cyclical bear markets. It is impossible to succeed at short-term market timing, as you have to get two things right: the short-term economic numbers and the market’s response to them, which in many cases may be irrational.

What I propose in the book (and practice at my firm) is active value investing. Instead of being a market timer, I’m a buy-and-sell investor, with a focus on valuing individual stocks.

Positioning against a decline in the dollar

Though problems in the US are well-known, I am not a long-term dollar bear (though, as a hedge, we own some stocks that would benefit if the dollar continued to decline).

If the dollar is to fall, one must ask what against currency will it fall?:

The Japanese yen? Japan has its own, more immediate crisis: its economy has been in recession since the late 1980s, it has one of the oldest populations in the developed world, and its savings rate has declined greatly and is still falling. Japan has been trapped in a zero-interest policy that it may not be able to sustain for much longer. Its debt-to-gross domestic product is second only to Zimbabwe’s, and even a small increase in interest rates will put a significant pressure on its budget. So the yen is not it.

As I have written previously, Japan was on the stimulus bandwagon for more than a decade; and with the exception of government debt-to-GDP tripling, Japan has nothing to show for it . Its economy is mired in the same rut it was in when the stimulus marathon started. It had a hard time giving up stimulus because the short-term consequences were too painful. Also, Japan is proof that a low (zero) interest-rate policy loses its stimulating ability over time and turns into a death trap for the economy as leverage ratios are geared to low interest rates. Now, even a small increase in interest rates (say, from 1% to 2%) would be devastating for Japan’s economy.”

The US is not Japan: our housing and stock market overvaluations were not as extreme; our corporations are in much better shape (though consumers are in worse shape); we are not xenophobic, thus our population is growing through immigration; we don’t have a significant cultural issue of “saving face” to overcome. Thus, although we sometimes don’t let bankrupt companies go bankrupt to the degree we should - at least not since Lehman - creative destruction is allowed to exist to a far greater degree here than it was in Japan.

The euro? The euro blankets a collection of 20+ countries with very different interests. As John Mauldin put it, and I agree, the euro was created for prosperity, not adversity. Europe has its own demographic issues, such as high unemployment. So I am not betting on the euro against the dollar, either.

The Chinese renminbi? The People’s Republic of China is neither the people’s nor is it a republic. Despite its economic progress, China is still a communist country with a totalitarian regime and limited human and property rights. The Chinese government made the choice of growth at any cost even if projects don’t (or barely) cover the return on capital. It has done so at the cost of undermining the purchasing power of its people by manipulating its currency, keeping it significantly undervalued. I’ve written a lot about significant Chinese economic problems will likely surface down the road.

Lately I’ve been hearing chatter of “nominating” the Chinese currency to reserve currency status. This is unlikely to happen for the reasons I’ve just mentioned, and also it goes against the Chinese business model. As long as the Chinese model is to be a low-cost producer and exporter to the world, reserve currency status is off the table. If the rest of the world decides to park their money in the Chinese currency, it will drive the renminbi up and decapitate China’s export industry.

Maybe the Russian ruble? Unfortunately, Russia is a a one-trick petrochemical pony. The natural resources of Russia are more a curse than a blessing, as they detract capital from and hinder development in non-commodity industries.

What’s happening in the US isn’t good for the dollar, but I’m not sure the rest of the world is in a much better position.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).

Tags: Bull Markets, China, Collapse, Commodities, Denver Co, Dividends, Earnings Growth, Emerging Markets, Financial Crisis, FTSE, Great Depression, Investment Management, Lehman Brothers, Management Associates, Market Cycles, Portfolio Manager, Practical Joke, Ratios, Secular Market, Stock Market, Stock Prices, Stock Returns, Valuations
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Sit Back and Relax - “The US and China, this is going to take awhile”

Thursday, December 10th, 2009

This post is a guest contribution by Rebecca Wilder*, author of the of the News ‘n’ Economics blog.*

Given the symbiotic relationship in the chart above, it’s hard to blame any one individual, group, or even country. But blame we do. Martin Wolf, at the Financial Times, wrote an interesting article about the need for a “co-operative adjustment” of global current account deficits and surpluses. He argues the following:

China’s exchange rate regime and structural policies are, indeed, of concern to the world. So, too, are the policies of other significant powers. What would happen if the deficit countries did slash spending relative to incomes while their trading partners were determined to sustain their own excess of output over incomes and export the difference? Answer: a depression. What would happen if deficit countries sustained domestic demand with massive and open-ended fiscal deficits? Answer: a wave of fiscal crises.

It sounds so imminent: re-balance now, or else. Sure the tides of portfolio flows must change; structural current account imbalances are now proven to cause economic catastrophe, as illustrated by the 2-yr case study of late. But it’s not going to happen over night. It takes a long time for re-balancing of any kind to fully pass through. Just look at Japan in the 1990’s.

Data note: you can download Japan Flow of Funds data here, and US Flow of Funds data here.

The chart above illustrates the debt bubbles in the US financial crisis and in 1990’s Japan. In Japan, the households didn’t accumulate as much debt relative to the non-financial business sector; however, both sectors dropped leverage. And notice, that it took about a decade for households and firms to do so.

What’s overly obvious is that the Chinese will not be bullied into revaluing the yuan just because the US says so. And also evident is that there is a (very lengthy) de-leveraging process underway in key economies. By default, the debt-reducing developed world will force the Chinese to focus policy more inward (domestic demand) and less outward (export demand), as US consumers drop debt levels. But sit back and relax, it’s gonna be a while.

This post is a guest contribution by Rebecca Wilder*, author of the of the News ‘n’ Economics blog.* Rebecca Wilder is an economist in the financial industry. She was previously an assistant professor and holds a doctorate in economics.

Tags: Account Deficits, Bubbles, Business Sector, China, Current Account, Economic Catastrophe, Emerging Markets, Exchange Rate Regime, Financial Business, Financial Crisis, Financial Times, Fiscal Crises, Fiscal Deficits, Households, Incomes, Martin Wolf, Portfolio Flows, Surpluses, Symbiotic Relationship, Tides, Trading Partners, Yuan
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Why Didn’t Canada’s Housing Market Go Bust?

Friday, December 4th, 2009

The following is a guest contribution by James MacGee of the Federal Reserve Bank of Cleveland. Mr. MacGee is an associate professor at the University of Western Ontario and a research associate at the Federal Reserve Bank of Cleveland.

by James MacGee

Housing markets in the United States and Canada are similar in many respects, but each has fared quite differently since the onset of the financial crisis. A comparison of the two markets suggests that relaxed lending standards likely played a critical role in the U.S. housing bust.

Despite their many points of similarity, housing markets in the United States and Canada have fared quite differently since the onset of the financial crisis. Unlike the U.S., Canada has not experienced a dramatic increase in mortgage defaults, nor has any Canadian bank required a government bailout. As a result, observers such as The Economist have pointed to Canada as “a country that got things right.”

The different housing market outcomes in Canada and the U.S. can tell us something about the underlying causes of the housing boom and subsequent bust. In particular, they can be used to evaluate the roles that low interest rates and relaxed lending standards played in the boom and bust.

Some observers blame monetary policy for lowering interest rates over 2002–2005, pushing up housing demand, increasing residential investment, and raising housing prices. In this view, the monetary-policy-induced housing boom thus set the stage for an inevitable housing bust.

Others contend that relaxed lending standards, highlighted by the rise in subprime lending, played a critical role. This loosening of standards led to an increase in housing demand, as mortgages were issued to households that were likely to have trouble making the mortgage payments. This extension of credit to risky borrowers helped fuel a housing boom and set the stage for the resulting surge in defaults, which were a big factor in the housing “bust.”

The Canada and U.S. housing market comparison suggests that relaxed lending standards likely played a critical role in the U.S. housing bust. Monetary policy was very similar in both countries from 2000 to 2008, but housing prices rose much faster in the U.S. than in Canada. This suggests that some other factor both drove the more rapid appreciation in U.S. prices and set the stage for the housing bust. A likely candidate is cross-country differences in the structure and regulation of subprime lending markets. That mortgage delinquencies began to climb before the recession in the U.S. but only began to rise recently in Canada (after the economic slowdown began), points to the significance of those structural and regulatory differences in explaining the U.S. housing crash.

Canadian and U.S. Housing Market Trends

Canada and the U.S. experienced significant increases in house prices and residential investment from 2000 to 2006, though prices in Canada appreciated more slowly. Figure 1 plots the S&P/Case-Shiller 20 city composite index and the (Canadian) Teranet-National Bank 6 city composite index. Both series are based on repeat sales, making these series a closer approximation to a “constant-quality” price index of nominal home prices than average house price sales. The Case-Shiller and Teranet series indicate that over 2000–2006, U.S. prices appreciated nearly twice as much as Canadian houses. However, Canadian house prices continued to appreciate until late 2008, and are now nearly 80 percent higher than in 2000.

1. Housing Prices

Sources: S&P/Case-Shiller (20-city) for U.S. house prices and Teranet (6-city) for Canadian.

The counterpart to rapid house price appreciation has been an increase in the ratio of mortgage debt to disposable income. While the comparison is complicated by different definitions of the household sector and debt categories in the Flow of Funds accounts, the trends are similar to those of house prices. Between 2000 and 2006, the ratio of mortgage debt to disposable income in the U.S. increased by roughly 50 percent, jumping from two-thirds to over 100 percent. In Canada, the increase was roughly half as large, with the debt-income ratio moving from 70 to 90 percent.

The potential risks of increased household mortgage debt depend critically upon its distribution across borrowers. To see how the distribution of mortgage debt has changed we examine the distribution of the ratio of the outstanding loan to house value (the LTV) of borrowers. A high LTV implies that a small decline in the house price would leave the owner with negative equity. Negative equity is problematic as it removes the option for a homeowner who is unable to meet their mortgage payments to sell their home to repay the mortgage.

As figure 2 illustrates, Canada has significantly fewer households with LTV ratios above 80 percent than the U.S. Before the housing bust, roughly 21 percent of American households with mortgages had LTV ratios above 80 percent, versus 15 percent of Canadian households. Restricting attention to households with LTV above 90 percent the comparison is even more striking: roughly 12 percent in the U.S. versus just over 6 percent in Canada.

2. Distribution of Mortgages by Loan-to-Value Ratio (percent)

Sources: Bank of Canada Financial System Review December 2007; American Housing Survey. The American Housing Survey reports the ratio of all outstanding mortgages (excluding home equity lines of credit) to the value of the house.

A surprising fact about these LTV ratios is how little the distribution of U.S. mortgages by loan-to-value changed during the housing boom. This is surprising given that the rapid house price appreciation acted to lower the LTV ratios of existing mortgages. Working in the opposite direction were two forces. First, some households undid the effect of higher house prices by extracting equity. Second, the rise in subprime and Alt-A mortgage originations from roughly 1.4 million in 2003 to 3 million in 2005 was accompanied by an increase in the median LTV of new subprime mortgages from 90 percent to 100 percent (as documented in Mayer, Pence, and Sherlund, 2009).

While broadly similar trends were occurring in house prices and mortgage debt in the U.S. and Canada, very different patterns of mortgage delinquencies and defaults were emerging. The best available comparison is for delinquencies on prime mortgages (which account for the bulk of mortgage credit) in the two countries (figure 3). Prior to 2006, delinquencies were comparable in both countries (and were slightly higher in Canada). While delinquencies increased more than four-fold in the U.S. after 2007, as of mid 2009 there has been little sign of an increase in mortgage delinquencies in Canada. A similar story holds in the subprime market. Researchers Mayer, Pence, and Sherlund reported that 8 percent of the U.S. subprime mortgages originated in 2007 had defaulted after 12 months, as opposed to 1.5 percent over 2000–2004. The available Canadian data also features an increase in subprime mortgage delinquencies, but the delinquency rate in 2007 was still under 2 percent, according to the Financial System Review in June 2008.

3. Mortgage Delinquency Rates (90+ days delinquent)

Sources: Mortgage Bankers Association. National Delinquency Survey.
Notes: The delinquency rate is the number of mortgages past due as a percent of the total number of mortgages at the end of the period. The delinquency rate does not include loans in the process of foreclosure.

These different patterns in delinquencies occurred during a period of similar macroeconomic performance. Unemployment rates were stable throughout 2007 and early 2008, at roughly 5 percent in the U.S. and 6 percent in Canada. The timing of the recent deterioration in labor markets has also been similar, with unemployment rates rising to 9.4 percent (U.S.) and 8.6 percent (Canada) by July 2009. What these data reveal is that mortgage delinquencies began to increase in the United States before the rise in unemployment, but in Canada they remained low and only began to increase after the rise in unemployment in 2008. That difference is a key clue to determining what caused the housing bust.

Monetary Policy and the U.S. Housing Bust

The low interest rate policy of the Federal Reserve over 2001–2005 is often cited as a key factor in the U.S. housing bust. The main narrative is that by lowering short-term interest rates, the Federal Reserve pushed down (longer-maturity) mortgage interest rates. This policy increased demand for housing, leading to upward pressure on housing prices, which encouraged builders to ramp up construction of new homes. This led to an “oversupply” of new homes, which triggered the housing bust.

The claim that interest rates were too low over 2001–2005 is motivated by a couple of observations. First, the federal funds rate was low by historical standards: declining from over 6 percent in early 2001 to 1 percent in 2003 and remaining low until 2005 (see figure 4). Second, interest rates over this period were much lower than those predicted by the Taylor rule for monetary policy (which relates the Federal Reserve target rate to inflation and GDP) over 2002 to 2006.

The Bank of Canada also made dramatic reductions in its target interest rate over 2001–2002. One might argue that Canadian monetary policy was not quite as “loose” as that in the U.S. as it maintained a higher overnight rate over 2002 to 2004. But a case can be made that Canadian and American monetary policy were very similar, at least in terms of the housing market. Ahrend, Cournede and Price (2008) estimate deviations from the Taylor rule for Canada and the U.S. over 2001–2006 and find that the cumulative deviations were nearly identical.

4. Central Bank Target Rates

Source: Mortgage Bankers Association. National Delinquency Survey.

In addition, mortgage interest rates—the main direct channel through which monetary policy impacts the housing market—tracked each other closely in the two countries. Unlike the U.S., where the mainstay of the mortgage market is the 30-year fixed mortgage, the most common mortgage product in Canada is a five-year fixed rate mortgage (with a 25-year amortization period). As figure 5 illustrates, the two benchmark mortgage interest rates move closely with one another until after the beginning of the U.S. housing market crisis, when U.S. rates fall significantly below Canadian rates.

5. Benchmark Mortgage Interest Rates

Source: International Monetary Fund,International Financial Statistics, COFER data.

The similarity of the impact of monetary policy and the absence of a housing market bust in Canada suggest that some other factor must have been present in the U.S. to generate the boom and bust. This is not to suggest that “loose” monetary policy did not put upward pressure on housing prices—indeed, both Canada and the U.S. experienced substantial levels of house price appreciation. However, the Canada-U.S comparison suggests that some other factor drove both the more rapid house appreciation and set the groundwork for a U.S. housing bust.

Relaxed Lending Standards: Different Subprime Lending Booms

The other leading explanation of the housing boom and bust relies critically on relaxed lending standards. This story is linked to the dramatic rise in subprime lending and high levels of loan securitization, which some commentators have argued reduced the incentives for mortgage originators to maintain underwriting standards. This is one area where there was a significant difference between the two countries, both in the size and nature of the subprime market and in the fraction of mortgages securitized.

The subprime markets in the U.S. and Canada include households with tarnished credit histories as well as borrowers with difficult-to-document income sources. Subprime lending has grown rapidly in both countries, though the magnitude has been far more striking in the U.S. While subprime mortgages accounted for less than 5 percent of mortgage originations in the U.S. in 1994, a fifth of all mortgages originated between 2004–2006 were subprime, according to data reported by James Barth in 2009.

But while subprime lending also increased in Canada, the subprime market remains much smaller than in the U.S. The most cited estimate is that subprime lenders had a market share of roughly 5 percent in 2006—compared to 22 percent in the U.S. (Mortgage Architects, 2007). Moreover, the Canadian subprime market never expanded significantly into newer products, such as interest-only or negative-amortization mortgages, whose popularity grew rapidly in the U.S. from 2003 to 2006. Instead, the Canadian subprime market mainly offered products popularized in the U.S. during the 1990s, such as longer amortization periods for loans (from 25 to 40 years), and mainly targeted near-prime borrowers.

Securitization has also been less common in Canada than in the United States, with roughly 25 percent of Canadian mortgages securitized in 2007 versus nearly 60 percent in the U.S. The Canadian securitization market has grown rapidly over the past decade, rising from roughly 5 percent of mortgages in 1998 to over 25 percent in 2008. However, in many ways, the Canadian market resembles the early stages of the U.S. mortgage securitization market, as most securitized mortgages in Canada are backed by an explicit government guarantee. This government guarantee requires limits on borrowers’ debt-service ratios and amortization periods, which makes it more difficult for lenders to offer some types of subprime loans.

The different magnitude of the subprime lending boom in the two countries is consistent with differences outlined above between the Canadian and U.S. housing markets over the past 10 years. The rapid growth of the subprime market provided an additional boost to demand in the U.S. that is consistent with the more rapid house price appreciation in the U.S. than in Canada.

The subprime story is also consistent with the different pattern of mortgage delinquencies in Canada and the U.S. In the U.S., mortgage delinquencies for both prime and nonprime mortgages began to rise before the recession began and unemployment rates began to climb. In contrast, mortgage delinquencies in Canada have only recently begun to increase—after unemployment rates started rising and the Canadian and world economies slowed sharply in the fall of 2008.

Finally, the relaxed lending story is consistent with the fact that the U.S. experienced a housing bust over 2007–2009 while Canada did not. While the expansion of subprime lending provided a temporary boost to housing price growth rates, when prices stopped rising, the inability of some borrowers to refinance homes they could not afford led to a spike of delinquencies. The resulting increase in liquidation and foreclosure sales put additional downward pressure on house prices, which in turn pushed more borrowers into default. This “negative feedback” cycle helped push a correction in the housing market into a housing bust.

One possible critique of this argument is that while Canada has not yet experienced a housing bust, it is likely to experience one in the next year. Indeed, a recent Merrill-Lynch-Canada report noted that Canadian house prices over the past decade closely resemble U.S. house prices with a two-year lag (see figure 1). Based on this, they concluded that Canada was also likely to experience a large decline in house prices over the coming year. Canada’s smaller subprime market share and fewer households with high LTV ratios, however, suggest that the country is less likely to see the rapid increase in defaults that helped trigger the bust in U.S. housing prices. So far the incoming data suggest that the Canadian housing market is likely to experience a housing market slowdown rather than a bust.

Why Was the Subprime Market in Canada Smaller?

Given the key role played by the “subprime” market, the question is why the Canadian subprime market was both smaller and levels of securitization were lower than in the U.S. While it is difficult to disentangle the reasons why Canada avoided the subprime boom, some factors can be identified that may have contributed to the differences in the Canadian and U.S. subprime markets.

Perhaps the simplest story is that Canada was “lucky” to be a late adopter of U.S. innovations rather than an innovator in mortgage finance. While the subprime share of the Canadian market was small, it was growing rapidly prior to the onset of the U.S. subprime crisis. In response to the U.S. crisis, some subprime lenders exited the Canadian market due to difficulties in securing funding. In addition, the Canadian government moved in July 2008 to tighten the standards for mortgage insurance required for high LTV loans originated by federally regulated financial institutions. This further limited the ability of Canadian banks to directly offer subprime-type products to borrowers.

There are also several institutional details that played a role. The Canadian market lacks a counterpart to Freddie Mac and Fannie Mae, both of which played a significant role in the growth of securitization in the U.S. In addition, bank capital regulation in Canada treats off-balance sheet vehicles more strictly than the U.S., and the stricter treatment reduces the incentive for Canadian banks to move mortgage loans to off-balance sheet vehicles. Finally, as noted above, the fact that the government-mandated mortgage insurance for high LTV loans issued by Canadian banks effectively made it impossible for banks to offer certain subprime products. This likely slowed the growth of the subprime market in Canada, as nonbank intermediaries had to organically grow origination networks.

A Challenge for Policymakers

The Canada-U.S. comparison suggests the low interest rate policy of the central banks in both countries contributed to the housing boom over 2001–2006 and that a relaxation of lending standards in the U.S. was the critical factor in setting the stage for the housing bust. A caveat worth emphasizing, however, is that the Canada-U.S. comparison tells us little about what would have happened if U.S. monetary policy had been tighter earlier. Tighter monetary policy in the early part of the decade may have helped to limit the subprime boom by slowing the rate of house price appreciation over 2002–2006. The Canada-U.S. comparison does, however, highlight the practical challenge facing policymakers in assessing whether a rapid run-up in asset prices is a bubble or a “sustainable” movement in market prices.

Recommended Reading

“Monetary Policy, Market Excesses and Financial Turmoil”, by Rudiger Ahrend, Boris Cournede, and Robert Price (2008). OECD Economics Department Working Paper No. 597.

The Rise and Fall of the U.S. Mortgage and Credit Markets, by James R. Barth (2009). Milken Press.

“Rebuilding the Banks,” The Economist, May 16, 2009.

“The American Mortgage Market in Historical and International Context,” by Richard Green and Susan Wachter (2005). Journal of Economic Perspective, 19(4), 93–114.

“The Rise in Mortgage Defaults,” by Christopher Mayer, Karen Pence, and Shane Sherlund (2009). Journal of Economic Perspectives, 23(1), 27–50.

“Comparing the Canadian and U.S. Subprime and Alternative Mortgage Markets: Why the U.S. Subprime Fallout Is a U.S.-only Phenomenon,” Mortgage Architects (2007). <http://files.newswire.ca/40/MASubprime.pdf, accessed: June 15, 2009.>

Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, by John B. Taylor (2009). Hoover Institutions Press.

“Structure of the Canadian Housing Market and Finance System,” by Virginia Traclet ( 2005). Background paper prepared for CGFS Working Group on Housing Finance in the Global Financial Market.

“The Tipping Point?” by David D. Wolf and Carolyn Kwan (2008). Merrill Lynch Canada, Economic Commentary.

Tags: Bailout, Boom And Bust, Borrowers, Canada, Critical Role, Dramatic Increase, Federal Reserve, Federal Reserve Bank, Federal Reserve Bank Of Cleveland, Financial Crisis, Housing Market, Low Interest Rates, Macgee, Market Outcomes, Monetary Policy, Mortgage Defaults, Mortgage Payments, oil, Research Associate, Residential Investment, Similarity, University Of Western Ontario
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Eliot Spitzer’s New Crusade Against Obamanomics

Friday, November 20th, 2009

Are Obama’s economic policies actually working? Eliot Spitzer says No!

Spitzer is taking aim at the [Obama} administration’s approach, accusing it of shying away from the kind of comprehensive reform that the financial system needs. The Obama administration is not so different from the Bush administration, at least so far as their approach to the banking crisis goes, he claimed:

“The fundamental error of this administration is that it is continuity. They have embraced the Bush Administration view that if you solve the problem of big banks everything else flows from that. They are wrong. Too big to fail is too big. They don’t get it. The only two people I know who don’t appreciate that are Tim Geithner and Larry Summers. Paul Volcker, Alan Greenspan, Henry Kaufman, Mervyn King — every major academic has said, We must get rid of too big to fail.”

Watch Spitzer make his case against Obama’s effectiveness as manager of the financial crisis below:

Eliot Spitzer arguing against Obamanomics from Intelligence Squared US on Vimeo.

Tags: Alan Greenspan, Banking Crisis, Banks, Bush Administration, Case Manager, Continuity, Economic Policies, Eliot Spitzer, Financial Crisis, Fundamental Error, Henry Kaufman, Intelligence, Larry Summers, Mervyn King, New Crusade, Paul Volcker, Taking Aim, Tim Geithner, Watch Case
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