The Float

El-Erian: Negative is an Arbitrary Level

Throughout the day, CNBC has compelled us to un-mute the television by playing clips of Michelle Caruso-Cabrera's recent interview with PIMCO's Mohamed El-Erian, one of the smartest cats in the business. (See this post from late May, for instance.) Various clips are available at CNBC's website. Note that the interview appears to be broken into three parts, all under the "El-Erian Speaks" label.

We were especially heartened to hear El-Erian say the following, in the context of talking about negative wealth, income, and credit effects (emphasis added in italics):

Caruso-Cabrera: Does that get us to negative growth?

El-Erian: It probably gets us to negative growth. I think the question is how fast we get there, and what does the rest of the world do. Negative is, after all, an arbitrary level. The critical thing is how quickly does growth fall. And how does the rest of the world react.

Negative is an arbitrary level. Yes indeed. This is a point we made in late January, and we'd like to hear the usual suspects adopt El-Erian's perspective on this question.

We recommend the entire El-Erian interview. His measured tones, careful language, and deep grasp of financial-market dynamics offer the perfect antidote to the breathlessness that characterizes so much commentary these days.

The Demand Side of the Credit Contraction

We began the week arguing that U.S. consumers find themselves in a credit bind, more indebted than ever just as kicking it down the road (by adding leverage or rolling existing debt further out into the future) has become much more difficult:

We continue to believe that U.S. consumers are entering a period of forced balance sheet rebuilding. Why forced? Because credit standards are tight...and likely to stay that way. If household balance sheet repair weren't effectively coerced in some fashion, we don't think it would happen.

Like many observers, we've focused primarily on the supply side of credit, both through the price of money (i.e., interest rates, and not just the fed funds rate) and its availability (i.e., lending standards, and not just in the mortgage sector). The key storyline here has been straightforward: With increasingly impaired balance sheets, banks have become less willing and able to lend as freely as they did in recent years.

Today's Wall Street Journal considers the demand side: Consumers' own willingness (eagerness doesn't seem like the right term these days) to tap into existing credit lines, let alone request new ones. With credit card delinquencies rising, growth in revolving credit is slowing abruptly.

Credit-card delinquencies are rising across the nation, a sign that some Americans are at the end of their rope financially. And these mounting delinquencies, in turn, have prompted banks to tighten lending standards, keeping people who have maxed out their cards from finding new sources of credit.

The result could be a sharp pullback in consumer spending that would further weaken the slowing U.S. economy.

Such a pullback may already be taking shape. Yesterday, the Federal Reserve reported an abrupt slowdown in consumers' credit-card borrowings. In December, Americans had $944 billion in total revolving debt, most of it on credit cards, a seasonally adjusted annualized increase of 2.7%. That was off sharply from seasonally adjusted growth rates of 13.7% in November and 11.1% in October. And it reflects the volatility in consumers' spending habits as economic growth sputters.

...

Evidence is mounting that the plastic-fueled spending spree won't last. In December, an average of 7.6% of credit-card loans were either at least 60 days delinquent or had gone into default, up from 6.4% a year earlier, according to research firm RiskMetrics Group.

As Peter Goodman wrote in Tuesday's New York Times, "[T]he same nation that pioneered the no-money-down mortgage suddenly confronts an unfamiliar imperative: more Americans must live within their means."

Goodman's story, like this morning's Journal piece, invokes real consumers who are feeling the pinch. These obligatory examples tend to be tiresome, but this one, from Goodman, seems more significant than the typical cliché:

Not long ago, Elena Gamble would have looked at the Cadillac parked across the street from her modest home in Elk City, Okla., and felt a twinge of jealousy.

"We live in a small town, and everybody looks at your clothes and what you drive and where you have your hair done," said Ms. Gamble, who earns about $2,600 a month as a grievance counselor at a local prison.

Now, she and her husband--a prison guard who brings home $2,000 a month--are grappling with $10,000 in high-interest debt. They no longer go to the movies or out to eat, except occasionally to McDonald's. They quit their Internet service. Their car was repossessed. "What we say now is, 'If we can't afford it, we can't buy it,'" Ms. Gamble said.

And when she looks across the street at that Cadillac, her envy has been replaced by pity for the neighbor on the hook.

It's easy to get caught up in the economics of the rational actor. But it's important to remember that we're talking about an economic system in which culture plays an important role in shaping norms, perceptions, preferences, and, ultimately, behavior.

Note to CNBC producers: Start booking anthropologists.

Sources

Robin Sidel, Sudeep Reddy, and Jane J. Kim, "Credit-Card Pinch Leads Consumers To Rein In Spending," Wall Street Journal, February 8, 2008 (subscription only)

Peter Goodman, "Economy Fitful, Americans Start to Pay as They Go," New York Times, February 5, 2008

Friday Reading

A few things to wrestle with as we slouch into the weekend...

• 1 million homeowners. $500 billion in option ARMs. Not a pretty picture.
• Via Calculated Risk, interesting (and refreshing) remarks on Fed independence from Dallas Fed President Richard Fisher.
• Writing in the FT, Bill Gross argues that a monoline rescue is no solution at all. And here's a question that answers itself: "How could Ambac, through the magic of its triple-A rating, with equity capital of less than $5bn, insure the debt of the state of California, the world's sixth-largest economy?" It couldn't. It can't. And it shouldn't be expected to.
• James Picerno sniffs a "bubble" in 10-year treasuries. We're not sure we'd use precisely that term, but one has to wonder what kind of capital appreciation investors see in 10-years yielding 3.68% (and thereabouts).
• This is a week old now, but the team at CXO has a tidy account of Robert Shiller's "Low Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Economic Models." Here's the central item in CXO's summary: "The concept of a real interest rate, though highly relevant in judging the reasonableness of asset prices, appears to have had its day and is dying. [...] Instead, the public seems attached to money illusion, the failure to recognize that dividend and earnings projections include inflation."

Global Perspectives on the U.S. Economy

A determined group of analysts with global roots wants to put U.S. economic policymakers on the couch--and stage a good old fashioned intervention. (Note: Yves Smith has been all over this story and deserves great credit for connecting these dots.)

First, Willem Buiter suggested that the U.S. might benefit from a recession:

A significant slowdown in the US, perhaps even a recession, is necessary to restore a sustainable desirable level of the national saving rate. There can be further beneficial longer-run effects from a recession, because recessions are quite efficient mechanisms for purging, through defaults, insolvences and financial and real restructuring, the distortions, inefficiencies and misallocation of resources that were created by the financial excesses in the US economy during these past five years. When it has to happen, why wait?

Then we had Harvard's Ricardo Hausmann in the Financial Times on January 30th:

It is easy to lose sight of the overall picture. Main Street consumers have overspent and over-borrowed and are unable to meet their obligations. The fact that households may have so behaved because they were enticed by "teaser loans" does not change the facts; it only assigns blame. Consumption has been above sustainable levels and needs to adjust down, whatever view one has about the responsibility of adults over their financial decisions.

...

An efficient adjustment to the US over-consumption imbalance (and Chin­ese under-consumption) in a way that does not hurt longer-term growth should be based on compensating for the decline of US consumption with an increase in domestic investment and in consumption abroad. It should not be based on giving the US consumer more rope with which to hang himself.

...

The US should face its need for adjustment with courage and reason, not fear. It should stop behaving as the whiner of first resort, ready to waste all its dry powder on a short-sighted attempt to prevent a 2008 recession.

Then, on Tuesday, Buiter went back to work on the recession question:

I don't understand why both Larry Summers and Martin Feldstein, who have for many years preached the need for America to save more, do a 180-degree turn whenever there are signs that a higher saving rate may actually be in the making, and recommend expansionary fiscal and monetary measures to prevent at all cost a decline in the level or even the growth rate of consumption. The American economy is broke. To fix it a slowdown is well-nigh inevitable and a recession is likely to be necessary.

But the ostriches in the Fed, the White House and the Capitol are unmoved by such concepts as unsustainability. The prevailing ethos is myopic at best: let's just put out this immediate fire, because it threatens today's comfort level. Postponing adjustment raises the expected cost of the eventual adjustment, but that is then and this is now. Also, something may turn up. Santa Claus could exist after all. We may learn to harness as a source of renewable energy the hot air put out by the Congress.

It is hard to have a rational discussion with those who embody and express the views of a nation that is in denial. The US establishment and political class, and quite possibly much of its electorate, are indeed in denial, and not just about the need for an early traverse to a higher national saving rate. The economic, social and political model of the US has developed serious albeit remediable flaws and needs major surgery. Unfortunately none of those running for office today are likely to be willing or able to wield the scalpel as required.

As if all that weren't enough, Harvard's Kenneth Rogoff wants U.S. policymakers to learn a few things from experts in developing economies:

As the United States' epic financial crisis continues to unfold, one can only wish that US policymakers were half as good at listening to advice from developing countries as they are at giving it. Americans don't seem to realize that their subprime mortgage meltdown has much in common with many previous post-1945 banking crises throughout the world.

The silver lining is that there are many highly distinguished current and former policymakers out there, particularly from emerging market countries, who have seen this movie before. If US policymakers would only listen, they might get an idea or two about how to deal with financial crises from experts who have come out safely on the other side.

Unfortunately, the parallel between today's US crisis and previous financial crises is not mere hyperbole. The qualitative parallels are obvious: banks using off-balance loans to finance highly risky ventures, exotic new financial instruments, and excessive exuberance over the promise of new markets.

Back in late August, we posted an item on the potential benefits of a recession (preferably a relatively short and shallow one, of course). We think it's time to revisit this key passage from the August 23rd Economist:

The economic and social costs of recession are painful: unemployment, lower wages and profits, and bankruptcy. These cannot be dismissed lightly. But there are also some purported benefits. Some economists believe that recessions are a necessary feature of economic growth. Joseph Schumpeter argued that recessions are a process of creative destruction in which inefficient firms are weeded out. Only by allowing the "winds of creative destruction" to blow freely could capital be released from dying firms to new industries. Some evidence from cross-country studies suggests that economies with higher output volatility tend to have slightly faster productivity growth. Japan's zero interest rates allowed "zombie" companies to survive in the 1990s. This depressed Japan's productivity growth, and the excess capacity undercut the profits of other firms.

Another "benefit" of a recession is that it purges the excesses of the previous boom, leaving the economy in a healthier state. The Fed's massive easing after the dotcom bubble burst delayed this cleansing process and simply replaced one bubble with another, leaving America's imbalances (inadequate saving, excessive debt and a huge current-account deficit) in place. A recession now would reduce America's trade gap as consumers would at last be forced to trim their spending. Delaying the correction of past excesses by pumping in more money and encouraging more borrowing is likely to make the eventual correction more painful. The policy dilemma facing the Fed may not be a choice of recession or no recession. It may be a choice between a mild recession now and a nastier one later.

Almost six months later, we're still staring at the same questions...

401k Expenses: Pending Disclosure Regs

Longtime readers of this space know that we've tried to shine a bright light on various problems in the 401(k) marketplace.

From excessive fees to a total lack of transparency to poor plan design to inadequate savings to bad decision-making by participants, the status quo in the defined contribution marketplace is horribly broken. It's a domain of employee benefits defined in law by fiduciary principles...and plagued in reality by non-fiduciary practices.

Yesterday we received the latest bulletin from Fred Reish, one of the country's leading ERISA attorneys. Topic: The Department of Labor's proposed rules requiring that advisors to ERISA plans disclose all fee arrangements and potential conflicts of interest to plan sponsors as a necessary condition of providing advisory services to the plan and its participants. (We mentioned this DOL effort in a brief December post.) Here's a key passage from Reish's excellent work:

In the past, the burden was almost entirely on the primary plan fiduciaries to investigate and understand the arrangement between a plan and a service provider and to determine if it was reasonable. Under a regulation proposed by the DOL in December, arrangements for most plan services will be prohibited unless the service provider has a written arrangement with the responsible plan fiduciaries and makes extensive disclosures about its direct and indirect revenues and about any potential conflicts of interest. Thus, the burden is shifted to the service provider to give information to the fiduciaries that is sufficient for them to determine whether the arrangement, including compensation, is reasonable and whether the conflicts are acceptable. Further, the information must be delivered sufficiently in advance of entering into the arrangement to give the responsible plan fiduciary time to review the information before entering into the transaction. Failure to fulfill the written agreement and disclosure obligations will cause the service provider's engagement to be a prohibited transaction, which means, at the least, that the service provider will presumably have to pay back any compensation it received and that excise taxes may be imposed on the service provider.

Our take on this is that it's long overdue. Because we operate as an RIA, we're required to disclose all this and more to our private clients, and there's absolutely no reason we and our colleagues in the industry shouldn't do so for our retirement plan clients as well.

Can any reasonable observer--which is to say, anyone not totally compromised by their affiliation with certain products--suggest that this kind of transparency would be bad for participants? After all, anyone working with ERISA plans has a legal obligation to act as a fiduciary. If it's good for participants, it's good. If it's bad for participants, it's bad. This is good for participants. Therefore it's good.

A couple more quick points on this. First, as we've noted before (here and here, for example), responsibility for the status quo problems in the 401(k) world do not lie only with the financial services industry. Plan sponsors especially, but rank-and-file participants too, simply must insist that their plans live up to ERISA's fiduciary premise.

Second, full disclosure of explicit costs makes all the sense in the world. But as we've noted repeatedly, the implicit costs of mutual fund ownership--trading expenses, market impact, impaired dividend reinvestment, and underperformance--are plenty consequential and, in some cases, greater than their explicit costs.

These implicit costs are not easy to establish. They vary by asset class, fund size, portfolio turnover, managers' luck and skill, and other factors. Our point isn't that precise values could be entered in a DOL-approved form to disclose implicit costs.

But we do think that any DOL form should include a general disclaimer that all mutual funds have implicit costs, and that those costs tend to be higher for actively-managed funds than for index-based vehicles. Through no fault of their own, vanishingly few sponsors and participants understand this. But they should. And if the DOL can help them do so, more power to 'em.

Source

Fred Reish, Bruce Ashton, and Debra Davis, "The DOL's Proposed 408(b)(2) Regulation: Impact of the Mandated Disclosures on Registered Investment Advisers (RIAs)," Bulletin, February 4, 2008

Wednesday Reading

The day after...

• At Index Universe, Larry Swedroe riffs on the importance of sound decision-making in and around recessions (and in every other environment, for that matter). Swedroe invokes one of our favorite passages from Warren Buffett: "Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."
• Yesterday, Barry Ritholtz posted an item on the so-called "Fed Model," which some cite to suggest that stocks are "cheap" these days. We've made the too-obvious point that the "E" in "PE" is just as much a variable as the "P" (here and here, for instance). Barry extends that argument nicely.
• Here's a very interesting item from The Economist's Buttonwood. Topic: Bank regulation. Key passage: "This does not look like a very good bargain from the taxpayer's point of view. The employees get all the rewards if things go well. The taxpayer pays the bill (or if he is a saver, sees his income fall) if things go badly."
• In today's Wall Street Journal (subscription only): Junk bond defaults could/should rise this year. Sharply. "In a closely watched report to be released today, finance professor Edward Altman projects that high-yield, or 'junk,' bonds will default by a rate of 4.64% this year. That would be the highest rate since 2003 and a nine-fold increase from the 0.51% rate in 2007, which was the lowest rate since 1981."
• We first noted this horrific story back in May. Today, Wachovia's complicity in systematic campaigns of identity theft is in the news once again: "[N]ewly released documents from that lawsuit now show that Wachovia had long known about allegations of fraud and that the bank, in fact, solicited business from companies it knew had been accused of telemarketing crimes."

ETF and Mutual Fund Data: A Reality Check

Last Friday we noted Michael Sesit's Bloomberg column on the threat posed by ETFs (and indexation more generally) to conventional long-only investment vehicles such as actively-managed mutual funds.

As Jeff Miller noted over the weekend at A Dash of Insight, this is a significant development. There's just no doubt about it. That said, there remains a vast chasm between the open-end mutual fund business and the ETF business--both in numbers of funds and in assets under management. The other side of that coin, however, is that ETF assets continue to grow at a much faster clip than do open-end funds. Consider the following three charts, all produced using data (through year-end 2007) from The Investment Company Institute.

First, a comparison of the number of open-end funds (not counting multiple share classes of the same funds) and ETFs. The last points in the series are 8,017 and 629, respectively.

Next, a comparison of total assets under management. The final points in the series are $12.04 trillion and $608 billion. (And yes, there are entries for the ETF column in each year; they're just too small to show up until 2000--which is exactly the point.)

Finally, a comparison of growth rates in the two categories. Note that ETF growth has outstripped open-end fund growth every year since 1995, in each case by a wide margin.

Now, given the scale of each business, and the limits on investable assets in any given year, it's clearly easier to expand ETF assets at a faster clip. But given the enormous difference depicted in our second chart, it'll take a long, long time for ETFs to close the asset gap with open-end funds in any meaningful way.

Our next project: Assessing the changing share of open-end funds in indexed strategies. After all, the threat in question isn't so much to open-end funds per se as it is to long-only money management delivered through big, diversified, expensive mutual funds.

From the Drawing Board

On days like this, a little draft cartoon from Tom Toles tells the story pretty well...

More on Lending and Spending

After posting yesterday's comment on consumer retrenchment, three items reaffirmed our view that U.S. households have entered a period of forced balance sheet repair--forced, that is, by tighter credit standards, which themselves are both cause and effect of falling asset values.

First, the Fed released its Senior Loan Officer Opinion Survey on Bank Lending Practices for January. Bottom line: Lending standards are growing more restrictive. See the adjacent chart from Calculated Risk.

Second, this morning's Wall Street Journal runs with "Credit Cards Are Playing Harder to Get" (subscription only). Here's a key passage:

As lenders tighten credit standards, many consumers have faced greater difficulty getting a mortgage or a home-equity loan or line of credit. Now, some are beginning to feel the squeeze on their credit cards -- despite the dramatic cuts the Federal Reserve recently made in its benchmark Fed funds rate, including last week's half-percentage point cut to 3%.

That "despite" bit echoes a point we've made repeatedly. The cost of money is one thing (and, of course, an important one). But the availability of it is another, and it's diminished availability that pretty much defines credit contraction. Note that Merrill's David Rosenberg has made exactly this point:

This is why we are not more bullish on the macro outlook given the dramatic rate cuts by the Fed because as the bad debts mount, lenders are pulling back--the Fed can influence the cost of capital perhaps, but not its availability.

Third, this morning's New York Times features a Peter Goodman story on lending practices and spending habits in the U.S. economy (emphasis added in bold):

For more than half a century, Americans have proved staggeringly resourceful at finding new ways to spend money.

In the 1950s and '60s, as credit cards grew in popularity, many began dining out when the mood struck or buying new television sets on the installment plan rather than waiting for payday. By the 1980s, millions of Americans were entrusting their savings to the booming stock market, using the winnings to spend in excess of their income. Millions more exuberantly borrowed against the value of their homes.

But now the freewheeling days of credit and risk may have run their course--at least for a while and perhaps much longer--as a period of involuntary thrift unfolds in many households. With the number of jobs shrinking, housing prices falling and debt levels swelling, the same nation that pioneered the no-money-down mortgage suddenly confronts an unfamiliar imperative: more Americans must live within their means.

Sources

Jane Kim, "Credit Cards Are Playing Harder to Get," Wall Street Journal, February 5, 2008

Peter Goodman, "Economy Fitful, Americans Start to Pay as They Go," New York Times, February 5, 2008

Monday Reading

Interesting perspectives to get the new week started...

• Wall Street types love small government...until they need help.
• Related: Slate's Daniel Gross on "The Toddler Economy."
• John Hussman's weekly comment dismantles the trite assessment of Newsweek's recent "Road to Recession" cover as a contrary indicator.
• From the FT's Alphaville: Tighter credit standards matter for corporate borrowers as well as households.
• This Barron's piece from Vitaliy Katsnelson is subscription only, but given what we've written about PE multiples lately (here and here), we had to pass along a key bit:

  Stocks are allegedly cheap now at 17 times 2007 earnings. And they are cheap by historical standards. Only seven years ago, they were at price/earnings ratios double today's; they are even cheaper if you compare their forward earnings yield of 6.7% to Treasuries' yield of 4.25%. They are cheap, cheap, cheap! Or so we've been told.

  Unfortunately, the cheapness argument falls on its face once we realize that pretax profit margins are hovering at an all-time high of 11.9%, almost 40% above their average of 8.5% since 1980. Once profit margins revert to their historical mean, the "E" in the P/E equation will decline. If the market made no price change in response, its P/E would rise from 17 to 23.8 times trailing earnings.