Good Ponzi Schemes?

The current Buttonwood column from The Economist continues the discussion that Hyman Minsky started back in the 1970's, a topic that has garnered increasing attention from economists around the world in recent months after the subprime mortgage meltdown became front page news.

Minsky theorized that there were three kinds of finance in a capitalist economy - hedge finance, speculative finance, and Ponzi finance - the latter named after Charles Ponzi, one of the greatest swindlers of all time.

Wikipedia has an excellent summary of both financial crises and Mr. Ponzi. The connection between the two is becoming clearer with each passing day and with each new revelation of mortgages originated for those with little ability and less intention to repay.

Ponzi finance is viewed by Minsky as a sort of "risk end-game", where, participants accept higher returns while ignoring risks that are known to exist.

In the case of the current housing bubble, credit was extended by mortgage lenders in the belief that even if the borrower ran into financial difficulty, perpetually rising home prices would bail out even the most egregious borrowers as they would be able to sell at a higher price and everyone would walk away with money in their pockets.

This worked well until home prices stopped rising.

Ponzi finance is best typified by the Ponzi Master himself, Alan Greenspan, who recently said that if home prices "would go up 10 percent, the subprime mortgage problem would disappear."

Amazing but true.

The current Buttonwood column asks the question that is sure to appear in economic textbooks years from now - whether there is such a thing as a "good Ponzi scheme". That is, whether markets that are just a confidence game can lead to a greater societal good.

Ponzificating
CHARLES PONZI was a likeable man. That helped him persuade American investors in 1920 that he could deliver returns of 50% in just 45 days by exploiting a loophole in the pricing of international postal coupons. In a way, he was advertising an early version of an arbitrage fund.

In reality, the loophole could not be practically exploited. So Ponzi exploited his customers instead. He could deliver returns only by taking money from new investors to give to his early backers. But although he died in poverty, the Italian immigrant achieved immortality of a sort: fraudulent moneymaking operations are often known as Ponzi schemes.
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Ponzi's original scheme was fraudulent from the start. But even if he had found some exploitable anomaly in the financial system, his rationale was flawed. Because he offered such a high rate of return over such a short period, claims on the “Bank of Ponzi” would quickly have reached ridiculous levels.

So perhaps there are good and bad Ponzi schemes. Good schemes will do more than funnel money from latecomers to early takers, allowing the foremost to prosper at the expense of the hindmost. And they will not allow claims to increase too fast. That was the big mistake of John Law, the pioneer of paper money in early 18th-century France. Law's system eventually collapsed, but he did have the insight that the creation of credit might increase trade, and thus general welfare.
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The American housing market seems to be suffering from the unravelling of a Ponzi-type system. Subprime loans were offered on generous terms that, implicitly or explicitly, depended on rising house prices. The banks that made these loans bundled them up and sold them in the credit markets to investors, eager for high yields. This was supposed to make the financial system more secure by dispersing risk more widely.

But look what is happening now. The buyers of these loans are asking the original mortgage-writers to buy them back. But these homelenders do not have the money to do so. The confidence that sustained their balance sheets has evaporated, leaving many in dire trouble.
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As lending standards tighten, consumer demand could suffer, possibly prompting a recession in the United States. No one knows when the credit cycle will end, he says. But the pyramid is beginning to look a bit top-heavy.

The question of whether the recent housing mania is The Biggest Ponzi Scheme Ever has been bandied about outside of the mainstream media for years now.

It's nice to see the same question being asked by writers with wider audiences, though the new twist was entirely unexpected.

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Spillovers

About a year and a half ago, a commentary by Stephen Roach was so impressive that not reproducing it in its entirety was imagined as being "Like Cropping the Mona Lisa".

[Another somewhat painful "royal we" flashback was felt just now - be careful.]

Friday's commentary falls into the same category, however, no qualms about shortening it up a bit were felt.

From bubble to bubble – it’s a painfully familiar saga. First equities, now housing. First denial, then grudging acceptance. It’s the pattern and its repetitive character that is so striking. For the second time in seven years, asset-dependent America has gone to excess. And once again, twin bubbles in a particular asset class and the real economy are in the process of bursting – most likely with greater-than-expected consequences for the US economy, a US-centric global economy, and world financial markets.
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It didn’t have to be this way. Were it not for a serious policy blunder by America’s central bank, I suspect the US economy could have been much more successful in avoiding the perils of a multi-bubble syndrome. Former Fed Chairman Alan Greenspan crossed the line, in my view, by encouraging reckless behavior in the midst of each of the last two asset bubbles. In early 2000, while NASDAQ was cresting toward 5000, he was unabashed in his enthusiastic endorsement of a once-in-a-generation increase in productivity growth that he argued justified seemingly lofty valuations of equity markets. This was tantamount to a green light for market speculators and legions of individual investors at just the point when the equity bubble was nearing its end. And then only four years later, he did it again – this time directing his counsel at the players of the property bubble. In early 2004, he urged homeowners to shift from fixed to floating rate mortgages, and in early 2005, he extolled the virtues of sub-prime borrowing – the extension of credit to unworthy borrowers. Far from the heartless central banker that is supposed to “take the punchbowl away just when the party is getting good,” Alan Greenspan turned into an unabashed cheerleader for the excesses of an increasingly asset-dependent US economy. I fear history will not judge the Maestro’s legacy kindly. And now he’s reinventing himself as a forecaster. Figure that!

Greenspan or not, downside risks are building in the US economy. The sub-prime carnage is getting all the headlines these days, but in the end, I suspect it will be only a footnote in yet another post-bubble shakeout. America got into this mess by first succumbing to the siren song of an equity bubble (see my 25 April 2005 dispatch, “Original Sin”). Fearful of a Japan-like outcome, the Federal Reserve was quick to ease aggressively in order to contain the downside. The excess liquidity that was then injected into the system after the bursting of the equity bubble set the markets up for a series of other bubbles – especially residential property, emerging markets, high-yield corporate credit, and mortgages. Meanwhile, the yen carry trade added high-octane fuel to the levered play in risky assets, and the income-based saving shortfall of America’s asset-dependent economy resulted in the mother of all current account deficits. No one in their right mind ever though this mess was sustainable – barring, of course, the fringe “new paradigmers” who always seem to show up at bubble time. It was just a question of when, and under what conditions, it would end.

Is the Great Unraveling finally at hand? It’s hard to tell. As bubble begets bubble, the asset-dependent character of the US economy has become more deeply entrenched. A similar self-reinforcing mechanism is at work in driving a still US-centric global economy. Lacking in autonomous support from private consumption, the rest of the world would be lost without the asset-dependent American consumer. All this takes us to a rather disturbing bi-modal endgame – the bursting of the proverbial Big Bubble that brings the whole house of cards down or the inflation of yet another bubble to buy more time.

The exit strategy is painfully simple: Ultimately, it is up to Ben Bernanke – and whether he has both the wisdom and the courage to break the daisy chain of the “Greenspan put.” If he doesn’t, I am convinced that this liquidity-driven era of excesses and imbalances will ultimately go down in history as the outgrowth of a huge failure for modern-day central banking. In the meantime, prepare for the downside – spillover risks are bound to intensify as yet another post-bubble shakeout unfolds.

The argument that the rest of the world will be lost without the American consumer may be proved wrong in the years ahead - it looks like, one way or another, that will be put to the test.

ooo

This week's cartoon from The Economist:

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The Week's Economic Reports

Following is a summary of last week's economic reports. Rising prices, tepid retail sales, faltering regional manufacturing, and fading consumer confidence are not what many economists and market observers were wanting to hear last week, but that's what they got. Aside from what appears to be a one-off boost in industrial production, there is little positive news in the most recent batch of economic reports. As for stocks and bonds, the S&P 500 Index fell 1.1 percent to 1,387, now down 2.2 percent on the year, while the yield of the 10-year U.S. Treasury note dropped 5 basis points to 4.54 percent.


Retail Sales: Rising gasoline prices made the February retail sales figures better than they would have otherwise been, but retail spending came in below expectations nonetheless. Overall sales rose only 0.1 percent in February following no change in January. If automobile sales are excluded, sales fell 0.1 percent in February after an increase of 0.3 percent in January. Inclement weather in much of the country likely depressed retail activity in the most recent reporting period.

Amid rising prices at the pump, gasoline station sales rose 1.2 percent in February and if these sales are excluded from the February data, overall retail sales were flat. On a year-over-year basis, overall retail activity was up 3.2 percent. If automobile purchases are excluded, the annual gain was 3.1 percent. Retail sales have unquestionably been trending lower over the last year, however, the American consumer has been resilient. With recently sagging consumer confidence, this may be about to change.

Import/Export Prices: Both import and export prices rose more than expected in February, a continuing sign that inflation has not yet been brought under control after oil prices plunged in the second half of 2006. The cost of petroleum products rose 2.0 percent in February contributing to the sharp increase in import prices, up 0.7 percent in February after rising 0.3 percent in January.

Producer Prices: Producer prices rose sharply in February, up 1.3 percent after a decline of 0.6 percent in January. The core rate, excluding food and energy, climbed 0.4 percent for the month after an increase of 0.2 percent in January. On a year-over-year basis, overall producer prices have risen 2.6 percent and core producer prices have gone up 1.8 percent.

After falling 4.6 percent in January as a result of falling prices for crude oil, the energy component of the overall index rose 3.5 percent led by rising prices for heating oil (up 6.0 percent), gasoline (up 5.1 percent), and natural gas (up 4.1 percent). Though the producer price data is much more volatile than the consumer equivalent, this report is a strong reminder that energy prices still play a key role in inflation statistics.

Empire State Index/Philadelphia Fed Survey: Both the New York Empire State Index and the Philadelphia Fed Survey showed weakness in regional manufacturing activity during the March reporting period. The New York survey has recently been stronger and far more volatile than the survey from Philadelphia, but for the first time since April of 2003, both readings are near the zero mark indicating little or no growth.

The Empire State Index fell from 24.4 in February to a reading of 1.9 in March, while the Philadelphia Fed Survey fell from 0.6 in February to 0.2 in March. Both measures were led down by fewer new orders, backlog decreases, and inventory contraction.

Consumer Prices: The consumer price index rose 0.4 percent in February after a 0.2 percent increase in January while core consumer prices rose 0.2 percent following a 0.3 percent gain the month prior. On a year-over-year basis, overall prices are up 2.4 percent and the core rate stands at 2.7 percent.

Energy prices rose 0.9 percent in February, led by fuel oil (up 1.7 percent) and gasoline (up 0.8 percent) with more price increases expected for the March report. Prices for food and beverages rose a hefty 0.8 percent for the month led by a 4.7 percent increase for fruits and vegetables while meats, poultry, cereals, and bakery products all rose 1.1 percent.

As shown in the chart depicting overall CPI below, after energy prices plunged last fall, there have now been three consecutive months of increases to overall consumer prices with higher energy prices expected for next month.


During the last two months core consumer prices have been rising at rates above most economists' comfort level, the year-over-year change to core inflation not receding significantly after soaring energy prices plunged in August and September.


This does not bode well for the Federal Reserve should they feel compelled to lower short-term interest rates in an effort to support falling asset prices in both the housing market and in recently stumbling equity markets. Continuing price pressures will make this decision more complex than it would otherwise be (more on this topic in the summary below).

Industrial Production/Capacity Utilization: Both industrial production and capacity utilization exceeded consensus estimates in February. Led by an increase in utilities output (up 6.7 percent), overall industrial production rose from 0.3 percent in January to 1.0 percent in February. Overall capacity utilization increased to 82.0 percent from a level of 81.4 percent during the month prior.

Consumer Sentiment: The measure of consumer confidence from the University of Michigan hit a six month low at 88.8, down from last month's reading of 91.3, and may be an indication that the mood of the American consumer is changing. Despite higher gasoline prices, inflation expectations remained at 3.0 percent, but as discussed at the blog last week in The Relevance of Inflation Expectations, there has been a good correlation between these two in recent years. Should gasoline prices remain elevated, look for a higher level of inflation expectations and a lower overall confidence level next month.

Summary: Get ready for more talk of "stagflation" after the inflation reports of last week are viewed alongside continuing weakness in manufacturing and housing. Across the board price increases with more upward pressure from energy prices in next month's inflation reports could mean that monetary policy decisions become exceedingly tricky in the months ahead.

It increasingly looks like the Fed will be faced with a choice of either trying to "save the economy" by lowering short-term interest rates or remaining "vigilant" in the face of price pressures that continue to put inflation at rates above well-publicized comfort levels.

There should be some indication as to what is on the mind of the Federal Reserve Chairman Ben Bernanke with the policy statement accompanying next week's Federal Open Market Committee meeting. In light of recent market turmoil and the latest round of inflation data, this will be one of the most widely anticipated Fed policy statements in since last summer.

The Week Ahead: The meeting of the Federal Open Market Committee will highlight next week's economic news. While no change to short-term interest rates is expected, Fed comments on mortgage lending and the housing market as they relate to economic growth will be closely scrutinized for any indication of a change in policy stance. Three important reports on housing are due including the homebuilders housing market index on Monday, housing starts on Tuesday, and existing home sales on Friday. The Conference Board's leading economic indicators will be released on Thursday.

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Economists are Sooo Optimistic

This survey($) of economists in today's Wall Street Journal seems to be at odds with itself. The consensus opinion of the 60 dismal thinkers polled points to spreading subprime problems and falling home price to go along with steady unemployment and no recession.

You have to cast some doubt on the assembled wisdom after reading that second paragraph - consumer confidence sentiment just plunged to a six month low this morning.

Most economic forecasters in a new WSJ.com survey believe recent turmoil in the subprime mortgage market is likely to spread to the broader mortgage market and they expect a widely followed index of home prices to fall this year. But they still think the U.S. will avoid a recession and even a significant rise in unemployment.

"The markets may have over-reacted," said John Lonski of Moody's Investors Service. "Only businesses significantly exposed to subprime will be hurt. Mortgage repayment problems aren't as widespread as we are led to believe. If most people were having trouble paying the mortgage, it would lead to declining consumer confidence and we haven't seen that."

Of the 60 economists surveyed, 32 said it is either "very" or "somewhat" likely that the intense and speedy unraveling of the market for subprime mortgages -- home loans made to people with poor credit histories – will spill over to the rest of the mortgage market.

But 26 said that's not likely. Two didn't respond.
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But, as is often the case, there is disagreement among the economists about the risks that the subprime market poses to the overall U.S. economy.

"Mortgage credit-quality problems go well beyond the subprime sector," wrote Jan Hatzius, chief U.S. economist at Goldman Sachs in New York, in a research note. "The underlying problem is not the subprime market per se, but the reset of large quantities of adjustable-rate debt -- some of which is classified as subprime some as prime -- to higher interest rates in an environment of flat or falling house prices in most of the United States."

Mr. Hatzius notes that the so-called teaser rate, or low initial rate on adjustable-rate mortgages, expires sooner for subprime mortgages. This implies that mortgage-holders with prime ARMs may come to experience the same woes currently making waves in the subprime sector.

The extent of any spillover from subprime to the broader housing market remains unclear. "You can tell a lot of scary stories," said Richard DeKaser of National City Corp., "but they're not broadly accurate. We're still talking about a small segment of the nation's homes that are affected." According to the American Housing Survey5 for 2005, the most recent date for which data are available, 33% of all homes are owned outright and 57% have traditional mortgages, leaving just 10% potentially affected by ARM woes.

The subprime concerns are also likely to weigh on prices, according to Mr. Lonski. "Home sellers will be forced to accept lower prices in the spring. The subprime issue reinforces that home prices would be subject to price recession, creating an expectation of lower prices among buyers."
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The economists were split on whether regulators should have acted sooner in the subprime mortgage market. Twenty-eight of the respondents said "yes," while 24 said "no." Robert DiClemente of Citigroup contended that the problem wasn't centered on regulated institutions.

But some economists put part of the blame on the Federal Reserve. "Was it necessary to cut the fed funds rate to 1%, supercharging the housing recovery?" said Mr. Lonski. The June 2003 move, which ended a three-year cycle of rate cuts, was aimed at fostering economic growth and contributed to continued low mortgage rates.

Well, at least they're asking the right questions - short-term interest rates at one percent combined with lax regulation and Wall Street ingenuity have brought us to where we are today.

Should so many people be so surprised?

No one is really sure about what to expect next, but it sure has gotten interesting.

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The End of the Liquidity Party?

Adventure capitalist and commodity investor Jim Rogers is down on just about everything according to this report yesterday from Reuters. He's predicting a none-too-pleasant conclusion for the latest asset bubble and fears the end of the liquidity party is at hand.

Doesn't he realize that Ben Bernanke, Hank Paulson, and the Federal Reserve Bank of New York will do whatever they need to do to keep asset prices inflated?

Well, not all assets, but the one's that they want to keep inflated they'll try their darndest to keep propped up.

What's the alternative? To let the malinvestments work themselves out?

Didn't they try that once before? Oh yeah, in the 1930s.

Commodities investment guru Jim Rogers stepped into the U.S. subprime fray on Wednesday, predicting a real estate crash that would trigger defaults and spread contagion to emerging markets.

"You can't believe how bad it's going to get before it gets any better," the prominent U.S. fund manager told Reuters by telephone from New York.

"It's going to be a disaster for many people who don't have a clue about what happens when a real estate bubble pops.

"It is going to be a huge mess," said Rogers, who has put his $15 million belle epoque mansion on Manhattan's Upper West Side on the market and is planning to move to Asia.
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"Real estate prices will go down 40-50 percent in bubble areas. There will be massive defaults. This time it'll be worse because we haven't had this kind of speculative buying in U.S. history," Rogers said.

"When markets turn from bubble to reality, a lot of people get burned."

Not that he needs the money, but he's probably a little perturbed by all the low-ball offers he's getting on his swanky New York property.

Barbara Corcoran is probably telling him, "Jim, you've got to lower the price. This is a different market now".

Maybe that helps to explain the doom and gloom that is being laid on thicker than usual. Or, maybe he just got up on the wrong side of the bed.

The fund manager, who co-founded the Quantum Fund with billionaire investor George Soros in the 1970s and has focused on commodities since 1998, said the crisis would spread to emerging markets which he said now faced a prolonged bear run.

"When you have a financial crisis, it reverberates in other financial markets, especially in those with speculative excess," he said.

"Right now, there is huge speculative excess in emerging markets around the world. There will be a lot of money coming out of emerging markets.

"I've sold out of emerging markets except for China," said Rogers, long a prominent China bull.

Even in China, the world's fastest expanding economy, Rogers said stocks were overvalued and could go down 30-40 percent.

But he added: "China is one of the few countries in the world where I'm willing to sit out a 30-40 percent decline."
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"This is the end of the liquidity party," said Rogers. "Some emerging markets will go down 80 percent, some will go down 50 percent. Some will most probably collapse."

Liquidity parties don't just end with a whimper and falling prices. Not any more.

As former Fed Chairman Alan Greenspan said in 1987, "The Fed stands ready to provide all necessary liquidity" that markets may require.

Just think how much money can be pumped into the system after the technology build-out left behind in the wake of the last asset bubble bursting seven years ago.

In times of financial panic, the Fed stands ready to do whatever needs to be done to prevent this whole thing from unraveling.

After 35 years of pure fiat money, there is one truism when it comes to responding to crises, "When you get in trouble, print more money".

Of course, at some point, this will no longer have the desired effect.

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The Relevance of Inflation Expectations

There's been a lot of wonk-talk lately about inflation expectations and their relevance to monetary policy - a real cat-fight amongst the dismal scientists.

It all started with the paper Understanding the Inflation Process(.pdf), presented at last week's U.S. Monetary Policy Forum 2007. Among other less notable items, the report stated that measures of "inflation expectations", an indicator long favored by policymakers at the Federal Reserve, have not provided "useful forecasts of the estimated trend in U.S. core CPI inflation" over the last twenty years.

Before getting on with the obligatory excerpt from some speech by a Federal Reserve board member, let's have a look at the relationship between current gasoline prices and expectations of future inflation.

As shown below, aside from some understandable overshoot, there is a high correlation between prices at the pump and the answer to the survey question, "How much do you think prices will rise in the next year?"


It makes sense when you think about it. Amid confusing pricing for groceries and medical expenses, most people are understandably perplexed when asked to provide a yearly rate of change - two percent, three, four, ten?

Caroline Baum at Bloomberg wrote an enlightening commentary earlier today with a "Man on the Street" approach to inflation expectations.

Most people don't have a clue when pressed for a figure.

With confusing media coverage of the plethora of inflation measures trotted out by many different government agencies - wholesale/consumer, overall/core, PCE/CPI, median, and many more - the only data about prices that is easily understood by the public is what they see as they fill up their gas tank.

Whatever its value in formulating monetary policy, the University of Michigan poll on "inflation expectations" and others like it seem to be redundant.

Wonk Talk

With that out of the way, a quick review of last week's events seems to be order. Reuters reported on the speech by Fed Vice Chairman Donald Kohn where he emphasized the importance of "anchoring" inflation expectations in response to the new study.

Of note in the speech were the following passages:

I do not agree with the authors’ assertion that central banks pay too much attention to inflation expectations. Those expectations may not be as much of a leading indicator of the inflation trend as I would like--although I am not sure that I find the paper’s conclusion, that the trend leads expectations, all that persuasive.
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We should always keep in mind how little we know about the economy. Monetary policy operates in an environment of pervasive uncertainty--about the nature of the shocks hitting the economy, about the economy’s structure, and about agents’ reactions.
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In addition, we do not yet have a consensus structural model of inflation dynamics that satisfactorily explains all the important aspects of the empirical data. As the paper demonstrates, a standard workhorse model--a sticky-price business cycle model with a drifting inflation target and a New Keynesian Phillips curve--cannot mimic one important feature of the inflation process. I will leave it to the modelers to debate the seriousness of this deficiency and to propose how it might be rectified. However, it is clear to me that our understanding of the inflation process still has far to go.

The issue of expectations illustrates our ignorance. As I have already indicated, inflation expectations are among the most important variables policymakers monitor, but we do not have answers to our most basic questions about them: Are available measures suitable indicators of true inflation expectations by households and businesses? How are expectations formed--and in particular what are the respective roles of central bank talk, central bank actions, and actual inflation outcomes? And how do expectations influence price and wage setting? In short, although I believe that inflation expectations are critical to assessing the inflation outlook, I cannot be sure (particularly in real time) that our expectational measures are accurate and so cannot know what precise role expectations play in wage and price dynamics.

There were other stories on the subject and at least one other speech by another Federal Reserve member, Governor Randall S. Kroszner, but, to be honest, the Kohn speech was enough.

It's not clear that anyone really knows what to expect for inflation, how to measure those expectations, or whether they are important.

The bottom line?

If the Fed thinks that "anchoring" inflation expectations would do some good, then they should get to work on lowering gasoline prices. If recent prices at the pump are any indication, inflation expectations are about to head back up.

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And Then There Were Two

Yesterday, DataQuick reported that only two of Southern California's six counties showed a positive year-over-year change in price.

Sales volume leader Los Angeles County and San Bernardino County showed median price increases of 7.8 percent and 5.3 percent, respectively, while other areas ranged from flat to minus 5.9 percent.

Overall in Southern California, largely a result of the much higher sales level in Los Angeles County, prices rose 5.3 percent from year ago levels.

Not too long ago, the median home price in San Diego County exceeded that in LA, by almost $100,000 at times, but as of about a year ago they parted ways. Now the separation is almost $50,000 in favor of the larger county to the north.

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The year-over-year price changes are getting really interesting now that Orange County and Riverside County have touched the zero mark. You can see just how strong the LA rebound is in the chart below.

Click to enlarge

How do you explain the clear difference in price trends between the six counties? Have a look at the census data and see what conclusions you can draw.

• Los Angeles County
• Orange County
• Ventura County
• San Diego County
• Riverside County
• San Bernardino County

No hints are offered and remember that your answer need not be politically correct.

Now that February sales data is in the books, the seasonal rebound in March looms large. As shown below, the change in sales volume from February to March is an annual event. This is the post-Super Bowl buying pickup that occurs every year and both the sales volume and the attendant price patterns will be the first real indication of what lies ahead in 2007.

Click to enlarge

Foreclosures should play a large role in this year's real estate sales volume and price trends. You can see pages of "Bank Owned" listings in those colorful real estate guides available at golf courses and supermarkets.

Also, take a look at Zillow.com and see if sales prices during the last two months show any strong trend in your neighborhood. Down the street from here, there was a house that sold last September for $850K and then the new owners put the place up for sale in January at $815K.

It was just reduced to $795K and recent comparable sales were $740K and $760K.

It's not known why the owners are selling - they are long gone now - prompting the question of whether they ever made a payment. Whatever the reason for leaving, that's a hefty haircut in only six months.

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