Goldman Sachs CEO Lloyd Blankfein has just bought a second home, this one in the Hamptons, the fabled playground for New York’s bankers and hedge fund managers. It was on the market for $33 million, and its sale in December contributed to a splurge of estate buying last year that saw record prices being set for country manors in the Hamptons. The luxury segment of the real estate market in the US had a very good year, and not just in New York. California mansions which would have sat idle two or three years ago were being snapped up in weeks, with multiple bidders pushing offers up well beyond the asking price. Nor were expensive properties subject to a buyers’ frenzy. All throughout the US, once-devastated real estate markets saw a remarkable recovery in sales volume. San Diego was up 13%, Los Angeles 15%, and on the east coast Boston rebounded 24%. Headlines talk about a national real east boom, or even a bubble, given the stories of properties lasting no more than a few days on the market and receiving dozens of offers. The only problem is, if you asked the average homeowner, they would say “What real estate boom?”
This is a real estate recovery restricted to just a few people, and it tells you a lot about the failure of the Federal Reserve’s approach to use monetary policy to revive the economy from the worst recession since the 1930s. First, it helps to remember that in many depressed markets home values fell from, as an example, $200,000 to $50,000, so a headline that trumpets the doubling of home values to $100,000 doesn’t mean much to most people. Homeowners who bought anywhere from 2005 onward were likely still underwater in their mortgage even if values came back to $100,000. The great bulk of homeowners who might be anxious to sell still have not been able to reach break even in this market. Then there is the question of the mysterious disappearance of inventory. In 2011, most major metropolitan markets had an overhang of houses and condominiums available for sale, and the great bulk of these were owned by banks who had repossessed the properties. Suddenly, in 2012 such properties were taken off the market. The number of houses available for sale dropped 68% in San Francisco, 61% in Los Angeles, 39% in Boston, and 28% in Las Vegas. The average decline in inventory across the US was 33%.
Where did all of the property go? Largely it all went back to the banks which have foreclosed on these homes. They have various motives for holding some of this property back. If the home is part of a securitized loan or is guaranteed by Fannie Mae, it might not be worth the trouble getting the legal clearance from these third parties to put the house up for sale. Next, there is a possibility with much of this property that the bank will have to declare an accounting loss if the property is sold, even in the current real estate bubble. Most of the big banks are still avoiding taking losses in order to appear as financially healthy as possible. Third, the property may not be suitable to the types of buyers that are fueling the real estate recovery. We’ve already mentioned that the average American homeowner is not a seller in this market, and nor are they a buyer. Even if they are looking for a first home and have no other property to sell first, most Americans cannot obtain a mortgage under the current requirements of 20% or higher down payment.
So who are the buyers? We know Lloyd Blankfein is one, and he typifies one big segment of the market with money to spend: the 1%. Most of the über-wealthy are looking for high returns and a quick turnaround in their investments, so they are willing to pool some of their money with hedge funds and let them do the work of finding the properties to buy. Hedge funds have been scouring the country for several years now, bottom fishing in all major markets, looking to make a quick buck by flipping properties, and since professional property flippers were such a feature of the housing bubble up to 2008, many of them have gotten back in the business to service the hot money that wealthy people have to invest. Flippers are looking for a fast return as well, so they avoid properties with major structural problems like water in the basement, cracked foundations, electrical faults, or mold. They are skilled in avoiding properties such as these, but that means only the best fixer-uppers are eligible for purchase in today’s market. The rest sit with the banks in foreclosure limbo, and not a few of these homes continue to be inhabited by their owners, some of whom haven’t paid anything on their mortgage in years.
If all this sounds like a rather warped and distorted market, you are right. This is not a healthy real estate market. This a mini-bubble or a full bubble, depending on how it develops. At least 30% of all purchases are made in cash, which tells you that only wealthy people can afford to buy in this market, and that mortgages are still very hard to come by. In addition, 40% or more of all purchases are made by buyers who do not intend to live in the home. In some markets it is well over 50% absentee buyers, who are interested only in renting out the home until they can make a decent return on their investment. On the West Coast, there is also an interesting phenomenon going on, according to anecdotal evidence. A large number of cash buyers are mainland Chinese investors, and in 2012 even the Chinese government began to complain about how wealthy Chinese are expatriating their wealth abroad rather than invest it at home.
Monetary Policy Distorts One Market After Another
Welcome to Ben Bernanke’s world, which is very much like Alan Greenspan’s world, in miniature. Bernanke has said that the Fed wants to see inflation of at least 2%, and last year he achieved this goal, but refused to recognize it. For awhile, the consumer price index was toying with 3% to 4% inflation, but in the wonderland that characterizes monetary policy, that didn’t count because the Fed removes price changes in food and energy from the index because it is only “temporary” inflation. The index did indeed back down below 2% last year when oil fell below $100/bbl, so the Fed can say they were vindicated in their stance. But what about 15% inflation in the housing market? Well that doesn’t count either, because that is asset inflation and doesn’t show up in the general price index. This was exactly Alan Greenspan’s argument for ignoring the housing bubble. Bernanke was asked a few days ago if the Fed is not once again missing a bubble in the making, and all he could say is that the Fed has enhanced tools for spotting such things, but doesn’t see any bubbles on the horizon.
Quite a few observers would say the government bond market has been in a bubble, with all the trillions of dollars of new bonds that have been issued in recent years (the deficit is at $16 trillion and increasing by about $100 billion a month). The Fed rejects that argument because they say in every moment of financial crisis, buyers come flooding back to the Treasury market, looking for the safest of investments. That is true, but it ignores the fact that not all buyers in recent years have returned on a regular basis. The biggest buyers of all, the governments of Japan and China, are both dealing with fairly drastic declines in their foreign trade revenue – Japan in fact has spent nearly all of 2012 experiencing foreign trade deficits, which is unprecedented for that country. The money isn’t there for them to join in the auction each month of $100 billion of new paper, or even participate in rolling over their part of the $16 trillion that is already outstanding.
In a normal functioning market, when the two largest buyers reduce their participation, assuming no one else in the market conveniently comes along to take their place, interest rates would have to rise to induce the rest of the market to take up the slack. The United States absolutely cannot afford higher interest rates on $16 trillion of debt (a 1% increase alone adds $160 billion to the yearly cost of servicing the debt). Since no private buyer has surfaced to replace the Japanese and Chinese, the Fed has been obliged to do so. It dresses up its activity in fancy words, such as Quantitative Easing designed to stimulate the economy, but don’t be fooled. On December 12, the Fed quietly announced it would be buying $45 billion every month in Treasuries from the market, and when you put this together with its other regular purchases, the Fed will buy over 75% of all of the debt issued by the federal government in 2013.
This is a very, very bad thing, and that can’t be overemphasized. A government which has to buy its own debt either is issuing too much debt, or is not as credit-worthy as it once was, or it has somehow perverted the pricing mechanism to prevent interest rates from reflecting the true cost of selling so much debt. All three of these things are at play here. Interest rates are being artificially kept low by the Fed’s Zero Interest Rate Policy, which it has announced will be in place at least through 2015. This isn’t a matter of convenience or of intelligent monetary policy – this is a necessity. The US Treasury after 2008 ceased to issue any new paper with maturities much beyond two years; it is in a sense hiding out in the tall grass of the short end of the maturity spectrum, where the Fed can protect it because the Fed can keep short term interest rates close to zero. The Fed has far less control over interest rates beyond two years, and the Treasury knows this, which is why it does not dare show itself in public in the Treasury note or bond market.
Because the Treasury no longer is issuing paper with maturities beyond two years, the long end of the bond market is shrinking, and this is made much worse by the Fed’s practice of buying up for itself whatever paper is out there (Operation Twist, for example, specialized in buying 10 year notes). Prior to 2008, the Fed had very few holdings in this part of the maturity spectrum – its balance sheet consisted of $800 billion of Treasury bills and some paper out to five years. Now it has a balance sheet that just passed $3 trillion, consisting of highly illiquid mortgage backed securities, and a great deal of Treasury bonds with 10 – 30 year maturities. In some of these issues, the Fed owns up to 70% of the paper auctioned, which is its limit in any issue.
There are some mechanical aspects of this “monetary policy” worth discussing. The US Treasury market was once considered the largest, and most liquid bond market in the world. That may still be so, because other markets haven’t caught up, but the Treasury market is a shadow of what it used to be. It has been reduced in size as the Fed vacuums up trillions of dollars of paper. This is what is known as benchmark paper – the safest investment in the world, and highly sought after as collateral. No wonder then, that there is a collateral shortage in the world for highly liquid securities. Even the European Central Bank has been complaining about this. When it set up its Long Term Refinancing Operation (LTRO) in late 2011 to allow cash-strapped European banks to borrow on a collateralized basis, it discovered many of these banks didn’t have liquid collateral in the amounts they wanted to borrow. Even the Fed a few years ago allowed banks in the US to borrow at the discount window using gold as collateral (not such a barbaric relic after all).
The Fed talks bravely about the day when it will begin reducing its balance sheet. Don’t believe any of that. The Fed is never going to sell these securities back to the market, because it cannot. It is trapped already in a liquidity vise of its own making. Note, for example, one other mechanical aspect of this situation. As more and more Treasuries wind up in the hands of the Fed, they are de facto retired. What is left in the market is a much smaller pool of Treasuries in private hands, which means less liquidity in the market, which means more volatility in pricing. We are already seeing the effect of this. On December 12 when the Fed announced its new $45 billion monthly Treasury buying program, rates should have gone down and prices gone up on news of the increased demand. The opposite happened; 30 year bond rates moved from 2.69% to 3.15%. They now appear to be heading to 3.50%. The market is less liquid now, and it takes but a few large players to get nervous and begin selling in order to create a sharp move in rates.
Remember December 12, 2012. It may have been the day when the financial markets finally said “enough is enough” to the Fed. Enough destruction of the bond market. Enough monetizing of the deficit (Bernanke says he is not doing that, but he would have to say that). If it is such a brilliant idea for one arm of government to buy on the open market the debt issued by another arm of that same government, central banks would have been doing this for years. The fact is, every time it has been tried has been a disaster, going as far back as the hyperinflation situation in Weimar Germany to the most recent hyperinflation in Zimbabwe (and now also in Iran).
One bond guru after another in the US has been warning about hyperinflation, including the famous Bill Gross of Pimco. You don’t need hyperinflation to inflict grievous damage on the economy. Out of control inflation will do, and especially the type that the Fed deliberately ignores – asset inflation. We’ve already chronicled how a mini bubble exists in the housing market, and one more in the government securities market. Even some of the Fed governors are noticing the phenomenon, and a few have cited the explosion in farm land prices, or the out-of-control student loan market. A student loan is the worst sort of loan a consumer can take on – it cannot be discharged in bankruptcy and will follow you around for life. It is also easy to obtain because the government guarantees these loans for the banks which issue them. This is why student loans have been the leading category of credit growth for the past five years, as out-of-work people seek to rejuvenate or retool their skills in the (usually desperate) hope that they will find work as a result. Often they do not, and there is no income to service the loan. The individual is left with an anchor around their neck, and the federal government is left with the defaults, currently running at a rate of 11% of all outstanding student loans.
So the US now has a mini-housing bubble, a government securities bubble, a student loan bubble, a farmland bubble, and to that we might add a car loan mini-bubble. GMAC, now named Ally Financial, is back to its old tricks, as are the other auto lenders. They are offering car loans to sub-prime credits for out to seven years – the longer maturity helps keep the down payment lower for the average cash-strapped consumer. One in four auto loans last year was to a sub-prime or worse credit, and that ratio is higher even than in 2007, when the financial bubble was about to burst.
We forgot one last thing – the stock market bubble. This is a deliberate distortion of the equity markets by the Fed – they have said for quite some time now that their Quantitative Easing programs, along with Zero Interest Rates, are designed to force savers into speculating in the stock market, which they hope will be higher “than it otherwise would be.” Boy, did they get that right. A study last year showed that the S&P 500 index, currently trading at 1500, would be four to five hundred points lower if you removed the gains made on just on those few days when the Fed Open Market Committee announced the results of its monetary policy deliberations. In almost every such meeting since 2008, the FOMC has announced one form or another of bank bailouts or Quantitative Easing, and the stock market has soared giddily ahead, sometimes more than 50 points in a day on the S&P 500.
Another study showed that intraday, the stock market moves ahead every time the Fed finishes a bond purchase, all of which are telegraphed in advance to the banks who have to find the paper to deliver to the Fed in exchange for cash. It is as if these banks turn around immediately and place the cash in the stock market, and the equity traders position themselves in advance. The third tell that the stock market is in a Fed-induced bubble is that on those infrequent spells when the Fed is not pumping the economy full of liquidity, the stock market suffers a setback. Late last year Goldman Sachs published a study that showed that not just the stock market, but the entire US economy, moves in cyclical synchronicity with Fed liquidity programs. Why this is, is not exactly clear, but it seems to indicate that all economic actors in the US are focused first and foremost on whether the government is continuing to push cash into the economy to keep it afloat.
When the Fed takes its foot off the monetary pedal, the economy begins to sink again. A curtain is drawn back, revealing the real underlying economic conditions: non-existent growth in real personal income, mediocre individual consumption, stagnant industrial and manufacturing production, flat corporate revenues, a chronic trade and current account deficit, and declining consumer sentiment and confidence in the economy. The real disappointment is with the job numbers. Job creation is averaging around 100,000 to 150,000 a month. Commentary always mentions the fact that this is too low to cover the number of new entrants to the job market every month, but most economists miss the salient fact that the jobs being created are usually lousy. They pay minimum wage, no overtime, and few if any benefits. They are concentrated in low-wage and low-skill services like basic health care, the hospitality industry, restaurants, and retail. Hidden beneath all this is another reality – wage compression continues in the “good jobs” that pay $40,000 or more a year, but haven’t allowed for a salary increase that covers inflation, and that force workers to absorb most of the raging health care cost increases that plague the economy.
The wage compression that has been a feature of the job market since the 1980s continues unabated. Without any change in this situation, the prospect of a “sustained economic recovery”, which so many economists are predicting for 2013, are nil. Yes, we could get the sustained economic recovery we saw from 2000 to 2007, which was built on a massive credit binge for the middle class, and this does seem to be what the Fed is desirous of happening, or it wouldn’t be bubbling up the financial and asset sectors the way it is. But who is going to extend the credit? The banks remain shut for business unless it is for a product that carries no risk for them, like student loans or government-guaranteed mortgages. All the liquidity that has been pumped into the big banks remains clogged in the financial system, building up day after day. You can see the results on their balance sheets: normally assets are equal in size to the deposits which fund them, but in this post 2008 world, assets have been building up tremendously and dwarf bank deposits.
Even if another credit blow-out occurred, we all know how that would end – very badly, as in 2008 credit crisis all over again. Unfortunately, without another credit splurge the results are the same. When the credit stops flowing, income is hit hard, because most of the growth in income in the economy is produced by debt, and it is not organic growth that would result from a normal recovery generated through capital investment, wage and benefit increases, revenue advances, and expanded global trade. This is precisely what the Fed understands, and why it is expanding its balance sheet ceaselessly, and enabling the Congress and Administration to build up debt at the tune of a trillion dollars a year. All this credit is the lifeblood of the economy, allowing the government to make Social Security and Medicare/Medicaid payments, feed 48 million people through food stamps, fight wars in multiple hot spots around the world, pay interest on the debt to keep bondholders happy, and shift unemployment money to the states.
The problem for the Fed is that the unraveling is already beginning. The stock market may be testing its highs, and 50 out of 50 economists may be anticipating a solid economic recovery, but without new sources of credit that is going to be impossible to achieve. Credit has already dried up in the real economy, which is why you hear so many retailers say “nobody has any money”. Worse still, for the consumer, austerity has come to Washington. Taxes are heading up – the first round hit taxpayers this January when Social Security deductions were increased. The Republicans are demanding much more still, and President Obama is sympathetic to their pleas because he does not seem to fully appreciate how the economy is balanced delicately on the tip of a needle pin, able to slip right back into a credit crisis at the slightest shock. Any sort of shock is going to hurt consumer spending even more than has occurred, which will constrict debtors payments to creditors, which will lead to defaults and stress on lenders. The big banks in particular do not need any more stress. The question then, is what sort of shocks need to be avoided? What should we be looking out for in 2013, the year everyone thinks a sustained economic recovery is in the cards?
The Fed Changes Course The December 12 decision of the FOMC was presented by Ben Bernanke as a near unanimous opinion by the committee to expand Quantitative Easing nearly forever. The truth as reported in the minutes that came out later was different. Several members of the committee were very concerned about the unwanted effect of the expansion into purchasing Treasury securities, and cited the evidence already in place that asset inflation is on the march in several markets. A few members wanted the new program to end at the end of this year, and some wanted to end by the summer. Unanimity is therefore not present, and with Ben Bernanke implying he will not be running for another term as Chairman, several analysts said he may join the hawkish crowd in favor of reducing or halting monetary stimulus, in order to give his successor a fighting chance at having some leeway in terms of policy. This does not contradict what I wrote earlier – that the Fed cannot reduce its balance sheet. True as that is, the Fed does not need to begin selling securities it already owns. To damage the economy, all it needs to do is stop buying any more securities. As we’ve seen in the past, that constitutes a form of monetary tightening that effects the economy immediately and for the worse.
The Fed Loses Control Over Interest Rates I noted that the Fed has never had strict control over long term rates, and that 30 year bond rates have begun creeping up despite the Fed being an active purchaser of bonds in that maturity. Fed control over short term rates is assumed, but what if this assumption is wrong? Could short term rates begin to head up in the market despite the Fed? The link between the Fed, commercial banks, and the economy is broken to a degree already. Zero interest rates have served to benefit the banks, but have not been passed on to the economy. Nobody on the consumer side is allowed to borrow money at anywhere near zero percent. Credit card rates are still anywhere from 15% to 35%., and fees in that business have expanded to encompass just about any mistake a consumer can make. Even 30 year mortgage rates, quoted at 3.5%, are given only to a small number of very wealthy clients; everyone else borrows near 5.0%. So ZIRP has been a bust, other than to serve as a way to transfer wealth to banks. Short term interest rates could therefore creep higher still no matter what the Fed does. The Fed could jawbone banks and pressure them to keep rates stable, but when self-interest or self-survival comes into play, the banks will and in fact must ignore the Fed. The Fed could begin buying Treasury bills for maturities under one year, but the FOMC is already nervous about expanding the central bank’s balance sheet any further. Statistics have shown over the years that the Fed follows the market when setting rates, and if the market deems that even short term rates are too low, inevitably the Fed must to some degree accept this. As to why the market would come to such a conclusion, it really is all a matter of confidence. If investors lose confidence that the US will ever gets its fiscal house in order, one hundred years of global economic dominance and reserve currency status is not going to save the day for America.
Asset Inflation Breaks Out Elsewhere Currently asset inflation is contained to the US, but it could occur globally now that central banks in the UK, Europe, China, and Japan have all joined the Fed in its unlimited quantitative easing program. The world has never seen a monetary experiment of such magnitude take place in all important countries at the same time, but suffice to say money printing is now the global order of the day. What could possibly go wrong? We have already seen what has happened in the United States – asset inflation in several markets, not unlike what happened under the Greenspan era. It is well worth watching global asset markets, such as precious metals, crude oil, commodities (particularly foodstuffs), equities, and high yield credit markets, for signs of inflation. Anything to do with food can be especially troublesome for governments, and could force an unexpected end to central bank money printing. Increased food costs have led to riots in many countries in the past, some of which as in China get little press coverage. Outbreaks of hunger can easily imperil social and political stability, and with the current fraught and teetering nature of global finance, a credit crisis can surely follow.
Exogenous Shocks There are so many potential non-financial shocks, with indirect substantial financial consequences, that it is impossible to list them all. The obvious ones at the moment consist of a military skirmish between China and Japan, military conflict between Israel and Iran, an expansion of the Syrian civil war that drags in larger countries like Russia and the US, continuing natural disasters due to climate change, an outbreak of global illness from a highly contagious pathogen, further destabilization in the Arab Spring countries that then leads to damage to the oil market, the eruption of a currency war among the major countries (a cold war of competitive devaluations is already occurring), the imposition of undue fiscal austerity in the US or Europe, trade sanctions or a trade war occurring, especially between the US and China but equally likely between the US and Japan, and a concerted effort by some countries to dethrone the US dollar as the world’s reserve currency (both Russia and China would dearly love to accomplish this, under the mistaken impression that somehow their currencies would replace the dollar to a degree). A sufficiently strong exogenous shock would find the world unable to summon up the financial resources to deal with it, not to mention that global cooperation has been deteriorating for years now, making it far less likely that a quick consensus could be formed to deal with it.
A Credit Crisis The 2008 financial crisis started out as a credit crisis with the Bear Stearns brokerage house. Most global financial crises in the past have been instigated by an unexpected default or bankruptcy, exposing weakness in the financial system. There are many obvious places where this could happen in the US – a bank could announce unanticipated large losses from student or auto loans, or in the bond market. There is also an obvious potential for an accounting fraud to come undone. Caterpillar recently announced it had to write off hundreds of millions of dollars of an investment in a Chinese company that was perpetrating massive accounting fraud. But if you really want to think about the unexpected, concentrate on the fiduciary side of the equation. The Fed’s Zero Interest Rate Policy has been devastating for fiduciaries, such as insurance companies, university endowments, foundations, charities, pension plans – anyone who is dependent on stable interest income for survival. As time goes by – and we are five years into this program – securities mature which yielded 5%, and have to be replaced with securities which earn 2% or less. Many fiduciaries skip investing in securities and instead play in the stock market, or in the high yield credit market, taking on substantial risks to maintain some yield. Wall Street analysts are already beginning to worry about declining net interest margins at banks, which is the difference between interest earned on assets vs. what is paid on deposits. Theoretically, in a Zero Interest Rate environment, the net interest margin itself will sink to zero or some very small number that cannot possibly pay for a bank’s expenses or protect it against risks. Banking becomes uneconomic in such an environment, and so does the insurance business, and so do pension plans. Very little press or publicity has been given to this problem, but it is insidious, it is growing, and it is one area where an unexpected event could expose dangers in the economy no one had realized.
The End Game Approaches
In the past two decades, inflation, where it does show up, is manifest as asset inflation. Price deflation, affecting the cost of goods and services, is however the underlying condition affecting the global economy in an age of labor arbitrage. The cost of labor in the developed world has shrunk year after year since globalization freed up billions of Chinese and Indian workers to participate in a competitive market place, and the effect has been felt in every developed country. Attempts by the central banks to fight global labor arbitrage (and the Fed now officially is in this game, promising to continue monetary easing until unemployment in the US goes substantially below 7.0%), have been futile and have only caused inflation to seep out into assets, but not into prices. Multinational corporations have been beneficiaries and instigators of global labor arbitrage and the deflation which ensues (everyday low prices at Wal-Mart, as an example), and their power remains unchecked at this point. A global deflationary collapse of the financial system has remained an increasing risk in this environment, and was only forestalled in 2008 by the concerted efforts of central banks and governments to prop up the major banks. Ever since then, central banks have been obliged to replace commercial banks as the purveyors of credit to the global market. This is a game the central banks cannot win. The global forces of deflation are too strong, unless you assume a billion Chinese citizens are going to be pushed backed into subsistence living under Communism, and so the central banks can only fight this battle by constantly escalating their efforts until no more escalation is possible. Compared to a year ago, the global economy has seen massive escalation of money printing, yet growth has shrunk or been converted into economic contraction in the UK and other parts of Europe, and in Japan. This is a losing battle; at some point living standards in the developed world are going to have to ratchet down to meet up with rising living standards of the middle classes in China and India. That “lurch down” is what we are worried about. It will be dramatic, and permanent, making this current depression much worse and far more memorable than anything that happened in the 1930s. The collapse of the system which propped up Western living standards for 25 or more years – a system built on credit and debt – is closer than ever. No one can predict when it will occur, but that it will happen is harder to deny as we all watch the central banks pull out every conceivable money printing trick, with no success to show for their efforts other than holding off the inevitable.