Tuesday, January 27, 2009

Roubini on the State of the US Economy in 2009 and Comments About 2010

Below is a link to an interview Nouriel Roubini had with Bloomberg News. Nouriel has called much of the current crisis correctly although there have been some timing problems with some of his comments. Nouriel has been a little aggressive on some of his calls, although the calls were correct. I guess Nouriel's problem has been his inability to judge how long the US capital markets could delude themselves. By the way, Nouriel believes that the unemployment rate will peak at 9%. I suspect he is low and 10%+ is probably more likely. I believe he is giving some credit to the various stimulus packages now being proposed. I believe they will be too slow and too late to have much effect in 2009.

http://www.bloomberg.com/avp/avp.htm?N=av&T=Roubini%20Sees%20Negative%20Growth%20Remaining%20Through%202009&clipSRC=mms://media2.bloomberg.com/cache/vXkZDJASdGtU.asf

Sunday, January 25, 2009

Trouble in Credit Card Land

Those familiar with the lending industry have known for some time that the health of the credit cards and auto portfolios was in jeopardy due to the deteriorating economy. Furthermore, they know that things will eventually get worse as the unemployment rate increases. Below is proof positive. From Market Watch. Text in bold is my emphasis.

Quarterly results from Capital One Financial suggest the credit card industry faces a tough 2009 as more borrowers struggle to repay debt and cut spending.

Capital One, one of the largest card issuers, reported a $1.4 billion fourth-quarter net loss late Thursday as it set aside another $1 billion to cover higher charge-offs this year.


The fourth-quarter charge-off rate in the U.S. card business was 7.08%, up from 6.13% during the third quarter. That's expected to jump to roughly 8.1% in the first quarter of 2009, up from the mid-7% range Capital One previously forecast.

Credit-card companies are being hit as falling house prices, the financial crisis and surging unemployment limit the ability of some customers to pay back debt racked up on their cards. (Credit card portfolios are most sensitive to the unemployment rate.)

Capital One said it expects the U.S. unemployment rate to reach 8.7% by the end of 2009 from 7.2% currently and that, on average, home prices will fall another 10% this year.


"From a credit perspective, 2009 is literally and figuratively a write-off," Richard Shane, an analyst at Jefferies & Co., wrote in a note to investors on Friday. "We view the entire industry embarking on a path of permanently lower equity returns."

American Express, a leading rival, slipped six cents to close at $16, the lowest level in more than 12 years.

In addition to more bad debt, companies in the industry have struggled to securitize the credit card loans they originate. That's forced them to fund the loans on their balance sheets instead, which requires more provisions up front, Shane explained.

Tighter regulations on the credit card industry are also limiting the strategies issuers usually use to improve returns, he added.

Meanwhile, some borrowers who are still able to pay their credit card bills are now spending less. Growth in Capital One's U.S. Card business was weaker than usual in the fourth quarter because of lackluster holiday spending.

"Revenue opportunities are less than we previously assumed," John Stilmar, an analyst at SunTrust Robinson Humphrey, wrote in a note to clients on Friday. . . . .

. . . . American Express was cut to sell from hold by Stuart Plesser, an analyst and Standard & Poor's Equity Research. He also slashed his target price on the shares to $14 from $20.
"Charge-offs for credit cards have picked up significantly," Plesser said.

"We also note that credit is starting to deteriorate for more credit-worthy customers," he added. That's an area American Express has traditionally focused on.

This Weekend's Contemplation - The Mix of Politics and Economics and its Effects on 2009

Below is an editorial I found in the WSJ that discusses the current economic situation and the part that politics will play in the process. The editorial is fascinating for two reasons: 1) it acknowledges the current situation is no longer in the hands of the "market' and is now in the hands of the politicians (i.e. TARP,the stimulus package, etc.), 2) by definition this will lead to inefficiencies (improper distribution of resources due to political considerations), and 3) this will bring into play an entire new set of considerations (i.e. political ramifications of buying all the US and UK debt). I usually do not pay much attention to politics, buy whether we like it or not the "camel has it's nose under the tent". This will what is going to make a tough 2009 even tougher. Text in bold is my emphasis.

Some optimistic experts are now saying that though this will be a turbulent year for global markets, the worst of the financial crisis is now behind us. Would it were so. We believe that 2009 will be tougher than many anticipate.

We enter the new year grappling with the most serious global economic and financial crisis since the Great Depression. The U.S. economy is, at best, halfway through a recession that began in December 2007 and will prove the longest and most severe of the postwar period. Credit losses of close to $3 trillion are leaving the U.S. banking and financial system insolvent. And the credit crunch will persist as households, financial firms and corporations with high debt ratios and solvency problems undergo a sharp deleveraging process.

Worse, all of the world's advanced economies are in recession. Many emerging markets, including China, face the threat of a hard landing. Some fear that these conditions will produce a dangerous spike in inflation, but the greater risk is for a kind of global "stag-deflation": a toxic combination of economic stagnation, recession and falling prices. We're likely to see vulnerable European markets (Hungary, Romania and Bulgaria), key Latin American markets (Argentina, Venezuela, Ecuador and Mexico), Asian countries (Pakistan, Indonesia and South Korea), and countries like Russia, Ukraine and the Baltic states facing severe financial pressure.

Policy remedies will have limited effect as insolvency problems constrain the effectiveness of monetary stimulus, and the risk of rising interest rates (following the issuance of a wave of public debt) erodes the growth effects of fiscal stimulus packages. Only when insolvent banks are shut down, others are cleaned up, and the debt level of insolvent households is reduced will conditions ease. Between now and then, we can expect further downside risks to equity markets and other risky assets, given the likelihood that markets will continue to be jolted by worse-than-expected financial news.

The U.S. twin fiscal and current-account deficits will rise over the next two years as the country runs trillion dollar-plus fiscal deficits. We're all aware that foreign actors have financed most of this debt over the past several years. During the 1980s, the U.S. also faced the burdens of twin deficits, but relied on financing from key strategic partners like Japan and Germany. This time, the situation is more worrisome because today's financing comes not from U.S. allies, but from strategic rivals like Russia, China and a number of relatively unstable petrostates. This leaves the U.S. perilously dependent on the kindness of strangers.

There's some good news in this interdependence. The mutually assured economic destruction that this relationship implies ensures that China can't simply pull the plug on all this financing without suffering a considerable amount of self-inflicted pain. Reducing its financing of Washington would, among other things, put significant upward pressure on the value of China's currency, sharply undermining its export sector and, therefore, the country's economic growth.

But over time, the ability and willingness of China and others to finance U.S. deficits will diminish as they begin to run fiscal deficits of their own. They'll need to use their financial resources at home just as a tsunami of U.S. Treasury bond issuances peaks.


Politics will make matters worse, primarily because governments in both the rich and the developing worlds are intervening in their economies more broadly and deeply than at any time since the end of World War II. Policy makers around the world are hard at work crafting stimulus packages filled with subsidies and protections they hope will breathe new life into their domestic economies, and preparing to rewrite the rules and regulations that govern global markets.
Why is this dangerous? At the G-20 summit a few weeks ago, world leaders pledged to address the crisis by coordinating their economic policy responses. That's not going to happen, because politicians design stimulus packages with political motives -- to satisfy the needs of their constituents -- not to address imbalances in the global economy. This is as true in Washington as in Beijing. That's why politics will drive the global economy more directly (and less efficiently) in 2009 than at any point in decades. Its politics that is creating the biggest risk for markets this year.

This is part of a worrisome long- term trend. In China and Russia, where histories of command economics predispose governments toward what we've come to call state capitalism, the phenomenon is especially obvious. National oil companies, other state-owned enterprises, and sovereign wealth funds have brought politicians and political bureaucrats into economic decision-making on a scale we haven't seen in a very long time.

Now the U.S. has gotten in on the game. New York, once the financial capital of the world, is no longer even the financial capital of the U.S. That honor falls on Washington, where lawmakers are now injecting populist politics into economics decisions. Companies and sectors that should be left to drown are being floated lifeboats. This drama is also playing out across Europe and Asia. As engines of economic growth, Shanghai is losing ground to Beijing, Mumbai to Delhi, and Dubai to Abu Dhabi.

Global markets will also face the more traditional forms of political risk in 2009. Militancy in an increasingly unstable and financially fragile Pakistan will continue to spill across borders into Afghanistan and India. National elections in Israel and Iran risk bringing the international conflict over Iran's nuclear program to a boil, injecting new volatility into oil markets. The impact of the financial crisis on Russia's economy could produce significant levels of unrest across the country. And Iraq may face renewed civil violence, as recently dormant militia groups compete to fill the vacuum left by departing U.S. troops.

The world's first global recession is just getting started.

Friday, January 16, 2009

Violence Due to the Economic Crisis

In December the head of the IMF warned about widespread civil unrest due to the deteriorating economic situation across the globe. There have already been problems in Greece, Russia, and China in the last several months. Now there are problems in Latvia and Bulgaria. I am no expert on the politics of these countries and I certainly do not profess any special knowledge about this situation, but the civil unrest in certain countries is just part of the unfolding tapestry of the economic crisis. We'll see how things go. Text in bold is my emphasis. From the NY Times:

Violent protests over political grievances and mounting economic woes shook the Latvian capital, Riga, late Tuesday, leaving around 25 people injured and leading to 106 arrests.

Officers cleared demonstrators on Wednesday in Sofia, Bulgaria. Several countries have faced protests over economic issues.

A protester faced riot police officers on Tuesday in Riga, Latvia. About 25 people were injured when the rally turned violent.


In the wake of the demonstrations, President Valdis Zatlers threatened Wednesday to call for a referendum that would allow voters to dissolve Parliament, saying trust in the government, including in its ability to deal with growing economic problems, had “collapsed catastrophically.”

For years, Latvia boasted of double-digit economic growth rates, but it has been shaken by the global economic downturn. Its central bank has spent a fifth of its reserves to guard against a steep devaluation of its currency, the lat, and experts expect a 5 percent contraction of the country’s gross domestic product in 2009. Salaries are expected to fall substantially, and unemployment is expected to rise.

The violence followed days of clashes in Greece last month over a number of issues, including economic stagnation and rising poverty as well as widespread corruption and a troubled education system. In Bulgaria on Wednesday, separate riots broke out in the capital, Sofia, after more than 2,000 people — including students, farmers and environmental activists — demonstrated in front of Parliament over economic conditions, Reuters reported.

Mr. Zatlers has long been aligned with the governing coalition, so his threat to dissolve Parliament came as a surprise — and was testament to nervousness about how economic troubles in the region could intersect with simmering political grievances.

The rioting broke out Tuesday after around 10,000 people protested in historic Dome Square over the economic troubles and grievances involving corruption and competence of the government.

Several hundred protesters lingered after most of the crowd had left and started throwing snowballs and cobblestones at government buildings.

Several demonstrators also threw Molotov cocktails, according to Mareks Mattisons, a spokesman for Latvia’s Interior Ministry. In a public statement on Wednesday, President Zatlers denounced the violence, but said it was more important to ask “why people gathered in Dome Square.”

“We must not face further confrontation, we must do the things that are demanded by the public,” he said. “I refer to constitutional amendments, a plan to stimulate the economy, and reform of the national system of governance.”

Krisjanis Karins, a member of Parliament and former leader of the opposition New Era party, said the violence showed that financial woes had injected a new vehemence into old political complaints.

Protests in Latvia, he said, tended to follow a pattern of “standing, singing and just going home,” but the young protesters who showed up on Tuesday evening “seem to think the Greek or French way of expressing anger is better,” he said.

“In our neck of the woods, this just doesn’t happen,” he said. “But it did this time. Everyone is trying to figure out how much of this was provoked. Who are these people? Where did they come from?”

Whatever the answer, he said, Tuesday’s protests seem likely to force political change.

“In six months, we’re going to look back and yesterday will be a watershed,” he said. “I would be deeply surprised if it were not.”

President Zatlers made a series of strict demands of the Parliament, including a constitutional amendment that would allow voters to dismiss Parliament, and a new supervisory council to oversee economic development and the state’s use of loans.

He called for “new faces in the government,” chosen for competence rather than “their influence in the relevant party.” He said the changes must be made by March 31, or else he would propose a referendum that could dissolve Parliament.

“Only with such specific work can we calm the public down and offer at least a bit of hope that the process in this country will develop in a favorable direction,” he said.


Tuesday, January 13, 2009

Bernanke in London - "timing and strength of economic recovery are highly uncertain"

Bernanke's comments to the London School of Economics are probably a little more realistic then some of his comments made 18 months ago. For example, the timing and strength of the recovery is uncertain, the Obama stimulus package is probably "too little too late", the inability of the banks to extend credit is central to the economic crisis, etc. Text in bold is my emphasis. From Market Watch:

There will be no lasting recovery without more government action and money to strengthen the financial system, Federal Reserve Chief Ben Bernanke said Tuesday.

The timing and strength of economic recovery "are highly uncertain," Bernanke told an audience in London. The text of his speech was released in Washington.

In what's likely to be a sobering message to Congress, Bernanke said that the stimulus package championed by President-elect Barack Obama likely would help the economy but wasn't going to be enough.

He said the next step is to get toxic assets off bank balance sheets. He outlined several ways to do this, including setting up "bad banks" to hold the troubled assets. These are likely to be very expensive.

As yet, there is no end of the financial crisis in sight, he said.

"With the worsening of the economy's growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance-sheet capacities of financial institutions," Bernanke said in a speech to the London School of Economics.

On a related note, coordinated government policy responses will be critical to turning the economy around, he said.

He also stressed the Fed still has the power to fight the financial crisis and economic downturn even though its federal funds target rate cannot be reduced "meaningfully further."

He said that he expects inflation to moderate further and that the Fed would make sure that its "exit strategy" from its unconventional easing would be accomplished in a smooth manner.

Since the crisis began, the Fed has slashed interest rates to record low levels and has expanded its balance sheet by more than $1 trillion to ease the financial crisis.

It has started an alphabet soup of programs that essentially are stepping in to prop up private markets.

Given this uncharted territory, Fed watchers have a slew of questions and Bernanke's speech could be seen as an attempt to address some of the most prominent concerns.

The Fed chairman attempted to ease concern that the new policy could turn out to be the Fed's Vietnam -- meaning it has no exit strategy.

Another question is how financial markets could react when the Fed has to unwind its operations.
Bernanke promised that the Fed "will take all necessary actions to ensure that the unwinding of our programs is accomplished smoothly and in a timely way."

Other analysts have worried that the Fed is taking too many long-term securities on its balance sheet, which may be hard to sell. Bernanke said that the central bank is watching this and does "not expect a significant problem in reducing our balance sheet to the extent necessary at the appropriate time."

Some observers have worried that the Fed is effectively printing money which will ultimately be inflationary.

Bernanke responded that the Fed sees "little risk of inflation in the near term; indeed, we expect inflation to continue to moderate."

Bernanke's talk was also aimed at members of Congress. He urged them to help explain to taxpayers why they must assist in restoring financial markets to health.

"The public in many countries is understandably concerned by the commitment of substantial government resources to aid the financial industry when other industries receive little or no assistance," he said.

"This disparate treatment, unappealing as it is, appears unavoidable," he insisted.

Without the free flow of credit, there would be an immediate downturn in economic activity.
"Responsible policymakers must therefore do what they can to communicate to their constituencies why financial stabilization is essential for economic recovery and is therefore in the broader public interest," he said

Sunday, January 11, 2009

This Weekend's Contemplation - The Real Ticking Time Bomb - Pensions

In the current crisis we hear constantly about the housing market, the stock market, banks, etc. But, the real ticking time bomb in the entire economic crisis is the effect that last fall had on the private pension plans and insurance companies in the US and abroad. It is pretty arcane stuff and certainly not as flashy as where the new President's children are going to go to school so the news media does not talk about. But make no mistake the damage that last fall's stock market did to pension plans and insurance companies could be the shot that sinks the ship. When pension benefits are cut for retired workers or existing workers are not sure if there pension benefits are going to be there, one of the key "social safety nets" everyone comments about that will keep the current economic crisis from turing into the Great Depression may have big holes in it. The article below from Portfolio.com is about pension companies, but the same sort of thinking can be applied to insurance companies. Text in bold is my emphasis.

Collapsing stock prices have created shortfalls in pension plans in dozens of large U.S. companies, which may require them to pump in tens of billions of dollars of cash, hurting earnings.

With corporate America facing pension plan shortfalls totaling several hundred billions of dollars, more companies will in 2009 need to shore up their plans to ensure they can handle commitments to retirees, several analysts said.

And with the recession expected to cause a growing number of companies to go bankrupt, the taxpayer burden could increase if the federally-chartered Pension Benefit Guaranty Corp were to step in to cover more shortfalls. Corporate defined-benefit plans cover nearly 44 million Americans, the PBGC has said.

"We have to teach the private sector not to add leverage and risky assets, and let future workers pay for the needs of current retirees by promising future benefits beyond what companies can deliver," said Laurence Kotlikoff, an economist at Boston University.

Credit Suisse accounting specialist David Zion said on Thursday that 360 companies in the Standard & Poor's 500 may have underfunded pension plans, including 304 whose plan assets may be less than 80 percent of liabilities.

He estimated the total amount underfunded at $362 billion, compared with a more than $58 billion surplus a year ago. The shortfall is nearly twice the $200 billion level in 2002, the last bear market in stocks.

"As you can see, pension plans are much worse off this time around," Zion wrote.
Pension plans of S&P 500 companies ended 2007 invested 61 percent in stocks, 28 percent in fixed income, 4 percent in real estate and 7 percent in other assets, S&P has said.


The Pension Protection Act of 2006 requires companies with underfunded plans to pay additional premiums, and closed loopholes that had allowed such plans to skip payments.
Some big companies including Boeing Co and Lockheed Martin Corp have already acknowledged big hits to pension plans from recent market turmoil.

Analysts said increased pension liabilities could reduce companies' ability to spend on day-to-day operations. It could also make it harder to preserve their credit ratings and book values, perhaps making it tougher to meet loan covenants.

The consultant Mercer this week estimated $409 billion of pension underfunding at companies that make up the S&P 1500.

Mercer, a unit of Marsh & McLennan Cos, estimated that S&P 1500 companies may have to pump $70 billion into pension plans in 2009, up from $10 billion in 2008.

That $60 billion increase would cut into earnings by 8 percent, based on $727 billion of net income in 2007. Any hit could be even greater in percentage terms if the recession were to cause overall profitability to decline, as is expected.

Mercer estimated that large U.S. companies could cover only 75 percent of their obligations at year end.

In a separate report, a Bank of New York Mellon Corp unit estimated a typical plan's assets-to-liability ratio slid more than 24 percentage points in November and December alone.

"The (Federal Reserve's) drive to bring down interest rates to help the economy has had the collateral effect of increasing the liabilities" of plans, said Peter Austin, executive director of BNY Mellon Pension Services.

In October, Congressional Budget Office chief Peter Orszag told a House committee that "severe stresses in financial markets almost inevitably cause wrenching adjustments by workers and employers."

But Orszag, now President-elect Barack Obama's choice to become White House budget director, said companies can avoid unnecessary risks through diversification, such as by investing in index funds rather than individual stocks.

Many companies have shifted in recent years to uninsured plans such as 401(k)s, where employees direct the investments.

The PBGC ended its fiscal year on September 30 with an $11.2 billion shortfall. It later took on or sought court permission to offer pension protection at investment bank Lehman Brothers Holdings Inc, auto parts supplier Visteon Corp and pulp company Pope & Talbot Inc.

Zion, of Credit Suisse, said 94 companies in the S&P 500 could see pension costs drop in 2009 from accounting mechanisms, though costs for some of these could rise in 2010.

He cautioned, though, that pension costs could create a "headwind" for 274 members of the S&P 500, potentially reducing earnings by more than 10 cents per share at 55 companies.
"Look for more companies to start working this into their 2009 earnings guidance over the next few weeks," he wrote. "Analyst estimates could be revised downward."

Saturday, January 10, 2009

The Unemployment Rate is Up to 7.2%, Worst Drop in Payrolls Since WWII

By now most people understand that the unemployment rate has hit 7.2%, but the article below contains additional information about unemployment, how it compares to past periods and what it holds for the future. What impresses me is most of the job losses have occurred in the last quarter of 2008. Text in bold is my emphasis. From Yahoo News:

The unemployment rate surged to the highest in nearly 16 years last month as a deepening year-long recession forced companies to axe more than half a million jobs, government data showed on Friday.

The U.S. economy lost an astonishing 1.9 million jobs in the past four months alone, an acceleration in layoffs toward the end of a year that brought the biggest drop in employment in more than a half century.

In all of 2008, 2.6 million people lost their jobs, the largest slump in employment since a 2.75 million drop in 1945.

The December data pointed to a bleak start for 2009 and increased chances the economic downturn could become the longest since the 1930s.

"This is a very dismal report. This paints a much worse picture in 2008 than we had thought," said Lindsey Piegza, market analyst at FTN Financial in New York. "This is one of the most significant downward quarters for jobs in post World War (Two) history."

The Labor Department said the unemployment rate jumped to 7.2 percent last month, the highest since January 1993, from 6.8 percent in November. The rise was driven by massive layoffs in all major sectors except government, education and health.

In all, employers cut nonfarm payrolls by 524,000 last month. While that was a bit less than analysts had predicted, job loss totals for October and November were revised upward and came in much higher than previously estimated. . . . .

. . . . The darkening labor market picture underscored the sense of urgency President-elect Barack Obama and lawmakers feel about enacting a huge economic stimulus plan.

"Clearly the situation is dire. It is deteriorating and it demands urgent and immediate action," Obama told a news conference on Friday. For more, see [ID:nN09296071]

The U.S. economy slipped into recession in December 2007 and the 12-month downward spiral is already the longest since the early 198Os. If it lasts more than 16 months, it will be the longest recession since the Great Depression.

"We expect the jobs hemorrhage to continue through much of 2009," said Nariman Behravesh, chief economist at IHS Global Insight in Lexington, Massachusetts.

"The current pace of job losses means that the unemployment rate will rise into the 9 percent to 9.5 percent range -- at a minimum -- before leveling off."

The collapse of the U.S. housing market triggered the worst financial crisis since the 1930s, and businesses and consumers alike have retrenched, with shock waves spreading worldwide.

December marked the second straight month of U.S. job losses in excess of half a million. The Labor Department said 584,000 jobs were lost in November, the biggest decline since December 1974, when payrolls dropped 602,000.

The November total was previously reported as a loss of 533,000. October's losses were revised upward to 423,000 from 320,000, meaning 154,000 more jobs were shed in those two months than had been thought.

Adding to the weak tone, the length of the average workweek fell to 33.3 hours, the lowest on record since the series started in 1964, suggesting more job cuts could be in store.

More worryingly, the number of people working part-time for economic reasons reached 8 million in December, up from an already high 7.3 million, and the labor underutilization rate, which includes discouraged job seekers, jumped to 13.5 percent from 12.6 percent. . . . .

. . . . In December, service-providing businesses shed 273,000 jobs, with retail payrolls shrinking by 67,000.

The blood-letting continued in building and manufacturing. Construction employment dropped by 101,000 and factories cut payrolls by 149,000. . . . .

The Real Risk of Buying a House Now - Further Declines in Value

Wow. An analyst from a home-builder is questioning why someone would buy a house in the current environment. The reason is that the real risk of buying a home today is further price declines. Why pay full price for a home that will decline in value 20% within a year? The other thing I like about this article is that the analyst draws the relationship between the unemployment rate and foreclosures. This relationship between unemployment and foreclosure is "muddied" by consideration for the the value of the home, but it is still strong. However, the relationship between the charge-off rate in auto (car and truck) and bankcard portfolios and the unemployment rate is much stronger. There is still a lot of tough sailing ahead. Text in bold is my emphasis. From Market Watch:

Fox-Pitt Kelton home-builder analyst Robert Stevenson said Wednesday he thinks this year will turn out to be "a bad time to buy a home" as the U.S. economy loses more jobs, especially if buyers don't plan on staying in the house for at least several years.

"While some suggest that now is great time to buy a home given low mortgage rates and falling home prices, we believe that for most homebuyers, the opposite is true," Stevenson said in a report to clients.

"Buyers who lose their jobs or who stay in their homes for less than seven years stand to incur substantial losses as home prices decline further in 2009 and the U.S. experiences more moderate home-price appreciation going forward," Fox-Pitt said. "We believe too few buyers do the simple break-even math before sinking their life savings into a house."

With average rates on 30-year mortgages falling to around 5% and the government pumping liquidity into the mortgage market, many homeowners are rushing to refinance. But while the lower rates make homes more affordable, the days of buying homes with little or no down payment and shaky credit scores are long gone.

For buyers, the big fear is purchasing a house that will be worth less a year later, or even longer. (Finally, someone, besides me, as stated the real risk of buying a home.) Homeowners who bought at the peak of the housing bubble are underwater on their mortgages, meaning they owe more on the loan than the house is worth -- and some are simply walking away.

According to the latest data available, home prices are back to their March 2004 levels nationally. Prices in 20 major U.S. cities fell 18% for the year ended October, according to the Case-Shiller price index published by Standard & Poor's.

National home prices were down 23% from their July 2006 peak through October, and Stevenson at Fox-Pitt predicted an incremental 20% drop in prices before bottoming, a peak-to-trough decline of roughly 40%.


"While a drop of 40% seems absurdly high ... it would only put home prices back to where they were at the beginning of 2002," Stevenson said.

The analyst's bearish outlook is based largely on escalating unemployment, and jobs are the lifeblood of the housing market.

"As if 2008 weren't bad enough for housing -- given the mounting foreclosures, falling home prices, and a tightening credit market -- millions more Americans are now in danger of losing their jobs," said Stevenson at Fox-Pitt. "As unemployment heads towards 8%, we expect foreclosures to spike, taking home prices down materially." . . .

. . . . "If unemployment can be held under 8%, we believe the housing market will start a slow recovery beginning in 2010," Stevenson said. "However, if the bears are correct and the U.S. experiences 9% [or higher] unemployment in [the second half of 2009] or 2010, we believe the housing market could experience a meltdown even more severe than the one we've experienced in the past few years."

On the supply side of housing, there remains a sizable overhang of unsold homes on the market. The supply of both new and existing homes is massive by historical standards, and a surge in foreclosures would only add to the glut if the government can't find a solution to the foreclosure problem.

Buyers who do jump into the housing market should consider the possibility that they may need to stay in the home for many years in order to come out ahead, assuming home prices fall substantially further.

"Given the likelihood of a meaningful decline in home values in 2009, we continue to wonder why anyone would buy a home today," said Stevenson, the home-builder analyst, in a loud and clear warning to buyers.

The housing market "is likely to remain significantly oversupplied into 2010," he said. "Given the likelihood of incremental home price declines, we see little reason for most Americans to rush into buying a home today."

Friday, January 9, 2009

The Great Dying

I like the article below because it does not mince any words about the current state of the economy. As the title indicates, now that the shopping season is over the earnings season is upon us and there is a lot of bad news to come, which will lead to the period of a "Great Die-Off" of companies. The author seems to think that when oil prices get low enough that equity markets will stage a large rally, but I don't buy that. I suspect that by late spring/early summer investors and the public will begin to understand how serious the economic situation is and the market will move to a state of "capitulation". Text in bold is my emphasis. From Market Watch:

Everybody should have known that the holidays would only delay it. The freight train of job cuts, plunging earnings and massive spending cutbacks set to hit the economy was, thankfully, pushed back a few weeks while stunned investors and workers across the globe caught their breath after the worst fourth quarter in decades.

But now the great dying has begun, and I'm not talking about German billionaires throwing themselves in front of trains or French aristocrats slitting their wrists, as alarming as these incidents have been. No, earnings season -- the time for companies to 'fess up just how bad it's been for them in the last three months -- is here.

Alcoa Inc. kicked it off late Tuesday, announcing 13,500 job cuts. Intel Corp. came in early Wednesday with its statement that fourth-quarter sales had plunged 23%. Few sectors were safe, as the carnage on the first awful day of the year for the stock market spread across the retail, energy, media and banking industries.

The Dow Jones Industrial Average's decline of 245 points, or almost 3%, was the first evidence of 2009 that we are about to finally arrive at that time when the worst, all along, had been yet to come. A rally since late November in the markets gave hope that equity investors, a forward-looking indicator, may see the bottom for the economy in the first half of this year.

That may still be true, but we have to get there. And the next few weeks of earnings warnings and then actual earnings, along with outlooks for the next three months, are expected to be littered with bad news. It's not just layoffs and plant closings, which are bad enough on hard-working folks and the surrounding economy. And it's not just bank failures, or collapsing investment banks and hedge funds.

Companies will start going completely out of business, including retail firms, biotech companies and many, many mom-and-pops out there in everything from auto parts to bars and restaurants. Much of it will be tied to a pulling in of horns among consumers. They were willing to buy the Christmas tree or the holiday trip to grandma's house. But now that we're in January, getting more exercise is no longer on the top of the annual resolutions list.

Investors won't be safe, either, especially with time bombs like Wednesday's fraud at India's Satyam Computer Services, causing its shares to fall almost 80%, going off with alarming frequency. This is the time in the cycle where all the frauds come out -- Enron, WorldCom, Madoff. They're all exposed when the tide goes out.

What will signal a turning point? Could it come during the worst of earnings season? Perhaps. But I expect it will come afterward, and that it will be tied to oil prices.

You think Ken Lay isn't chuckling on some cloud somewhere about all this? Is it a coincidence that Jeff Skilling was back in the news this week? Already somebody is calling Satyam "India's Enron." There will be more to come. So what will signal a turning point? Could it come during the worst of earnings season? Perhaps. But I expect it will come afterward, and that it will be tied to oil prices.

The collapse of the oil bubble was stunning in its ferocity, equally if not more stunning than the rapid inflation of the bubble itself. Likewise, crude is now oversold, and, while it looks set to fall below $40 a barrel and maybe well into the $30s, investors will flock back to it at the first sign of an economic rebound. That will in turn spark energy stocks, and probably financial stocks, and we'll be off to the races again. (We'll see, I am not buying it.)

Obama's inauguration and the swift passage of his economic stimulus package will provide some gauze for the wounded markets, but there is still too much to work through to think a passing of the torch can be the catalyst.

In the meantime, financial advisers will continue to recommend the old saw that the best position for investors is indeed the fetal one, and asset managers sitting on cash and low-yielding bonds will be awaiting any sort of signal that the worst of the actual economic pain is over. When the economy does get ready to turn, the markets will react quickly. (Sorry, I not buying into this point.)

But it isn't there yet.

Thursday, January 8, 2009

Investment Vs. Business Risk - It is All About the Risk

Below is one of the best articles I have read about the current credit/housing/stock market crisis. After you read the article you will realize that it is all about the risk. From the Atlantic:

Well, we did it again. Only eight years after the last big financial boom ended in disaster, we’re now in the migraine hangover of an even bigger one—a global housing and debt bubble whose bursting has wiped out tens of trillions of dollars of wealth and brought the world to the edge of a second Great Depression.

Millions have lost their houses. Millions more have lost their retirement savings. Tens of millions have had their portfolios smashed. And the carnage in the “real economy” has only just begun.
What the hell happened? After decades of increasing financial sophistication, weren’t we supposed to be done with these things? Weren’t we supposed to know better?


Yes, of course. Every time this happens, we think it will be the last time. But it never will be.

First things first: for better and worse, I have had more professional experience with financial bubbles than I would ever wish on anyone. During the dot-com episode, as you may unfortunately recall, I was a famous tech-stock analyst at Merrill Lynch. I was famous because I was on the right side of the boom through the late 1990s, when stocks were storming to record-high prices every year—Internet stocks, especially. By late 1998, I was cautioning clients that “what looks like a bubble probably is,” but this didn’t save me. Fifteen months later, I missed the top and drove my clients right over the cliff.

Later, in the smoldering aftermath, as you may also unfortunately recall, I was accused by Eliot Spitzer, then New York’s attorney general, of having hung on too long in order to curry favor with the companies I was analyzing, some of which were also Merrill banking clients. This allegation led to my banishment from the industry, though it didn’t explain why I had followed my own advice and blown my own portfolio to smithereens (more on this later).

I experienced the next bubble differently—as a journalist and homeowner. Having already learned the most obvious lesson about bubbles, which is that you don’t want to get out too late, I now discovered something nearly as obvious: you don’t want to get out too early. Figuring that the roaring housing market was just another tech-stock bubble in the making, I rushed to sell my house in 2003—only to watch its price nearly double over the next three years. I also predicted the demise of the Manhattan real-estate market on the cover of New York magazine in 2005. Prices are finally falling now, in 2008, but they’re still well above where they were then.
Live through enough bubbles, though, and you do eventually learn something of value. For example, I’ve learned that although getting out too early hurts, it hurts less than getting out too late. More important, I’ve learned that most of the common wisdom about financial bubbles is wrong.


Who’s to blame for the current crisis? As usually happens after a crash, the search for scapegoats has been intense, and many contenders have emerged: Wall Street swindled us; predatory lenders sold us loans we couldn’t afford; the Securities and Exchange Commission fell asleep at the switch; Alan Greenspan kept interest rates low for too long; short-sellers spread negative rumors; “experts” gave us bad advice. More-introspective folks will add other explanations: we got greedy; we went nuts; we heard what we wanted to hear.

All of these explanations have some truth to them. Predatory lenders did bamboozle some people into loans and houses they couldn’t afford. The SEC and other regulators did miss opportunities to curb some of the more egregious behavior. Alan Greenspan did keep interest rates too low for too long (and if you’re looking for the single biggest cause of the housing bubble, this is it). Some short-sellers did spread negative rumors. And, Lord knows, many of us got greedy, checked our brains at the door, and heard what we wanted to hear.

But most bubbles are the product of more than just bad faith, or incompetence, or rank stupidity; the interaction of human psychology with a market economy practically ensures that they will form. In this sense, bubbles are perfectly rational—or at least they’re a rational and unavoidable by-product of capitalism (which, as Winston Churchill might have said, is the worst economic system on the planet except for all the others). Technology and circumstances change, but the human animal doesn’t. And markets are ultimately about people.

To understand why bubble participants make the decisions they do, let’s roll back the clock to 2002. The stock­-market crash has crushed our portfolios and left us feeling vulnerable, foolish, and poor. We’re not wiped out, thankfully, but we’re chastened, and we’re certainly not going to go blow our extra money on Cisco Systems again. So where should we put it? What’s safe? How about a house?

House prices, we are told by our helpful neighborhood real-estate agent, almost never go down. This sounds right, and they certainly didn’t go down in the stock-market crash. In fact, for as long as we can remember—about 10 years, in most cases—house prices haven’t gone down. (Wait, maybe there was a slight dip, after the 1987 stock-market crash, but looming larger in our memories is what’s happened since; everyone we know who’s bought a house since the early 1990s has made gobs of money.)

We consider following our agent’s advice, but then we decide against it. House prices have doubled since the mid-1990s; we’re not going to get burned again by buying at the top. So we decide to just stay in our rent-stabilized rabbit warren and wait for house prices to collapse.
Unfortunately, they don’t. A year later, they’ve risen at least another 10 percent. By 2006, we’re walking past neighborhood houses that we could have bought for about half as much four years ago; we wave to happy new neighbors who are already deep in the money. One neighbor has “unlocked the value in his house” by taking out a cheap home-equity loan, and he’s using the proceeds to build a swimming pool. He is also doing well, along with two visionary friends, by buying and flipping other houses—so well, in fact, that he’s considering quitting his job and becoming a full-time real-estate developer. After four years of resistance, we finally concede—houses might be a good investment after all—and call our neighborhood real-estate agent. She’s jammed (and driving a new BMW), but she agrees to fit us in.


We see five houses: two were on the market two years ago for 30 percent less (we just can’t handle the pain of that); two are dumps; and the fifth, which we love, is listed at a positively ridiculous price. The agent tells us to hurry—if we don’t bid now, we’ll lose the house. But we’re still hesitant: last week, we read an article in which some economist was predicting a housing crash, and that made us nervous. (Our agent counters that Greenspan says the housing market’s in good shape, and he isn’t known as “The Maestro” for nothing.)

When we get home, we call our neighborhood mortgage broker, who gives us a surprisingly reasonable quote—with a surprisingly small down payment. It’s a new kind of loan, he says, called an adjustable-rate mortgage, which is the same kind our neighbor has. The payments will “reset” in three years, but, as the mortgage broker suggests, we’ll probably have moved up to a bigger house by then. We discuss the house during dinner and breakfast. We review our finances to make sure we can afford it. Then, the next afternoon, we call the agent to place a bid. And the house is already gone—at 10 percent above the asking price.

By the spring of 2007, we’ve finally caught up to the market reality, and our luck finally changes: We make an instant, aggressive bid on a huge house, with almost no money down. And we get it! We’re finally members of the ownership society.

You know the rest. Eighteen months later, our down payment has been wiped out and we owe more on the house than it’s worth. We’re still able to make the payments, but our mortgage rate is about to reset. And we’ve already heard rumors about coming layoffs at our jobs. How on Earth did we get into this mess?

The exact answer is different in every case, of course. But let’s round up the usual suspects:

• The predatory mortgage broker? Well, we’re certainly not happy with the bastard, given that he sold us a loan that is now a ticking time bomb. But we did ask him to show us a range of options, and he didn’t make us pick this one. We picked it because it had the lowest payment.

• Our sleazy real-estate agent? We’re not speaking to her anymore, either (and we’re secretly stoked that her BMW just got repossessed), but again, she didn’t lie to us. She just kept saying that houses are usually a good investment. And she is, after all, a saleswoman; that was never very hard to figure out.

• Wall Street fat cats? Boy, do we hate those guys, especially now that our tax dollars are bailing them out. But we didn’t complain when our lender asked for such a small down payment without bothering to check how much money we made. At the time, we thought that was pretty great.

• The SEC? We’re furious that our government let this happen to us, and we’re sure someone is to blame. We’re not really sure who that someone is, though. Whoever is responsible for making sure that something like this never happens to us, we guess.

• Alan “The Maestro” Greenspan? We’re pissed at him too. If he hadn’t been out there saying everything was fine, we might have believed that economist who said it wasn’t. • Bad advice? Hell, yes, we got bad advice. Our real-estate agent. That mortgage guy. Our neighbor.

Greenspan. The media. They all gave us horrendous advice. We should have just waited for the market to crash. But everyone said it was different this time.

Still, except in cases involving outright fraud—a small minority—the buck stops with us. Not knowing that the market would crash isn’t an excuse. No one knew the market would crash, even the analysts who predicted that it would. (Just as important, no one knew when prices would go down, or how fast.) And for years, most of the skeptics looked—and felt—like fools.

Everyone else on that list above bears some responsibility too. But in the case I have described, it would be hard to say that any of them acted criminally. Or irrationally. Or even irresponsibly. In fact, almost everyone on that list acted just the way you would expect them to act under the circumstances.


That’s especially true for the professionals on Wall Street, who’ve come in for more criticism than anyone in recent months, and understandably so. It was Wall Street, after all, that chose not only to feed the housing bubble, but ultimately to bet so heavily on it as to put the entire financial system at risk. How did the experts who are paid to obsess about the direction of the market—allegedly the most financially sophisticated among us—get it so badly wrong? The answer is that the typical financial professional is a lot more like our hypothetical home buyer than anyone on Wall Street would care to admit. Given the intersection of experience, uncertainty, and self-interest within the finance industry, it should be no surprise that Wall Street blew it—or that it will do so again.

Take experience (or the lack thereof). Boom-and-bust cycles like the one we just went through take a long time to complete. The really big busts, in fact, the ones that affect the whole market and economy, are usually separated by more than 30 years—think 1929, 1966, and 2000. (Why did the housing bubble follow the tech bubble so closely? Because both were really just parts of a larger credit bubble, which had been building since the late 1980s. That bubble didn’t deflate after the 2000 crash, in part thanks to Greenspan’s attempts to save the economy.) By the time the next Great Bubble rolls around, a lot of us will be as dead and gone as Richard Whitney, Jesse Livermore, Charles Mitchell, and the other giants of the 1929 crash. (Never heard of them? Exactly.)

Since Wall Street replenishes itself with a new crop of fresh faces every year—many of the professionals at the elite firms either flame out or retire by age 40—most of the industry doesn’t usually have experience with both booms and busts. In the 1990s, I and thousands of young Wall Street analysts and investors like me hadn’t seen anything but a 15-year bull market. The only market shocks that we knew much about—the 1987 crash, say, or Mexico’s 1994 financial crisis—had immediately been followed by strong recoveries (and exhortations to “buy the dip”).

By 1996, when Greenspan made his famous “irrational exuberance” remark, the stock market’s valuation was nearing its peak from prior bull markets, making some veteran investors nervous. Over the next few years, however, despite confident predictions of doom, stocks just kept going up. And eventually, inevitably, this led to assertions that no peak was in sight, much less a crash—you see, it was “different this time.”

Those are said to be the most expensive words in the English language, by the way: it’s different this time. You can’t have a bubble without good explanations for why it’s different this time. If everyone knew that this time wasn’t different, the market would stop going up. But the future is always uncertain—and amid uncertainty, all sorts of faith-based theories can flourish, even on Wall Street.

In the 1920s, the “differences” were said to be the miraculous new technologies (phones, cars, planes) that would speed the economy, as well as Prohibition, which was supposed to produce an ultra-efficient, ultra-responsible workforce. (Don’t laugh: one of the most respected economists of the era, Irving Fisher of Yale University, believed that one.) In the tech bubble of the 1990s, the differences were low interest rates, low inflation, a government budget surplus, the Internet revolution, and a Federal Reserve chairman apparently so divinely talented that he had made the business cycle obsolete. In the housing bubble, they were low interest rates, population growth, new mortgage products, a new ownership society, and, of course, the fact that “they aren’t making any more land.”

In hindsight, it’s obvious that all these differences were bogus (they’ve never made any more land—except in Dubai, which now has its own problems). At the time, however, with prices going up every day, things sure seemed different.

In fairness to the thousands of experts who’ve snookered themselves throughout the years, a complicating factor is always at work: the ever-present possibility that it really might have been different. Everything is obvious only after the crash.

Consider, for instance, the late 1950s, when a tried-and-true “sell signal” started flashing on Wall Street. For the first time in years, stock prices had risen so high that the dividend yield on stocks had fallen below the coupon yield on bonds. To anyone who had been around for a while, this seemed ridiculous: stocks are riskier than bonds, so a rational buyer must be paid more to own them. Wise, experienced investors sold their stocks and waited for this obvious mispricing to correct itself. They’re still waiting.

Why? Because that time, it was different. There were increasing concerns about inflation, which erodes the value of fixed bond-interest payments. Stocks offer more protection against inflation, so their value relative to bonds had increased. By the time the prudent folks who sold their stocks figured this out, however, they’d missed out on many years of a raging bull market.
When I was on Wall Street, the embryonic Inter­net sector was different, of course—at least to those of us who were used to buying staid, steady stocks that went up 10 percent in a good year. Most Internet companies didn’t have earnings, and some of them barely had revenue. But the performance of some of their stocks was spectacular.


In 1997, I recommended that my clients buy stock in a company called Yahoo; the stock finished the year up more than 500 percent. The next year, I put a $400-a-share price target on a controversial “online bookseller” called Amazon, worth about $240 a share at the time; within a month, the stock blasted through $400 en route to $600. You don’t have to make too many calls like these before people start listening to you; I soon had a global audience keenly interested in whatever I said.

One of the things I said frequently, especially after my Amazon prediction, was that the tech sector’s stock behavior sure looked like a bubble. At the end of 1998, in fact, I published a report called “Surviving (and Profiting From) Bubble.com,” in which I listed similarities between the dot-com phenomenon and previous boom-and-bust cycles in biotech, personal computers, and other sectors. But I recommended that my clients own a few high-quality Internet stocks anyway—because of the ways in which I thought the Internet was different. I won’t spell out all those ways, but I will say that they sounded less stupid then than they do now.

The bottom line is that resisting the siren call of a boom is much easier when you have already been obliterated by one. In the late 1990s, as stocks kept roaring higher, it got easier and easier to believe that something really was different. So, in early 2000, weeks before the bubble burst, I put a lot of money where my mouth was. Two years later, I had lost the equivalent of six high-end college educations.

Of course, as Eliot Spitzer and others would later observe—and as was crystal clear to most Wall Street executives at the time—being bullish in a bull market is undeniably good for business. When the market is rising, no one wants to work with a bear.

Which brings us to the last major contributor to booms and busts: self-interest.

When people look back on bubbles, many conclude that the participants must have gone stark raving mad. In most cases, nothing could be further from the truth.

In my example from the housing boom, for instance, each participant’s job was not to predict what the housing market would do but to accomplish a more concrete aim. The buyer wanted to buy a house; the real-estate agent wanted to earn a commission; the mortgage broker wanted to sell a loan; Wall Street wanted to buy loans so it could package and resell them as “mortgage-backed securities”; Alan Greenspan wanted to keep American prosperity alive; members of Congress wanted to get reelected. None of these participants, it is important to note, was paid to predict the likely future movements of the housing market. In every case (except, perhaps, the buyer’s), that was, at best, a minor concern.

This does not make the participants villains or morons. It does, however, illustrate another critical component of boom-time decision-making: the difference between investment risk and career or business risk.

Professional fund managers are paid to manage money for their clients. Most managers succeed or fail based not on how much money they make or lose but on how much they make or lose relative to the market and other fund managers.

If the market goes up 20 percent and your Fidelity fund goes up only 10 percent, for example, you probably won’t call Fidelity and say, “Thank you.” Instead, you’ll probably call and say, “What am I paying you people for, anyway?” (Or at least that’s what a lot of investors do.) And if this performance continues for a while, you might eventually fire Fidelity and hire a new fund manager.

On the other hand, if your Fidelity fund declines in value but the market drops even more, you’ll probably stick with the fund for a while (“Hey, at least I didn’t lose as much as all those suckers in index funds”). That is, until the market drops so much that you can’t take it anymore and you sell everything, which is what a lot of people did in October, when the Dow plunged below 9,000.
In the money-management business, therefore, investment risk is the risk that your bets will cost your clients money. Career or business risk, meanwhile, is the risk that your bets will cost you or your firm money or clients.


The tension between investment risk and business risk often leads fund managers to make decisions that, to outsiders, seem bizarre. From the fund managers’ perspective, however, they’re perfectly rational.

In the late 1990s, while I was trying to figure out whether it was different this time, some of the most legendary fund managers in the industry were struggling. Since 1995, any fund managers who had been bearish had not been viewed as “wise” or “prudent”; they had been viewed as “wrong.” And because being wrong meant underperforming, many had been shown the door.

It doesn’t take very many of these firings to wake other financial professionals up to the fact that being bearish and wrong is at least as risky as being bullish and wrong. The ultimate judge of who is “right” and “wrong” on Wall Street, moreover, is the market, which posts its verdict day after day, month after month, year after year. So over time, in a long bull market, most of the bears get weeded out, through either attrition or capitulation.


By mid-1999, with mountains of money being made in tech stocks, fund owners were more impatient than ever: their friends were getting rich in Cisco, so their fund manager had better own Cisco—or he or she was an idiot. And if the fund manager thought Cisco was overvalued and was eventually going to crash? Well, in those years, fund managers usually approached this type of problem in of one of three ways: they refused to play; they played and tried to win; or they split the difference.

In the first camp was an iconic hedge-fund manager named Julian Robertson. For almost two decades, Robertson’s Tiger Management had racked up annual gains of about 30 percent by, as he put it, buying the best stocks and shorting the worst. (One of the worst, in Robertson’s opinion, was Amazon, and he used to summon me to his office and demand to know why everyone else kept buying it.)

By 1998, Robertson was short Amazon and other tech stocks, and by 2000, after the NASDAQ had jumped an astounding 86 percent the previous year, Robertson’s business and reputation had been mauled. Thanks to poor performance and investor withdrawals, Tiger’s assets under management had collapsed from about $20billion to about $6billion, and the firm’s revenues had collapsed as well. Robertson refused to change his stance, however, and in the spring of 2000, he threw in the towel: he closed Tiger’s doors and began returning what was left of his investors’ money.

Across town, meanwhile, at Soros Fund Management, a similar struggle was taking place, with another titanic fund manager’s reputation on the line. In 1998, the firm had gotten crushed as a result of its bets against technology stocks (among other reasons). Midway through 1999, however, the manager of Soros’s Quantum Fund, Stanley Druckenmiller, reversed that position and went long on technology. Why? Because unlike Robertson, Druckenmiller viewed it as his job to make money no matter what the market was doing, not to insist that the market was wrong.
At first, the bet worked: the reversal saved 1999 and got 2000 off to a good start. But by the end of April, Quantum was down a shocking 22 percent for the year, and Druckenmiller had resigned: “We thought it was the eighth inning, and it was the ninth.”


Robertson and Druckenmiller stuck to their guns and played the extremes (and lost). Another fund manager, a man I’ll call the Pragmatist, split the difference.

The Pragmatist had owned tech stocks for most of the 1990s, and their spectacular performance had made his fund famous and his firm rich. By mid-1999, however, the Pragmatist had seen a bust in the making and begun selling tech, so his fund had started to underperform. Just one quarter later, his boss, tired of watching assets flow out the door, suggested that the Pragmatist reconsider his position on tech. A quarter after that, his boss made it simpler for him: buy tech, or you’re fired.

The Pragmatist thought about quitting. But he knew what would happen if he did: his boss would hire a 25-year-old gunslinger who would immediately load up the fund with tech stocks. The Pragmatist also thought about refusing to follow the order. But that would mean he would be fired for cause (no severance or bonus), and his boss would hire the same 25-year-old gunslinger.

In the end, the Pragmatist compromised. He bought enough tech stocks to pacify his boss but not enough to entirely wipe out his fund holders if the tech bubble popped. A few months later, when the market crashed and the fund got hammered, he took his bonus and left the firm.

This tension between investment risk and career or business risk comes into play in other areas of Wall Street too. It was at the center of the decisions made in the past few years by half a dozen seemingly brilliant CEOs whose firms no longer exist.

Why did Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, AIG, and the rest of an ever-growing Wall Street hall of shame take so much risk that they ended up blowing their firms to kingdom come? Because in a bull market, when you borrow and bet $30 for every $1 you have in capital, as many firms did, you can do mind-bogglingly well. And when your competitors are betting the same $30 for every $1, and your shareholders are demanding that you do better, and your bonus is tied to how much money your firm makes—not over the long term, but this year, before December 31—the downside to refusing to ride the bull market comes into sharp relief. And when naysayers have been so wrong for so long, and your risk-management people assure you that you’re in good shape unless we have another Great Depression (which we won’t, of course, because it’s different this time), well, you can easily convince yourself that disaster is a possibility so remote that it’s not even worth thinking about.

It’s easy to lay the destruction of Wall Street at the feet of the CEOs and directors, and the bulk of the responsibility does lie with them. But some of it lies with shareholders and the whole model of public ownership. Wall Street never has been—and likely never will be—paid primarily for capital preservation. However, in the days when Wall Street firms were funded primarily by capital contributed by individual partners, preserving that capital in the long run was understandably a higher priority than it is today. Now Wall Street firms are primarily owned not by partners with personal capital at risk but by demanding institutional shareholders examining short-term results. When your fiduciary duty is to manage the firm for the benefit of your shareholders, you can easily persuade yourself that you’re just balancing risk and reward—when what you’re really doing is betting the firm.

As we work our way through the wreckage of this latest colossal bust, our government—at our urging—will go to great lengths to try to make sure such a bust never happens again. We will “fix” the “problems” that we decide caused the debacle; we will create new regulatory requirements and systems; we will throw a lot of people in jail. We will do whatever we must to assure ourselves that it will be different next time. And as long as the searing memory of this disaster is fresh in the public mind, it will be different. But as the bust recedes into the past, our priorities will slowly change, and we will begin to set ourselves up for the next great boom.
A few decades hence, when the Great Crash of 2008 is a distant memory and the economy is humming along again, our government—at our urging—will begin to weaken many of the regulatory requirements and systems we put in place now. Why? To make our economy more competitive and to unleash the power of our free-market system. We will tell ourselves it’s different, and in many ways, it will be. But the cycle will start all over again.


So what can we learn from all this? In the words of the great investor Jeremy Grantham, who saw this collapse coming and has seen just about everything else in his four-decade career: “We will learn an enormous amount in a very short time, quite a bit in the medium term, and absolutely nothing in the long term.” Of course, to paraphrase Keynes, in the long term, you and I will be dead. Until that time comes, here are three thoughts I hope we all can keep in mind.

First, bubbles are to free-market capitalism as hurricanes are to weather: regular, natural, and unavoidable. They have happened since the dawn of economic history, and they’ll keep happening for as long as humans walk the Earth, no matter how we try to stop them. We can’t legislate away the business cycle, just as we can’t eliminate the self-interest that makes the whole capitalist system work. We would do ourselves a favor if we stopped pretending we can.

Second, bubbles and their aftermaths aren’t all bad: the tech and Internet bubble, for example, helped fund the development of a global medium that will eventually be as central to society as electricity. Likewise, the latest bust will almost certainly lead to a smaller, poorer financial industry, meaning that many talented workers will go instead into other careers—that’s probably a healthy rebalancing for the economy as a whole. The current bust will also lead to at least some regulatory improvements that endure; the carnage of 1933, for example, gave rise to many of our securities laws and to the SEC, without which this bust would have been worse.

Lastly, we who have had the misfortune of learning firsthand from this experience—and in a bust this big, that group includes just about everyone—can take pains to make sure that we, personally, never make similar mistakes again. Specifically, we can save more, spend less, diversify our investments, and avoid buying things we can’t afford. Most of all, a few decades down the road, we can raise an eyebrow when our children explain that we really should get in on the new new new thing because, yes, it’s different this time.

Are Asset Bubbles and Crashes Inevitable?

Is the human brain wired in such a way that asset bubbles and crashes inevitable? Certainly a lot of psychology research suggests that. Below is an article that someone sent me that I found interesting.

I actually took part in some of the earliest experiments in the field of economic psychology (as it was known then) in the late 1970s when I was at the University of Arizona. I can personally confirm the results below. The results of my experiment reminds of a line from the western (I think it came out in 1957 or 1960) "The Magnificent Seven" made by Eli Wallach, a Mexican bandit about to rob a Mexican village, "if God did not want them sheared, He would not have made them sheep". From The Atlantic:

In these uncertain economic times, we’d all like a guaranteed investment. Here’s one: it pays a 24-cent dividend every four weeks for 60 weeks, 15 dividends in all. Then it disappears. Unlike a bond, this security has no redemption value. It simply provides guaranteed dividends. It involves no tricky derivatives or unknown risks. And it carries absolutely no danger of default. What would you pay for it?

Before financially sophisticated readers drag out their calculators, look up interest rates, and compute the present value of those future payments, I have a confession to make. You can’t buy this security, and it doesn’t really pay dividends every four weeks. It pays every four minutes, in a computer lab, to volunteers in economic experiments.

For more than two decades, economists have been running versions of the same experiment. They take a bunch of volunteers, usually undergraduates but sometimes businesspeople or graduate students; divide them into experimental groups of roughly a dozen; give each person money and shares to trade with; and pay dividends of 24 cents at the end of each of 15 rounds, each lasting a few minutes. (Sometimes the 24 cents is a flat amount; more often there’s an equal chance of getting 0, 8, 28, or 60 cents, which averages out to 24 cents.) All participants are given the same information, but they can’t talk to one another and they interact only through their trading screens. Then the researchers watch what happens, repeating the same experiment with different small groups to get a larger picture.

The great thing about a laboratory experiment is that you can control the environment. Wall Street securities carry uncertainties—more, lately, than many people expected—but this experimental security is a sure thing. “The fundamental value is unambiguously defined,” says the economist Charles Noussair, a professor at Tilburg University, in the Netherlands, who has run many of these experiments. “It’s the expected value of the future dividend stream at any given time”: 15 times 24 cents, or $3.60 at the end of the first round; 14 times 24 cents, or $3.36 at the end of the second; $3.12 at the end of the third; and so on down to zero. Participants don’t even have to do the math. They can see the total expected dividends on their computer screens.
Here, finally, is a security with security—no doubt about its true value, no hidden risks, no crazy ups and downs, no bubbles and panics. The trading price should stick close to the expected value.

At least that’s what economists would have thought before Vernon Smith, who won a 2002 Nobel Prize for developing experimental economics, first ran the test in the mid-1980s. But that’s not what happens. Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then, as the 15th round nears, it crashes. The problem doesn’t seem to be that participants are bored and fooling around. The difference between a good trading performance and a bad one is about $80 for a three-hour session, enough to motivate cash-strapped students to do their best. Besides, Noussair emphasizes, “you don’t just get random noise. You get bubbles and crashes.” Ninety percent of the time.

So much for security.

These lab results should give pause not only to people who believe in efficient markets, but also to those who think we can banish bubbles simply by curbing corruption and imposing more regulation. Asset markets, it seems, suffer from irrepressible effervescence. Bubbles happen, even in the most controlled conditions.

Experimental bubbles are particularly surprising because in laboratory markets that mimic the production of goods and services, prices rise and fall as economic theory predicts, reaching a neat equilibrium where supply meets demand. But like real-world purchasers of haircuts or refrigerators, buyers in those markets need to know only how much they themselves value the good. If the price is less than the value to you, you buy. If not, you don’t, and vice versa for sellers.

Financial assets, whether in the lab or the real world, are trickier to judge: Can I flip this security to a buyer who will pay more than I think it’s worth? In an experimental market, where the value of the security is clearly specified, “worth” shouldn’t vary with taste, cash needs, or risk calculations. Based on future dividends, you know for sure that the security’s current value is, say, $3.12. But—here’s the wrinkle—you don’t know that I’m as savvy as you are. Maybe I’m confused. Even if I’m not, you don’t know whether I know that you know it’s worth $3.12. Besides, as long as a clueless greater fool who might pay $3.50 is out there, we smart people may decide to pay $3.25 in the hope of making a profit. It doesn’t matter that we know the security is worth $3.12. For the price to track the fundamental value, says Noussair, “everybody has to know that everybody knows that everybody is rational.” That’s rarely the case. Rather, “if you put people in asset markets, the first thing they do is not try to figure out the fundamental value. They try to buy low and sell high.” That speculation creates a bubble.

In fact, the people who make the most money in these experiments aren’t the ones who stick to fundamentals. They’re the speculators who buy a lot at the beginning and sell midway through, taking advantage of “momentum traders” who jump in when the market is going up, don’t sell until it’s going down, and wind up with the least money at the end. (“I have a lot of relatives and friends who are momentum traders,” comments Noussair.) Bubbles start to pop when the momentum traders run out of money and can no longer push prices up.

But people do learn. By the third time the same group goes through a 15-round market, the bubble usually disappears. Everybody knows what the security is worth and realizes that everybody else knows the same thing. Or at least that’s what economists assumed was happening. But
work that Noussair and his co-authors published in the December 2007 American Economic Review suggests that traders don’t reason that way.

In this version of the experiment, participants took part in the 15-round market four times in a row. Before each session, the researchers asked the traders what they thought would happen to prices. The first time, participants didn’t expect a bubble, but in later markets they did. With each successive session, however, they predicted that the bubble would peak later and reach a higher price than it actually did. Expecting the future to look like the past, they traded accordingly, selling earlier and at lower prices than in the previous session, hoping to realize a profit before the bubble burst. Those trades, of course, changed the market pattern. Prices were lower, and they peaked closer to the beginning of the session. By the fourth round, the price stuck close to the security’s fundamental value—not because traders were going for the rational price but because they were trying to avoid getting caught in a bubble.

“Prices converge toward fundamentals ahead of beliefs,” the economists conclude. Traders literally learn from experience, basing their expectations and behavior not on logical inference but on what has happened in the past. After enough rounds, markets work their way toward a stable price.

If experience eliminates bubbles in the lab, you might expect that more-experienced traders in the real world (or what experimental economists prefer to call “field markets”) would produce fewer financial crises. When asset markets run into trouble, maybe it’s because there are too many newbies: all those dot-com day traders, 20-something house flippers, and newly minted M.B.A.s. As Alan Greenspan told Congress in October, “It was the failure to properly price such risky assets that precipitated the crisis.” People didn’t know what they were doing. What markets need are more old hands.

Alas, once again the situation is not so simple. Even experienced traders can make big mistakes when conditions change. In
research published in the June 2008 American Economic Review, Vernon Smith and his collaborators first ran the standard experiment, putting groups through the 15-round market twice. Then the researchers changed three conditions: they mixed up the groups, so participants weren’t trading with familiar faces; they increased the range of possible dividends, replacing four possible outcomes (0, 8, 28, or 60) averaging 24, with five (0, 1, 8, 28, 98) averaging 27; finally, they doubled the amount of cash and halved the number of shares in the market. The participants then completed a third round. These changes were based on previous research showing that more cash and bigger dividend spreads exacerbate bubbles.
Sure enough, under the new conditions, the experienced traders generated a bubble just as big as if they’d never been in the lab. It didn’t last quite as long, however, or involve as much volume. “Participants seem to be tacitly aware that there will be a crash,” the economists write, “and consequently exit from the market (sell) earlier, causing the crash to start earlier.” Even so, the price peaks far above the fundamental value. “Bubbles,” the economists conclude, “are the funny and unpredictable phenomena that happen on the way to the ‘rational’ predicted equilibrium if the environment is held constant long enough.”


For those of us who invest our money outside the lab, this research carries two implications.
First, beware of markets with too much cash chasing too few good deals. When the Federal Reserve cuts interest rates, it effectively frees up more cash to buy financial instruments. When lenders lower down-payment requirements, they do the same for the housing market. All that cash encourages investment mistakes.

Second, big changes can turn even experienced traders into ignorant novices. Those changes could be the rise of new industries like the dot-coms of the 1990s or new derivative securities created by slicing up and repackaging mortgages. I asked the Caltech economist Charles Plott, one of the pioneers of experimental economics, whether the recent financial crisis might have come from this kind of inexperience. “I think that’s a good thesis,” he said. With so many new instruments, “it could be that the inexperienced heads are not people but the organizations themselves. The organizations haven’t learned how to deal with the risk or identify the risk or understand the risk.”

Here the bubble experiments meet up with another large body of experimental research, first developed by Plott and his collaborators. This work explores how speculative markets can pool information from lots of people (“the wisdom of crowds”) and arrive at accurate predictions—for example, who’s going to win the presidency or the World Series. These markets work, Plott explains, because people with good information rush in early, leading prices to reflect what they know and setting a trajectory that others follow. “It’s a kind of cascade, a good cascade, just what should happen,” he says. But sometimes the process “can go bananas” and create a bubble, usually when good information is scarce and people follow leaders who don’t in fact know much.
That may be what happened on Wall Street, Plott suggests. “Now we have new instruments. We have ‘leaders,’ who one would ordinarily think know something, getting in there very aggressively and everybody cuing on them—as they have done in the past, and as markets should. But in this case, there might be a bubble.” And when you have a bubble, you will get a crash.