Interview with Mish from Global Economic Trend Analysis: Deflation, Housing, the Credit Bubble, and Bond Insurers.

One of my favorite economic blogs is Mish’s Global Economic Trend Analysis. Mish has been blogging about economics and the ultimate busting of the credit bubble for years, standing by his economic model in the face of nearly everyone touting some sort of new paradigm. It takes guts to stick with your economic models especially when everyone around you is showing you how things are really different this time. Now everyone is trying to understand the magnitude and impact of the bursting credit bubble. This weekend I had the pleasure of interviewing Mish over the phone for about an hour with some additional email exchanges to fill in the pieces.

Much of what we discussed will shed new light and give you insight onto a potential housing bottom and other factors that are affecting the current economic landscape.

Peter Schiff has been arguing that we are heading toward inflation. You argue that we will see deflation. What are your thoughts regarding inflation and deflation?

Inflation is a net expansion of the money supply and credit. Deflation is the opposite, a net contraction of money supply and credit.

It is in the Fed’s best interest that people do not know what inflation is. That way, the Fed can talk about the price of oil, capacity utilization, productivity, and numerous other things while ignoring money supply. We have a Fed that sets monetary policy yet they talk about anything and everything but money! This is on purpose.

The bursting of the credit bubble and associated drop in prices of real estate has now permeated our economy. Banks and brokerage houses have written off hundreds of billions of capital. Citigroup was bailed out by Dubai and China. Merrill Lynch, Morgan Stanley, Lehman and others have received capital from China and Singapore. If I would have told you that US banks were going to be bailed out by Dubai, Singapore, and China two years ago you would have thought I was nuts.

Now capital impaired banks and brokerages are afraid or unwilling to lend. The municipal bond market has virtually shut down. The velocity of money is plunging. Liquidity is in hiding. Cash is being hoarded. These are deflationary conditions even though we have not yet seen a net reduction in overall credit.

What about gold and commodities?

Some point to gold as pointing toward inflation. From 1980 to 2000 we had positive inflation yet gold went from $800 to $250. If gold is predicting inflation, what exactly was it predicting from 1980 to 2000? Inflationists cannot explain this away.

The Kondratieff (K-Cycle) explains this all nicely. And as we enter K-Winter (deflation), gold should rise and interest rates fall. Gold is the only currency that has no associated liabilities. Its value stands to go up in deflation although I am open to the possibility of one more potentially large downdraft as deflation forces a reduction in leverage everywhere and the carry trade in Yen unwinds.

In the meantime, if gold is predicting anything at all, it is a further destruction of credit.

With that, I predict that more cuts are coming and we will see the Fed Funds Rate at 2 percent this summer. Inflationist models can’t explain 2 percent interest rates. My deflation model not only explains it, but predicts it.

What of Ambac and MBIA?

AAA or AA ratings on Ambac and MBIA are preposterous. Together they insure something like $150 billion in CDOs that are now worthless. They argue that they will not have to pay this out now, but rather over the next 30 years or whatever. While true on the surface, their argument does not hold water in terms of what their stock is worth . Net present value analysis of their assets and liabilities shows that Ambac and MBIA cannot survive without massive infusions of capital.

Warren Buffet essentially called their bluff by offering them reinsurance. I talked about this idea in Buffett’s Kiss of Death. The bottom line of this is that greed kills. Ambac and MBIA had a nice gravy train going but they wrecked it by getting away from their core business into insuring CDOs and other such nonsense.

How does Buffett’s offer influence a government bailout?

Buffet is looking to ensure the municipal bonds for a fee. For someone well capitalized, this is likely to be a profitable business. More to the point, Buffett’s offer exposes MBIA and Ambac for the charlatans that they are. The monolines claim they do not want a bailout but the reality is they are begging Congress for that bailout.

The bailout comes from pleading for an AAA rating they clearly do not deserve. Any business that needs an AAA rating to stay in business is a flawed business right from the start. Worse yet, they jeopardized that rating willingly by diving into insurance on CDOs, and other derivatives they clearly did not understand.

By offering to insure the municipal bond portion of the business, Buffett has removed the argument that government needs to bailout the industry.

I’m looking at the profile of Ambac now and see that they have $1 billion in market cap and you mention that they have potentially $100 billion in bad debt. Am I reading this right?

You are reading things correctly. Not only are Ambac and MBIA leveraged to the hilt, they foolishly wandered into an even riskier business they did not remotely understand. Even without those CDOs, Ambac and MBIA would not deserve an AAA rating, just from the leverage factor alone!

The argument coming from the monolines is that the bad debt estimates are exaggerated and they can pay the claims off over time. While it is true that they do not have to take an upfront immediate hit on the entire CDO package they guaranteed, cash flow analysis suggests enormous problems.

With Buffett entering the municipal bond business, future cash flows to Ambac and MBIA will diminish from competition. Look at it this way: Would you rather have insurance from Buffett or from Ambac and MBIA whose guarantee is questionable at best and most likely worthless in practice?

What are your 2008 market predictions?

  • A massive consumer led recession will become so severe it will shock the bears.
  • People will continue to walk away from their homes.
  • All the housing bailout plans fail, one right after another.
  • Unemployment will skyrocket, ultimately hitting 6.5% to 7% as reported by the BLS. In actual practice, unemployment will be way higher.
  • Commercial real estate will undergo a massive implosion and capital impaired banks will not only stuck with huge numbers of houses but with commercial real estate as well.
  • Credit card defaults continue to soar.
  • Over the next couple of years, a dozen banks minimum will fail and most likely at least one big bank will fail. Commercial real estate will be the final straw for many banks.

Why are you so grim on corporate real estate?

Commercial real estate follows residential real estate with a lag. Miles and miles of strip malls were created, as subdivisions were overbuilt. There is rampant overcapacity everywhere.

We do not need more Pizza Huts, Home Depots, Lowes, nail salons, Wal-Marts, Targets, or anything else. With consumers going on strike, we need far less of what has actually been built. Lease rates will drop. Vacancies will soar. A cascade of defaults will flow starting from small stores going bust and ultimately leading to defaults by the mall owners who cannot make their mortgage payments. Already we are seeing huge numbers of store closings. I talked about that in Does the Shopping Center Economic Model Work?

Is the raise in caps by Fannie Mae and Freddie Mac simply a show or will it really help the market?

It’s a dog and pony show that’s all dog and no pony. If Fannie Mae and Freddie Mac start going after more high priced homes with an implied higher risk, they will need to spread the risk across all loans which may cause loan rates to rise across the board.

However, more than likely they won’t. Given the enormous declines in home values we have seen in California, Fannie and Freddie will not go plunging in. Neither will be willing to refi houses that are underwater. That alone knocks out a huge portion of the business.

Also keep in mind that lending standards have tightened. 0% down loans have vanished. Who in California can afford a home, including a substantial down payment, that wants a home and does not already have a home? The answer to that is virtually no one.

How does the US compare to Japan and the deflation they faced in the last decade?

Prices fell in Japan for 18 straight years even though there was nowhere in Japan to build. Yet we foolishly heard that San Diego, San Francisco and other such places would be immune because there was no place to build. That myth has clearly been shattered.

I have a chart that shows just how much further we have to go if we follow the path of Japan. Inquiring minds can find my most recent update in Housing Bottom Nowhere In Sight.

There are those who claim we cannot compare the US to Japan. I say “nonsense”. Differences between Japan and the US can easily be quantified. Furthermore, most of the differences increase the odds of deflation in the US, while others will speed up the timeline.

One of the biggest difference between Japan and the US is consumer debt. US consumers are far deeper in hock than Japanese consumers were. Debt is enormously deflationary in an environment where debt cannot be serviced. Global wage arbitrage enhances the problem.

First we saw a massive outsourcing of manufacturing jobs. Now outsourcing is spreading to white collar work. For example, we can outsource X-rays to India where they will do the evaluation and diagnosis and send out a treatment plan back to the states. The treatment is done here, but much of what can be outsourced will eventually be outsourced. This puts enormous pressure on wages.

Some point out that “Japan is a nation of savers”. The striking thing about this argument is how foolish it is. Trends do not last forever. Consider the popping of the housing bubble! How many times did we have to listen to the NAR and the NAHB say housing always goes up, there is no national bubble and all kind of other nonsense? Now clowns are telling me that the trend of consumer spending in the US will last forever. Phooey.

A massive attitude change in the US is now underway. Boomers headed into retirement have reached the realization phase that housing prices will not go up forever, and will in fact decline. This puts a new light on the need to save. Indeed Changing Social Attitudes About Debt are right at the forefront of the deflation argument. Attitudes change first, then prices. For proof, think about the popping of the housing bubble in 2005. Suddenly, almost overnight people went from camping out overnight to buy Florida condos, to no lines and a glut of supply.

Only after attitudes changed did prices fall. It was slow at first then it picked up steam. A year later people were not only unwilling to buy houses, they were actually walking away from them. The national debate now is about the Moral Obligations Of Walking Away. And the trend continues to evolve as Businesses Are Advised To Walk Away.

With businesses walking away from stores, and consumers walking away from houses, and fewer new stores being built, where are the jobs going to come from? The long and short answers are both the same: There is no source of jobs. With no jobs, how are people going to pay debt back? Debt that cannot be paid back will be defaulted on. And that is deflation.

When do we reach the bottom?

I would expect 2012 to 2014 based on the analysis I presented in Housing Bottom Nowhere In Sight and When Will Housing Bottom. Essentially we are at least four years away from a bottom. California is 4 years off and Washington is 4 years off as well.

Some places like Florida (which was ground zero of the housing bust) may bottom earlier. Areas that didn’t experiences a boom like Detroit may just flat line for a few years. Places in small town USA may flatline as well. Vast areas in this country where there isn’t much real estate wealth may stay flat for a few years. But everywhere else there was a major bubble (all the major population centers), the bottom is still many years off.

Reports show the median price in Los Angeles County peaked in August of 2007 at $550,000. The median price is now $458,000. That is a 16 percent, $92,000 drop in 6 months. How low can we go?

Median prices can be misleading. For example, sales dried up at the lower end first, inflating median price. Some reports such as the Shiller Index and DataQuick show real prices are now down 16% in some California locations as well. However, such declines are dramatically understated because they do not include incentives and they only look at resales. As such, these reported 16 percent declines are a mere down payment as to what is going to happen.

I am now seeing advertisements from major California builders for up to 50% off new homes, in select locations. 50% off! Imagine you bought a home with 0% down two years ago for $500,000 and the builder is now offering the home for $250,000 or even $350,000. This is “reverse sticker shock” and fertile ground for more people with little skin in the game to decide to hell with it all and just walk away.

Do you have anything else you would like to add?

Yes, thanks. Things I am Told That Can’t Happen are now happening.

I liked to thank Mish over at Global Economic Trend Analysis for taking the time to do this interview. You may want to add his site into your feed reader since he has been spot on with everything we are living through.

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17 Responses to “Interview with Mish from Global Economic Trend Analysis: Deflation, Housing, the Credit Bubble, and Bond Insurers.”

  • From Wolf Laurel in NC mountains – I believe Merrill Lynch is correct about the arrival of recession in the United States. The housing downturn is negatively impacting property sales in second home communities in Florida. This is also slowing sales in NC mountain resorts that depend on Florida buyers.

    Still the downturn in prices and building of inventories is starting to attract second home buyers from Florida looking for cool temperatures in our mountains. Also the dramatic decline in the dollar combined with weakness in American real estate markets are beginning to interest some bargain hunting European investors.

    Ron Holland, Broker/Realtor with Wolf’s Crossing Realty. See Ron markets resale mountain and ski resort properties in NC in Wolf Laurel and The Preserve at Wolf Laurel.

  • ‘Some point to gold as pointing toward inflation. From 1980 to 2000 we had positive inflation yet gold went from $800 to $250. If gold is predicting inflation, what exactly was it predicting from 1980 to 2000? Inflationists cannot explain this away.’

    Perhaps the 1981-2002 period was one of disinflation and the post 9/11 world we live in is a period of rising inflation?

    Perhaps someone smarter than I should explain to me why we didn’t even have deflation in the first half of the 1990’s when our commercial RE market nationwide dropped an average of 65-70%, residential RE in our three largest states had crashed 30%+, Japan was starting their decade long depression, Greenspan was still fighting the wrong war from the stagflationary 70’s keeping short term rates way too high and our banking system was insolvent with very tight credit and S&L’s falling at depression era rates?

    Mish, Roubini and others are only rehashing Ravi Batra’s ‘Depression of 1990’ all over again IMHO. A major backup in long term rates before all the excesses of this recent mania are corrected is the huge risk. Backside of a rapid rise in inflaitonary pressure, interest rates and a collapse of the bond market during the decade of the 2010’s. A different set of winners and losers. Ironically. the ultimate bubble that needs to burst today is the bond market….

  • A lot of good information, but I fear he’s over-estimating the whole matter.
    Is there a housing bubble? Yes, unquestionably. I think it needs to deflate about 50% here in Cal to reach near bottom.
    One item that Mish dismisses (that I will not) is the tendency of the Japanese people to save. This is very reverse of us here in the US. Mish dismisses this as a trend, however if you look at Japanese history you will realize this is a very cultural thing. They have learned from their isolationist history,as well has history with great disasters (some of the world most frequent and harsh earthquake) that you must plan for bad times.
    I project that this has led to the people saving even in recent bad times – and thus the Government keeping lending rate near “0” for over 10 years which will never occur here in the US (let me know how long we’ll stay below 3, let alone approach “0”)…
    In short, you cannot compare the Japanese economy to the US and therefore you cannot parallel the two countries housing markets.
    …. With that said, I do agree that the US housing market will bottom in 4 years, but most the fall will occure this and early next.

  • Great interview Doc. I have one question. I am starting to hear about foreign investors who are waiting on the sidelines for bargains on “vacation” homes here in the States. Have you heard any news regarding this potential situation? If this is a possibiilty how will this affect the potential for hard worker folks in the States who have saved money to get into the game after watching the housing insanity for the past 8 years?

  • quote:
    “If gold is predicting inflation, what exactly was it predicting from 1980 to 2000? Inflationists cannot explain this away.”

    Actually, it can be easily explained. In 1980 inflation was 13.5% ..inflation dropped over the next several years eventually to as low as 1.9% in 1986. Inlation has since been fairly tame UNTIL NOW ! The M3 (no longer reported) explosion is being reflected in both Gold and the Dollar.
    We will see asset deflation eventually, but right now inflation is upon us!!!!!

  • @ John

    There are not 2 million European buyers lining up to purchase the glut of inventory across the US. BTW, the realtor pushing his wares in the first comment should buy space on Doc’s site rather than trying to get a free plug for his business. Doc- how about deleting the alluded business website in his comment? He can say what he wants but as soon as he plugs something he should pay up.)

    Let’s examine the foreign buyer concept. First, ‘wealthy’ overseas buyers get that moniker often because of exchange rates and not necessarily because they did or made something to ‘earn’ it. Even if they did, that means they are somewhat more ‘business-minded’ than the average bear. And if that’s true, they read up on what they intend to invest in. Including newspapers, magazines (e.g. The Economist), and yes, blogs. They DON’T only read realtor shill pieces produced by the NAR or commission-based brokers. Consequently, these prudent, ‘wealthy’ foreigners recognize that there is an excellent chance that property values will continue to sink.

    Now, why would a prudent business-minded person buy a property than can deflate another 5% – 15% – 25%? Because their money is worth more than the US dollar? What? No matter WHAT currency you’re using, worth less means, well, worth less! These foreigners didn’t get wealthy by being stupid and buying declining-in-value assets.

    So there are some properties in desirable areas coming up for purchase – Newport Beach, Miami, the Hamptons. Fine. Maybe the uber-wealthy will buy some fancy $10 million property. IMO, if they are that wealthy, they would have bought it regardless of whether the Euro outperformed the dollar. The average European who is coming to the US to take advantage of favorable exchange rates is not going to purchase the 15,000 houses in Riverside, or the 20,000 houses in Detroit and Cleveland, or even the 10,000 houses in south Orange County. Maybe a few, maybe even a few dozen. But not enough to make a difference.

    So for the hard working US folk who have saved money – I don’t think there’s much to the hypothesis that foreigners are coming to buy houses and prop up prices.

  • This is my first time commenting on this great blog.

    To the question of where will home prices fall to in LA: I was quite pleased to find an old analysis here on this site of why people can’t afford their houses just by looking at how much people actually make compared to the prices of houses. The answer is that a median income earning family, and a mean income earning family needs to be pretty close to qualifying for the median and mean price homes under normal, pre-bubble qualification criteria. That’s an easy question. That’s the only perspective the question should ever have been viewed from.

    As to whether we’re going to see deflation– would be that were the case! I’m predicting hyper-inflation myself, as the economy struggles to help service debts that no one can afford, and the economy struggles to prop up the ridiculously overinflated housing values. The idea of deflation caused by the factors listed here might keep my vision in check– acting as a sort of homeostasis perhaps. I wish I could be that optimistic.

  • Indeed it does look very deflationary if we were only facing a contraction of credit and resulting economic slowdown of the 1930’s type. However, the US has an enormous current account deficit that has been spewing trillions of dollars into foreign central banks for many years now. If our currency tanks we are going to face a godawful situation where , as our real incomes shrink, the cost of the goods we buy from abroad or are made from our own commodities are going to soar. We are seeing record prices for grains, cotton, oil and now coal. Half or our electricity is derived from coal, 20 percent from nuclear ( uranium is going up too)
    and natural gas prices have long since risen so high as to make gas turbine power generation uneconomic for base plant duty. So imagine electricity prices rising 50% or more. Food prices rising the same. Steel, aluminum, copper all going up even further as our currency slides. Could we not have domestic deflation in wages and housing while at the same time have a rising CPI?

  • @stevejust – an intentionally induced bout of inflation is political suicide…seniors vote in large numbers, and the damage that inflation wreaks on fixed incomes would elicit a powerful political response from that growing sector that the guys in power understand very well.

    @ronaldholland – a pox on you and your shameless marketing of worthless NC hillbilly properties in this haven for introspection on equally worthless California Beverly Hillbilly properties.

    Mish couldn’t be more right on bond insurers and AAA ratings. If you want something truly AAA in today’s market, I can recommend a US auto club that gives out neat strip maps for your vacation trips.

    I think gold is irrelevant…if there’s a weakness in Mike Shedlock’s (Mish) credibility is that he often seems to be talking his book on gold. In the modern world, I think gold only has intrinsic value to a jeweler or a circuit board manufacturer. Otherwise, may as well invest in baseball cards.

    @Pat – some real truth there. The Japanese do save far more than we do. I think they would have recovered long ago had they not been so dependent on foreign resources (e.g. energy, iron ore, copper) paid for in foreign currency ($).

  • Doc, great interview.

  • Europeans don’t buy houses in North Carolina to ski. The skiing in Europe is just, oh, a tad better than the ice skating rinks that double as ski areas in N.C.
    The Euros are buying a LOT of stuff over here on a temporary basis only. The Euro is starting to fall now and all currencies are competing to see who can hit bottom the fastest. The dollar is simply falling the fastest.

  • I have read Mish’s blog concerning deflation and one of his points is that the Fed can not force people or businesses to borrow money AND they can’t just give money away. This theory loses it’s foundation in the age of “economic stimulus packages”. The Fed can’t make me borrow money, but they can in fact give money away, (with a little help from D.C.) Those $600.00 dollar checks will be in the mail soon enough. It’s a safe bet that I won’t send it back un-cashed. When that package doesn’t do the trick, another BIGGER package will be on the way. The act of printing money and giving it away is by definition the very foundation of inflation. I agree that some prices will deflate, like real estate, but if the Fed and gubmint keep giving money away, we will have inflation.
    @Bob… I will take my pile gold versus your pile of baseball cards any day, but it won’t make rats A$$ worth of difference for either of us if we don’t have any food to eat!

  • A very good interview with MISH and as always, your writing is impeccable. One thing MISH did not address directly was our national debt which optimists say is no big deal as a percent of the GDP because it was higher in previous times. Now that our GDP is shrinking, that however may no longer be the case. I know I am not the sharpest tool in the tool box, but I would like some help trying to understand how our national debt is funded? My understanding is the US Treasury issue bonds that someone has to buy. I thought the price was set by bid. That is, the interest rate was bid up until someone bought the issue. Well, seems to me that if the Federal Reserve keeps lowering short-term interest rates, at some point, the people/governments/banks/bond funds etc. buying these bonds are going to stop because they see the demise of the Fed’s fiscal discipline, and the shrinking value of the dollar. Investors simply will be able to get better security and returns elsewhere, in another currency. So… seems to me, the long term interest rates on these instruments will eventually be bid up to keep them attractive… REGARDLESS OF THE FED’S ACTIONS. Again, seems to me, at this point, the Federal Reserve will lose the ability to control interest rates. Since home loans are based on the longer term rates, they too will go up and as a direct result of the Federal Reserves dollar-weakening policies! If I may go one step further, and say that that is exactly what Paul Volker was afraid of in the early 80’s when he raised the discount rate! (I bought my first house and had a VA loan at 15 ½%). Please help me as typing this has made my head hurt but I really don’t understand where I am wrong in my assumptions. And please, keep up the good work!

  • I’m with Scott. There seem to be counter pressure here and little precedent. The Fed has an interest in inflation, to shrink the unmanageable debt they’ve piled up, so I don’t trust them to fight it. With the recent rate cuts they certainly don’t seem to be worried about it, at the very least. But after reading the very nice interview, I’m curious about something which may be a restatement of Scott’s question, but I’m going to reframe it so I’m clear on it in my own head:

    Is inflation only ever caused by an increase in the money supply? Can it be caused any other way? The interview sorta implies that it can’t, but when I look at the bad ethanol policy and what it’s done to food prices, on top of what must be another imminent adjustment of the yuan and therefore our imports, on top of declining world wide oil production… it just seems like the price pressures are irresistible. Barring a worldwide recession that drops demand enough to keep oil prices stable and makes Chinese exporters cut profits… and axing of what is probably yet another unkillable government subsidy to farmers…. won’t prices (in dollars at least) just go up, even if there isn’t more money chasing the goods?

  • great to see you interviewing mish; more people like yourself dr hb and mish (and elliott wave) need connecting so more people can see the growing thread (and of course there is more and other good people too 🙂

    re interest rates, esp long term rates, i still am wondering (truly, not just pretending and thus posing a question) what the effect on long bond rates would be if every single person had access to purchasing them through their 401k plan at work; how many individuals would opt for that, short or long term, if they could in lieu of a limited choice of mutual funds?

    and with all the muni ins problems, how many people wish that their pension funds and city and state and county govt’s would (could) get out from under crazy auction bond rate structures and other risky investments into 4 plus % long term bonds?

    it would be interesting, and maybe with enough of a need to revamp our retirement system options we’ll get to find out (and the effect that would have on long term rates and the fear of foreign ownership)


    ps – in re to the fed’s interest in inflation, i feel their interest is more in maximization of the interests they represent within the context of a (now) global economic war

    i always seem to end back up with thomas jefferson’s quote from over 200 years ago, “If the American people ever allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their property until their children will wake up homeless on the continent their fathers conquered.”

    it would be ironic if because of the competitive threat from other newly emerging countries, the banks and “the people” could end up on the same firing line

    (yea, i know, maybe 2 or 3 ps’s 🙂

  • “The act of printing money and giving it away is by definition the very foundation of inflation.”

    The other description for this is…

    “More bread and circuses!”

    Let me take a closer look at our SNAFU economic/geopolitical climate.

    1. Fiat currencies worldwide that are backed by the full faith and credit of there underlying govts/electronic printing presses.
    2. Global turmoil.. Middle East, Korea with nukes, India/Pakistan with nukes, etc.
    3. Clowns running for President in the U.S.
    4. Global housing bubble bust.. Now spreading to the rest of the global economy.
    5. Worldwide central bank response.. Jam rates to zero and print as much as possible. Bail out the banks and ‘F’ everyone else.

    This obviously means that a global financial/economic/geopolitical crisis is not immenent, so we should all just give up on gold and instead have full faith and trust in our govt. and its wonderful fiat currency.

  • In the coming weeks and months the pressure building in the archane market’s will cause the Howard Milstein’s of the world to get louder and louder,

    Gov’t will Quielty take on the debt of the private sector (wall street).

    The Real economy may crash.

    Creative efforts will take place to try to keep the bond market from blowing up.

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