Ponzi finance, government style!

My wife is beginning to dread it when I talk about the economy (perhaps I’m being over-generous in saying “beginning”…).  This past week, I even dragged my dear sister down into the muck.  Now, poor reader, it’s your turn.

Government finances are looking more and more scary to me.  I was reminded of this recently when recalling much of what I read about housing finance in 2003-2005 (yes, I was that early…and no, I didn’t make any money betting against it…).

In particular, I remembered the intellectual framework of one Hyman Minsky, a great economist most people have never heard about.  His “Financial Instability Hypothesis” was frequently quoted with respect to subprime home loans.

In general, he said there are three types of lending, one following the other.  As lenders proceed from one financial crisis to the next, they walk farther and farther out on the risk limb until they fall off.  Then, they start all over again.  Silly, isn’t it?

The first type of lending he called “hedge finance.”  This is lending where the bank expects to be repaid both interest and principal.  Seems infinitely prudent, huh?  It is.  But, when it works well for some time, financiers move out the risk limb.

Next comes what Minsky called “speculative finance.”  This is where the lender expects to be paid interest, but not all the principal.  Does that sound imprudent to you?  It may, but it’s quite common.  If you’ve ever paid 20% interest on a loan or credit card, you’ve participated in speculative finance.  Banks charge that high interest rate because they don’t expect you (or someone else offered the same loan) to fully repay the principal.  The high interest rate allows them to still make money even without full principal payment.  This is very profitable business in good times, which leads lenders farther out the limb.

The final phase is called “Ponzi finance.”  This is where the lender expects neither full interest nor principal payment.  It only works as long as asset prices are rising, as was the case with the housing market, or as long as a “greater fool” can be found to buy the loan from the lender, also the case with housing.  This is the phase that ends in tears.

Which, brings me back to government debt.  A long time ago, the developed economies of the world went from hedge financing to speculative financing.  They did this when they decided never to repay their debts, but simply to roll them over (which means using a new loan to pay off the old one) each time they come due.

Because governments don’t die like people do, they can–in theory–keep rolling their debts over forever.  In practice, every government dies and every single one has defaulted at some point.  If they haven’t, yet, it’s only a matter of time.  If you don’t believe me, see the excellent work of Niall Ferguson, and Carmen Reinhart and Kenneth Rogoff.

Just like home loans progressed from speculative to Ponzi finance, I believe government debt is walking out the same limb, too.  This struck me most profoundly this week because of two data points.

The first was when I read that U.S. mutual fund investors were putting 6 times as much money into bond funds as they were putting into stock funds.  At the same time, any poll you read will tell you that the very same investors openly acknowledge that U.S. debt levels are a major problem and that they are skeptical the debt can be repaid.  If people are investing in debt they think is bad, they are not expecting principal and interest–they are expecting a greater fool to buy their bonds at a higher price!  That, my friends, is Ponzi finance.

The second data point comes from very smart, professional investors who support the deflation premise.  Most such investors openly acknowledge that U.S. debt problems are almost insurmountable, but that they are investing in U.S. debt because they believe deflation will happen and that they can make money as U.S. debt prices rise (in deflationary times, people seek the same safe havens, like U.S. debt, thus driving up the price).  Such investors aren’t saying they expect to hold that debt long term–they doubt that interest and principal will be repaid!  They are overtly expecting to offload such “investments” on other dumb investors.  Ponzi finance!

Like the housing market, this is likely to end in tears.  The problem is getting the timing right (as it was with the housing market).  With so many buying government debt they openly acknowledge is dodgy–at best–everyone will be looking for greater fools to sell to at the same time, and the race to the exits is likely to be ugly.

Although my wife hates to hear me say it, it’s getting scary out there.  We can still pull back from the precipice, but time is running out.  Our elected officials may suddenly become prudent (not in any democracy I know of).  We may experience a growth boom that saves the day–until the next crisis.  But, at some point over the next 5 to 10 years, we are going to live through the transition from Ponzi finance back to hedge finance, and that’s just plain scary. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Ponzi finance, government style!

Tipping Point?

The next crisis we face may be much worse than the housing crisis. It’s what I’ve talked about in the space before: sovereign subprime or too much government debt.

This may seem like a problem facing far-off Greece or Hungary, but it’s bigger and more problematic in the developed economies. Here, I’m talking about the big economies we typically associate with stability: Japan, Germany, France, Britain and the United States.

The issue is that such developed economies have borrowed too much money, like subprime borrowers, to live high on the hog today. This borrowing is going and has gone to generous social programs, defense, and, most insidiously, growing interest payments.

When the burden of paying debt, both interest and principal payments, get too high relative to incoming money (taxes) or an economy’s size (GDP), you get to a tipping point where there’s no where to go but down.

This problem is exacerbated by two additional issues: who did you borrow from and when do you owe them principal.

If you borrow from your own citizens, you’re in a better situation than when you borrow from foreigners, especially when those foreigners aren’t your best friend (hello, China).

If you borrow the money short instead of long term, you face the same problem as paying off a credit card versus a home loan–no credit card will give you wiggle room while you get your financial house in order.

Japan and Britain borrowed mostly from their own citizens. The U.S. borrowed mostly from Japan and China. Japan and Britain predominantly borrowed long term, the U.S. borrowed short term and must roll over most of its debt over the next several years.

The U.S. has an advantage over Japan, Britain, France and Germany, though: our economy grows faster and so does our population (both organically and from immigration). This gives us some wiggle room they don’t have.

Back to the tipping point issue. When interest payments get too high relative to economic production or tax revenues, those who lent you money want a higher interest rate. Guess what a higher interest rate does to those interest payments? Yep, higher and higher.

You can see why there’s a tipping point–once you reach a certain threshold, people start to doubt you can pay and want higher interest payments (or won’t lend you money), which creates a vicious cycle.

The developed economies of the world are entering that vicious cycle over the coming years. We stand on a knife’s edge and can chose, now, to stay on the good side or go to the dark side. And, we don’t have much time to chose.

If you tip to the dark side, what do you have to do? Theoretically, you can grow your way out of trouble, lower your interest payments, get bailed out by someone else, cut spending and jack up taxes, print money (inflation) to pay back loans, or default (also known as restructuring, repudiation, rescheduling, etc.).

The U.S. has been growing its way out of trouble for over 200 years. Unfortunately, when government spending grows to a certain percentage of the economy, your growth rate slows dramatically. We’re reaching that point, so we need to allow a lot of immigration, cut government spending, and reduce taxes to increase growth. I’m guessing the chance of any of those three happening is as great as finding a snowball near the sun’s core.

Is there any way we could lower the interest rate on our debt? You’ll have to ask Japan and China on that one, but don’t count on it.

Is it possible that any country in the world is capable of bailing out the U.S.? Please see snowball reference above.

Can we cut our spending and raise additional taxes? We could, but in a populist environment like we’re in, that will probably work as well as it has in Greece (please see riot footage as reference).

Can we inflate? This is the most likely outcome, and it won’t be a lot of fun for those who lent us money or for those on a fixed income here in the U.S.–and, by the way, that’s a lot of people!

Can we default? Like inflation, we can do it, but it won’t be pretty and will likely be a disaster for many.

Standing on the knife’s edge and looking at those six options, I would chose to knuckle down now, so we don’t have to go down the path of the six. I’m not optimistic that will happen in a democracy, so I’m planning on inflation.

So should you.

(I think we’ll still experience slight inflation/deflation over the next couple of years, but the turning point is hard to predict because our lenders will get to chose the timing).

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Sovereign subprime

In my opinion, the next default wave (other than commercial real estate, Alt-A residential, and option adjustable rate mortgage residential) will be public instead of private debt.

Greece is working hard to illustrate why I’m worried about this, as is Argentina, the Baltic states, Spain, Italy, Portugal…you get the picture.

But, it’s not just smaller countries that are getting into the subprime spirit, it also includes (currently) prime credits like Japan, the United Kingdom, and (shock, horror!) the United States.

And, it’s not just countries, it includes other public debtors like California, New York, Dubai World, Fannie Mae, etc.

How did this mess get so bad? The same way subprime borrowers and lenders got into trouble. Namely, public bodies are spending more than they are taking in, and lenders are doing a lousy job making sure borrowers can repay. This is not rocket science.

Whether it’s California, the U.K., or Greece, the problem is incurring too many obligations while not taking in enough revenue to pay.

Japan is unique in that it’s as much of a demographic time bomb as anything else. Their real estate, stock market and banks collapsed 20 years ago, but they decided not to face the music. Added to this, their population isn’t having enough kids to replace the elderly, and they won’t allow enough immigration to make up for that deficit. Finally, a big dash of inflexible labor markets and decreasing savings rates and you get a country most likely unable to pay its debts.

How do countries go into default? If they are small, they tend to get bailed out by bigger countries or the International Monetary Fund. Big countries, on the other hand, tend to inflate their way out of debt. The trouble there is that when lenders (bond buyers) realize inflation is the solution, interest rates take off. Not a pretty picture.

The financial crisis of the last two years has made this problem dramatically worse. Instead of letting bad borrowers and lenders face the music, governments of the world have bailed out uneconomic borrowers and uncritical lenders. We haven’t eliminated the debt problem, we simply shifted it from private to public. But, the scale is so large, as are the promises governments have made to pay future benefits, that the end-game is much sooner than anyone thought.

When will these defaults come about? Probably not for several years in the case of prime credits, but much sooner for smaller sovereigns. This is likely to stir credit markets and cause a lot of volatility in commodities and stocks.

It used to be you could count on countries, or at least the right countries, to pay their debts. But now, it costs less money to insure against the default of IBM than it does the U.K. May you live in interesting times, indeed.

This is a good time to be very selective of investments (especially debt), to be prepared for very volatile markets, and to expect higher interest rates and inflation. It may take some time to arrive, but when it does, you won’t want to own low interest debt or highly indebted companies.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The perils of leverage

One of the biggest lessons of the current financial crisis is: don’t take on too much debt.

This may sound like common sense advice, but it’s amazing how often people forget it.

If you buy a house with cash and its value increases 20%, you’ve gotten a 20% return. If, however, you borrow 80%, put 20% down, and its value increases by 20%, you’ve just doubled your money. There’s a big upside to using leverage.

But, debt is a double-edged sword. It doesn’t just give you bigger returns if things go well, it also gives you bigger losses if they don’t go well.

Using the same example above, someone who pays cash for a house that decreases 20% in value losses 20%. Someone who only puts down 20%, though, has lost everything.

Archimedes said he could move the world with a large enough lever. The lever multiplies the impact of your input. But, such leverage works both positively and negatively.

When banks were as free as they’ve been, in the late 19th century (1800’s), they carried 40% equity and borrowed 60% (levered 2.5 to 1). Banks operated that way could generally survive the inevitable economic storms that come along with economic cycles.

But, banks nowadays are regulated to be levered 10 to 1: they borrow 10 dollars and only contribute 1 of their own (or shareholders’). Such leverage is a double-edged sword, too. If a bank levered 10 to 1 makes loans and 9.1% of them go bad, the bank is basically insolvent. That’s what’s been happening recently.

Investment banks were levered 30 to 1. The top 5 investment banks are all gone or have been forced to become levered 10 to 1. Mortgage insurers and bond insurers were levered as highly as 140 to 1, they are now almost all insolvent. Many other insurers were levered up too much, such as AIG, and they didn’t understand the leverage they had taken on. That lack of understanding didn’t save them (or taxpayers).

Our current crisis is a perfect illustration of the perils of leverage. Companies like GM and GE are in trouble because they financed their companies with too much debt. It is difficult for almost any but the least levered companies to borrow money, now. As a result, almost any company with too much leverage has had their stock price massacred.

Everyone seems to understand that too much leverage is bad. But many businesses and individuals took on too much leverage and they blew up. Those are the folks getting bailed out now, and they are being bailed out by those who didn’t take on too much leverage. That just doesn’t seem right.

It seems like taking on too much leverage is a lesson that must be learned periodically. Those who survived the Great Depression were terrified of borrowing money.

Unfortunately, our country is currently trying to fix our leverage problems by levering up our government. It’s hard to understand how you can solve the problem of leverage with more leverage.

When a government gets too levered, the resulting problem is almost always inflation. Inflation solves the government’s problem with leverage, but not its citizens’.

Beware leverage. Beware inflation.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

At some point, inflation

Sometimes it’s useful to look beyond the current headlines to what may be coming over the next 3 to 5 years.

From my vantage point, what I see coming is inflation.

Currently, the news is filled with signs of deflation. Asset prices are collapsing. Housing prices are down significantly. Almost anything, other than U.S. Treasury securities, seems to be down over the last year.

Commodities have been particularly hard hit. It wasn’t that long ago that oil was at $147 per barrel and people were talking about it going over $200. Now, it’s below $40.

But, what has changed? Mostly, demand has dropped dramatically. As Economics 101 will tell you, when the demand curve shifts down and the supply curve stays the same, you get lower prices. I think I can safely say that has happened.

So, why had demand been crushed. In a word, deleveraging. The economy as a whole–businesses and consumers, at least–have been paying back debts to keep from going bankrupt. Not everyone is succeeding.

This reduction in debt has led to a tremendous fall-off in demand for goods and services of all sorts. You can see that clearly in the GDP and employment numbers. For those those who thought only Wall Street was in trouble, take another look.

But, the biggest debtor out there–the U.S. government–has been borrowing and printing money like it’s going out of style.

Eventually, such borrowing and printing will get credit markets going. And, when they do, we’ll all owe a lot more debt and have a lot more dollars chasing the same number of goods. In other words, inflation.

I don’t think it will happen soon. Although the Fed is printing money and Congress is finding all kinds of ways to spend it, economic activity has slowed down so much that all it’s doing is making deflation happen less quickly. Eventually, and over the next several years, economic activity will pick back up again and this will be visible in the so-called velocity of money.

When that happens, the demand curve will shift back up and prices will recover. But–and there’s always a but–the government will be in a lot more debt and there will be a lot more dollars chasing the same amount of demand.

In 3 to 5 years, and perhaps sooner, the news won’t be about deflation, but inflation. And, that inflation will be a lot higher than in the 80’s, 90’s or 00’s. In fact, it wouldn’t surprise me to see $300 a barrel oil and double digit inflation rates (not the core rate, but including food and energy).

With that in mind, you may want to consider inflation-proofing your portfolio over the coming years. Think about companies that can jack up their prices and customers will still pay. Think about commodity producing companies. Be wary of bonds with low payouts or higher risk of default.

It may not happen right away, but over the next several years, get prepared for inflation.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.