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SPEAKING
FREELY
Waiting for a
tsunami
By Doug Wakefield
Speaking Freely is an Asia Times
Online feature that allows guest writers to have
their say. Please click here
if you are interested in
contributing.
In December 2004 we
watched the devastating impact of the tsunami. For
those living away from the area, what we saw,
horrifying as it was, was impossible to grasp. How
could so much destruction occur? How could over
240,000 people die from a natural disaster that
started from shifting plates on the earth's floor?
How can water top speeds of 500 mph? We heard
stories of individuals looking at the ocean as it
pulled back hundreds of yards from the beach only
to then be totally surprised by the high wall of
water that returned. It left observers no time to
prepare.
Today, as we look at our
financial markets, most of the talk is of
comfortable retirements, funded pension plans, and
safe social security and medicare benefits. And
yet, as the event of December has shown, things
are not always what they seem and can change
quickly. Now is the time for every investor to
ask, "What evidence is there that a major decline
could occur in the financial markets and what
actions can I take to address any systemic risks?"
As we look out across the exchanges,
everything appears calm. The bond market continues
the bull run that started in the early 1980s. The
Dow Jones Industrial, after dipping below 7,200 in
2002, looks to be safely resting on a 10,000
floor. Nationally, real estate has appreciated
moderately for years, and substantially in the
last few. However, as we look beyond the happy
talk about "how the Dow has held strong above the
10,000 level since late 2003" or "how resilient
the American markets are", we begin to notice that
long-term investing records are still tarnished by
the "downturn" of 2000-2002. When we consider that
the S&P 500 is still down 10.64% over the
six-year period ending June 30, 2005 or that the
Dow is down 3.17% during the same timeframe, then
the first signs of concern start to creep into our
thinking.
Some dismiss 2000-2002 as an
aberration that was dealt with by the Federal
Reserve lowering interest rates and making credit
readily available to help kick-start our economy.
Most Wall Street pundits and government officials
continue to talk about "comfortable retirements"
and our "strengthening economy". If they are
right, we can feel confident that the breather the
Dow has taken between 10,000 and 11,000 over the
last 19 months is but a pause before it resumes
its upward movement as reflected by our stronger
economy. Articles like this can be dismissed as
nothing more than another hair shirt worried over
nothing because he has read too many
gloom-and-doom newsletters and scary books
(though, in my defense, the majority of books that
I have read were written prior to 2000).
If, on the other hand, the information
presented is from various US government sources,
then we must take the data over the rhetoric and
prepare for the wave that is coming. Let's leave
the surface statistics and look beneath to see if
we can better understand our current situation. We
need not look too far. All we need is to take the
trouble of downloading a few government documents.
The pressure point that we will review
first is the American consumer. Since June 1999,
national income has increased from $8,161 billion
to $10,913 billion (as of March 2005). While an
increase of 34% in six years may sound like a good
thing, we need to examine this information in
light of inflation and debt. During this same
period, consumer credit went from $1,347 billion
to $2,129 billion, an increase of 58%. I'm sure we
can all share numerous stories of the telemarketer
or the credit card applications in the mail. We
have everything under the sun bought on credit.
When we run up our credit card, if we are having
trouble paying it off, we can always roll the
balance to another credit card that has a 0%
interest for a period of time.
Sure, the
interest rate may be higher, but there always
seems to be another sub-prime lender who would
love to get our business. If the credit gets too
far out of hand, we'll just start over by taking a
home equity loan to pay them all off. Our homes
have turned into another major source of cash
flow. What could be better: our house value goes
up, we take out another loan, pay off our
revolving debts, and in no time our home price has
climbed enough again to withdraw even more cash
from the ATM machine. In regard to the perpetual
upward motion of housing prices, the LA Times
shows how deluded the minds of Los Angeles
homeowners have become. Many actually believe that
home prices will continue to move up by 22% a year
for the next 10 years.
Are these just
pockets where "froth" has crept into the local
housing market, or are there signs of a much
larger problem? Fortunately, the Federal Reserve
leaders, who tell us that there is only "froth" in
some local housing markets, are the same group
that prepares the Flow of Funds Report. These
numbers give a much deeper and different view of
things that have impacted the price of real
estate.
In June 1999, total mortgages in
the US stood at $6,021 billion. At the end of
March 2005, the number is $10,774. This is a 79%
increase. Keep in mind our incomes have only risen
34% while our credit card bill has grown by 58%.
So what have we, as a nation, done? The answer is
painful, if not obvious. We have borrowed the
money with our homes as collateral for the loan.
As our credit has got increasingly splotchy and
our cash flow needs have increased, institutions
have lowered their lending standards and moved
toward riskier finance products. In a May 5, 2005
report issued by Fannie Mae, we see the share of
interest-only Adjustable Rate Mortgages (ARMs) "A"
paper selling in the Mortgage Backed Securities
(MBS) market has grown from 3% in 2001 to 50.9% in
2004 while ARMs for the same class and timeframe
have grown from 18% to 72.1%. The Jumbo MBS market
has grown from 5.4% to 52.5% during the same
period. In addition to this we learn that the
sub-prime MBS finished 2004 with 66% of their
loans as two-year ARMs. In other words 66% of
these notes face a likely upward adjustment in
payments as early as 2006. These are astonishing
numbers.
Before we go any further, let's
look at this huge and growing risk that will
affect our financial markets. The question is not
if, but when. In a society where everything is
focused on how we can make payments, versus what
can we afford to purchase, the lending environment
must become more lax when the consumer starts
tapping out. If we cannot afford the house payment
with a fixed mortgage, we can buy the house with a
lower payment with the understanding that the
payments will adjust upward in the future. If we
still cannot afford the payment, the lender cuts
the loan terms to interest-only for a period of
time, so that even less may be required of our
consumer today. Tomorrow ... well, why worry about
that today? Besides, house prices have been
increasing and players in the real estate game
give us the impression that our property will only
be valued higher in 2-4 years when we look to
either refinance or sell. So again, we ask, what's
the problem?
On the surface, nothing. But
let's look at this a little closer. If this
phenomenon only affected the consumer, it would
just be an issue for the lending institution
reckless enough to allow it. However, since each
of these mortgages are packaged in groups and sold
in the bond markets as mortgage-backed securities
to investors, it becomes a concern for the
stability of the financial system as a whole. When
those investors are mutual funds, large
endowments, or pension funds, the problem becomes
an issue for thousands of investors who never
intended to flip condos. Pretty pie graphs and the
last quarterly statement are nice, but they do not
go far enough in disclosing the true risk each
investor is taking.
While it would be easy
to blame one politician, investment institution,
or Federal Reserve official and demand changes,
the size of the markets make it extremely
improbable that one individual could "fix" these
problems. History reveals that the pressures we
now face have been building for decades. Keynes
believed that the way to keep an economy from
recession was to keep consumers spending. He
advocated slashing personal savings as a means to
achieve increased consumption. As a nation, we
have fully embraced Keynes' idea. From June 1999
to March 2005 we have seen national savings
increase from $1,619 billion to $1,819 billion. To
place these numbers in context, this is a 10% rise
during a period where national incomes went up
34%, consumer credit went up 58%, and total
mortgages went up 79%.
But why would John
Maynard Keynes have so much influence? In a
nutshell, take a group of people who have
experienced economic calamity, promise them a
"safety net" so it wouldn't happen again, present
printing more money by expanding credit as the
best option for "strengthening the economy", and
tell them that by spending more they can pull
themselves out of their own problems. Tell me if
that sounds familiar? It should.
Incredibly, this idea, presented as the
solution to America's Great Depression, actually
created the problem in the first place. In the
1920s, we had created so much money through
massive credit and lending programs, markets (and
eventually prices) became inflated. The problem
was that the weight of the debt repayment was too
much for the consumer to bear. As banks began
collapsing and people became increasingly afraid
of what was happening, the euphoria of the 20s
became the Crash of '29 and the ensuing
depression.
The problem we face today is
forgetfulness. Since the US went off the gold
standard in 1971, our dilemma has been compounded.
Bailouts and inflating our way out of our debts
has become a staple in the American economy. Many
of us remember major bailouts over the last 30
years. Who could forget Chrysler in 1978,
Continental Illinois (the seventh largest bank at
the time) in 1982, the S&L Crisis in 1989, the
Mexico Peso devaluation in 1995, and the collapse
of Long Term Capital (the largest hedge fund in
the world at the time) in 1998? In a classic
fallacy of composition, most investors seem at
ease with the "bailout" of the US economy in 2001.
One can debate whether it works or not to bail out
companies. Bailing out countries, even
temporarily, has always proved disastrous.
We started the year 2001 with a Fed Funds
rate of 6.5%. By the end of the year it was 1.75%.
History has revealed multiple times that when
credit is cheap and accessible, the floodgates to
spending are opened. From June 1999 until June
2005 we have seen the amount of money in our
country increase from $6,237 billion to $9,727
billion. This is an increase of 55% in six years.
The dictionary definition of inflation is "an
increase in the volume of money or credit relative
to available goods, resulting in a substantial
rise in the general price level". This makes it
plain why assets have gone up in value and why it
has been hard to keep up with the cost of living.
Oddly enough, the Consumer Price Index (CPI) has
gone up only 17%, from 497.9 in June 1999 to 582.6
in June 2005. So, according to these numbers,
inflation has only gone up 17% while the money
supply has grown by 55%.
While I could
show many other numbers emphasizing the tremendous
pressure being placed on the markets, I will leave
that to another day. Like a real tsunami, these
numbers, and the ramifications behind them, are
frightening. They could leave us numb and
apathetic or we could dismiss this information,
thinking our lives have too much stress right now
and there is nothing we can do about this anyway.
If these are your thoughts, I implore you to start
learning from the many great sources about the
money game. Don't think, "They are smart and I am
dumb". Until we come to our own conclusions,
versus blindly accepting those of others, we are
all susceptible to a great deal of risk. We must
stop asking, "What was the bottom line last
quarter?" and start asking, "What are the chances
of losing a substantial amount of my portfolio in
the future?"
For the thousands who lived
near and around the Indian Ocean, they had no
warning. Yes, today the warning systems are in
place, but only after the tragic event.
Fortunately, investors today have a great deal of
information warning them of events to come.
History warns us to avoid the pitfalls of not
heeding its voice. My desire is that many people
could learn to profit from the decline so that
when it comes, they may be able to help those who
have had no opportunity to do so. For those today
who have many opportunities to protect themselves
but continue to deny that a tsunami could occur in
the financial markets, I only stand amazed at the
blatant denial of reality.
Doug
Wakefield is the president of Best Minds Inc,
a registered investment advisor. He can be reached
at doug@bestmindsinc.com
(Copyright
Best Minds Inc 2005)
Speaking Freely
is an Asia Times Online feature that allows guest
writers to have their say. Please click here
if you are interested in
contributing. |
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