Crisis Note 2008-6: We Will Never Live This Well Again


I've been meaning to write this Crisis Note for a while. It shocks me that our leaders appear to be ignorant about the underlying causes of the economic problems the world is experiencing - they have only identified the symptoms so far. Not surprisingly, their 'solutions' have been misdirected, to date. The actions taken to date over the past year (cutting rates, bailing out some institutions while allowing others to fail, pumping liquidity, allowing savings to be 'invested' in insolvent institutions, bailout, TAF, TARP, etc), have made a terrible situation worse, and increased the probability that the global economy is on a path to collapse.

I do not believe in non-market solutions to problems - I believe that markets are as fundamental to the activity of man as breathing - yes, I chose to go to University of Chicago for a reason. But, if we are going to attempt to use non-market solutions to deal with the Global Financial Crisis, then I think that our policy makers have a lot to learn from Scenario Analysis (as exemplified by Royal Dutch Shell's experience in the 70s) to prepare for extreme outcomes, and have plans in place if any of them were to occur.

Here, I describe a draconian scenario, and a "clean sheet of paper" non-market set of policies to address the various pieces of the problem. Please recognize that these are not recommendations to take action, but a thought process that can lead to preparedness in the event the scenario occurs.

Many of my themes could do with more research and quantification. If anyone with a research capability would like to volunteer their time and resources to dig into these issues, please contact me.

Here goes: This is what I think can happen:

- Home-owner defaults will continue unabated, and house prices will remain in free-fall. The main reason for this is not subprime mortgages, nor is it unaffordable mortgages. It is because Americans live in homes that are too big for their incomes, and it is the TOTAL cost of homeownership (mortgage, property taxes, maintenance, heating) that is bankrupting them. On average, we probably live in double the space we need (compare the size of the house you grew up in with your current home), and we cannot afford this - our salaries have not doubled since the 1990s, while our cost of homeownership has MORE than doubled. In addition, we have about 5 million excess houses, but that is less of a problem.

- Towns and cities will stop getting property taxes from banks that own the REOs, as they try to survive. They will attempt to raise taxes (or get loans to defer the problem). New York City's Mayor Bloomberg is talking about doing this. This will make the free-fall in home prices accelerate.

- Without sufficient income, and an inability to issue bonds cheaply, municipalities will start filing for bankruptcy protection, or attempt to get loans from the government.

- In the meantime, in a typical knee jerk reaction, the Fed, and other central banks, will cut rates.

- This will make the dollar (and other currencies that are recipients of the carry trade - Brazil, Iceland, etc) drop vs yen. Oil and other commodity prices could shoot up, creating the next wave of foreclosures. Equity hedge funds using the Yen Carry trade will post more losses, and investors will redeem more. The stock markets will delever as Yen is repatriated, and the Dow will collapse, down to 6000, as the Yen heads to 75 or maybe 50.

- All corporations with credit lines will draw them down before their banks collapse, and start conserving cash. This is already happening. Banks will see involuntary jumps in C&I lending. Whatever banks are left will conserve more cash, further starving corporate America.

- Corporations will start firing people as they cannot make payroll, and start defaulting on their debt and loans. High yield debt and leveraged loans will crater first, causing yet another round of attempted capital raising for the few remaining banks that still have these loans on their books (unless TARP buys them first). The commercial mortgage and CMBS markets will widen. Housing will see another wave of foreclosures from the newly jobless, who will make no attempt to stay in their houses, but will move in with relatives and friends that have double the space they need.

- Americans will stop spending money; this will lead to the scenario described by Martin Wolfe:

How might households seek to reduce their indebtedness, collectively? They can try to sell assets. But they can sell houses only to one another, which would not, in aggregate, help. They can sell equities to the rest of the world, but their prices might crash first. They can default. Indeed, many seem likely to do so. But that would damage the financial sector’s solvency and, through that, either the government’s balance sheet, via bail-outs, or the balance sheet of other households, via losses on financial assets. 

- Between stocks collapsing, corporate debt failing, municipal debt defaulting, and mortgage securities performing worse, the pension and insurance systems in the US, and possibly globally, will collapse.

- When things like this happen, Emergencies are declared. Markets and borders get closed. Trading is halted and countries file for bankruptcy. Governments are blamed and overthrown. Countries seek resources for their citizens, and impose themselves on other countries.

- Its bleak. With the current course of arbitrary actions our governments and their economists are taking, this progression will be difficult to stop.

Here's the good news: I don't think the Dollar or the United States will cease to be THE global safe haven.

The reason: Aircraft carriers.

We own 11 of 21 that are in service in the world, and as such, are the only thing that will prevent Japan and the Middle East from being overrun if civilization collapses. Our greatest creditors have no choice but to keep funding our deficits.

Aircraft carriers in the world
Source: Wikipedia

Step I to Recovery - Understanding the Problem:

This section will repeat relevant material from my previous Crisis Notes. I don't think I've learned anything over the past year that sheds any more light on the problem - in fact I think I nailed it last year.

First, I still don't believe the Fed and the US Treasury understand the nature of the problem. They still view the problem as 'Bad Assets' or 'Bad Mortgages' (defined as assets whose values have declined and that can no longer find buyers at legacy prices), and are addressing their policies at the asset side of balance sheets.

THIS IS A HUGE MISTAKE. I believe the fundamental problem is LEVERAGE, and unless it is addressed, all assets will become 'bad assets', including stocks, and ultimately the economies of the western world.

Most importantly, I don't think there is an understanding that the leverage comes from global sources (Japan mostly). They are still focused on domestic sources of balance sheet and leverage, which are only a small part of the problem, and therefore, solution.

Excerpts from my prior Crisis Notes are in italics:

Everyone is coming to the realization that this crisis is a result of leverage. But the conversation also goes hand in hand with the comment that "this is a subprime problem". The US press is the main culprit here.

- The bull market in debt and equity has been driven by GLOBAL LEVERAGE.
In the 8/10/2007 article, I state: Leverage has come from 3 primary sources:
- Repo & ABS CP (hedge funds, SIVs, SPVs),
- Levered Loans and bridge loans (private equity - stock markets @ premium)
- Yen Carry Trade (invested in stocks and bonds, euro, USD, NZ, Aus, Iceland)
- CDOs & CLOS helped re-leverage a lot of this leverage. Blame Basel.
- When you peel back the onion, global leverage has come primarily from FUNDING COUNTRIES - those with low interest rates.
- Hedge funds borrow cheap money in funding countries, for the most part don't hedge the currency risk, and invest in high yielding countries.

THIS IS KNOWN AS THE CARRY TRADE, AND HAS CONSISTENTLY BEEN THE MOST PROFITABLE TRADE FOR HEDGE FUNDS SINCE THE 90s. This money has resulted in asset price appreciation globally, typically to the detriment of the funding countries.

- Till recently, there has only been one country that has been able to absorb this torrent of investment: The US.

- There have been 3 funding countries in the last decade - Japan (big), Switzerland (small), and (drum roll) the US (while it lasted - 2001-2004).

- Yes, the US. Greenspan's bailout of LTCM made the US a funding country too. However, people have not historically referred to the US as a funding country, as the money raised through debt (also repo, margin, etc) also got invested in the US. To me this is just a coincidence. Fund managers will take cheap funding from anywhere..

- This led to waves of bubbles in the US. All this "free money" created from thin air thanks to the magic of leverage, at the time, really had no choice but to be invested in the US.
- Once we raised rates in the US in 2004, Dollar Carry collapsed, and Yen Carry became the main game in town.

The result:

- MANY FINANCIAL PRODUCTS AND REAL ASSETS WERE CREATED TO FEED THIS FRENZY OF CHEAP MONEY. Miles of fiberoptic cables, homes all over the US, subprime loans to get people into those homes. M&A investment banking morphed into the private equity market and created levered loans, covenant lite loans, highly levered private equity loans, equity bridge loans, etc.



- This is coming back to bite us. Subprime borrowers are the weakest of all the asset types created, and they are folding first. But, it is inevitable that levered loans will fold at some point too, as the lofty growth assumptions made to justify these purchases will no longer work. And with the collapse of the $/Yen, so will the stock market.

- Assets that are being delevered are not finding homes, as they were excess assets without natural balance sheets to belong to. Thus the prices for ALL assets are falling, due to the incessant pressure from the sales. Weak assets and their collateral will need to get wiped out before equilibrium is reached.

- Cutting rates will lead to capital flight and inflation at the same time, as the dollar depreciates. Yen carry trades will be unwound, and the deleveraging will be extremely painful. With our banks mostly in distress, they may not be able to increase money supply enough to replace leverage lost from yen carry exits. IT'S A HUGE MISTAKE TO CUT RATES. The Fed needs to prevent capital flight, and retain foreign investments and leverage.

From Crisis Notes 08-1: the fundamental problem is that we have created way too many assets (globally). Without leverage, there is not enough equity to own these assets. As a world, we just have not saved enough out of our $46.6T of annual GDP: the Fed has $1 trillion (just under), the SWFs are appx 2,2T. Plus whatever cash the hedge funds and private equity firms have. 4-5 trillion will not be enough worldwide. Assets prices, as a whole, will continue to decline, and capital markets will not be orderly.
Whats this Yen Carry trade you're talking about?

The US press has been irresponsibly remiss in not understanding and focusing on this over the past 18 years, given its importance as the primary driver of the US economy (my opinion). It is extremely difficult to research this on the internet.

The story of the Yen Carry trade goes as follows:

In the late 80s and early 90s, Japan's financial institutions got devastated when the stock market and property markets collapsed.

Rather than bankrupt the financial institutions, Japan decided to drop rates to 0 to let the institutions earn their way capital back. The problem was that Japan's economy was not closed, and its currency floated, so capital fled Japan to be invested anywhere it could. The large hedge funds discovered that they could borrow in yen, and did not need to hedge the currency, as the Japanese economy showed no signs of growth (local savings were not being invested locally, and thus there was no money supply formation.) The Japanese government’s response was to keep issuing debt to support the economy and institutions. Japan's gross debt rose from 70 per cent of GDP in 1990 to 180 per cent at the end of 2007. Financial institutions began issuing samurai bonds to take part in the game, and the leveraged growth of the investment banks began.

The only place the Yen borrowings could be invested in scale was the US, and we now had the start of a fantastic decade and a half of "wealth creation". Hedge funds invested in stocks, and they went up. Stock market PEs rose. The private equity market got created. Pension balances went up. Everyone got richer and spent more. Home prices went up. Commercial properties went up. We moved into larger houses. We binged on consumer items, and created the economic juggernaut that is China. Money circulated globally and got spent. The world manufactured to meet this unprecented demand, and this resulted in the commodities boom and in the wealth of the oil producing nations.

These links should be read:

Lehman's collapse has highlighted the risks to the samurai bond market. Japanese buyers are now on strike. Lehman's largest unsecured creditors were also Japanese.

Its likely Japan will suffer losses on the Yen Carry unwind, as hedge funds will be unable to get out of a falling stock market intact. Repatriation of the Yen will lead to a strengthening of the Yen. US hedge funds will lose money on the currency side of the unwind as well, while our Japanese benefactors' losses will be partially offset by a strengthening of the currency.

Here is a concept no one mentions: PE ratios are also a form of leverage. Declining PE ratios will wipe out wealth and savings faster than subprime mortgages. A 1/3 decline in PE ratios is an automatic 1/3 decline in the stock market.

The US stock markets still have an almost perfect correlation with the Yen, even and especially interday. It is not a 'measure of risk aversion' as the WSJ keeps telling us – it is the Yen carry trade in action, and when Japan calls for its savings back, it will be "game over" for the US stock market. (See the graphs in some of the previous Crisis Notes.)

What’s the problem with housing?
There are 2 basic problems. Everyone knows about subprime. There are 5mm subprime loans that were created suddenly in 2003 in response to the availability of money. These are essentially homes that should have never been lent on, and by extension, never been built. So there are about 5 million excess homes that are unlikely to find QUALIFIED buyers. Yes, things like forbearances, maturity extensions etc can delay the inevitable foreclosure, but its unlikely that these borrowers will have the savings to stay in their houses if they loose their jobs. Without opening the door to immigrants that have savings, there is no hope for permanently placing these assets in safe hands.

Homes that are empty create blight, and lower home prices more. Municipalities still have to provide services, for which they are not getting property taxes and income from the local economy. They are forced to raise taxes on the remaining homeowners, further reducing home prices. Home prices are likely to stay in free fall, until excess homes either find buyers, or are torn down.

The bigger problem is that each homeowner has too much house. There were 114 million occupied homes in the US in 2008, up from 71 million in 2000. I'll venture to guess, based on an informal survey of friends and co-workers, that the average home today is probably twice the size of the average home in 1990. This is a result of the growth of the 90s. As our 401ks and investment portfolios appreciated, we felt wealthier. More people bought homes, and others bought larger homes.

That means we have twice the mortgage of our initial homes, and double the property tax. In addition, you have twice the maintenance cost, and twice the utility bill (in BTUs). And last year’s interest rate cut doubled the price of oil, so your real energy cost is probably 4 times what it used to be. Mortgage costs as a % of total home ownership are likely to be lower than they were in the early 1990s (mine are), while most incomes have not increased much. Even with the recent decline in oil, energy costs are still a big issue.

Here is a link to President Bush's former home, currently listed for sale in Midland, TX. This should drive home this point: it is a 2,406-square-foot, three bedroom, two bathroom home listed for $239,900.


Until we solve the problem of too much home, in addition to too much housing, the mortgage component of this deleveraging crisis will continue. Mortgage assets purchased by the government are unlikely to benefit from this.

What about the current LIBOR crisis?

This was covered in the 12-12-2007 Crisis Note:

I asked this question (Where's the Balance Sheet?) in Crisis Note II, and its still THE question to answer. I don't think ANYTHING the Fed and other central banks have done to date can have any impact on the funding freeze. We are all basically participants in a collateralized lending business. If our counterparties dont have sufficient fungible collateral, no one will lend to them. With rising Level 3 assets, the stated capital numbers of banks and brokers are rather meaningless, as level 3 assets are by definition non-funglible. And no one knows better what games are being played in Level 3 than the banks themselves. Thus the banks won't lend to each other, and LIBOR has become a quote, with no transactions in any size (we hear and read), and is not a market at present. Safe cash bonds are clearing well above libor. If and when the LIB market reopens, I think its yields will RISE to approach the cash bonds. The TED spread is likely to go to unprecendented levels in 2008 (350-400 wont surprise me).

What does it take for the LIBOR markets to restart? Collateral, in the form of real capital behind the banks and investment banks. This means they have to dilute their current shareholders and recapitalize in a big way. My recommendation for a safe level over and above their Level 3 assets. That may mean a 25% or greater dilution for many of these institutions.

So, what about the Fed and other central banks’ new pet project? Well, I don't think it can work, as it does not raise new capital for the banks. MLEC had a better chance of working, as it would take assets off balance sheets, leading to deleveraging. This maintains the size of balance sheets, and in fact lowers capital ratios as it increases liabilities instead of forcing sales and deleveraging. I don't think it will spur lending, as they still wont have free capital to leverage up the economy.

The current 750BB TARP/Bailout is the same thing as MLEC fundamentally, just bigger - it too addresses the asset side of bank balance sheets. But without capital added to the liability side of the balance sheets, it will not spur lending. I believe it to be a massive waste of money that will squander capital that could have been used to fix the system.

The most important insight I have that might lead to a solution:

It is my opinion that the Fed and most developed nation central banks do not control money supply anymore, and have not done so for over a decade. YOU CANNOT CONTROL MONEY SUPPLY IN ECONOMIES WITH NO BARRIERS TO CAPITAL MOVEMENTS. 

The Fed Funds rate is a toothless monetary policy instrument, and should be relegated to history. In "developed nations", money is created synthetically by banks, via domestic and international debt (Samurai bonds anyone?), and at the margin, it has been off balance sheet money (SIVs, Yen Futures, etc) that has resulted in money supply, our standard of living, and the bubbles we love. It totally bypasses the central banks. 

Central banks that believe they control the economy are the problem, as they prevent policy action and regulation structure that is appropriate for current economic activity. 

The only long term solution is to abolish central banks, and have one global currency, and let markets dictate rates and money supply. 

Step II: Lets think of solutions:

I am not going to waste time discussing the 'solutions' implemented and proposed by the government and central banks to date, as I view most of them as ill-conceived, and at best, short-term. They do not address the need to keep leverage in the system.

First, let me state again that I am not a believer or fan of non-market solutions. The market will dominate always. There will be unintended consequences that often exacerbate the problem. But, since we do need to slow down the deleveraging process, here are some ideas.

Most of my proposals are going to appear far-fetched, and unlikely to be palatable any time soon, and might in fact be construed as going against the fabric of American society (eg. the "right/dream to own a home"). But, what I am attempting to do here is think beyond the visible horizon, and to get people thinking about the problem. If you accept my identification of the problems, then what I've proposed are clean-sheet solutions to the problems. Maybe there are others. We are likely to converge over time to some of my solutions.

Lets identify the objectives of what governments should be attempting to achieve:

- The most important: Limit the damage to Japan from the unwind - Japan is likely the world's largest savings pool, and their capital will be needed for a reconstruction of global economies.
- prevent stock market declines
- get credit flowing again
- create money supply growth
- preserve asset values
- prevent further financial institution crashes with their unintended consequences due to massive inter-linkages.
- prevent trade wars
- figure out what to do with excess assets
- increase jobs

I) The first step would be for central banks to team up. 

\Rather than messing around with coordinated interest rate policy (while still leaving interest rate differentials), they should immediately cut all government rates to 0, and freeze all currency exchange rates indefinitely. They should also set up currency swap agreements between each other to maintain liquidity in all currencies.

- By freezing exchange rates, they will prevent the currency depreciation effect of a rate reduction.

- All currencies will be equally secure, due to the commitment of the central banks to help each other. There will be no need for flights to quality into the US$.

- Hedge funds will no longer need to dump stocks to get out ahead of other people dumping stocks, or ahead of a Yen strengthening. This will maintain the carry trade in stocks, and limit the double whammy of declining stocks AND declining $ that levered traders currently face. This will also limit losses to hedge fund investors, who might be willing to stay in the game a little longer instead of demanding redemptions.

- This will also limit damage to Japan. While the Yen will not appreciate vs the $, redemptions will also lead to lesser losses.

- Will there be a flight into alternative currencies, like gold or commodities? It might be a side effect.

- There will be other unintended consequences.

II) Put economists that understand the role of money supply in credit creation in charge of every central bank.

Will the Austrian school economists please stand up? (Also economists that are specialists in the Japanese economy of the 1990s.) In addition, I believe the person in charge of the Treasury should come from a large industrial company and have a broad background in finance, trade, employment issues, pension liabilities, understanding of currencies, etc. We need a finance person from Boeing, IBM, GE, HP, P&G, Microsoft, etc. Wall street deal-makers do not meet this criteria.

III) Hedge funds will no longer be making levered returns, and will be getting redemptions, resulting in a stock market that will continue declining. There will still be too much market capitalization in the stock markets. Privatizing Social Security and allowing citizens to invest their social security pensions in stocks will create a new pool of demand for stocks, replacing the deleveraging sellers, and reducing the decline in the stock markets. Maybe the governments should buy equities directly.

IV) Guarantee all existing bank deposits and money market funds globally.
- This will prevent money in the US from leaving checking and savings accounts to be moved into gold, or USTs, or leaving the country entirely to Switzerland, Norway, Japan, or to the newly insured bank accounts in Ireland and Germany.
- This reduces the probability of bank runs, and increases the probability of money being lent out, and put to work in the economy. Banks might honor lines of credit, as they have deposits. Payrolls might be met.
- There will be no more LIBOR. Any banks that are lending will get the funds they need from the central banks.

V) Create a clearing house for all CDS contracts - maybe turn it over to an exchange. I'm shocked this was not done in March after Bear Stearns. Help clear out the issues that might prevent financial Darwinism from occuring through arbitrary reponses to bank failures. Nothing should be too big to fail.

The next 3 appear to be really upsetting people. However, its actually a less drastic solution compared to my initial reaction of tearing down houses as they hit foreclosure - a measure that would have helped reduce the damage of the 1980s Texas housing bust, and which was eventually implemented in the Dallas area. If you think American homes are sized 'just right', feel free to ignore the next 3 recommendations. If foreclosures get out of hand, remember where you read this. 

VI) Home Energy Consumption Policy:
- Subsidize and freeze electricity and heating oil prices for a year. 
Let's get homeowners through this winter. Lower energy costs will lower foreclosures as they will lower the total cost of homeownership.
Mandate a maximum supply of energy to any house based on occupancy, at this subsidized rate, estimated using a standard 2000SF house - ie. a BTU/person ration, to be enforced by the utility. Have a penalty rate of 10x the standard rate for over-usage. So, for example, every single family home occupied by 4 people will get allocated the same amount of energy. If a family of 4 lives in a 4000 SF house, they will get penalized and will have to close up part of the house, tear it down, or encourage another family to move in with them.
- Require all zoning boards to allow conversions of single family homes to multi family status.
- Require all banks to allow modification of titles to allow shared ownership.
- This will gradually increase the efficiency of the housing stock in the US.
- This will also reduce the cost of housing down to levels that match incomes.

VII) Gasoline prices should be not subsidized. Force people that own large cars to make their own cost/person/mile decisions and if necessary, car pool, convert their SUVs to operate on 3 or 4 cylinders, strip out the interior to reduce weight, or sell them for a smaller used car. Will SUVs become the next mobile home?

VIII) Home Foreclosure and recycling policy.
- When a homeowner is facing foreclosure and eviction, a home sharing agency should help introduce them to another homeowner facing foreclosure. By moving into one of the two houses, both families would have shelter, lower housing costs, and the foreclosure rate would get halved.
- Costs of converting homes from single family to multi family would be both tax deductible and also get a subsidy through a tax rebate.
- Foreclosed homes should only stay on the market for a fixed period of time. If they are not sold in 4 months, for example, the local community should have the right to tear them down and recycle the materials, or claim eminent domain and turn them into homeless shelters, in exchange for forgiveness of property taxes owed. This will help local communities reduce the services they provide, as well as reduce the risk to firemen when blighted homes catch fire.
- Both conversion and recycling of houses should add jobs to the economy.

IX) Create a new bank without any legacy balance sheet assets.
- Take some of the 700BB bailout money and start a new bank. Invite Warren Buffet to lend his name to it. Allow an existing bank to go bankrupt, and take over its operations for the new bank.
- Without any legacy issues, and government subsidized debt, this bank should attract deposits and grow rapidly.
- It will thus be in a position to lend, to corporations, municipalities, educational institutions, and individuals that are looking to start up businesses to participate in the reconstruction and recycling of America.
- This will create jobs and money supply growth.

X) Existing banks should be given a one-shot deal to come clean.
- Mark assets accurately, including all Level Three assets. Off balance sheet structures like SIVs should be moved on balance sheet. Declare your true net worth or negative net worth.
- The government will buy preferred stock to recapitalize the institution. Required capital after the dilution should equal a minimum of 125% of Level 3 assets, or 25% of assets. (I'd expect asset prices to continue declining for a while still - the economies of the world will take years to recover from this.)
- Financial institution bankruptcies would be made illegal, unless the institutions are deemed criminal.Laws would be changed to mandate debt-equity conversions and change of control when financial institutions go insolvent in the future. This will maintain the franchise value of the organizations, and allow employees to remain employed.

XI) There is nothing wrong with market value based accounting. Banks are meant to be safe institutions. Insurance companies are in the business of taking risk. If they cannot price their assets or liabilities, they should either not be in business, or be forced to auction them off in the marketplace to reduce future risk to the institution. Phase out 'Level 3 assets'.

XII) Corporate leverage. Corporations with massive debts, either due to past mistakes, and pension liabilities will be coming to the taxpayer till for handouts - if the banks can get bailed, why can't we.Pension liabilities are likely to become a serious issue as stock markets decline. Corporate cash hoards are likely to be deployed to service pensions, putting normal debt service at risk. Like equities, corporate bonds and municipal bonds pose a massive risk (if not greater) to the pension system as well.Bondholders and/or corporations should be allowed to convert a percentage of their bonds into government issued preferred stock as well. This will delever the institutions without providing a direct subsidy.

That world economies are going to slow is not in doubt. That there will be excess assets is not in doubt either, some of which will never find buyers. There will also be massive consolidation in most industries to increase efficiencies, as global manufacturing has been sized for a leveraged global economy which no longer exists. There will be many bankruptcies. Will the massive amounts of money printed lead to inflation? Or will the destruction of industries and the shrinkage of consumption lead to deflation? It remains to be seen.

Once the system has been stabilized, nations can ponder the structure of their financial institutions and markets, and their regulation and governance, as well the nature of money in general. As I've discussed, I believe we will see a single global currency and a global central bank within the next decade.

Samir Shah, 10/04/2008