The Week's Economic Reports

Following is a summary of last week's economic reports. Steady employment growth, inline with expectations, highlighted the week causing many to breathe a sigh of relief that the labor market, if not exceptional, remains stable during a period when other parts of the economy are showing weakness. For the week, the S&P 500 Index rose 1.1 percent to 1,403 and the yield of the 10-year U.S. Treasury note rose 7 basis points to 4.59 percent.


ISM Non-Manufacturing Index: The Institute for Supply Management's non-manufacturing index came in well short of expectations in February, falling to 54.3 from a January level of 59.0 (reading above and below 50 indicate expansion and contraction, respectively). Declines were led by backlog orders and new orders. This is the lowest reading since April of 2003 and is a clear indication that the services sector is now slowing along with the manufacturing sector. Note that the ISM manufacturing index, reported last week, bounced up to 52.3 after showing contraction in two of the three prior months.

Productivity and Labor Costs: Productivity fell and labor costs rose - not a good combination for policy makers at the Federal Reserve. In line with the downward revision to fourth quarter GDP reported last week, annualized productivity for the fourth quarter fell from an earlier estimate of 3.0 percent to a revised 1.6 percent. For the year 2006, productivity also stands at 1.6 percent, the lowest level since 1997.

Unit labor costs increased much more than expected, rising from an annualized rate of 1.7 percent to 6.6 percent, following an annualized rate of 1.1 percent in the third quarter. The increase was a result of both higher hourly compensation and lower productivity. For the year 2006, unit labor costs rose 3.4 percent, the largest increase since 2000.

Factory Orders: Factory orders plunged 5.6 percent in January, the largest decline in more than six years, led by a decline in aircraft orders. This follows last week's 8.7 percent drop in new orders for durable goods, further evidence of a slowdown in the nation's manufacturing sector.

Pending Home Sales: After two consecutive months of gains, pending home sales dropped 4.1 percent in January, the decline attributed to inclement weather in much of the country during the reporting period. On a year-over-year basis, pending home sales are down 8.9 percent.

Consumer Credit: After a downwardly revised increase of $5.0 billion in December, consumer credit rose $6.5 billion in January. The bulk of the new debt was non-revolving credit (e.g., vehicle sales) rather than revolving credit (e.g., charge cards) despite weak automobile sales.

Labor Report: The employment report for the month of February showed a total of 97,000 new jobs and an unemployment rate that fell 0.1 percentage points to 4.5 percent. Upward revisions were reported for the two prior months - the gain of 111,000 initially reported in January increased to 146,000 and the December increase of 206,000 improved to 226,000.

For the month, categories showing improvement were Government (+39K), Leisure and Hospitality (+31K), Education and Health Services (+31K), and Professional and Business Services (+29K). Construction declined sharply (-62K) along with Manufacturing (-14K).

As shown in the chart below, even the now-dubious employment data from the BLS shows an underlying trend that is changing dramatically, just in the last few months. While the weather was blamed for the most recent job losses in construction, the sharpest monthly decline since 1991, there has been a steady erosion in this category for many months now as other categories such as education and health, leisure and hospitality, and professional services have remained firm.


Looking at the detail behind the construction employment data, it appears that the nonresidential construction hiring spree may now be over. Again, weather was surely a factor, but February's declines erased almost all of January's gains for nonresidential building and specialty trade, following two very weak months to close out 2006.

Residential construction employment (both residential building and specialty trade) has been declining steadily since early 2006 and took another turn for the worse last month.


On a year-over-year basis, nonfarm payroll employment increased by 1.5 percent in February. Average hourly earnings rose 0.4 percent in February after a 0.2 percent increase in January and wages are now up 4.1 percent from year ago levels. The average workweek fell slightly from 33.8 hours in January to 33.7 hours in this report.

Despite new claims for unemployment that have been rising in recent months, from a moving average of near 300,000 per week to near 330,000 per week, nonfarm payrolls have yet to show any real distress. To some degree, the loss of construction jobs was masked over by the sharp increase in new government jobs, and as always, this data is subject to massive revisions in the months ahead.

Yes, housing is a lagging indicator but, so far, there is no clear distress in the labor market.

International Trade: The trade deficit narrowed from $61.5 billion in December to $59.1 billion in January, largely a result of higher exports led by sales of civilian aircraft. While oil prices rose during the reporting period, the dollar amount of imported consumer electronics fell a whopping $1.4 billion, helping to narrow the gap.

The trade deficit with China once again grew, from $19.0 billion in December to $21.3 billion in January and, as a result of higher oil prices, the trade gap with OPEC countries widened from $7.9 billion to $9.3 billion. Trade with the European Union became more balanced, the December deficit of $9.0 billion narrowing to $6.5 billion.

Beige Book: Anecdotal information gathered from the 12 Federal Reserve districts showed a modest expansion of economic activity during the month of February. Retail sales remained strong, particularly consumer electronics, while automobile sales were weak. Housing shows continuing signs of distress both in real estate sales and for home-improvement retailers.

Summary: The case for a soft landing was bolstered by this set of economic reports. A decline in productivity and slowing growth in the ISM Services index along with plunging factory orders were countered by a narrowing trade deficit and respectable employment growth, even after a sharp decline in construction jobs. Wage pressure is still present, as evidenced by higher unit labor costs and average hourly earnings, but, the most important economic statistic of all, job growth, continues to surprise many.

The Week Ahead: Two important inflation reports will be released next week - producer prices on Thursday and consumer prices on Friday. Also scheduled for release are retail sales on Tuesday, import/export prices on Wednesday, two regional manufacturing reports and international capital flow on Thursday, and both industrial production and consumer sentiment on Friday.

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After Pressing the Reset Button...

Looking back on the week just concluded, it feels as though somebody hit the reset button on global financial markets last week and now everything is slowly booting up again.

After a shellacking (the new favorite word this week) administered ten days ago, the S&P500 rose about one percent this week while the Dow and the Nasdaq were about flat. The Shanghai Composite Index was up almost four percent and Nikkei ended the week about where it began.

Commodity prices fell back on Friday after rising for much of the week, although related equities did rather well. The "booting" process is not yet complete, it will continue next week - let's hope that no errors are reported.

Oil breached the $62 level for the first time in quite a while, but fell back on Friday after someone said something about the weather getting warmer. Spring will arrive in less than two weeks - maybe someone should look at the calendar. Gasoline prices were firm as other energy prices fell. This is a part of the normal spring ritual - the weather warms, and gas prices rise.


Oil stocks fell about five percent last week and made almost all of that back this week. It's hard to argue with these share prices when the multiples are so low.


G0ld rose one or two percent while silver was flat. All the hard work of the last two months will have to be done again, but somehow, it feels like there will be another "spring fever" this year with precious metal prices.


Gold mining stocks made up only a few percent of the drubbing from last week. Apparently gold prices are going to have to go a lot higher before anyone gets too excited about gold producers - the smaller companies are a completely different story, but actually producing the metal really doesn't seem to be much fun these days.


And the dollar rebounded back up over the 84 mark on the U.S. Dollar Index. No one knows quite what to make of the U.S. Dollar these days, or any other currency for that matter.

Hopefully, Hank Paulson is accomplishing something over there in China. Maybe he's caught on to the trick where prior to each of his visits, the Chinese central bank announces another loosening of the currency band or something like that so they can't be put on the spot during each visit. Maybe the Treasury Secretary figures that he'll just have to visit every six weeks and, over time, the yuan will seek a "proper" level against the dollar.

At least nothing broke this week.

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Fewer Drywall Nailers, More Baristas

The Bureau of Labor Statistics released the February jobs report earlier today. A total of 97,000 new jobs were created in February and the unemployment rate fell to 4.5 percent.

Upward revisions were reported (surprise!) for the two prior months where the initially reported gain of 111,000 in January increased to 146,000 and the December increase of 206,000 improved to 226,000.

For the month, categories showing improvement were Government (+39K), Leisure and Hospitality (+31K), Education and Health Services (+31K), and Professional and Business Services (+29K). Construction declined sharply (-61K) along with Manufacturing (-14K).

The headline numbers have pleased the "Goldilocks" crowd, someone on CNBC commenting, "Every month, it seems like the employment number that we get refutes all the other numbers that have us thinking that things are slowing down. It's been happening month after month. Oh, it's a lagging indicator and it will show up eventually - it still isn't."

As shown in the charts below, even the now-dubious employment data from the BLS shows an underlying trend that is changing dramatically, just in the last few months. While the weather was blamed for the most recent job losses in construction, the sharpest monthly decline since 1991, there has been a steady erosion in this category for many months now as other categories such as education and health, leisure and hospitality, and professional services have remained firm.


Looking at the detail behind the construction employment data, it appears that the nonresidential construction hiring spree may now be over. Again, weather was surely a factor, but February's declines erased almost all of January's gains for nonresidenial building and specialty trade, following two very weak months to close out 2006.

Residential construction employment (both residential building and specialty trade) has been declining steadily since early 2006 and took another turn for the worse last month.


One of the more interesting categories in the labor report is leisure and hospitality. It was number two in job creation last month, right behind new positions created by federal, state, and local governments.

As shown below, while hoteliers and Mickey Mouse operations may have taken on some new staff recently, the bulk of the job creation in this category continues to come from dining and drinking establishments.


Hey, all the health care workers, educators, and government workers have to eat somewhere!

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The Smell of Desperation

The title of this post had been reserved for comments about visiting a few open houses in an area far north of here not long ago, but, it applies equally as well to the promotion of this weekend's Real Estate and Wealth Expo in Los Angeles, put on by The Learning Annex.

As for the open houses, it was an odd sight indeed. Older realtors spoke plainly of the slowdown in second home sales over the last year while younger agents attempted to instill a sense of urgency - that the bottom might be in - perhaps motivated by the inevitable arrival of next month's Escalade payment whether they sell anything or not.

Not that there are any thoughts of buying any real estate in 2007, but being in an area where open houses were held, it provided a great opportunity to look a little closer and to talk to some realtors about rentals.

Seeing inside some of these homes after just driving by for many years, it was nice to see what some of these places really looked like.

Like many other areas, some people went to excess in recent years. A $5,000 chandelier in an otherwise typical home seemed to serve no function beyond what a $200 one would provide but, what the heck - a couple years ago, money was falling from the sky.

What was most surprising (aside from the price reductions) was the length of time on the market for some of these residences. Six months seemed to be typical with one year or more not at all unusual. It must get tiring lugging those "Open House" signs around every Sunday afternoon when just a trickle of seemingly uninterested potential buyers stroll through along with the usual gaggle of nosy neighbors. Inquiring about rentals must make them thrilled.

With few sales in the last few months, a spring face-off is sure to develop between motivated sellers and a dwindling supply of buyers. The paltry number of deals that have been made over the last few months show a very steep decline in sales price, a fact that both buyers and sellers will likely be aware of as the weather warms.

Cue The Donald!

Down south, the LA Convention center braces for an underwhelming crowd of real estate and wealth enthusiasts. Well, not really. Given the trend of the last two years, the entry price for next year's session will likely be negative (i.e., they'll have to pay people to attend.)

Having written about this show last year, it's clear that the price of admission is plunging right along with real estate prices in some parts of the Southland. Robert Kiyosaki is noticeably absent this year, having been replaced by the likes of Magic Johnson and "Mega Grill Entrepeneur" George Foreman.

Last year they had a special "DONALD" code that could be utilized to reserve a spot at a special low price of only $99 and they made it sound like it was a bargain. In today's LA Times they advertise the price of admission as $49 (discounted from $179) - an even sweeter deal.

If you are on the LA Times mail list, it gets better still - the irony is rich when Donald Trump's mug sits just above something priced at $10.


They're giving away 3-hour Peak Performance Training sessions with success coach Tony Robbins along with the largest SPEED NETWORKING EVENT in the world, whatever that is.

"Finding, funding, and flipping foreclosures" is number two on the list of 52 "nonstop classes on every wealth topic imaginable".

How quickly times change.

Becoming an "eBay entrepreneur" is number four on that same list, surely a growth market in the years ahead as all the useless stuff purchased to fill up new homes over the last couple years gets resold at much lower prices before bank-owned properties go up for auction.

The smell of desperation is probably going to linger for a while.

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China's Military Buildup

The first day of April will mark the six-year anniversary of the Hainan Island Incident in which a U.S. Navy reconnaissance plane, flying in international waters, was intercepted by military aircraft from the naval branch of the Chinese People's Liberation Army.

During the encounter, one plane bumped into another, one of the Chinese fighters crashed, and the U.S. spy plane made an emergency landing on Hainan Island. Following procedure, the 24 crew members destroyed sensitive equipment prior to landing and once on the ground, the plane was boarded and the crew shuffled off to a military barracks where they were interrogated.

Eleven days later, after sometimes tense negotiations, the crew was released, however, the disassembled spy plane was not returned until months later.

Naturally, the events of September 2001 make this incident all the more difficult to recall, but thinking back on George W. Bush's first international crisis in light of China's recently announced military spending plans provides an uncomfortable reminder of how much the world has changed in just six years.

With the astonishing buildup of largely U.S. Dollar denominated foreign exchange reserves combined with their first manned space flight and the somewhat reckless shooting down of their own weather satellite with a ground-based missile, the Chinese military has taken on much greater significance in the global balance of power.

The team of Chinese government officials scouring the globe, buying infrastructure and forming partnership agreements to secure steady supplies of natural resources complicates the new world view further. If activity in Sudan is any example, the Chinese government clearly employs a different set of standards than that to which the West has become accustomed.

A review of some recent news stories sheds additional light on these developments. This story is sure to take on added significance over time.

Over the weekend, ChinaDaily reported on the country's new defense budget:

China's defense budget for 2007 is expected to hit 350.921 billion yuan (44.94 billion U.S. dollars), 17.8 percent higher than that last year, a spokesman for China's top legislature's annual session said in Beijing Sunday.
...
"China won't pose a threat to any country, as it does not intend nor has the capacity to seek arms races against other countries," he added.
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The United States has repeatedly said it does not believe China 's figures and doubts that China has spent more than what is reflected in the budget.
...
"All facts prove that China's increased military budget is used to enhance its defense capacity," Yao said, adding that it echoes the persistent stance China takes in following a defensive policy on military building and opposing hegemony and arms expansion.

On Monday, Chinese Premeir Wen Jiabao pledged a stronger military, also commenting on the eventual reunification with "break-away province" Taiwan:

Reflecting the increased focus on information technology in the People's Liberation Army, Wen also called for an improved ability to fight a "defensive IT war."

The White House said it was concerned over the increase in military spending, warning it was "inconsistent" with Beijing's policy of peaceful development.

"This kind of spending not only concerns us but raises concerns among China's neighbors. This is inconsistent with China's policy of peaceful development," said national security spokesman Gordon Johndroe.
...
"Taiwan is part of our territory. That of course is a factor (in boosting defence spending), but it's not the only one... there are lots of factors threatening China, and they come from all corners."

Reunification with Taiwan is one of China's long-term objectives, and analysts have said Beijing is beefing up its military partly to enable it to take the island back by force if necessary.

Yesterday, an article($) in The Economist commented on the prospects of American involvement in a conflict between the two.

“Our aim,” says a senior Chinese diplomat, “is to win an information war in the Taiwan Strait.”

Some Chinese policymakers believe that if confronted with a fait accompli, America would lack the heart for a fight to liberate Taiwan. They point to opinion polls showing that a solid majority of Americans oppose using troops over Taiwan. Not wanting to see matters put to the test, the State Department was almost as critical of Mr Chen’s remarks as was China.

Meanwhile, the question of China's impact on global energy security was addressed by Ma Kai, the minister of the National Development and Reform Commission:

China's per capita oil consumption in 2005 is 242 kilograms, compared with the world average of 590 kilograms, over 3 tons in the US and 1.9 tons in Japan, noted Ma on the sidelines of the National People's Congress session.

For per capita oil import, the figure in China is 100 kilograms, 400 for the world average, 2.1 tons for the US and roughly 2 tons for Japan, added the minister.

"So I can't imagine why some people are saying that we, with a low consumption and import, pose a threat to global energy security, instead of those countries with high consumption and import, " said Ma. "It is unfair."

And in the U.S., the new Defense Secretary, clearly with more pressing issues on his mind, quickly dismissed concerns about the new Chinese military spending plans.

"I do not see China, at this point, as a strategic adversary of the United States," he said. "It's a partner in some respects, it's a competitor in other respects, and so we are simply watching to see what they're doing."

Gates also said: "I think it's very important for us to engage the Chinese on all facets of our relationship as a way of building mutual confidence."

Anyone who takes seriously the argument for potential global conflict in the years ahead over energy security will see the increased emphasis on defense spending in China as a troublesome development.

The fact that the government has banned new internet cafes for a year, citing growing problems with internet addiction and online gambling, should be troubling as well.

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Pick Your Favorite Analogy

If the last week is any indication of what's in store for the rest of the year, the world may have a severe case of Greenspan-fatigue by the time his book tour concludes this fall.

Not only do his recent musings appear to be in great demand and widely reported, but he may just be getting warmed up to do the bidding of his publishers.

Maybe he thought the initial printing was too small and set out to generate some early buzz - to show that he can still command attention and move markets.

He'll always command attention here.

Thoughts that the name of this blog would begin to lose its relevance as 2007 progressed have quickly subsided.

As for the recent spate of comments about recession probabilities, carry trades, and a number of other topics, the analogies are beginning to flow freely from the mainstream media.

The star quarterback who graduated last year, but who continues to show up at games yelling loudly from the sidelines has been a popular one here.

From the Financial Times Alphaville blog comes a new one from Philippe Bonnefoy, director of the Cedar Fund, a fund of hedge funds:

“[Greenspan] is not running the aircraft, but he’s still in the plane, and his comments make one pause for thought. He’s not a scaremonger.”

Now seems as good a time as any to expand on the Paulson-Bernanke imagery also cooked up here - the one where Hank is up front driving the car while Ben sits in the back seat with one of those PlaySkool steering wheels. In the updated seating arrangement, Alan Greenspan is in the trunk poking Ben through the back seat and yelling loud enough that others can hear.

Of course getting poked in the back may just be part of the job, as evidenced by Paul Volcker's numerous comments in recent years, one of which appears on the right sidebar of the main page:

"There's a 75 percent chance of a financial crisis in the next 5 years."
- Paul Volcker, 2004

Uh oh.

Mr. Volcker's 2005 commentary "An Economy on Thin Ice" probably didn't sit well with the former Fed Chairman, just as the former Fed Chairman's words are probably not welcomed by the present one.

Or are they?

In an interesting take on that subject, Chris Farrell of BusinessWeek suggests that Alan is actually helping Ben.

Of course, I don't know for sure, and neither Greenspan nor Bernanke is talking about their relationship. Yet I bet Bernanke is mouthing a silent thank-you to his predecessor. Greenspan just made Bernanke's job a bit easier.

The reason lies with a four-letter word: risk. Pension funds, hedge funds, private equity pools, and other investors are scouring the globe seeking higher returns ... Bernanke and the other Fed governors have crisscrossed the country openly worrying about excessive risk taking and investor complacency, to no avail.

Maybe investors will pay more attention to Greenspan. In the speech where he talked about recession, he also said: "We have extraordinarily low risk premiums now. Risk is no longer perceived as major risk, at least as it was in years past, and that, I must say, I find disturbing."

No, investors probably won't heed this warning - more likely they'll be emboldened.

Yesterday, the former Fed Chairman told Bloomberg that there is a one in three chance of a recession - an assessment that is at odds with the current Fed Chairman's soothing words before Congress not long ago.

The apparent second-guessing of the Bernanke Fed's economic view by its former chief risks adding to the volatility and undermining the current chairman's efforts to establish his authority in the markets.

Mr Greenspan on Tuesday told Bloomberg he was "surprised at this recent episode". He said: "I was aware of the problem that if I stayed public I could make it difficult for Ben. For the most part it has worked. I was beginning to feel quite comfortable that I was fully back to the anonymity I was seeking."

Comfortable with the anonymity he was seeking? Who's he trying to kid? Surely he misses swaggering up to Capitol Hill to deliver Delphic messages to elected leaders who would then fall quickly under his spell. He probably misses these encounters more than anyone could possibly imagine - he didn't do that job for 18 years for the money.

And today, CNN reports that the yen carry trade has been "put on notice", as Stephen Colbert might say (better than the more severe "dead to me" admonishment, but still not good). That might prompt a little more selling in the days ahead.

The carry trade in which global investors have borrowed cheaply in yen to buy higher-yielding assets elsewhere has got to turn around, said former Federal Reserve Chairman Alan Greenspan Wednesday.

Speaking at a trading technology conference in New York, Greenspan said the yen carry trade is still going strong, but "at some point it's got to turn".

When does that book tour begin?

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What Good is the Carry Trade?

Much of the blame for last week's shellacking of financial markets around the world has been attributed to the "unwinding" of the Yen "carry trade". That is, when hedge funds and other financial institutions closed out investment positions funded by money borrowed at low rates of interest from Japan.

After the Bank of Japan raised interest rates a few weeks back, the Yen strengthened and the higher borrowing cost combined with a narrowing exchange rate differential began to eat into investors' gains.

Spurred by a recession warning from Alan Greenspan and the plunge in the Shanghai Composite index last Tuesday, carry trade profits were promptly taken, resulting in the sale of stocks, commodities, currencies, probably a few paintings, and who knows what else.

The after-hours plunge of over $20 in the price of gold on the New York Access market last Tuesday is being attributed, at least in part, to the sale of more than six tonnes of gold bullion by the streetTRACKS Gold ETF (AMEX: GLD), a trading vehicle that has apparently become quite popular with hedge funds and other speculators.


The price of the metal had fallen only a dollar or two when the COMEX closed at 1:30 PM, but as of 4:15 PM, the gold ETF had lightened its load by a couple hundred thousand ounces. Clearly, there were few buyers for the supply being liquidated.

Similarly, high-yielding currencies in countries such as New Zealand and South Africa plunged as foreign currency positions, funded by the carry trade, were liquidated.

For the rest of the week, the rout was on for equity markets around the world, margin calls were made, and forced selling ensued.

The highly leveraged bets of hedge funds using cheap money denominated in the lowest yielding currencies once again wreaked havoc with financial markets.

When Rates were Low in the U.S.

Not more than a few years ago, in the aftermath of the bursting of the U.S. stock market bubble when the short-term interest rate was only one percent, the U.S. Dollar was the preferred funding source for the carry trade.

There was great trepidation in mid-2004 when former Fed Chairman Alan Greenspan, a staunch backer of hedge funds over the years, began his "baby step" interest rate normalization campaign that eventually saw short-term rates climb 425 basis points .

Though many expected some sort of disaster, there were few problems. However, interest rates rising at a snail's pace over a two year period emboldened borrowers around the world and at the top of the list of confident punters were buyers of real estate in the U.S.

Many of these loans are now going bad.

If not for the carry trade would interest rates in the U.S. have been raised at a faster pace avoiding some of the most egregious practices of the last two years in the U.S. housing market?

No one will ever know, but all of this prompts the question, "What Good is the Carry Trade?"

In comments yesterday in Greenwich, Connecticut, Assistant Treasury Secretary Anthony Ryan noted that, "few groups are more adept at identifying opportunities and moving capital around the world than those managing hedge funds."

But do they have to do it with money borrowed from countries with weak economies?

This distorts the entire exchange rate picture and only benefits hedge fund managers and their investors. There is no discernible improvement in the "allocation of capital" - it's just "asset shuffling".

More Bubbles

It seems that all the carry trade really accomplishes is a further "bubbleization" of the world economy. Some hedge funds will reap huge profits and others will fail disastrously. Some rich investors will get a little richer and some will lose out. Some pension funds will have huge surpluses and some will have to resort to plan "B" to fund retirements.

Meanwhile, emerging economies struggle to survive the torrent of carry trade money and markets become more volatile.

There is an enduring idea that if the "the market" sets the price of currencies, equities, commodities, and other assets, then this is somehow better. The market knows best. But if "the market" is dominated by hedge funds with easy access to cheap money, this can be more destabilizing than beneficial.

Now Hank Paulson is over in Asia trying to reassure everyone that things are going to be OK - that another meltdown is not in store.

Speculators have always played an important role in financial markets, but why must they be provided with such easy access to cheap money?

What good is the carry trade?

Full Disclosure: No position in GLD at time of writing, but the author owns many gold coins.

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What to do with the Bryco Post?

Oh Dear! Mail came earlier today from the headquarters of Bryco Funding asking if the eighteen month old post about their company - Thank You Bryco! - could be removed.

This appeared back in 2005 around the time that government regulators were first getting about the task of doing something about home equity extraction that had become as easy as picking up a phone and fogging a mirror.

The piece was inspired by transcribed from a TV ad that was happened upon one Sunday morning, and in light of news at that time about changes to home equity lending standards, it was a no-brainer.

It attracted a fair number of comments, clearly not evenly balanced, but both sides were duly represented - a 62-year old grandmother even wrote in to say a few good words about the kind people at Bryco.

Of course a few ex-employees showed up too and had a few unkind thoughts to share, but generally speaking it didn't appear to be doing anyone any harm.

Well, a quick search on Bryco Funding reveals the problem and surely explains the motivation for the correspondence received earlier.


Having just read through the entire post and all the comments, one thing becomes immediately and painfully clear.

No longer using the "royal we" was an excellent mid course adjustment for this blog. It's not clear where that originated - at the time, the use of pluralis majestatis (the majestic plural) to avoid singular pronouns may have seemed like a good thing to do, but in retrospect, it sounds like there was a mouse in my pocket.

Where did that come from?

[Note the use of a single "my" thus far - it's not easy, but it's worth it.]

These days, pronouns are avoided completely if possible, though that makes story telling a bit more difficult. There are a few exceptions where the word "I" is littered throughout a post, but that's more for dramatic effect - a sort of shock to the system where regular readers may notice something different, but not know what it is at first.

There's nothing more annoying to some readers than to constantly hear "I this" and "I that". "I think that he should do this" and "I know that she can do that" - it can be quite annoying to see and read that word over and over.

More than likely, most people write this way naturally because that's the way they speak. But, it looks a little different in print, especially when the word is used over and over.

The fact that my last name starts with that letter makes it all the more awkward here, and at first the "royal we" seemed the perfect solution.

Looking back now, it just sounds a little silly - surely, it was the right thing to do.

Anyway, where were we?

Oh yeah.

It's not clear what should be done with that old post that keeps popping up when Bryco Funding is Googled. In a sense, maybe that's what makes the internet great. The comments for and against Bryco both seem compelling in their own way and perhaps leaves potential customers walking away better informed than they would otherwise be.

On the other hand, this may be affecting the company's bottom line, so maybe strategy sessions have been held where management figures that if they could only get that blog post down, then business would pick up and they won't have to lay off Suzy in accounting.

I (oops!) don't know. What do you think?

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Plankton and Ponzi Finance

Ever since subprime lenders started going belly-up at an alarming rate, everyone's quickly coming to the same conclusion - people with bad credit buying houses with no money down may not have been the best way to increase the level of homeownership.

Paul McCulley over at Pimco is the latest to jump on the bandwagon with his March communication in which first time homebuyers are compared to microscopic organisms in the sea - plankton - the bottom of the food chain that serves as the ultimate source of nourishment for most aquatic life.

[Whales don't actually eat in the normal sense - they just swim around in the ocean with their mouths open and somehow the tiny organisms get filtered into their stomachs. No chewing required. ]

Mr. McCulley's archive revealed no recent writing on lending standards, though he has written two pieces over the last year or so that come quickly to mind. One story addressed the impact of mortgage equity withdrawal where the wonderful acronym MEW was first heard. In the other, Austrian Economics got a little respect from the establishment. Aside from the fact that he thinks a bit too much like a an economist at the Federal Reserve, he seems like a pretty nice guy.

His most recent missive goes into great detail on the relationship between plankton (first time homebuyers) and Ponzi Finance (what passed for mortgage lending, up until a few weeks ago).

Watching the on-going meltdown in the sub-prime mortgage market, which is triggering a sharp tightening of underwriting standards to these dicey credits, I was reminded of prescient writings by two serious thinkers: Bill Gross and Hyman Minsky. Both narratives go back a long ways, with something that Bill wrote in August 1980 – 27 years ago! – particularly poignant:

“The Plankton Theory, like life itself, begins and ends in the ocean. Plankton, of course, are almost microscopic organisms that serve as food for higher life forms.
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In the case of real estate, the plankton would be the first-time buyer (perhaps a young married couple) with a desire to own their own home but with very little capital to carry it off. When the time comes that they can’t pull it off – either through an inability to come up with a down payment, or to service the monthly mortgage – then the ‘plankton’ would disappear and the rapid escalation in housing prices would ease as well. For, unless the current homeowner has someone to sell his house to, he’ll be unable to afford the house with the view or that extra bedroom, and the process would continue into the echelons of Beverly Hills and Shaker Heights. In the end, the entire market would wither on the investment vine and home prices would stop increasing at the same rapid rate. So to gauge the health of the housing market, look first at the plankton. Without their presence and financial vitality, the market’s not going to repeat the experience of the past 10 years.”

Bill’s call was a good one, as displayed in Chart 1: home price appreciation tumbled in the first half of the 1980s, as the homeownership rate fell: the Plankton Theory at work! Draconian Fed tightening at the beginning of the 1980s had something to do with it, too, of course, as the Plankton were priced out of the market by high interest rates, independent of the availability – or underwriting standards – for home mortgage loans.

But the theory held: it’s the first-time buyer, stretching to buy, that is the life’s blood of vibrant property markets. And intrinsically, there is nothing wrong with a young family stretching to buy that first house; most all of us did, as did our parents (many with the aid of the GI Bill). Optimism about rising incomes and making lives better for our children is the cornerstone of the American Dream.

Conclusion so far? Maybe a home ownership rate above 65 percent really isn't that great an idea. That extra one percent back in the late 1980s had a tough time holding it together and in many parts of the country, foreclosures and short-sales were common.

In early 1990s California, home prices retreated up to 40 percent in some areas.

Fast-forward to the present and the chart above shows that we are now four percent over the magical 65 percent homeownership rate. Don't extrapolate the 1990s California price decline to today. Not only would that be unfair, it would be impossible.

The second integral part of Mr. McCulley's story involves theories of financial crises espoused by Hyman Minsky, a fellow who has been heard of a time or two before around here, most notable for coining the term "Ponzi Finance".

Minsky, who passed away in 1996, was the father of the Financial Instability Hypothesis, providing a framework for distinguishing between stabilizing and destabilizing capitalist debt structures. He first articulated the Hypothesis in 1974, and summarized it beautifully in his own hand in 1992:
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"In particular, over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make positions by selling out positions. This is likely to lead to a collapse of asset values.”

Clearly, the explosion of exotic mortgages – sub-prime; interest only; pay-option, with negative amortization, et al – in recent years, have been textbook examples of Minsky’s speculative and Ponzi units.

And as Bill Gross explained long ago, such mortgages have been the food of the Plankton, the first-time homeowner, driving the homeownership rate to record highs, as displayed back in Chart 1, while also fueling accelerating home price appreciation. But as Minsky had forewarned, eventually this game must come to an end, as Ponzi borrowers are forced to “make positions by selling out of positions,” frequently by stopping (or not even beginning!) monthly mortgage payments, the prelude to eventually default or dropping off the keys on the lenders’ doorstep.

As noted here a year and a half ago in The Biggest Ponzi Scheme Ever?, like asset bubbles in the eyes of Federal Reserve economists, the "Ponzi" label can only be properly applied to today's housing market "after the fact".

That is, only if the value of the underlying asset collapses will it be confirmed that today's housing market is a true "Ponzi scheme". Though "Ponzi financing" has played a key role, housing in the U.S. will surely fare better than the company for which Charles Ponzi collected money and paid huge returns to early investors during six months in 1920.

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Shiller vs. Lereah: No Contest

Two recent interviews, one with Yale University economist Robert Shiller and the other with National Association of Realtors Chief Economist David Lereah, paint a wildly divergent picture regarding the state of the nation's housing market.

The interview with Robert Shiller appears in the current issue of BusinessWeek and David Lereah was interviewed for Fortune Magazine.

You really don't have to read the interviews - one look at these two and you know who's trying to give it to you straight and who's just blowin' smoke.

Wouldn't it be cool to have lunch with Robert Shiller? Wouldn't it be creepy getting anywhere close to David Lereah?

----- Robert Shiller----- ----- David Lereah -----

While this sort of face value assessment of these two men may strike some as too quick and judgmental, reading what they have to say about real estate does little to alter this view.

Here are some selected excerpts to prove that point.

On the future of home prices:

Shiller: Looking at our national home-price index [the Standard & Poor's/Case-Shiller Home Price Indices], it appears that the boom is over. [Prices] had been rising at an accelerating rate from the late 1990s through 2004. Since then the rate of increase has been decelerating.

We're going through a peak. There hasn't yet been a big price decline, like 20%. For instance, out of the 20 major cities in the country the biggest drops are in Detroit and Boston, which are down 5.9% and 5.1%, respectively. I think there's a good chance home prices will be down 10% to 30% over the next five years.

Lereah: I don't [think a price drop will happen] because we're already seeing some parts of the real estate market picking up again. It looks like we've bottomed out. The worst was the fourth quarter of 2006.

For the past two months now the inventory numbers actually improved for the country. Mortgage rates are still low. The Fed is going to behave. So there are a lot of good signs that the worst is over for housing.

So when it's all said and done, this contraction in housing is probably going to be the least severe contraction we've ever had, which is going to surprise a lot of people.

On the market psychology:

Shiller: Bubbles don't pop suddenly. The air comes out gradually. More and more people decide that the market is turning. The other large factor is a big supply of homes.

I've been reading old newspapers and advertisements to see how past booms ended. It's usually when stories start to circulate that embarrass people who believed in the boom. For example, there was a Florida land boom [in the 1920s]. There were stories of people buying land that was swamp. Booms end when prices start to fall, and then there are stories of buyer stupidity that are told and retold. I sense that's happening now.

Lereah: He (Shiller) thinks psychology will play a major role here, and my view is no. We haven't strayed from the fundamentals. The only part where we strayed from the fundamentals was the speculative investors coming in during 2005. And that exaggerated everything in real estate.

On troubles with subprime lending affecting the housing market:

Shiller: It could. Problems like this can change market psychology. The subprime loan problem will get much bigger if prices really start falling.

Lereah: I was giving a speech in Atlanta about two years ago. During the question and answer period, someone asked me something about interest-only loans. I said, they're kind of dangerous and you have to be careful. Someone rose their hand and said, Did you know that in Atlanta, the percentage of interest-only loans in 2005 was 40 percent of the market? Atlanta didn't even have a boom.

That's when I knew we were in trouble. Regulators and the big lenders need to get together and work out some arrangements to accelerate refinancings. They need to take people out of these crazy loans and get them into longer term loans that work for them over the next 10 or 15 years.

On blogs dedicated to documenting what they say in public:

Shiller: Not applicable.

Lereah (David Lereah Watch): At first I was kind of laughing. And now, it's enough already. This is a 26-year old that could not afford a townhouse and blamed it on the boom. And then he said, Who's talking about the boom and my name kept coming up. So I became Satan to him.

The worst was that my mother read one of those things, and she almost started crying. And I had to say, Mom, you have to have thick skin. I'm going to be in the public and make statements about real estate, and if someone doesn't like what I'm saying, they have every right to say something opposing me.

Now should they go so far as to call me Satan? I don't understand where that's coming from. That's just weird.

No contest.

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They Should've Seen Those Things Coming

More than any other period in the current era, historians are sure to remember the last few years as a time when, "Yeah, they really should've seen those things coming".

Of course it's much easier to see some things after the fact. Two cases in point came over the weekend on the subjects of inflation and asset bubbles.

Ben Bernanke spoke at Stanford University on Friday and commented on the relationship between globalization and domestic inflation.

In the major industrial economies over the past decade or so, import prices--particularly the prices of imported manufactured goods--have generally risen at a slower rate than other consumer prices, slowing overall inflation. The slower growth in import prices reflects to some extent rapid productivity gains in the production of manufactures, an important component of trade.
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On the other hand, not all aspects of globalization and trade reduce inflation. For example, globalization has been associated with strong growth in some large emerging-market economies, notably China and India, and this growth likely has contributed to recent increases in the prices of energy and other commodities.
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Accordingly, in the past several years, the effect of growth in developing economies on commodity prices has been a source of upward pressure on inflation in the United States and other industrial economies.

When the offsetting effects of globalization on the prices of manufactured imports and on energy and commodity prices are considered together, there seems to be little basis for concluding that globalization overall has significantly reduced inflation in the United States in recent years; indeed, the opposite may be true.

In many cases it's not just a slower rate of growth for imports. When quality adjustments are taken into consideration, there have been outright declines in prices for many imported goods, notably the price of televisions over the last ten years.

Compare the above price trend to buying movie tickets or other domestic services that do not benefit from falling import prices and a completely different picture emerges.

Combine the prices of television sets and movie tickets and you get benign inflation - the norm for most of the last two decades.

This was key to Alan Greenspan's tenure at the Federal Reserve where easy money policies were carried out amid an environment of low inflation. He commented many times on this subject, here is one example from just two years ago.

Over the past two decades, inflation has fallen notably, virtually worldwide, as has economic volatility. Although a complete understanding of the reasons remains elusive, globalization and innovation would appear to be essential elements of any paradigm capable of explaining the events of the past ten years. If this is indeed the case, because the extent of globalization and the speed of innovation are limited, the current apparent rapid pace of structural shift cannot continue indefinitely.

Someone really should have figured out that if exporting nations with cheap labor and fixed currency exchange rates continue to depress prices in the U.S., that eventually the demands of this global growth on natural resources might become a problem.

Ben Bernanke now grasps this present day reality, but the former Fed Chairman seems to have been blithely unaware.

The second example of how a little foresight might have mitigated a set of problems (problems that only get worse with each passing day) comes from Justin Lahart in this morning's Wall Street Journal. Justin writes($) about the most recent asset bubble and how it's a lot like the last asset bubble.

Seven years after the stock-market bubble busted, the troubles in the housing market look strikingly familiar. In fact, everything is going according to the textbook -- the textbook in this case being Charles Kindleberger's 1978 classic, "Manias, Panics, and Crashes."

Mr. Kindleberger found speculative bubbles tended to follow similar patterns. First, there is some "displacement" -- such as the development of the Internet or a prolonged period of ultralow interest rates -- that radically improves the outlook for some area of the economy. People take advantage of the opportunity, fueling a boom that is fed by progressively easier access to cash. At the height of the bubble, there's "pure speculation"; assets are bought to quickly sell them again at a higher price -- day-trading in 2000, condo-flipping more recently, tulips long ago.
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As Mr. Kindleberger showed, financial shenanigans in housing are coming to light. A jump in "early defaults," where borrowers stop paying shortly after taking out their mortgage, stems in part from questionable lending practices.
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In early 2004, then-Fed Chairman Alan Greenspan said he thought "we don't have to worry much about the emergence of bubbles for a while because it takes a number of years for the trauma of the collapse to wear off." Back then, of course, the Fed's ultralow interest rates were helping to feed the housing boom.

Mr. Kindleberger documented that bubbles frequently come not long after the previous bust. The 1800s included repeated bubbles in canal and rail securities in the U.S. and abroad. Housing wasn't the only place where low rates bred an easy money culture. Emerging-market stocks and bonds, corporate debt and buyouts come to mind.

Anyone with just a little common sense would have realized that the U.S. real estate market had already detached from its fundamentals two or three years ago. Like most manias, when prices are going up, many people stop asking questions.

Easy money policies, enabled by benign inflation which was in part a result of globalization, have led to the most recent asset bubble and a large part of the blame rests squarely with the former Fed chairman.

He really should've seen those things coming.

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Ahhhh....

Well, the update for the website is done for the week and now it's time to get things ready for tomorrow to go back to w...

Uh oh. No worky on Monday. Not on any Monday from now on - what a weird feeling. Though my last day as a software engineer was three days ago, it hadn't felt like retirement around here until just an hour or so ago when the email went out to subscribers informing them that the weekend update had been posted.

The radical change made last week (no, not to my investment portfolio, to my career) still hasn't really sunk in yet because weekends around here have been a flurry of activity over much of the last year to finish off the weekly update, then get something ready for the blog so it can be proofread at 6:30 AM PST Monday morning and then posted at the blog.

Now, a completely different schedule will be developed with significantly more time to do many more things other than writing software, reading other people's technical documents, and participating in code reviews. Those activities will not be missed, but many of the people will.

Time will be available to read some books finally - they have stacked up here over a foot high with little chance of the pile going down in recent months from them being read. It's been more a matter of creating more, smaller piles as the weeks have gone by.

Two just arrived in the mail in the last week or so. Peter Schiff's Crash Proof and Michael Panzner's Financial Armageddon both showed up and are ready to go.

When you write a blog with a name like this one, publishers send you titles like these at no charge hoping that you'll have a look and say a few nice things about them.

Not having cracked either of these book's backs, I can only offer a brief description that is also available over at Amazon.com:

Crash Proof: A provocative and insightful examination of our difficult economic future and what investors can do to protect their wealth

The economic tipping point for the United States is no longer theoretical. It is a reality today. The country has gone from the world's largest creditor to its greatest debtor; the value of the dollar is sinking; domestic manufacturing is winding down-and these trends don't seem to be slowing. Peter Schiff casts a sharp, clear-sighted eye on these factors and explains what the possible effects may be and how investors can protect themselves.

For more than a decade, Schiff has not only observed the U.S. economy, but also helped his clients reposition their portfolios to reflect his outlook. What he sees is a nation facing an economic storm brought on by growing federal, personal, and corporate debt, too-little savings, a declining dollar, and lack of domestic manufacturing. Crash-Proof is an informed and informative warning of a looming period marked by sizeable tax hikes, loss of retirement benefits, double digit inflation, even-as happened recently in Argentina-the possible collapse of the middle class. However, Schiff does have a survival plan that can provide the protection that readers will need in the coming years.


Financial Armageddon: According to Michael Panzner, the US is less than two years away from "financial Armageddon." When the stock market bubble burst in March 2000, the collapse that followed wiped out over two-thirds of the value of the technology-laden Nasdaq Index and decimated the hopes and dreams of millions of Americans.

Now, imagine not one, but four such disasters looming on the horizon. Four key elements--Debt, Derivatives, Government Guarantees, and the Retirement system--are quickly unraveling, and because they are so intricately connected, there will be an unremitting domino effect. With time running out, this is a disaster-in-the-making on which every American must be informed so they can protect themselves, their families, and their economic well-being before it's too late.

A book about inflation in Weimar Germany currently rests at the top of the pile and will receive attention first, but a look at the two tomes above will soon follow and some sort of a review will appear here.

While I can't really argue with the characterization of the world economy implied by these titles without first having read the books, it should be noted that, around here, the situation is simply considered to be a "mess".

Aside from reading more books, it's hard to say what will change around here. As for the blog, there is sure to be a different cadence of postings and there will be time to do more than just cursory research during the week for the blog.

We'll see how things go.

For now one word and one feeling take precedence over all others.

Ahhhh....

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