Archive for November, 2008

Key Rates: 1980 vs 2008

Kurt Brouwer November 26th, 2008


Source: Carpe Diem

In this chart from the excellent Carpe Diem blog, we see a comparison of key interest, inflation and unemployment rates between our present economic environment and that of 1980.  We certainly have problems these days, but having lived through the early 1980s, I have a difficult time equating the difficulties we have now with the horrendous economic environment we had in 1980-82:

Double Digits in 1980-82: Inflation, Unemployment & Mortgage Rates

In the late 1970s and early 1980s we had sky-high inflation, unemployment and mortgages rates. At that time, the Federal Reserve’s Chairman, Paul Volcker, had to raise interest rates to unheard-of levels. These rate hikes led to a prolonged economic contraction that was the worst since the Great Depression of the 1930s. This description from Wikipedia gives a sense of how severe the reaction was [emphasis added]:

“…However, the change in policy contributed to the significant recession the U.S. economy experienced in the early 1980s, which included the highest unemployment levels since the Great Depression, and Volcker’s Fed also elicited the strongest political attacks and most wide-spread protests in the history of the Federal Reserve (unlike any protests experienced since 1922), due to the effects of the high interest rates on the construction and farming sectors, culminating in indebted farmers driving their tractors onto C Street and blockading the Eccles Building…”

The image of farmers blockading Washington D.C. with tractors is hard to imagine now, but those were tough times.  The reason Volcker raised interest rates so aggressively was that inflation went wild in the late 1970s. For example, inflation hit 11.3% in 1979, 13.5% in 1980 and 10.3% in 1981 before Volcker’s harsh medicine began to kick in and inflation moderated to 6.2% in 1982.

As inflation ratcheted higher, so did home mortgages rates. Thirty-year fixed rate mortgages went up to nearly 13% in November 1979 and did not fall under 12% again until November 1985. The peak rate for mortgages was 18.45% in October 1981. 18.45%!

But, even though high interest rates began knocking down inflation, soaring rates also led to sharply higher unemployment. The unemployment rate peaked at 10.8% in December 1982. However, it had been soaring for years and it remained at 8% or higher until January of 1984. Given all this, it is not surprising that investors and consumers were very negative in that time period 1980-82.

As you can see from the chart, there is a huge disparity between interest rates, inflation and unemployment today versus 1980.  It is true, that government statistics on inflation and unemployment have changed since then.  Nonetheless, inflation was much higher back then as was unemployment.  See the Does the Government Understate Inflation?

In that period, the Federal Reserve had to fight pervasive inflation and the only means available was to raise interest rates.  As a result of higher interest rates, bond yields soared and bond values plummeted.  Higher interest rates hurt the real estate market and values fell.  Higher rates also hurt the stock market. So, when people tell you this is the worst downturn since the Great Depression, just quote a few facts and figures from 1980.

Bill Gross: Potential Returns Are Very Attractive

Kurt Brouwer November 25th, 2008

Bill Gross at Pimco discusses the group’s current outlook on bonds in his latest Investment Outlook.  It would appear that Pimco likes government guarantees in all their glorious profusion these days [emphasis in the original]:

So CQish (Pacific Investment Management / Investment Outlook, November 2008, Bill Gross)

…There will come a time, however, perhaps over the next few weeks or months, when deleveraging of the private sector is met by the leveraging up of the government sectors: the TARP, CPFF, and MMIFF will inject over a trillion dollars of liquidity into the system over a short period of time. At that point, our nuclear atom will begin to stabilize and it should be safer to move a little distance back out toward the perimeter where yields and potential returns are very attractive. PIMCO would focus on the following:

  1. A continued above-average allocation to agency mortgage-backed securities – now yielding close to 6%.
  2. An overweight position in bank capital – bonds and preferred stock in companies where the Treasury has an equity stake. With Uncle Sam as your partner, default seems remote.
  3. A focus on the frontend of the yield curve. The Fed will stay low for an extended period of time while the inevitable inflationary pressures of government bailouts lay further out on the yield curve…

The argument for agency (Fannie Mae, Freddie Mac etc.) mortgage-backed securities is that they have far higher yields than Treasury bonds, yet both are backed by the U.S. government.  Presumably, the Pimco brain trust believes the bond market will figure out that a U.S. government guarantee works equally well on agency bonds as it would on Treasuries.

Similarly, Pimco is following the government into bank securities (bonds and preferred stocks) as well.  Again, partnering up with the Feds seems like a winning bet to them.

Essentially, Gross is betting that the bond market retreats from its doomsday scenario (see Bonds Markets Pricing In Armageddon).  Given how solid his predictions have been during this financial panic, I figure it’s a pretty good bet to tag along (see Bill Gross Was Correct — Treasury To Take Over Fannie & Freddie).

This post from the Wall Street Journal’s Real Time Economics blog adds a little substance to Pimco’s argument for agency-backed bonds [emphasis added]:

Fed Announcements on Household Credit, GSEs (Real Time Economics Blog, November 25, 2020)

…The Federal Reserve announced on Tuesday that it will initiate a program to purchase the direct obligations of housing-related government-sponsored enterprises (GSEs)–Fannie Mae, Freddie Mac, and the Federal Home Loan Banks–and mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Spreads of rates on GSE debt and on GSE-guaranteed mortgages have widened appreciably of late. This action is being taken to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.

Purchases of up to $100 billion in GSE direct obligations under the program will be conducted with the Federal Reserve’s primary dealers through a series of competitive auctions and will begin next week. Purchases of up to $500 billion in MBS will be conducted by asset managers selected via a competitive process with a goal of beginning these purchases before year-end. Purchases of both direct obligations and MBS are expected to take place over several quarters. Further information regarding the operational details of this program will be provided after consultation with market participants.

I thought it was intriguing to see that the Feds will be working with ‘selected’ asset managers to buy up $500 billion in mortgage-backed securities.  I wonder if Pimco is one of those selected asset managers? In any case, it would appear that Gross’s argument in favor of agency bonds and mortgage-backed securities was right on target.

A Trillion Here…A Trillion There

Kurt Brouwer November 24th, 2008

For this post, I’m updating a sarcastic comment the late Senator Everett Dirksen made referring to the casual way that government bureaucrats tossed around the term billion.  Many years ago Dirksen said, “A billion here and a billion there.  After a while, it adds up to real money.”

Now, of course, we have ramped up to tossing the term trillion around quite casually.  Who says we have not made any progress (just kidding of course)? This piece from Bloomberg tallies all the bailout commitments and comes to the grand total of $7.4 trillion.

Fed Pledges Top $7.4 Trillion To Ease Frozen Credit (Bloomberg, November 24, 2020, Mark Pittman and Bob Ivry)

The U.S. government is prepared to lend more than $7.4 trillion on behalf of American taxpayers, or half the value of everything produced in the nation last year, to rescue the financial system since the credit markets seized up 15 months ago.

The unprecedented pledge of funds includes $2.8 trillion already tapped by financial institutions in the biggest response to an economic emergency since the New Deal of the 1930s, according to data compiled by Bloomberg. The commitment dwarfs the only plan approved by lawmakers, the Treasury Department’s $700 billion Troubled Asset Relief Program. Federal Reserve lending last week was 1,900 times the weekly average for the three years before the crisis.

When Congress approved the TARP on Oct. 3, Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson acknowledged the need for transparency and oversight. Now, as regulators commit far more money while refusing to disclose loan recipients or reveal the collateral they are taking in return, some Congress members are calling for the Fed to be reined in.

“Whether it’s lending or spending, it’s tax dollars that are going out the window and we end up holding collateral we don’t know anything about,” said Congressman Scott Garrett, a New Jersey Republican who serves on the House Financial Services Committee. “The time has come that we consider what sort of limitations we should be placing on the Fed so that authority returns to elected officials as opposed to appointed ones.”

…Bloomberg News tabulated data from the Fed, Treasury and Federal Deposit Insurance Corp. and interviewed regulatory officials, economists and academic researchers to gauge the full extent of the government’s rescue effort.

The bailout includes a Fed program to buy as much as $2.4 trillion in short-term notes, called commercial paper, that companies use to pay bills, begun Oct. 27, and $1.4 trillion from the FDIC to guarantee bank-to-bank loans, started Oct. 14.

William Poole, former president of the Federal Reserve Bank of St. Louis, said the two programs are unlikely to lose money. The bigger risk comes from rescuing companies perceived as “too big to fail,” he said.

…”No question there is some credit risk there,” Poole said.

That would be an understatement Mr. Poole.  Anytime you take on an obligation that starts with a T as in trillion, that’s a big number and a big potential risk.  Just to put the size of this neverending bailout in perspective, let’s compare $7.4 trillion to some other large numbers such as the value of all home mortgages, government debt and consumer debt.  $7.4 trillion is:

  • 60% of the total value of all U.S. home mortgages (approximately $12 trillion)
  • 75% of total U.S. government debt as of year-end 2007 (almost $10 trillion)
  • 300% of U.S. consumer debt (approximately $2.6 trillion)

In other words, $7.4 trillion is a big number.  The Bloomberg piece continues:

The money that’s been pledged is equivalent to $24,000 for every man, woman and child in the country. It’s nine times what the U.S. has spent so far on wars in Iraq and Afghanistan, according to Congressional Budget Office figures. It could pay off more than half the country’s mortgages.

…President Franklin D. Roosevelt’s New Deal of the 1930s, when almost 10,000 banks failed and there was no mechanism to bolster them with cash, is the only rival to the government’s current response. The savings and loan bailout of the 1990s cost $209.5 billion in inflation-adjusted numbers, of which $173 billion came from taxpayers, according to a July 1996 report by the U.S. General Accounting Office.

The 1979 U.S. government bailout of Chrysler consisted of bond guarantees, adjusted for inflation, of $4.2 billion, according to a Heritage Foundation report.

I remember the original Chrysler bailout and it was quite controversial at the time.  Now, we may have the dubious pleasure of doing it again.  I suspect we would have been money ahead just by giving Chrysler’s workers an annuity in 1980 and sending them home.  Perhaps if we had let Chrysler fail back then, the other two (GM and Ford) would have gotten the message that their business models needed to change (see More Retirees Than Workers In Domestic Car Companies and Should We Let GM Fail?).

At least, back then, it was fairly clear what the government was doing.  Now, we have trillions in commitments with little or no transparency as to who is getting it.  The Bloomberg piece continues:

Bloomberg has requested details of Fed lending under the U.S. Freedom of Information Act and filed a federal lawsuit against the central bank Nov. 7 seeking to force disclosure of borrower banks and their collateral.

Collateral is an asset pledged to a lender in the event a loan payment isn’t made.

“Some have asked us to reveal the names of the banks that are borrowing, how much they are borrowing, what collateral they are posting,” Bernanke said Nov. 18 to the House Financial Services Committee. “We think that’s counterproductive.”

The Fed should account for the collateral it takes in exchange for loans to banks, said Paul Kasriel, chief economist at Chicago-based Northern Trust Co. and a former research economist at the Federal Reserve Bank of Chicago.

“There is a lack of transparency here and, given that the Fed is taking on a huge amount of credit risk now, it would seem to me as a taxpayer there should be more transparency,” Kasriel said.

A trillion here and a trillion there and we are not even sure exactly where our money is going.

See also Will The Guilty Pay — In Washington or Wall Street? and Bailout Bonanza for Bad Businesses — Will it ever end?.

More Retirees Than Workers In Domestic Car Companies

Kurt Brouwer November 22nd, 2008

In this chart, we see graphically one important factor in why the Big 3 domestic car companies are struggling so much.  They have more retirees than active workers.  That trend will continue as the auto companies downsize.  Clearly, this is situation cannot be maintained for long.

I was listening to a radio program while driving the other day.  One of the callers was a retired auto worker who mentioned that he has been receiving a pension for more years than he actually worked at the company.  He’s probably unusual, but the trend toward longer life spans has added to the burden of auto companies that promised a pension for life along with lifetime health insurance. I hope we can figure out a way to ease the burden for retirees in this process, but this is a topheavy situation that cannot last long.

As an analogy, does anyone think that Social Security could be maintained with four people on Social Security for every worker paying in?  Currently, we have about three paying in for every retiree on Social Security and even that 3 x 1 ratio is a bit dicey, much less 1 x 3.

Source: Carpe Diem

In my opinion, the best solution would be for the Big 3 to file for bankruptcy (Chapter 11).  This would allow them to make drastic changes such as getting rid of the current senior executives, eliminating duplicative dealers, cutting back on duplicative car lines (Oldsmobile, Pontiac, Chevrolet etc.), changing onerous work rules and overly generous labor contracts and so on.  Filing for bankruptcy does not mean they shut down nor does it mean they lay off all their workers.  Rather, it means the bankruptcy court supervises the company’s reorganization and is given broad latitude to change or even cancel contracts.  This gives the company in Chapter 11 bankruptcy breathing room to restructure its business.

To those who think no one will buy a car from a company in bankruptcy, I can attest that most Americans have flown at one time or another on a bankrupt airline.  I regularly flew on United when it was in bankruptcy and I also flew on Aloha when it was in bankruptcy.  The maintenance of a large jet is quite critical to passengers yet we all seemed to have faith that maintenance would be handled.  I think the same would be true of service contracts and warranties for cars.

Update:  The New York Times editorial board puts forth its point of view in this editorial:

…Michigan’s three car manufacturers have said that they would go bankrupt this year without an infusion of taxpayers’ money. Failing to provide it would be a truly irresponsible act that could obliterate one or more companies, potentially causing other bankruptcies and costing many hundreds of thousands of jobs.

Unpalatable as it seems to underwrite the proven record of failure of Detroit’s automakers, Congress must provide sufficient money to shore them up until the Obama administration takes office. Then, the new president and new Congress can decide how to manage either a rescue package with tight strings attached or a bankruptcy process that ensures the fallen companies have a reasonable shot at picking up the pieces.

In this section above, the NYT advocates an immediate government loan or bailout that gives these companies time for…something.  I really don’t disagree with this, but I have very little faith in the desire of the senior executives or the unions to make the necessary changes.  This stopgap loan may be necessary, but it just kicks the can down the road a bit.

I do agree fully with the following:

Bankruptcy proceedings are designed to allow ailing companies to be restructured into profitable businesses, but that is by no means guaranteed - and it requires infusions of credit.

…To get America’s carmakers back on their feet, difficult choices will have to be made - including cutting labor costs and the cost of health insurance. That is likely to mean selling off some product lines, laying off workers and closing the least productive plants. It could mean renegotiating the deal with the auto workers’ union to pay billions into a fund to cover retiree medical costs…

I agree that difficult choices have to be made, but I did not hear much support for those choices in the recent Congressional hearings.  In my opinion, if we just give these companies billions in loans without changing their present failed management and operating structure, we just make future failure or liquidation more likely.

For example, Congressional leaders seem to be saying that a bailout loan would be tied to the Big 3 making cheaper, more fuel efficient cars.  Unfortunately, the cost structure at the companies is such that they cannot make money on cheaper cars.  Detroit has focused on SUVs, light trucks and expensive passenger cars because those are the only models on which they make a healthy profit.  Ordering them to build a higher proportion of smaller cars would just accelerate the cash burn.

At a minimum, I believe the present senior management of the companies has to go and I would prefer it if the board of directors of the companies did the deed.  As just one example of how out-of-touch the senior executives are, just consider the recent hearings before Congress.  All three CEOs came to Congress begging for a bailout, but they did so by flying in separately on private jets.  Brain dead?  You bet.  With that kind of ‘leadership’ it is no wonder these companies have problems.

See also Should We Let GM Fail? and General Motors May Be Worthless.

Stock Investors Bail Out — Bottom Near?

Kurt Brouwer November 21st, 2008

This is a fascinating chart that was put together by the American Association of Individual Investors.  For 21 years, this fine organization has tracked the stock market allocation of individual investors.  The chart may be a bit confusing at first because it has as its zero point the historical average of 60% in stocks.  So, the chart tracks the allocation of individual investor over — or under — that long-term average commitment of 60% to stocks.

Source: Fusion IQ / American Association of Individual Investors

Over the time span shown, it appears that individual investors’ allocation to stocks generally hits bottom during or shortly after market downturns.  With one exception (1989), the low points for stock allocation (circled areas) coincide with low points in the market.  Those points that mark low points for investors’ allocation to stocks have historically been buying opportunities.  Let’s hope that trend continues.

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