September 03, 2010

Annaly Salvos is taking the day off. Enjoy the end-of-summer weekend!

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August 31, 2010

Asset bubbles and leverage are kindred spirits. Just look at housing, tech stocks, and tulip bulbs. But if this is a necessary bubble condition, bonds don’t make the cut. Thanks to data provided by AMG and the Fed, we know there has been real, unleveraged buying behind the bond rally. In fact, many have failed to participate in 2010’s U.S. Treasury market’s climb. As a data point, last week Stanley Druckenmiller, a veteran hedge fund manager, expressed his frustration with missing this year’s bond rally. We surmise he has plenty of company in the hedge fund community.

Real money demand for bonds reaches beyond the Fed’s portfolio activities. Specifically, mutual fund data indicates bond performance has been fueled by long-only traditional investors. This group has been pouring money into the asset class en-mass for two years now. In the table below, we show the cumulative net inflows into mutual funds from 2009 to present. The trends show a stark contrast in asset type preference: income over growth. Consider that money funds, which pay no income, and equity funds which thrive off growth, have either lost assets or held steady.

Fixed income sectors have enjoyed robust inflows. For example, the sizable category of Taxable Bond Funds has witnessed asset growth of a massive 39% due to new-money flow. The bond market has delivered the returns. Consider that the 10-year Treasury note has posted a staggering 18% annualized return this year thanks to a 125 basis point drop in its yield and a little convexity. While the initial impetus of real money to asset allocate into bonds may have been safety and yield, it has arguably morphed into something more fundamental. As the disinflation/deflation concept has become more entrenched in the collective psyche, investors are willing to accept lower long-term nominal yields. The stellar past returns have been more accidental than anticipated. As we noted last week, it appears further disinflation is priced into the current level of U.S. nominal yields. As evidence, consider that 10-year Treasuries are trading 75 basis points rich to JGBs in real terms, a relationship that may be supporting Yen’s recent strength.

So - what will trigger a reversal in the real money flows? This seems critical to the “bond call”. Given that cash, stock, bonds and real estate are the lion’s share of most investors portfolio mix, perhaps we should posit the question differently. When will investors start buying stocks again? Here the deflation theme rings ominous: firms become price takers rather than price makers and earning and margins adjust accordingly. Another factor that may still be vivid in the memories of investors is the realized losses experienced by stocks holders. The below AMG data show, that there was heavy selling of equities at the 2009 lows. Ouch!

Comments [0] | Bond Markets | Equity Markets | Macro Economics

August 27, 2010

The “bond bubble” discussion in the mainstream media has become deafening lately. Some of the commentary has been thoughtful and interesting, but not all of it. Much of the bubble-watch has focused on asset flows into fixed income funds, the total return of Treasuries over the last 10 years, and the theoretical possibility of a bubble in an asset class that guarantees return of principal.

Asset class inflows or high total returns can be symptomatic of a bubble, but a true bubble must be characterized by extreme overvaluation. Beyond pointing to a nominally low yield, the discussion of Treasury valuation has been lacking. Certainly the Siegel/Schwartz WSJ editorial comparing 10-year TIPS to tech stocks valued at 100x earnings is not a realistic comparison. Treasuries aren’t valued on a P/E basis; Investors buy Treasuries to earn risk-free income. In the short run, Treasury yields are driven by the usual suspects: fear and greed. But in the long run, the biggest influence on yields is anticipated inflation. Investors demand a certain return, after inflation, for risk-free investments. The chart below plots the 10-year Treasury yield against the year-over-year change in core inflation.

When “valuing” the 10-year Treasury, your estimate of future inflation seems to be the most salient input. The problem is that nobody knows what inflation will be like for the next 10 years, so we have to guess. Behavioral economics defines the overweighting of recent experience as the “recency effect.” During the late 1960s and 1970s, yields on the 10-year rose but didn’t quite keep up with the rising level of inflation, as investors had grown accustomed to the preceding period of low inflation. Throughout much of the 1980s, investors were reluctant to push the yield on the 10-year yield down in line with inflation, for fear of its imminent return. The mispricing during this period is more evident when looking at the spread between the 10-year and core inflation.

The mispricing that happened from the late 1960s throughout much of the 1980s was due to a volatile period where there was much uncertainty about the future rate of inflation. The average spread between the 10-year and core inflation in the chart above is 2.66% (it falls to 2.63% if you use the CPI-All Items index…essentially the same). The data series of the constant maturity 10-year from the Federal Reserve is admittedly small (it only goes back to 1953), but back-checking it using Professor Robert Shiller’s much longer data set yields an average spread of 2.42% on comparable data going back to 1871. The current 2.03% spread is certainly not out of the norm for this data series, unlike the valuation of tech stocks in 1999 which was many standard deviations away from normal.

When viewed in this context, the 10-year doesn’t look like a bubble. It looks like market participants are expressing an opinion about where inflation is going. And based on the historical relationship between Treasury yields and inflation, they aren’t doing it in an extreme way.

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August 24, 2010

Existing home sales can’t go to zero, can they? They clocked in at 3.83 million on a seasonally adjusted annualized basis in July, down 27% from the prior year, half of the 2005 peak of 7.25 million and the lowest since the National Association of Realtors started keeping records in 1999. The reason given most often for the steep drop is the end of the $8,000 tax credit that pulled future sales back to the spring. We understand this line of reasoning; we made the same one when we watched the pullback in auto sales after the end of the Cash-for-Clunkers program. The distorting effects of government support for any market will be made manifest when that support is removed.

The new question for the housing market—if not the whole US economy—is where we go from here. In the graph below we lagged existing home sales by eight months so that the top in the market prior to the expiration of government support, April 2010, coincides with the Cash-for-Clunkers driven top in new car sales, November 2009. (So forgive our graphmaking…the x-axis directly corresponds to car sales.)

Cars are not homes. The product is different: Cars have more limited life spans, lower price points, no down payment requirements and they can be junked or left to rot in front yards at their depreciated value. And the market is different: Carmakers can calibrate production more precisely, and a leased car is counted as a sale. So the experience of car sales shouldn’t necessarily be a guide for home sales. That said, both typically require financing, are economically sensitive and a barometer of consumer confidence. We certainly observed that each market will respond to government stimulus and will behave similarly once the government support is removed. Thus, if we want to use the experience of the car market as a template for home sales, then eight months from now we should expect to see existing home sales still at cyclical lows but gradually improving.

But what this very simplistic analysis fails to take into account are the prices at which those home sales may occur. The housing market is dealing with a huge supply problem right now. The number of existing homes for sale has stayed rather flat at 4 million, but based on the latest sales figure, the inventory now stands at a record 12.5 months of supply. But the graph below, courtesy of Ivy Zelman and her eponymous Zelman & Associates, tells an even worse story. After factoring in the growing amounts of homes in the shadow pipeline supply of 90-day delinquent homes and homes in the foreclosure process, there are over 26 months of supply. Based on the graph below, unless we hear about a big uptick in bulldozer sales, the experience of the car market may also be accompanied by a downdraft in home prices.

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August 20, 2010

My fellow mortgage market participants,

On Tuesday, I attended the “Conference on the Future of Housing Finance” hosted by Treasury Secretary Tim Geithner and Housing and Urban Development Secretary Shaun Donovan in the Cash Room at Treasury. I believe Annaly was invited because we have been actively engaged in the process in Washington, including submitting a response to Treasury’s request for public input on housing finance reform, and because we are a sizeable representative of the constituency of mortgage investors. We’re glad to be a part of the discussion, as I feel it is incumbent on us to share our views with policymakers and legislators on this matter of great national importance. As a company we are active in the markets, and we believe that our experience and insight can help provide some context and sense of consequences for different policy options.

The purpose of this letter is not to provide a play-by-play summary of the conference, as these details have been well-described in other venues and media. Rather, with this letter I hope to provide a few of my main take-aways.

First, the scope of the panelists, the diversity of the attendees and the range of breakout sessions was sufficiently broad to make this conference a success at airing a wide range of perspectives and opinions, but it was not a venue for making any progress towards a resolution. Thus, anyone who was anticipating a momentous announcement or watching the live webcast or the TV coverage should have ratcheted down their expectations about the conference’s intentions. While the nominal intent of the day was, as Secretary Geithner put in his opening remarks, to “consider the challenge of how to build a more stable housing finance system,” the best outcome was that every constituency could come away from it feeling that their voice had been heard. At the end of the day, the conference was substantive and informative, but it did not advance the ball.

After all, it was a fairly straightforward exercise to go to www.regulations.gov to download the submissions of the panelists or visit their websites to know, more or less, what each of them was going to say. Alex Pollock was going to advocate for a transition to a market with no GSEs, just private secondary market support. Lew Ranieri’s take was that securitization isn’t the villain, bad underwriting is. Keep the wrap, but make it for a smaller segment of the market within FHA. Susan M. Wachter was on the Center for American Progress’s Mortgage Finance Working Group (even though it wasn’t mentioned in her biography that was circulated at the conference), and their proposal, in brief, is they believe in the government guarantee and support continuing Ginnie Mae in its current form and creating “Chartered MBS Issuers” (CMIs) to insure securities. A CMI could be a utility, a co-op, a mutual or other private investor model, but with sufficient capital to protect the taxpayer. Leaders of the home mortgage businesses of Bank of America and Wells Fargo both generally agreed on risk-based pricing for a government guarantee although they didn’t have a specific model in mind. They probably would agree, however, with the proposal of the Mortgage Bankers Association, which favors government support of the secondary market through a security-level government guarantee, much like a Ginnie Mae wrap, which would in turn be backed by “private, loan level guarantees from privately owned, government chartered and regulated mortgage credit-guarantor entities (MCGEs).” The MCGEs would be the issuers of the MBS. Other panelists addressed affordable housing, multi-family housing and affordable rentals.

So if I basically knew what each speaker was going to say, and if expectations were managed to an appropriate level, why did I go? Well, sometimes we learn more from attending a live event than from watching it on TV or reading transcripts. For example, the Cash Room at Treasury is a small, but ornate room with a long history associated with it. It lent a certain grandeur, gravitas and excitement to the conference, and as a result I felt the participants were engaged, maybe even a little on edge about being there. It was a very scripted event, with Secretary Geithner and then Donovan each running their panels very tightly, with little exchange between panelists and no questions or comments at all from the audience. Also, I sensed that Secretaries Geithner and Donovan were uncomfortable serving as panel moderators, and if they were I can’t blame them. Think about it: They are the people supposedly providing leadership on housing finance reform, and during this conference they were little more than facilitators. I suppose their involvement was intended to show the seriousness with which the Administration is taking this issue, but I can only speculate on the execution.

I also went to represent a particular constituency which too often is overlooked in the discussions—the secondary market investors who provide the majority of the capital to the $11 trillion mortgage market. I believe all the discussion and theorizing about housing policy reform that is done by most of the panelists is done in a virtual world, a world without costs or consequences because they do not consider my perspective. Academicians and dogmatists, think-tanks and policy wonks can come up with myriad models and theories, but there is scant attention paid to the fact that reforming housing policy is about price. It is, or should be, about what mortgage rates will be in any new model, which in turn will affect the value of the nation’s housing stock. And we in the secondary market set that price. And as Annaly said in its submission to Treasury, “The market will adapt to whatever policy objective comes out of Washington, most likely by repricing the risk, uncertainty and friction of whatever replaces the current system. The consequences of change are that the size, scope, availability and efficiency of the current housing finance system will change as well. If the new system is significantly different than the housing finance system we have now, the consequences may be that our housing finance system is smaller, perhaps more appropriately priced, but with lower housing values and less flexibility and mobility for borrowers.” We could have added that the knock-on effect of any significant change would likely be felt in industries and workers in related fields, like home construction, real estate brokerage, building materials and housing-related consumption.

Which brings me to my next take-away, which is related to Bill Gross’s comments on the first panel. Mr. Gross also represents the investor base in mortgage-backed securities, and I agree with much of what he said, with two minor exceptions. In particular, I don’t agree with his belief that a cure for what ails the economy is a blanket refinancing option for anyone who is current on a GSE securitized mortgage, regardless of credit history, documentation and loan-to-value. Treasury has already taken the unusual step of refuting the possibility. “The administration is not considering a change in policy in this area,” Treasury spokesman Andrew Williams said on August 5. Leaving aside the moral hazard involved (the lender has no responsibility under a mortgage agreement to protect the downside risk of home prices falling just as the homeowner has no obligation to share any upside with the lender), the rumored plan doesn’t hold water. First, the potential stimulus amounts—Gross’ estimate of $50 billion per year is in line with others—is not insignificant, but it is not a game changer and it is not without cost. Look how effective the stimulus plan has been. Not least is the extent to which we get a population that is entrenched in their low mortgage rate homes in the event they had to move in the middle of a higher interest rate environment. But more to the point of how we got here, if there are no underwriting standards as part of a refi/stimulus plan under the GSE umbrella, the government would essentially be guaranteeing un-diligenced borrowers with un-valued collateral. The actual process of refinancing itself would constitute a large capital call on banks needing to refinance the mortgages. Furthermore, to the extent that Fannie Mae and Freddie Mac are taking steps to recoup money for taxpayers—through putting back mortgages that were improperly underwritten or suing issuers of fraudulent private label securities—a refinancing program like this would undermine that effort. This idea is nothing more than an interesting hypothetical thought exercise. In any event, refinancing activity is picking up of its own accord through conventional channels and with appropriate underwriting standards as mortgage rates continue to drop.

Another point Gross made is that “PIMCO would not buy a private or a privately insured mortgage pool unless it was accompanied by a 30 percent down payment…” As we said in our submission, the market will adapt to whatever policy decision comes out of Washington by repricing. PIMCO may decide it needs to reprice by demanding a 30 percent down payment, but that is unrealistic in today’s market. We think the market would likely reprice through a combination of stronger underwriting standards and higher, potentially much higher, rates.

Despite these quibbles, I am in total agreement with the main thrust of his statement: “To suggest that there’s a large place for private financing in the future of American housing finance is unrealistic….To suggest that the private market can come back in and take the place [of the government balance sheet] and do the same thing that they’ve done for the past 20 or 30 years is simply impractical. It won’t work.”

To prove the point, consider the following graph. It shows the trends in home mortgage debt and bank deposits in the United States over the past 35 years. What becomes clear is that with almost $11 trillion in home mortgage debt and less than $8 trillion in deposits, the banking system alone is not sufficient to fund all home mortgages in the United States.

The size of the shortfall between home mortgage debt and deposits is illustrated in the following graph. In it, we have to start with an assumption that not all deposits would be used to fund mortgages. Instead, we use the recent historical evidence that the average mortgage-to-deposit ratio among FDIC-insured banks is about 25%. In this case, the hole is about $8 trillion.

This hole between the demand for housing credit and the supply of capital is mostly filled by the securitization market. Taken together, in round numbers, that $8 trillion represents a good approximation for the amount of Agency and non-Agency mortgage-backed securities outstanding. About 70% of that is held by investors in rate-sensitive Agency MBS, with the balance in credit-sensitive non-Agency MBS. To paraphrase Gross, it is unrealistic to think that the buyers of credit-sensitive non-Agency MBS will show up in sufficient numbers to supplant the installed base of rates buyers. I would add, at least not at the current price. Without the support of mortgage values and home prices that is provided by the government guarantee, that hole will get smaller not by increasing demand from the traditional non-Agency buyer but by shrinking the value of the collateral and the mortgages needed to finance them.

My final take is that the general consensus among all participants in the room about how to restructure the housing finance system is a desire to 1) maintain the government guarantee in the mortgage market, 2) continue to enable the to-be-announced (TBA) mortgage market, and 3) find a replacement for the hybrid business model of Fannie Mae and Freddie Mac that can deliver these items in a manner that offers the greatest protection to taxpayers. In short, keep what works and get rid of what doesn’t. Treasury has indicated that it is working to have a plan for release by January 2011, and it has not indicated whether it currently has a plan in hand. But if we take Secretary Geithner’s on-the-record remarks at face value, I have to conclude that he agrees with this general consensus and that Treasury’s plan will reflect this.

After sitting in the Cash Room, my recommendation to Secretary Geithner is to lay out the plan as soon as possible. The cacophony of voices, proposals, hearings, conferences and headlines will not shed any more light or break any new ideas on the subject, and the delay only adds to the uncertainty that is already in the market. The fact remains that if we did not have Fannie Mae and Freddie Mac right now, the government would be trying to create something like them in order to have housing finance operate in the national interest, much like when the Roosevelt Administration created Fannie Mae in the depths of the Great Depression. And one look at the holders of Agency MBS shows me that this market is virtually on the Federal balance sheet already, so don’t shrink from it. Banks, the Fed and Fannie and Freddie themselves are already government-backed, and foreign investors have only shown interest in the asset class because of that government backing. Since 2007, the Fed has diluted the foreign holders.

I believe that Fannie and Freddie should continue to operate in conservatorship with a goal of winding down their retained portfolios over a set period of time. At that point in time they would be nationalized and perhaps merged into one entity. This would enable them to continue to have their MBS guaranteed with a government wrap, enforce underwriting standards, and enable the flow of credit from the secondary mortgage market to the primary mortgage market for conforming borrowers through the TBA mechanism.

The one aspect of Fannie and Freddie’s current business model that would have to be replaced would be their portfolio activities. That is, their mandate to provide support and stability in times of market crisis or illiquidity. The private market could step up to play that role in tandem with the Federal Reserve. Funding is an integral part of the mortgage market. The majority of Agency MBS investors in the above pie chart are leveraged. Banks, insurance companies, foreign financial institutions and many private investors use varying degrees of leverage, while the GSEs themselves and the Federal Reserve are infinitely levered. These investors fund themselves in different ways, but they are all financed by different segments of the credit market. Whether it is deposits, the repo markets, the debt markets, the Agency debt market or Treasury sales, all of these investors are levered and this financing is available and priced where it is because of the government guarantee. Rather than establish a procedure by which some instrumentality or agency of the US government sets itself up as a potential investor in mortgage assets in times of market crisis or illiquidity (like Fannie or Freddie used to, or the Federal Reserve did with its $1.25 trillion buying program), I suggest setting up a funding mechanism that would enable the private market to step into that role. In other words, the government would not be an investor of last resort, rather it would play its more traditional role as a lender of last resort. This could take the form of a TALF‐like program which comes into existence during proscribed market conditions, charges high enough margin and rates yet still enables private capital to earn a return.

There is a lot of emotion surrounding Fannie Mae and Freddie Mac. When people ask, “Where is the outrage?” regarding the mortgage debt bubble, more often than not it is the GSEs that are effigied. My suggestion to any legislator or Treasury official who is met with outraged voters at this plan is to ask a series of questions: How many of you have 30-year fixed-rate mortgages? How many of you were able to get a 60-day or 90-day rate lock when you went through your mortgage process? How many of you cashed-out home equity to pay down credit card bills, pay for college or finance a small business? Do you appreciate that you could get a mortgage from a local bank or mortgage lender as opposed to one of a small number of Wall Street money-center banks? Who here would choose to pay a higher rate in exchange for no government involvement? How much higher? 2%? 3%? 4%? How many of you understand that a likely consequence of these higher rates is that your house will be worth less?

In conclusion, please note that I addressed my letter to “fellow mortgage market participants.” This is an extremely wide swath of America; it includes stock and bond investors, lenders and borrowers, home-owners and home renters, pensioners, realtors and builders, lawyers, accountants and retailers. It underscores the primacy of this discussion to the American way of life. Housing finance reform is no less important or socialized with entitlement to the average American than healthcare or Social Security. You don’t have to own an Agency mortgage-backed security to be affected by it. As Martin Luther King put it in his letter to his fellow clergymen 47 years ago, “Whatever affects one directly, affects all indirectly.”

Yours,

Michael A.J. Farrell                                                                                                        Chairman, CEO and President

Comments [2] | Current Events | Government Policy | Housing | Macro Economics | Mortgage Markets

August 17, 2010

The initial estimate of 2.4% annualized real GDP growth in 2Q 2010 will likely be revised lower (probably to something with a 1%-handle, depending on who you ask) in light of new data for June that was worse than the estimated (net exports, personal spending, etc). The third quarter isn’t starting off so hot either, based on some of the early data points for July. ISM manufacturing index for July ticked down and continues to roll over (though still above 50), retail sales have been relatively weak, consumer confidence has faded recently as initial jobless claims have been on the rise throughout the back half of July and into August. We’ve already discussed the weakness in July nonfarm payrolls in great detail. Consumer credit continues to decline.

That’s why today’s data on industrial production looked a little strange. Industrial Production came in much better than expected in July, up 1% month-over-month versus an expected increase of 0.5%, and appears to be continuing its unrelenting march higher. Looking through the underlying sector data, one group in particular jumped out: transportation equipment. We’ve included it in the chart below along with total industrial production.

What follows is a case study on seasonal adjustment factors.

About half of transportation equipment is auto and auto parts, and this is the segment that drove the upside in transportation equipment production in the month (the rest consists of aerospace, rail, boat, and other, all of which were muted). This seemed particularly strange, given the very moderate level of auto sales in July.

Production of transportation equipment tends to track sales, though not perfectly; aerospace and the rail/boat/other segments drove the increase in this index into late 2007 as auto sales were falling off. So why the unexpected spike in production during the month?

The Fed’s industrial production data is seasonally adjusted. You may recall how decreased auto plant shutdowns were skewing the initial claims data during July, which was widely reported. Based on the chart below, it appears that this same phenomenon is affecting the industrial production data as well.

As you can see in the chart above, the typical production decline in July is substantial before adjustments are made, and the July 2010 decline is relatively small in comparison. This may be having the effect of skewing this month’s seasonally adjusted numbers much higher, causing the noticeable spike seen above.  It’s unclear how seasonal adjustments are affecting other sectors of the index, but the transportation sector is an interesting example where we have some evidence that the data is skewed.

We aren’t certain of the future path of industrial production (nobody is), but we would caution against extrapolating July’s relatively strong month-over-month results forward. Given the disappointing reading of the new orders sub-index of the Fed’s Empire Manufacturing survey, which tends to lead changes in industrial production, it seems reasonable to expect more moderate results as the effects of questionable seasonal adjustments fade.

Comments [0] | Macro Economics

August 13, 2010

Back in June we wondered out loud, “What is a dollar?”  That exercise—as well as the recent schizophrenic behavior of the currency market and the lamentations regarding the Fed’s “printing press”—has led us to wax philosophical on this Friday in August, and ask the question that is the title of our post today.

We tend to give the concept of money very little thought. For example, how many transactions does the average person engage in every day, and in how many forms?  Our first transaction of the day is handing $1.25 in cash to a guy in a cart on 47th Street for our morning coffee. Throughout the day we buy lunch with a debit card, buy a book  online with a credit card, transfer money to pay bills online and write a check to pay ConEd.  In this parade of transactions, the relevant questions are “How much money do I have?” and “Do I have enough of it to pay for these things?” At no point during the typical day do we question the unit of exchange for all this activity, the US Dollar, or even wonder if it will be accepted as a form of payment (regardless of the form—cash, check, megabytes over an internet line).

The typical complaint about the dollar is that it is a fiat currency, one that is backed by nothing but the faith in America and its institutions.  Some feel more comfortable knowing that their paper money can be exchanged at any time for a set amount of gold; it seems more grounded somehow, less faith-based. But a quick look at gold, despite it having a limited quantity (it can’t be printed at will), reveals that the major drawback of fiat money also applies to gold, meaning it only has value because we have always ascribed it value.  Essentially, it is a malleable and ductile metal with a limited range of inherent utility. At the end of the day, you can’t eat it, or live in it (but you can wear it). As Willem Buiter, the chief economist at Citigroup and a gold bear, said, gold has benefitted from “the longest-lasting bubble in human history.”

So, with money, backed by gold or otherwise, what do we really have? Maybe we have something of a modified “greater fool” theory where we expect that it will have a value to somebody else in the future. If people start doubting the future value of money, then people will be less likely to take that money today. This is starting to sound like a very fragile system. It may or may not be, but nevertheless there is a natural tendency towards developing and using some form of money, like water flowing downhill.  It makes things easier.  A barter system is cumbersome, constrained by a double coincidence of wants requirement (i.e. for two people to trade, they both have to have exactly what the other person wants).  That is why it is necessary for groups of people to form their own currencies.  Think about cigarettes in US prisons (actually, now that smoking is banned in prisons, mackerel is the new currency).  The natural first step is commodity money, where the form of currency typically has an actual use (cigarettes), but is different from barter because there is a fixed unit of measurement that goes along with it (i.e. 10 cigarettes for a sandwich). Commodity money makes transactions easier, but some forms aren’t very durable (like fish), and can be hard to transport and store.  Gold (and dollars) as commodity money fixes the issue of transportability, storage and durability, but why would we have developed a system of money based on something that is inherently worthless when it comes to sustaining actual human life (unlike milk or codfish)? In short, because doing so is beneficial to us. The value of money/gold stems not from any specific utility but from the options that it presents to its holder. 

Consider a haircut and a movie ticket in a world with no money. In this world, a barber will only get to see a movie every few weeks, or every time the movie theater owner needs a haircut.  He has no other options.  What he eats for dinner depends on what the farmer who needs a haircut that week grows or raises.  But when the same haircut is purchased with money, the barber can then use that currency to purchase whatever he wants.  He has options.  He can go to a movie whenever he desires, he eats what he wants for dinner.  The value of any currency derives from the options it affords its holder, and the flexibility and opportunity that come along with those options.  “Wealth” really means that we have enough money to access many options.  Whether people realize it or not, at its most atavistic level the propensity to accumulate large amounts of money stems entirely from a desire for choice.  When we desire those extra bills in our pockets or the additional zeroes in our bank accounts, what we are really after is access to more options for ordinary and fundamental wants and needs: more clothes, educational options for our children, more living space, future financial stability, the ability to satisfy more philanthropic impulses, etc.  We value money not for what it is, but for what we believe it can obtain in exchange.

Money, whether gold or fiat currency, is at its essence a belief system. And like anything based on beliefs, certain events over time can call those systems into question. The seeming capriciousness of cancer or Alzheimer’s can test some people’s faith in religion, and the events of the last three years certainly tested our belief in this system of money. Nevertheless, there is a natural tendency in human society towards the use of money.  It makes things easier, greases the wheels of everyday life. In the essay "I, Pencil,"  Leonard Read describes the coordination of productive forces to create a simple item that we use every day:

“I, Pencil, am a complex combination of miracles: a tree, zinc, copper, graphite, and so on. But to these miracles which manifest themselves in Nature an even more extraordinary miracle has been added: the configuration of creative human energies—millions of tiny know-hows configurating naturally and spontaneously in response to human necessity and desire…”

It is impossible to imagine this process without the use of money.  The act of cutting down trees and trimming wood, mining graphite and zinc, the creation of machinery and the organizing of workers to run those machines, would simply be impossible without a readily acceptable currency to grease the wheels.

It may not be an exaggeration to extend this idea to the success of humans themselves as it relates to money as the ultimate form of cooperation and tolerance, allowing us to come down from the trees and populate the world.  Thus, there should be a fairly strong tendency for a monetary system not to break down, similar to mutually assured destruction, but it does happen, and it can happen in different ways, such as a group of people choosing an alternative, like the euro for the dollar, or creating an alternative. This is happening today in different parts of the world, from California to Brixton and from Ithaca to Ireland, as well as that small kingdom known as Disney.

As faith wavers in the current system of money and exchange, and as people contend with swings in the value of their local currency, it is worth remembering that the world needs money—the concept and the thing itself. Moreover, it needs a form of money that people will continue to have faith in, because we all want to know that the pile we have in our bank account today will be able to afford us the same options in the future. It isn’t a store of value that we need as much a store of faith and an instrument of cooperation. It can be the dollar, gold, or the yuan, or it can be Ithaca Hours or Disney Dollars.

Why is money? Because we’re humans.

Comments [0] | Consumer

August 10, 2010

The coverage of nonfarm payrolls is pretty exhaustive, so there isn’t much to add. The massive inflow/outflow of temporary census workers has not only distorted the underlying trends a bit, it’s also confused the reporting. The headline number is skewed by census hiring and firing, so news reporting services needed to come up with a new headline number. They chose “private nonfarm payrolls” as their metric. As several smart people have pointed out (Calculated Risk, David Rosenberg, TJ Marta, and a host of others), this “pro-forma” nonfarm payroll number isn’t comparable to the historical data series, because non-census government job trends can’t be overlooked. A comparable number would simply take out Census workers, not all government workers. Thus, private payroll gains of 71,000 were touted in the headlines, the comparable nonfarm payroll number ex-census workers for July was a paltry +12,000. The federal government fired 11,000 non-census workers and state and local governments dropped another 48,000 workers. The chart below shows the headwind to job growth posed by state and local government budget problems. To normalize the somewhat volatile monthly payroll changes, we look at the trailing 3 month average monthly change.

Don’t worry, the federal government is on the way: the House of Representatives votes today on an aid package already approved last week by the Senate that will provide $26 billion to state and local governments. This new $26 billion aid package will be added on to the pile of federal grants-in-aid to state and local governments, which was running at a seasonally-adjusted annual level of $525 billion in the 2^nd quarter of 2010.

Current receipts of state and local governments always dip during recessions, but at 25% of total current receipts, Federal aid to state and local governments is starting to look structural.

Comments [1] | Current Events | Government Policy | Labor Markets

August 06, 2010

Connecting two data events from the last 24 hours serves as a reminder to policy makers that if they really want to improve the housing finance system in the United States they should first work on improving the jobs picture.

First, Fannie Mae released its quarterly earnings last night, August 5. Behind the headline event—that the company will be asking for a smaller amount of capital from the Treasury in order to maintain positive net worth—is the news of generally improving credit trends. In the second quarter, the percentage of loans in Fannie’s single-family book of business that are seriously delinquent (90+ days delinquent) fell from 5.47% to 4.99%. The graph below, from the always useful credit supplement to the earnings release, sets forth the serious delinquency rate of Fannie Mae’s overall single-family book, with breakouts for selected states.

The company attributed the improvement to “the home retention and foreclosure alternative workouts that the company completed, as well as a higher volume of foreclosures.” If we understand that sentence correctly, it means that Fannie Mae is working assiduously on its mortgage credit problem (a problem that is not unique to Fannie Mae, by the way). Loans stay in the seriously delinquent bucket until there is a resolution, and Fannie Mae has been stepping up its resolution activity. Not only is it apparently removing loans from the seriously delinquent bucket at a faster pace (its real estate-owned portfolio continues to rise, and currently stands at 129,310 up from 109,989 at the end of the first quarter 2010 and 62,615 a year ago), but the quality of the remaining loans in the broader portfolio have a better credit profile. The graph below, also from the credit supplement, shows how the recent vintages are performing better than 2006 and 2007 originations.

In its second quarter 2010 10Q, Fannie Mae looked ahead and stated its estimation that the credit-loss pig may be almost through the python: “Since the beginning of 2009, we have reserved for or realized approximately $100 billion of credit losses on single-family loans, almost all of which are attributable to single-family loans that we purchased or guaranteed from 2005 through 2008. While loans we acquired in 2005 through 2008 will give rise to additional credit losses that we have not yet realized, we estimate that we have reserved for the substantial majority of these losses.” Eventually, the Agency stated, as the need to draw on Treasury for credit losses recedes, it will likely be replaced by the need to draw from Treasury to fund preferred dividend payments.

The second data point is this morning’s jobs numbers. Non-farm payroll growth underwhelmed again—the headline number fell 131 thousand and last month was revised down from -125 thousand to -221 thousand—and the unemployment rate held steady at 9.5% (thanks again to a decline in the worker population). As the Fannie Mae numbers illustrate, we are still witnessing the deflationary effects of the decline in underwriting standards of 2005 to 2008, but the baton of misery will continue to be carried by the poor jobs picture. The graph below shows the relationship between delinquency rates in mortgages and credit cards and the unemployment rate. Any good news on the credit front, whatever the source, will likely be more than offset by further drops in home prices and a continuing weak jobs picture. The correlation between the delinquency rate in mortgages and the unemployment rate since 1991 and through 2010 Q1 is 78%; since the end of the last recession it is 91%.

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August 03, 2010

The market is engaged in a discussion over what the Federal Reserve will do next. St. Louis Fed president James Bullard published a provocative paper about ratcheting up quantitative easing to avoid the Japanese dilemma. Conversely, Philly Fed president Charles Plosser has said that any more stimulus at this juncture would be premature. Chairman Bernanke is sticking to the script of being alert to any change in the call for slow but steady growth, and yet the front page of today’s Wall Street Journal lays out the argument for growing the Fed’s balance sheet. Mix in the chatter about extending Bush-era tax policies and rumors of a government-instigated refinancing boom and the discussion has become a full-blown debate.

Perhaps the Fed and its various talking heads can be accused of stirring this particular pot; however this could be more a case of some market participants wanting to avoid another leg down in this multi-year process of deleveraging, falling asset prices and reduced consumption. This morning’s income and spending data show an increase in the savings rate to 6.4%, the highest since May 2009 and before that 1993. Consumer credit continues to decline and will likely show another drop when it is released on Friday. The second quarter GDP preliminary estimate showed growth slowed as consumer spending declined and inventory building subsided. Job growth is still not happening.

So we suppose the debate is timely. Despite the fact that earnings have topped analysts’ average estimates at 76% of S&P 500 companies that have released their quarterly results, we believe that we are indeed in a part of the economic cycle where muddling along might be the best possible outcome while the financial system—corporations, banks, households, municipalities—get their houses in order. The revenue numbers of corporate bellwethers reflect that. The following graphs lay out the trailing 4-quarter top line for Procter & Gamble, Home Depot, Wal-Mart and FedEx. Taken together they tell a story (which we will resume below).

The story to be gleaned here is that the enormous top line growth that these companies enjoyed were inextricably linked to the economic growth we have witnessed since the end of the 2001 recession—not coincidentally, the graphs above look a lot like the graph below of nominal GDP growth (particularly Wal-Mart….hmmm…). And that economic growth, we would suggest, was largely built on the growth in credit (as we wrote in our June 8, 2010 blog post, "Debt Growth Drives GDP Growth"). So without debt growth, what is going to get the revenue trajectory on track again? Maybe, just maybe, the thing to do is let the deleveraging/saving/expense cutting process take place. Just as forest fires are a part of the natural life cycle of forests, so is the cleansing and seeding process of an economic downturn.

Comments [1] | Consumer | Equity Markets | Macro Economics