Some will point to smaller countries that suffered rampant inflation after their central banks printed money but we have more in common with Japan, what was the 2^nd largest economy in the world.  In this article we will try to carefully look at research on the Japanese boom and bust and also take a look where we stand in our current financial crisis.

Source:  The Economist

The first definite comparison we can make is with the rampant rise in home values.  Japanese real estate values saw a massive ten year boom during the Heisei boom.  The chart above clearly shows the trajectory of land values.  Yet research shows that a large part of this was concentrated on a few urban cities.  In this regard, the U.S. had a much larger and more pervasive boom impacting multiple cities across the nation like Miami, Las Vegas, New York, Los Angeles, San Francisco, Phoenix, and many other locations.  If we separate Tokyo out we see that overall Japan did have a bubble but it doesn’t seem as large or as widespread:

Source:  Debt Deflation

The above is an interesting chart because it reflects a concentrated urban bubble.  We had many suburbs popping up with home builders trying to create demand where there was nothing more than a bubble to chase.  Many of these areas including the Inland Empire in California have large homes selling for half off (or more) with very little demand chasing after the homes.  It is an interesting case study as to why values go up so quickly but miscalculations by the Federal Reserve and misguided policies led to the biggest and most widespread housing bubble here in the United States.

A 2003 paper by the Bank for International Settlements (BIS) focused on the Japanese housing bubble and concluded the following:

“What should be noted regarding Japan’s experience is that the enthusiasm of market participants, together with the inconsistent projection of fundamentals, contributed to a large degree to maintaining temporarily high asset prices at that time. Such enthusiasm is often called euphoria, excessively optimistic but unfounded expectations for the long-term economic performance, lasting for several years before dissipating.”

“It was thus excessive optimism rather than consistent projection of fundamentals that mainly supported temporarily high asset prices.”

There is little to debate that what fueled housing prices in the U.S. was also ignited by euphoria for real estate that was largely disconnected from fundamentals.  Let us construct a chart similar to the above with Tokyo and Japan but in this case, we will look at the Los Angeles MSA and the 10 city composite from the Case Shiller data:

Although it would appear that Tokyo had a much quicker and faster rise in prices, an area like Los Angeles saw a very similar trend.  Yet what separates the two bubbles is that the U.S. as an entire nation also saw a massive rise in prices over a short period of time.  Looking back, we see that the peak for U.S. housing values was reached in 2006 with the Los Angeles MSA also reaching a peak in this year.  The chart above shows the clear decade long boom in housing values.  What we find over this decade period is that home values in the U.S. increased by a factor of 3 while home values in L.A. increased by a stunning factor of 4.  In other words, the U.S. housing bubble was equally as large in magnitude as that faced by Japan but much more widespread.

The BIS paper also makes the comparison that Japan faced nearly two decades of bubbles, one started in the stock market followed by the real estate bubble:

“First, at the time of the Iwato boom, when Japan’s economy entered the so-called “high economic growth period”, asset prices increased rapidly, reflecting an improvement in fundamentals due to technological innovations. The real economic growth rate exceeded 10% per annum, driven mainly by investment demand due to technological innovations that replaced the post World War II reconstruction demand. On the price front, consumer prices rose while wholesale prices remained generally stable, thus leading to the so-called “productivity difference inflation”.

“Kakuei Tanaka, who became Prime Minister in 1972, effected extremely aggressive public investment based on his belief (remodelling the Japanese archipelago) that it was necessary to resolve overpopulation and depopulation problems by constructing a nationwide shinkansen railway network, which led to an overheated economy.”

This economy is largely seen by the charts below:

We have a very similar parallel here with our NASDAQ boom of the 1990s followed by the real estate boom reflected on the previous chart looking at Case Shiller home values.  If we look at the NASDAQ, we realize that even after the recent boom in stock values prices are nowhere near their peak:

On a nominal level the NASDAQ is still off by 55 percent from the peak reached a decade ago.  Often we hear about the lost decade comparison.  In stock values, we are already there.  In terms of real estate values, we are quickly approaching that point.  So we have more similarities in our booms and busts with Japan than many would like to admit.  The 1990s saw a rise also in productivity brought on by technological innovation but this also paved the wave for an economy largely decentralized on a global level.  This hit hard in the manufacturing core of our country.  Someone made the argument to me at the height of the real estate boom that “you can’t outsource real estate” which is true but that is a double edged sword as we are seeing.  The Nikkei peaked on December 29, 1989 closing at 38,915.87.  Today it stands at 9,431, a drop of over 75 percent.  Massive bubbles can have long lasting impacts on the economy.

Missing asset bubbles and targeting inflation

Another important comparison made in the paper is that of perceived stable inflation and how central banks can miss asset bubbles while they are happening.  It is the mistaking of a bubble for real economic growth:

“Third, in the Heisei boom, asset prices increased dramatically under long-lasting economic growth and stable inflation. Okina et al (2001) define the “bubble period” as the period from 1987 to 1990, from the viewpoint of the coexistence of three factors indicative of a bubble economy, that is, a marked increase in asset prices, an expansion in monetary aggregates and credit, and an overheating economy. The phenomena particular to this period were stable CPI inflation in parallel with the expansion of asset prices and a long adjustment period after the peaking of asset prices.”

“The decline in asset prices was initially regarded as the bursting of the asset price bubble, and an amplifying factor of the business cycle. Although the importance of cyclical aspects cannot be denied, further declines in asset prices after the mid-1990s seem to reflect the downward shift in the trend growth rate beyond the boom-bust cycle of the asset price bubble.”

This is an important key point.  The Federal Reserve publicly stated that during the bubble (it wasn’t labeled as such) that inflation overall remained tame and therefore keeping interest rates low was viewed as a prudent policy.  If the economy is growing and is stable, then the central bank should keep liquidity flowing into the system to keep building up legitimate businesses.  Yet separating real growth with an asset bubble can be tricky especially when the policies taken are part of the reason for the asset inflation.  Japan viewed there measures as stable.  We did this in a similar fashion but part of it was that our metrics to measure inflation largely missed the housing bubble.  The CPI measures “owners equivalent of rent” which completely ignored the rise in home values.  This measure is the biggest in the CPI so the data was skewed.  Also, innovation in mortgage products with teaser payments altered the true monthly payment and understated it.  The government for most of this time also only focused on OFHEO (now FHFA) which only looked at home loans secured by Fannie Mae and Freddie Mac and ignored the vast majority of subprime Alt-A, and option ARMs that fueled the last stage of the housing bubble.  In fact, year over year changes in the inflation measure from 1980 to 2000 seemed to be as stable as they come:

During this time we saw the massive NASDAQ bubble and also, the subsequent real estate bubble.  Inflation data largely ignored most of it because the measure was flawed when it came to measuring bubbles.  Japan had similar problems and taking policy decisions on this data has given their economy two lost decades and their economy is still suffering.  Then why follow that same path?

Japan gives us a working sample as to what can happen with asset deflation, a stock bubble popping, allowing banks to remain propped up by government funding, and massive government spending:

*Japan asset, stock and CPI measures

Some seem to think that Japan just sat back and did nothing during this time.  There is nothing further from the truth.  Japan was the first major economy to go down the path of quantitative easing.  Japan also injected enormous amounts of money into their economy to stimulate growth.  Yet the above chart is rather clear in the outcome.  Some point to unemployment in Japan remaining low.  This is more a sleight of hand with economic data.  Although the official rate is low, nearly 1 out of 3 Japanese workers are considered part-time employed.  That is, no security of long-term employment.  We have seen a massive rise in the number of Americans that now work in a part-time fashion.  No benefits, lower wages, and job security that is no longer an option in the longer term.  It is easy to see why asset prices in Japan have remained depressed for so long.  Prices in the U.S. are showing no sign of inflationary pressures because there is little mechanism to force wages up with such a giant over supply of labor in the market.  This is possibly one of the major points missed by those who predict inflation or hyper-inflation in the future.  Central banks can print but they can’t force wages up especially in a global market where cheap wages are the status quo.  To the contrary, banks are following the zombie like behavior of Japan banks by hoarding funds:

Now that we’ve had three full years after the bubble popped, we can see what banks have done to “fix” the problem:

-Hoard money to fix balance sheet imbalances

-Suspend mark to market (Japan banks zombie like tool of preference)

-Ignore major commercial real estate problems

-Drag out the real estate problems (we have done the same with banks delaying the foreclosure process, stopped lending their own capital in place of government loans, and banks have turned inward with government bailout funds).

The above chart shows that banks are still sitting on an enormous amount of excess reserves.  Now that due diligence is back (to a certain degree) who are banks going to lend to?  4 out of 10 workers in the U.S. are employed by the low paying service sector.  Close to 15 million are officially unemployed and unless we go back to the easy lending mortgage days, they won’t be getting any bank money soon.  We have another 9 million workers that are employed part-time for economic reasons (similar to the large employment base of Japan).  You think this group is going to get a loan for a home anytime soon?  Banks have turned their profits inward while the real economy is largely in stagnation.  Yet if Japan is any indicator, these profits will start to go down:

While it is easy to make money right now since a large part of the competition has failed while a select few have been given government backing and funding, as time goes on this profitability goes away.  And the real economy in Japan has languished all this time.  The BIS paper in 2003 gives a wonderful synopsis of what led to the Japanese boom and bust economy:

“The intensified bullish expectations were certainly grounded in several interconnected factors. The factors below are often pointed out as being behind the emergence and expansion of the bubble:

• aggressive behaviour of financial institutions

• progress of financial deregulation

• inadequate risk management on the part of financial institutions

• introduction of the Capital Accord

• protracted monetary easing

• taxation and regulations biased towards accelerating the rise in land prices

• overconfidence and euphoria

• overconcentration of economic functions in Tokyo, and Tokyo becoming an international financial centre

Focusing on monetary factors, it is important to note the widespread market expectations that the then low interest rates would continue for an extended period, in spite of clear signs of economic expansion. The movement of implied forward rates from 1987 to 1989 (Figure 5) shows that the yield curve flattened while the official discount rate was maintained at a low level.”

You might as well put this label on the U.S.  Aggressive behavior of financial institutions?  Doesn’t get more aggressive than giving a loan to someone with no job and no income.  Progress of financial deregulation?  What about repealing Glass-Steagall in 1999, protection we had put in place back from the Great Depression.  Inadequate risk management?  We need only look at AIG, Lehman Brothers, Bear Stearns, Fannie Mae and Freddie Mac, and many others.  Protracted monetary easing?  Does a zero percent interest rate and buying up of mortgage backed securities count?  Taxation and regulations biased toward rising prices?  How about giving new home buyers a tax credit when they were going to buy anyway?  Over confidence and euphoria?  Just go to YouTube and watch some of the real estate commercials from the peak days of the housing bubble.

We have a lot that is similar to Japan and their boom and bust economy.  If their path is any indication of our own, we have a long road ahead and getting home prices back up is probably going to be the least of our concerns.

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“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.”

-Ernest Hemingway

Anyone thinking that breaking a one-dollar bill into four quarters is a method of creating more money is simply trying to create something out of thin air.  Yet that is the path that we are following.  The Federal Reserve and U.S. Treasury who seem to be tempting the ire of the demons of inflation are now targeting the U.S. dollar with every weapon in their arsenal.  As a nation, we still have a difficult time realizing that we have consumed too much for too long and debt only provided an illusion of prosperity.  Some time ago, I walked into a staged open house.  In the air the smell of bread baking, beautiful furniture adorned each room, and what would any home be without a nice mounted flat screen television?  Yet none of this was real.  The visceral feeling of this staging of course is to give you an idea of what you want.  Or better yet, what you don’t have and should buy.  The advertising machine is designed to keep you perpetually wanting.  The staged home visually makes you forget the dollar and cents of the deal.  Those that control the levers of power of our economic system have decided that tempting inflation is a small price to pay to continue on a spending spree that is clearly unsupportable.

Ernest Hemingway understood the problems of inflation even though an economist he was not.  In fact, many countries have been burned by massive eras of inflation.  Just ask Germany or Zimbabwe what printing money at a feverish pitch does to your economy eventually.  As I have pointed out, we have seen an extraordinary amount of wealth destruction over the past 20 months.  Some estimates have global wealth declining from $40 to $50 trillion; this has decreased with the recent rally.  Yet the fact of the matter is much wealth is no longer filtering itself through the plumbing of our global economy.

So what is the impetus of the recent rally?  How can a market move up so vigorously when the fundamentals like deficits and unemployment seem to be rising with no end in site?  The market is currently believing that the masters of the universe can summon the inflation genie out of the bottle and somehow put it back in once all things are cleaned up.  That is the kind of hubris that brings down entire countries or puts then on a path of mediocrity.  To think that the global economy can be systematically managed by a few people is on par with thinking we had no debt problems in early 2007 as many key leaders voiced.  To understand where we currently stand, let us take a look at historical data with the CPI:

As you can see from the chart above, the CPI almost went negative on a year over year basis.  Much of this had to do with a collapse in energy prices but also a decline in auto sales and the fall of prices in many things including commodities.  This sounds more like the echoes of deflation.  The CPI measures consumer price inflation.  That is, the price of goods.  We can get caught up in Austrian arguments about money and inflation or deflation but for our purposes, we are talking about consumer good inflation and deflation.  For the last 20 months, we have seen across the board consumer price deflation.  What items have been falling in price?  Let us list them:

-Housing

-Energy

-Automobiles

-Commodities

-Stocks

In fact, it is hard to find anything that has gone up in price.  Yet much of this has to do with the stubbornness of the U.S. dollar to yield to currency manipulation and also the myth of decoupling has fallen flat on its face and people have fled to a safe haven, which is still the U.S. dollar.  With all this spending, the U.S. dollar has stood up relatively well:

After 20 crazy months of volatility, the U.S. dollar is virtually unmoved from when the crisis started in August of 2007.  Yet now that the global markets realize that decoupling is unrealistic at least for now, markets are adjusting to this reality.  In addition, the Fed’s new policy of buying treasuries outright is keeping rates on bonds unattractive for foreign investors.  Many are only buying them because of the global flight to safety.  But what happens if rates suddenly start to push up?  A fascinating thing is happening with the Fed buying up this paper.  That is, the rates have actually moved up a few times!  Auctions have been weak because who in their right mind is going to lock in a rate of 2.7 percent for 10 years?

We have committed over $12 trillion in multiple programs to prop up the economy.  This is the equivalent of nearly one year of U.S. GDP.  Yet the problem with this commitment is 80 percent of the money is targeted to banks and Wall Street.  The $700+ stimulus bill that was passed should have really been called a relief bill.  It was needed.  Yet it was merely a mixture of tax cuts, extension on unemployment insurance, funds for various programs, and additional funds to keep programs going.  There really wasn’t much left to create a NASA like program to launch a new workforce.  It was a tiny consolation prize to the public for $11 trillion of gifts to banks and Wall Street.

Committing so much money to the financial sector may in the end become our undoing.  It is obvious to anyone with two eyes that there is no inflation on the horizon.  Yet close to $4 trillion of that money has been used leaving nearly $8 trillion untapped.  We have deficits in budgets that project out until 2018.  If we did not have the status of reserve currency and were any other country, would you really funnel your money here?  Would you as an investor, give money to a person that has maxed out his credit cards, has been late on their auto loan, is arrears on their mortgage, only on the basis that they were once able to pay it?  This isn’t to say other countries are immune.  In fact, the countries of Europe are equally, if not in more dire problems.  They bought into this same form of financial driven market economies.

How quick can inflation hit?  Just take a look at inflation in Germany during the early 1920s:

There have been many cases of currencies collapsing leading to hyperinflation.  Shanghai in 1949, Argentina in 1989, and recently in Iceland.  But what caused the hyperinflation in Germany during the 1920s?  Well initially the government suspended the ability for banknotes to be converted to gold.  Eventually the government was freed from any restraint to print money at will and this they did to finance the war.  Of course prices rose with all the printing.  By 1918 the mark had fallen more than 50 percent against the dollar.  As time went on, even from 1919 to 1923 the government continued to run massive deficits.  The tax rate never was higher than 35 percent of expenditures.  So this gigantic gap was covered by immense money printing.  It also didn’t help that their were massive reparations to the Allied Powers.  In the end, the German government defaulted on reparation payments.  And as the chart above shows, things went from bad to horrific rather quickly.  In fact, in early 1923 unemployment was modest yet by October 19 percent of metal workers were out of work and many others were only working part-time.  When prices stabilized the damage had been done and so had the impact on the psyche of many in the country.  Many blamed international financiers for the problems they were facing.

This isn’t too say we are even remotely close to seeing this.  But you cannot print money at full speed and expect that nothing will change.  Eventually, these actions should cause the U.S. dollar to lose further value and that will make Ben Bernanke the happiest man in the world.  He would love to see nothing more than to see inflation.  Why?  This would make our massive debt seem cheaper and cheaper as time went by.  The debt remains fixed while more money flows into the system.  Bernanke has made it abundantly clear that he will do everything he can to prevent deflation.  Yet Japan did everything it could during its lost decade and land values in many areas saw prices decline by 80 percent from peak to trough.  And what has this left Japan with?  One of the largest amounts of government debt of the global large economies:

Now we are a long way from Japan but we are heading down that path.  Let us take a look at the impact of stimulus:

This chart doesn’t really highlight the entire story since this is government debt held by the public.  In the U.S. we have a sizable chunk of debt held by foreigners.  As we have also mentioned, with $12 trillion committed to various programs, we can expect our debt to explode in the next few years.  So what has Japan garnered from this massive amount of spending?

Many don’t realize that over this timeframe Japan spent $5.5 trillion in stimulus, or 180 percent of their GDP.  And the stock market slowly has fallen for nearly 20 years with short term moves up but overall a lower price level and an economy where nearly 1 out of 3 are part-time workers.  Sure, unemployment is low but a large number are transient employed.

We have yet to see major down moves with the U.S. dollar because every other country is on a race to zero.  We are simply outpacing each other.  Yet what happens when we hit zero as many have?  Quantitative easing?  How is that going to play out?  These are all things yet to be seen.  There is no example in a global crisis where the solution was simple.  I have yet to see an example that shows us that inflation is the healthy way out.  The genie is out of the bottle but will it listen to us once we need to put it back in the bottle?

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This economic crisis has been building over 3 decades with the last ten years being the apex of crony capitalism.   You would think that we would learn our lessons and are still rubbing the fresh blue and purple bruises from this given we are still in the path of the economic hurricane.  Nope.  Instead, we go for the low hanging fruit and pick off the country scapegoat, the American automakers to feed the masses some red meat.  What about Ken Lewis of Bank of America or Vikram Pandit of Citigroup?  The amount of money they have received from the government would make the loans to the automakers look like a bill from a night out by the firm at a local Manhattan bar.

The double standard is alive and well.  Who is going to argue about ousting the CEO of GM?  That was an easy call and most would concur with the move.  And enough with this “…but the government is getting involved and that is scary!”  Yeah, that is what happens when you come begging for government money.  You don’t want to be told what to do?  Easy.  Don’t ask or touch any government (aka taxpayer) funds.  My only suggestion is this political capital and energy should be directed at the main culprits of this economic and global calamity, Wall Street and the banking system.  Simon Johnson, a former chief economist of the International Monetary Fund gives us a taste of how sausage is made and it confirms much of our beliefs in The Quiet Coup published in The Atlantic.  It is a lengthy read but well worth your time.

So back to our topic of the new toxic loan breeding ground.  What got us into this mess is an entire system designed to be corrupt and full of short sighted workers only looking out for their own good while putting the majority of the population at risk.  Leveraging the future for a short term fix. Finance, at least in an ideal sense should be nothing more than a tool to keep the real economy growing and expanding at a sustainable level.  A method of allocating resources to the best uses.  In the system that is crashing finance was seen as part of the “real” economy and became much too big where now, the real economy is imploding.  Someone once told me, “there are a few rotten apples in the barrel.”  I responded, “not only are most of the apples rotten, the barrel itself is being gnawed away by termites.”  Most people now see this is the case with the edifice of our financial system crashing and burning in a horrific spectacle.  After the subprime and alternative mortgage world imploded, the government has now stepped in to be the uber player in the mortgage markets making up for much of the lost volume from the questionable mortgage sector.  The funny thing is many of those toxic mortgage dealers went ahead and got trained in FHA and government loans and now work pumping out government toxic waste:

The demand for FHA loan processors has skyrocketed.  At least we know someone in the sausage factory is hiring!  The reason is that many FHA loans require only 3 to 5 percent down.  As I have discussed in a previous article regarding Seller Funded Down payment Assistance Programs, this has taken the place of many of those no money down loans.  So yes, maybe adjustable rate mortgages are out and no-doc loans are out but knowing that those with no skin in the game default at higher rates, why in the world would we continue pushing programs like this?  The private sector did an abysmal job for a decade with these loans.  Why are we now going to take this and apply this to government backed loans?  It simply does not make sense.  And right on time FHA insured loans are skyrocketing:

“(WSJ) Defaults on home mortgages insured by the Federal Housing Administration in February increased from a year earlier.

A spokesman for the FHA said 7.5% of FHA loans were “seriously delinquent” at the end of February, up from 6.2% a year earlier. Seriously delinquent includes loans that are 90 days or more overdue, in the foreclosure process or in bankruptcy.

Since the collapse of the subprime mortgage market in 2007, most home loans for people who can’t afford a sizable down payment are flowing to the FHA. The agency, which is part of the U.S. Department of Housing and Urban Development, insures mortgage lenders against the risk of defaults on home mortgages that meet its standards. FHA-insured loans are available on loans with down payments as small as 3.5% of the home’s value.

The FHA’s share of the U.S. mortgage market soared to nearly a third of loans originated in last year’s fourth quarter from about 2% in 2006 as a whole, according to Inside Mortgage Finance, a trade publication. That is increasing the risk to taxpayers if the FHA’s reserves prove inadequate to cover default losses.”

This would be funny if it weren’t real.  I remember a few months ago when I berated these loans a few comments popped up saying, “well government loans have historically low default rates!”  Of course.  You should parse that statement with “the government HAD low default rates…” sort of like “housing prices NEVER go down.”  Well they didn’t in large moves until this crisis.  The rules are now different.  Don’t take my word for this.  Let us look at the hard facts:

*Click for sharper image

In 2004, FHA and VA insured loans only made up 4.6 percent of the entire mortgage origination market of $2.9 trillion.  In 2008?  FHA and VA insured loans now make up 16 percent!  In 2009 it is expected to make up 25 percent!  1 out of every 4 loans in 2009 will be insured by the FHA or VA.  And we are thinking that 3 percent down is sufficient?  Didn’t this housing bubble teach us something?  The problem once again is this notion that you can somehow go around those boring conventional standards like a 20 percent down payment, modest debt to income ratios, and 30 year fixed mortgages.  You can’t!  Why?  Because we have a bunch of unethical people running the system looking out for number one and would reinflate this bubble again if they had the chance.  And guess what?  Many are getting this chance.  $291 billion in FHA and VA insured loans last year.  Default rate now soaring.  Didn’t see that coming right?

And if you think the mentality from the industry is any different take a look at the idea of one VP at Union Bank interviewed on 3/30/2009 by the OC Register:

“Q. How does one qualify for the special program?
A. Cole said to be eligible borrowers must have household income that equals up to 80 percent of the median income for their area – that would be in the range of $57,000 to $67,000 for Orange County. Those earning more could also qualify if the property they are buying is in a Census tract with 80 percent median income compared to the county. Also, borrowers must not have a serious delinquency in the past 24 months.

He also said lenders usually only want 38 percent of the borrower’s income going to household payments, including the mortgage, taxes and insurance. But Union Bank will go as high as 42 or 43 percent.

Q. Your company says the lower-income program isn’t a subprime program. What’s the difference?
A. “There are two major differences. First of all, subprime lending by its very nature means people who have established bad credit.”

Cole said subprime borrowers haven’t paid their bills on time nor have a high level of debt to their income, or both. He also said subprime loans have large payment jumps, hefty fees and higher interest rates. None of those factors are true of Union Bank’s loans to lower income borrowers, he said.

Q. With subprime gone have you seen an increase in demand?
A. “We have seen demand increase. I think the biggest increase in the marketplace in general is in FHA and VHA loans. But, yes, we have seen a surge in new applications.”

Q. How about stated income? Do you ever allow borrowers to just say what they earn?
A. “Not currently.”

I love that last statement.  “Not currently.”  And this is someone who is supposedly arguing that they are careful in their lending practices.  It is amazing to me, that many on Wall Street now assume that without those pesky Pay Option ARMs and Alt-A loans that somehow, any 30 year loan is now okay.  With the California unemployment rate at 10.5% and growing even a fixed rate is too much for someone without a job.  Push their PITI to 43 percent of their income and you are asking for trouble.  And that is what we are getting with these higher default rates.  Freaking amazing.

HUD, which is now picking up a growing number of foreclosed FHA and VA insured backed properties is realizing that they are now part of the toxic asset world.  Take a look at some of the HUD owned properties in the Inland Empire here in Southern California:

So this is their idea of making the market healthier?  Giving loans to people that will default in a few months or a couple of years?  Renting is freaking okay!  Home ownership isn’t a damn right!  What the government needs to focus on if it is intent on pumping trillions into making the economy better is job creation!  You know how many jobs you can create with $1 trillion?  The infuriating premise goes back to Bear Stearns in the spring of 2008 where we started hearing that glorious mantra, “…we would have systemic failure.”  Then we had Fannie Mae and Freddie Mac, Lehman Brothers, AIG, and all the other poor souls that were too big to fail.  And here is the main joke of it all.  If these “too big” to fail institutions simply made too big of bets, then what do you think happens when the government suddenly backs these up?  What we are doing is now putting the risk of our entire country for these companies.  There is no assurance the government will be able to back up these loans without decimating our currency with mega-deficits running as far as the eye can see.  Just look at the FHA and VA insured loans that are making up a bigger and bigger portion of the mortgage market.  Many of the former subprime and toxic lenders now work pumping these loans out.  Do you suddenly think they became ethical over night?

The reason it is so important to be vigilant regarding the mortgage market is its sheer size:

The government is increasingly becoming the only game in town.  Unlike some of the PPIP participants that’ll be able unload toxic waste to taxpayers, these government backed loans are already ours since Fannie Mae and Freddie Mac for all purposes are nationalized.  What happens when these properties default as we are seeing?  And the problem is these agencies are projecting Pollyanna scenarios:

Wrong on GDP and already wrong on unemployment.  Those are two gigantic economic indicators and here we are 3 months after this forecast was made and they are off base.  And this is the kind of data they are using to project loss ratios for FHA and VA insured loans.  These are the new subprime loans.  It is no surprise default rates are soaring.  You bring in the crew from the previous mortgage disaster, repackage it, and then you assume things will be better just because you aren’t using horrific Pay Option ARMs or other absurd bubble mania products?  Glad to know we have learned our lesson well from the biggest economic mess since the Great Depression!

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Yet the story of Allen Stanford is only shocking in the light of denial and downright naïveté that many had when the story of Bernard Madoff hit only a few months ago.  Many were saying that this was the “fraud of the century” and nothing else could compare.  Well guess what?  Here we are at the well again.  The SEC now feeling that it needs to make up for lost time, is now going to start pulling out a few sacrificial lambs to placate the masses.  Make no mistake, the true fraud is what is being perpetrated by the Federal Reserve, Wall Street, and the U.S. banking industry.

At the heart of the Allen Stanford story is high-yielding CDs.  Of course as we all know many banks and institutions that have now gone into the graveyard like WaMu and IndyMac were offering competitive rates on CDs only days before their demise in a last ditch effort to raise capital.  “Sir” Allen Sanford is estimated to have a net worth of $2.2 billion and is 58 years old.  Stanford is the chairman of the Stanford Financial Group of Companies.  Ironically this guy made his first fortune in real estate in the early 1980s when he was based out of Houston, Texas.  What a stunner.  In 1983 Stanford had a default judgment of $31,800 slapped on him for back rent on a failed health club in Waco.  Since that time Stanford has expanded on the greed that has fed this crony capitalistic enterprise and branched out to insurance and real estate.  And now Stanford is showing us how to do the bezzle dance:

“(MarketWatch) Stanford’s Antigua-based bank, Stanford International Bank, sold roughly $8 billion of certificates of deposit to investors through a network of financial advisers by promising “improbable and unsubstantiated” high interest rates, the regulator said in a statement.

The rates were “supposedly” earned through the bank’s investment strategy, which “purportedly” allowed the bank to achieve double-digit returns on its investments for the past 15 years, the SEC added.

The agency also charged Stanford International Bank’s Chief Financial Officer James Davis and Stanford Financial Group’s Chief Investment Officer Laura Pendergest-Holt. “Stanford and the close circle of family and friends with whom he runs his businesses perpetrated a massive fraud based on false promises and fabricated historical-return data to prey on investors,” said Linda Chatman Thomsen, the SEC’s enforcement-division director, in a statement.

A U.S. District Judge entered a temporary restraining order, froze the defendants’ assets and appointed a receiver to marshal the assets, according to the SEC.”

This kind of stuff has been going on for years.  So the first myth that we should dispel is that these are isolated cases.  No.  The system is rotten to the core and Stanford and Madoff are only the tip of the iceberg.  We have other small time players like Art Nadel running around all over the country.  The crony capitalistic system set this ecosystem up for them.  Cases like that of Stanford only highlight the corruption embedded in the system.  No country can survive on a debt enterprise and one where those in the financial industry can reach the pinnacles of stardom of being called “Sir” when you have people like Bernard Madoff running made up numbers and what is worse, people believed it because they too aspired to be part of the crony elite.

Second Half Financial Recovery

Where are all the delusional folks calling for a second half recovery?  This mantra was going around for the last few months of 2008 with no basis in reality.  Here we are, only a few weeks into 2009 and we are now back testing the market lows of November:

This is an incredibly fast drop.  In fact, the NASDAQ is down 6.7% for the year, the S & P 500 is down 12.6%, and the Dow is down 13.9%.  And we’re only in February!  Keep in mind all this is happening with trillions and trillions of dollars being but at risk for the corrupt banking and finance industry and a $789 billion stimulus plan being signed.  Even with all this, the market is now back to the lows seen in November!  What do we need to do to get a brief recovery?  Announce a $100 trillion bailout plan?  I mean we are now in silly season here.  The problem is our economy was dependent on a frat like force of financial wizards who didn’t care about the financial long-term stability of the nation.  They built models to make a small select few richer and richer at the cost of the American taxpayer.  After all, this money we are funneling to them is basically the insurance policy they bet on while feeding both Republican and Democratic legislatures.  Their bets have paid off.  Why else would such a inane plan like the TARP even get off the ground?  Well if you leave it to a former Goldman Sachs crony to write the legislation, guess what is going to happen?

Even if there is a second half recovery it won’t feel like it for 90 percent of the American population.  Those claiming and preaching a second half recovery are those already in these albatross industries and are getting bailout funds.  Why not bailout Circuit City when we had the chance?  Why not send Burger King some extra money?  Just look at who is receiving bailouts and you’ll understand who is running the show.

The current phase we are in is what John K. Galbraith calls the “bezzle” stage.  That is, we are now in the process of discovering the Madoffs and Stanfords and what they have been doing for years if we only had competent enforcers and politicians who would have had the guts to take a stance.  Only now after things have gotten so rotten, do we take action.  Yet the deed is done.  I liken this to many California homeowners thinking their home was “worth” $600,000 only to realize that when they go to sell, they can only get $300,000.  They lived a life of phony money and are now coming to terms with a brutal contracting economy.

And how can there be a second half recovery?  The stimulus plan will take some time to get into the economy.  Let us look at some of the key points:

-$1,000 child tax credit for low income families

-Middle-income and wealthy taxpayers will receive help from the Alternative Minimum Tax

-First-time homebuyer tax credit of $8,000

-Those receiving unemployment insurance won’t pay federal income taxes on the first $2,400 they receive

-Millions will receive an extra $13 a week in their paychecks starting in June

-$90 billion to infrastructure projects like repairing roads, waterlines, and bridges
-$42 billion to energy related investments

-$54 billion to help states with education expenses

-$25 billion for No Child Left Behind and other such programs

-$4 billion for the Head Start and early education program

These are only a few key points but all the above does is blunt the economic tsunami coming our way.  How is this a second half recovery?  What the above does is keeps us from going to soup lines and homeless shelters but a second half recovery it is not.  The financial and real estate industries have hurt our country and economy so deep, that it will take years before we see a healthy economy.  At least in this bubble, we have homes which are more valuable than tulips if you want to find to find a tiny silver lining.  Needless to say, there will be no second half recovery.

Decoupling is Now Proven Wrong

Japan’s Finance Minister Shoichi Nakagawa has figured out how to deal with the current financial crisis.  Get plastered:

Well shortly after his drunken news conference Mr.  Nakagawa called it quits.  Honestly, who could blame the guy?  Japan is in a massive recession and last week, we learned that GDP contracted at its largest pace in 35 years.  Why is this important?  Japan is the number 2 economy in the world and you already know where we stand.  Germany is also in a recession.  And what about China?  Let us look at their stock markets:

In fact, China is having more trouble in their markets!  After all, the U.S. was the consumption machine for much of their exports.  Europe was supposedly a backstop but they have bigger housing bubbles than the U.S. which is amazing in itself.

So this notion of decoupling is proven false.  What other proof do you want?  Take a look at the global stock markets and they are in tatters.  The last time we had such synchronized global wealth destruction was during the Great Depression.  People forget that the Great Depression was global in reach and wasn’t only isolated to the 1929 Crash on Wall Street.  It was much larger and more complex than the Fed simply not stepping in.  We had conflicts in Europe with Germany drowning in war reparations.  You had a collapsing commodities market.  You had rising unemployment in supposedly stable countries.  So all these things entered into a perfect storm.  It took us nearly a century to come back to something similar to that time and here we are again.

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Let us first take a look at the job loss numbers by month.  The 598,000 jobs lost in January amounts to nearly 20,000 job losses per day but is also the deepest month of cuts since the recession started in December of 2007:

Chart #1 – Previous Job Losses over 13 Months

I wanted to put 13-month timeframes above to give you a perspective at how deep these cuts are.  Certainly you have to factor in for population adjustments but clearly this recession is much deeper than 2001 and that of the early 1990s.  So far, 3.5 million jobs have been lost.  Yet the more troubling sign is the job losses in the last 4 months, that of 2.1 million.  Three more months like January and we will be at 5 million job losses and does anyone really believe we will be in recovery by May?

What is troubling regarding this recession is the speed and severity at which it is deepening.  Yet looking at previous periods, we would have to go back to the Great Depression to see job losses and the unemployment rate spike up so quickly and dramatically:

Chart #2 – Unemployment Great Depression

The most dramatic rise in the unemployment rate was from 1929 to 1930 when the rate went from 3.3% to 8.9%.  Yet the unemployment rate did not peak until 1933 at 24.9% and remained over 14% until 1941.  I know many people have a hard time imagining this and given our official rate of 7.6%, some may find it difficult to understand why our current situation is so deep.  Well if we look at more accurate measures of unemployment we are already at Great Depression levels:

Chart #3 – Current Unemployment Levels

Source David Rosenberg, Merrill Lynch

The problem that we are facing is that the official unemployment rate is slated at 7.6% yet the real unemployment rate is at 13.9%, a number that can be pulled right from the Great Depression.  The only slight change from the mainstream number is those looking for full-time work but are working part-time and those who have given up looking for work are calculated in the U-6 number.  I’ve seen some articles now highlighting the U-6 number which gives a better perspective of how the average American feels the employment situation.

This is troubling yet falls into a thesis that this will be a recession similar to what Japan faced with its lost decade in the 1990s and arguably, is still battling.  And you may be thinking that Japan had rampant unemployment but to the contrary, there unemployment rate even at their peak was below our current unemployment rate:

Chart #4 – Japan Unemployment

Even at the peak, Japan’s unemployment rate was below 6%.  So this is promising for us if we are going to have a Japan like scenario instead of the Great Depression right?   Not necessarily.  The explosion in part-time workers is now a mainstay and makes up over 30 percent of the Japanese work force:

“(LA Times)  Over the last few years, temporary employees have gone from being a rarity in Japan to accounting for one-third of the workforce of 67 million. They enjoy far fewer protections than full-time workers — placing their necks squarely on the layoff chopping block.

By March, the government predicts, 85,000 part-timers will fall prey to haken-giri, or temporary-worker cutbacks — a relatively small number compared with U.S. layoffs but high for a nation where job security has long been a staple.

On Wednesday, embattled Prime Minister Taro Aso made the plight of part-timers a major piece of a proposed stimulus package. Aso pledged to create 1.6 million jobs, partly by turning part-time jobs into full-time ones.”

You may still be thinking this scenario is impossible here in the United States.  Think again.  The BLS recently issued a report showing the incredible rise with “involuntary part-time” work:

Chart #5 – The Rise of Part-Time Work

If you are wondering where the big difference from 7.6% to 13.9% is coming from with the unemployment figures, there it is.  This is a troubling trend because the perception is unemployment is not that bad when in fact it is.  What the above data is telling us is many Americans are severely underemployed yet are not showing up in the data.  This above scenario looks more similar to what Japan is facing than what we faced during the Great Depression.  Plus, part-time work during the Great Depression wasn’t all that common or at least wasn’t recorded in the data that accurately.  This may be for a variety of reasons including a high reliance on agriculture and manufacturing at that time.  Now, you can get a few hours at McDonalds or Burger King but does that really mean you are part of the full-time work force?  Doubt it.

Another reason this is looking more like Japan is that we are not following some patterns from the Great Depression:

Chart #6 – Fed Lending During Great Depression

Source John Kemp Reuters

The Fed during the Great Depression was not as active as it is right now.  But just because we do the opposite of something doesn’t mean it is the right thing.  Clearly we cannot say that we are following this same path with Ben Bernanke increasing the Fed balance sheet like we’ve never seen before:

Chart #7 – Current Fed Assets

So clearly the Fed is not shy about taking on more assets onto its books.  But here is the main problem.  During the Great Depression speculation was also rampant and questionable assets were all over the map.  So these so-called assets were still going to come down one way or another because of their bubble prices.  Hence the deflationary period in wealth and money destruction.  If the Fed brought these assets to its own books, then it would have been the taxpayer who paid for it.  Ultimately, the Great Depression also occurred in a time when the entire world was facing economic calamity so it wasn’t like the U.S. was the only one with problems.  So to assume that if the Fed would have borrowed more to improve the economy is simply a hypothetical.  In fact, Ben Bernanke has had his chance right now to put his thesis to work and it has failed miserably through various Term Auction Facilities, ABCP mechanisms, and in conjunction with the U.S. Treasury failed TARP.

Now you might ask, why is this now failing even though we are doing the opposite of what the Fed did in the Great Depression?  The answer is really simple.  First, the Fed is extending loans (aka, they need to be paid back) to these troubled institutions.  This is the same thing if you extended another $10,000 credit card to a family making $30,000 a year and already has $50,000 in debt.  There problem is a revenue and cash flow problem.  To think that giving loans to crony capitalist firms is the solution basically just gives us a different flavor from the Great Depression.

We’ve never had to confront another Great Depression but here it is.  Just because we are doing the opposite does not mean it is right or will help.  The unemployment rate is already at 13.9% and will continue to go up because guess what?  Our economy is massively dependent on consumption making up 73% or more of our GDP.  And consumers are now spending less and borrowing less:

Chart #8 – Consumers Saving More

This is probably the most disturbing chart because it shows how perverse our system has gotten over these past 3 decades.  First, savings should be encouraged for Americans to repair their balance sheets but this is where the paradox of thrift rears its ugly head.  With so much of our economy dependent on consumption people need to spend to keep the current economic order moving.  The irony is we have heard ZERO about a policy that encourages savings.  Everything coming out of Wall Street and associations like the NAR is veiled attempts to get Americans to buy more cars and homes.  Like we need more of those.

The irony is consumers have stopped borrowing because they are maxed out or are losing their jobs:

Chart #9 – Americans Borrowing Less

You already know that Americans are borrowing much less through homes and cars because they simply are not buying these items.  But the above chart should be telling because revolving debt is imploding.  That is, the credit card is officially maxed out.  Unlike Wall Street Americans don’t have a TARP or Term Auction Facility to exchange their SUV for a nice $30,000 check.  So this exposes the fraud of what is going on.  Americans are to believe that spending money they don’t have is going to be the solution to this crisis?  That is absurd!  If that is the case, why not give $700 billion straight to American families instead of the waste that is the TARP?  In fact, let us do the math of TARP:

$700 billion

Total U.S. Households:           105,480,101

Total per household with TARP:        $6,636

Why not give $6,636 to each household?  The irony is that this would have actually helped the economy much more than TARP because many people would have spent this money.  Of course, this is money we don’t have in the first place and shows the absurdity of having an economy run on pure debt with producing very little.  That is why it is important to have manufacturing as part of your economy instead of people flipping houses to one another and Wall Street being the financier of this epic bubble.  It is important to have a financial arm of course, but to the magnitude that we have is financially problematic as we are now seeing.  That is why banking after all is said and done will once again be a boring conservative industry like that after the Great Depression.

And whatever path we do take, do not expect the stock market to bounce.  Whether we have a minor depression or a Japan lost decade stocks will not come back anytime soon:

Chart #10 – Great Depression Stocks and Japan

So here we have two major economic downturns that have been studied to the extreme.  Japan is at multi-decade lows and the Dow didn’t see 1929 highs for nearly one-quarter of a century.  Anyone thinking that a country with $14 trillion in household debt, $11 trillion in national debt, and a world that is full of debt is really deceiving themselves to think that this will be a short and shallow recession.

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