The Float

Words of Wisdom

Two useful items from two of our favorite participant-observers: Mohamed El-Erian and John Hussman. Frist, from El-Erian's interview with Advisor Perspectives (bold text in original):

Another principle you advocate is the separation of alpha and beta in portfolio construction (something we have written about in our publication). Why has this principle gained in importance and how can advisors best implement it?

The dispersion of returns among actively managed strategies has become very large. In the old days, the dispersion resembled a "fan chart." It started with relatively small dispersion in fixed income classes, to larger ones in public equities and very large ones in illiquid asset classes. Today, we are seeing much more dispersion across all asset classes. The result is, unless you are absolutely confident of your active management choices, it is better to go passive.

The cause of this greater dispersion is that markets are more volatile. We came from a period (until the middle of 2007) that was very good to investors. Risk premia across all asset classes were compressing, delivering high returns and declining volatility. As long as investors were exposed and levered they did well. Now investors can get easily caught with the wrong position in a highly volatile environment. The hurdle for active management has gone up. You have to be sure you are actually getting something. You are paying higher fees and being exposed to more risk.

And here's Hussman, on the intertwined roles of government and Wall Street in the unwinding of the credit bubble:

As with the stock market bubble of the late 1990's, it is generally true that bad investments tend to go bad. There is little to prevent that from occurring. The only question is who bears the cost. Essentially, the Federal government issued hundreds of billions in debt, much of the proceeds which tax cut beneficiaries invested in mortgage bonds, without concern about loan quality because the debt had been tied to the good faith and credit of Uncle Sam, and now we've got to issue more government debt to bail out the losses from the bad investments.

One of the reasons that the recent credit crisis has been so wrenching is that the losses are being borne by institutions that have the explicit or implicit backing of the U.S. government, so it feels like the things that ought to be safe really aren't safe. But that is no accident -- bad credit sought out those institutions and their government backing, as the inevitable result of the swap markets (as described above). In the end, the implicit and explicit backing of the U.S. government -- which allowed all of this to occur -- is also what will be called upon to clean up the mess.

Read the whole Hussman comment, especially for his take on the making of the credit bubble. We think it's one of his best efforts.

Just How Terrible is Housing as an Asset Class?

For some time now, we've been noting that the recently-concluded housing bubble wasn't like most of the bubbles that preceded it. Unlike the railroad, telegraph, and dot-com bubbles--which, for all their short-term wreckage, created new infrastructure of immense economic value, as Daniel Gross argues in Pop!--the housing bubble has left behind virtual ghost towns, economically useless infrastructure (e.g., roads, water, and power leading to virtual ghost towns), and a brutal overhang of household and government indebtedness.

So we were pleased to see the (sometimes breathless, often prophetic) Nouriel Roubini make special note of the unproductive nature of the U.S. housing stock. Here are the key passages from Roubini, via Naked Capitalism:

Sixth, the existence of [Government-Sponsored Enterprises,] GSEs...is a major part of the overall U.S. subsidization of housing capital that will eventually lead to the bankruptcy of the U.S. economy. For the last 70 years investment in housing –- the most unproductive form of accumulation of capital -– has been heavily subsidized in 100 different ways in the U.S.: tax benefits, tax-deductibility of interest on mortgages, use of the FHA, massive role of Fannie and Freddie, role of the Federal Home Loan Bank system, and a host of other legislative and regulatory measures.

The reality is that the U.S. has invested too much – especially in the last eight years – in building its stock of wasteful housing capital (whose effect on the productivity of labor is zero) and has not invested enough in the accumulation of productive physical capital (equipment, machinery, etc.) that leads to an increase in the productivity of labor and increases long run economic growth. This financial crisis is a crisis of accumulation of too much debt -– by the household sector, the government and the country –- to finance the accumulation of the most useless and unproductive form of capital, housing, that provides only housing services to consumers and has zippo effect on the productivity of labor. So enough of subsidizing the accumulation of even bigger [McMansions] through the tax system and the GSEs.

We're not sure that the subsidization of housing capital "will eventually lead to the bankruptcy of the U.S. economy," but we're pretty sure it's not a very good use of currently-finite resources in growing the country's real wealth. But aside from that non-trivial quibble, we think Roubini gets this under-appreciated story exactly right.

El-Erian on Squawk Box

As we've noted in this space (here and here, for example), we think PIMCO's Mohamed El-Erian is one of the sanest voices on Wall Street. So when he appeared on yesterday's Squawk Box, we put the DVR to work so we could pass along a few of his most incisive observations. Here's our collection of El-Erian's highlights:

• "Things are bad because the credit crisis has morphed into an economic crisis. Things are bad because policymakers don't have easy solution. No matter how well-intentioned they are, they will create collateral damage."
• "As long as you can underwrite the volatility, there are major bargains out there...things high up in the capital structure."
• "If you're going to recapitalize the financial system, which has to be recapitalized, you're going to dilute somebody. And who are you going to dilute? You're going to dilute existing shareholders."
• "It takes time to recapitalize the financial system. It doesn't happen overnight."
• "You need to be able to hold on when it gets bumpy, because this is not a linear journey."
• "If you get an unexpected rise in prices that people are not ready for, the next move will be up. It's what economists call perverse [unintelligible]. When prices go up, people demand more rather than less; when prices go up, people supply less rather than more. It builds on itself, it feeds on itself, until it exhausts itself. The big question is: Do you break something in the process. It will exhaust itself at some point, but what is the collateral damage?"
• "It's been a puzzle to many of us how 2-and-20 has lasted so long, given that most hedge funds don’t do that well. There are a few hedge funds that deserve it, but many that don't. And at some point investors will wake up and investors will realize that they can get the same service from more conventional providers of investment services. And I think another few quarters of disappointing returns, that will be the wake-up call."
• "There are times, as they say, when you work about the return on your capital, and there are times when you worry about the return of your capital. These days you should worry about the return of your capital."

Wise stuff from Mr. El-Erian.

Toles on Stagflation

While this blog was dormant, Tom Toles was at it again...

The American Debt Culture

We're argued repeatedly in this space that whatever short-term challenges the U.S. economy faces--and there are plenty--the bigger problem is more chronic than acute, more diffuse than concentrated, and more pervasive than our society would like to admit: the unsustainability of debt-funded consumption.

To work our way out of our acute problems, the Fed will innovate, the federal government will cut checks, builders will build fewer homes, and we'll muddle through. To work our way out of our chronic problem, we'll have to save more and consume less. It's really that simple. But it won't be easy, in large part for the reasons columnist David Brooks describes in today's New York Times. Here are two key passages from Brooks:

The United States has been an affluent nation since its founding. But the country was, by and large, not corrupted by wealth. For centuries, it remained industrious, ambitious and frugal.

Over the past 30 years, much of that has been shredded. The social norms and institutions that encouraged frugality and spending what you earn have been undermined. The institutions that encourage debt and living for the moment have been strengthened. The country's moral guardians are forever looking for decadence out of Hollywood and reality TV. But the most rampant decadence today is financial decadence, the trampling of decent norms about how to use and harness money.

...

The agents of destruction are many. State governments have played a role. They aggressively hawk their lottery products, which some people call a tax on stupidity. Twenty percent of Americans are frequent players, spending about $60 billion a year. The spending is starkly regressive. A household with income under $13,000 spends, on average, $645 a year on lottery tickets, about 9 percent of all income. Aside from the financial toll, the moral toll is comprehensive. Here is the government, the guardian of order, telling people that they don't have to work to build for the future. They can strike it rich for nothing.

Payday lenders have also played a role. They seductively offer fast cash -- at absurd interest rates -- to 15 million people every month.

Credit card companies have played a role. Instead of targeting the financially astute, who pay off their debts, they've found that they can make money off the young and vulnerable. Fifty-six percent of students in their final year of college carry four or more credit cards.

Congress and the White House have played a role. The nation's leaders have always had an incentive to shove costs for current promises onto the backs of future generations. It's only now become respectable to do so.

Wall Street has played a role. Bill Gates built a socially useful product to make his fortune. But what message do the compensation packages that hedge fund managers get send across the country?

This is enormously important stuff, and the column is a non-negotiable must-read. Thinking in ideological terms, as we're more inclined to do with the political season heating up, it seems to us that both the left and the right will have to make some concessions here. For its part, the left will have to admit that the debt crisis is, as Brooks argues, a matter of values, not just economic deprivation or determinism. The right, on the other hand, will have to acknowledge that some business practices (predatory lending, cynical credit card pitches to college kids, &c.) are sufficiently harmful to merit the state's regulatory intervention and, in some cases, prohibition.

As a darkly funny aside, Brooks' mention of the distinction between the "investor class" and the "lottery class" evokes a true classic from The Onion: "New Instant Lottery Game Features Three Ways To Win, 19,839,947 Ways To Lose."

For more, check out this assessment of the issue from Barbara Dafoe Whitehead: "A Nation In Debt."

And here's the pitch-perfect Tom Toles:

Sources

David Brooks, "The Great Seduction," New York Times, June 10, 2008

Barbara Dafoe Whitehead, "A Nation In Debt," The American Interest, July/August, 2008

Election-Year Tax Politics

With the major parties' presidential nominees now known, the world's attention turns to the overwrought parlor game of projecting/guessing what will happen if one or the other is elected. Too often, which is to say almost always, these discussions miss some basic features of American political institutions, most importantly that presidents don't impose their pre-existing preferences on a perfectly receptive system. Thinking about Obama and McCain only makes sense in the context of a Congress that what will almost certainly feature bigger Democratic majorities in 2009.

Apart from the basic concepts of Poly Sigh 101, discussions of tax policy in particular often miss another basic but important point: income tax rates are marginal. Let's see how recognition of this simple fact can change the way a potential policy change is perceived.

In the most recent BusinessWeek, Jane Sasseen riffs on potential changes in federal tax law in the aftermath of the 2008 elections, in particular those provisions affecting upper-middle-class (or lower-upper-class, depending on your perspective) taxpayers (i.e., BusinessWeek's subscriber base). Here's a classic example (emphasis added in bold):

The soaring deficit, along with the fact that the Bush tax cuts expire at the end of 2010, provide much of the impetus for the coming fight over high-end taxes. If Washington doesn't act, tax rates on income, capital gains, dividends, and other areas will return to the higher rates in effect before the cuts were enacted in 2001 and 2003. Senator John McCain (R-Ariz.), the presumptive GOP Presidential nominee, has said he would extend the cuts for everyone, while Obama says he'll maintain them for all but the wealthiest. If Obama wins, some taxes could go up as soon as 2009.

By "wealthiest" Obama means married couples earning more than $250,000; for a single taxpayer, the equivalent income would be roughly $200,000. Today, taxpayers making that much fall into the top two federal income tax brackets, paying rates of 33% or 35%. Their rates would revert to the 36% and 39.6% top rates used in 2000. The same households would also see a bump up in the rates they pay on capital gains and dividends, both of which now stand at 15%.

BW readers unschooled in marginal tax rates might read this to say that affluent households' total tax bills would rise from 33% or 35% to 36% or 39.6%, respectively. But that's not the case. Instead, only that portion of a household's income over a certain point (the dividing line between brackets; north, say, of $250k) would be taxed at the higher rate.

Let's take Sasseen's example of the Hammer family, where the doctor/lawyer combo of Howard and Hope reportedly earn $300,000 a year. Now, let's assume that half of their $3,000 monthly mortgage payment is deductible interest. Let's further assume that after they take various other deductions (for their kids, charitable contributions, 401k contributions, &c.), they report $260,000 in taxable income.* Under the Obama plan--which, again, will surely be sublimated into something different in the legislative process--only the last $10,000 of their income would be subject to a higher marginal tax rate. In other words, a family with a quarter-million dollars in annual taxable income would see their federal income tax bill rise by $300 or $400 per year.

Naturally, taxpayers with much higher incomes would pay more tax, but again, only on their marginal dollars. And yes, we realize that Obama's program involves changes to capital gains and dividend tax rates. But our point here isn't to defend Obama's program, or any other program. It's to shed some light on an important feature of income tax law, which is that households' effective tax rates are much lower than their highest marginal rates. It's a distinction with an enormous programmatic--to say nothing of political--difference.

A recurring theme in Sasseen's piece is that households between the 96th and 98th percentiles (those reporting incomes between $200,000 and $500,000) would experience non-trivial hardship if their taxes were to rise. We think Sasseen's point about the cost of living varying widely across the country is absolutely spot-on. But we hope The Stanford Group's Anne Mathias had her tongue planted firmly in her cheek when she told Sasseen that the next couple years "will be a very bad time to be rich." Ummm...compared to what? It's this sort of attitude that leaves working- and middle-class Americans yelling "Cry me a river!" at the copies of BusinessWeek they pick up in the waiting rooms of their friendly neighborhood HMOs.**

Raising taxes on affluent households may or may not be a good idea. And if it's a good idea in the abstract (good, that is, relative to the alternatives, which are (a) more long-term debt for all of us, (b) big cuts in current government spending, or (c) both), reasonable people can and will disagree about what concrete form any revenue-raising should take.

We'd like to see better fiscal discipline out of Washington, and we'd like to see it start on the spending side of the equation. But whatever debates we need to have about the revenue side, let's make them precise and informative, not breathless and misleading.

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* It's probably less than $260k, but we're trying to be conservative here in order to make a general point.

** To see this in action, scan a few of the comments submitted to BusinessWeek.com in response to Sasseen's piece. Here's one example: "Oh my God, I can't believe this article. The families cited in this article may not be rich, but they are not middle class either. They are way upper class. Our income is about half of what the families in this article earn, and we live in the expensive SF Bay Area, and have no problems living comfortably. We also had no problems with the higher tax rates when they were in effect. There is something wrong when people earning $ 300,000 a year can't make ends meet. Try explaining that to families making the median of $ 48,000 a year. Your article reinforces the stereotype of business magazines that live in an alternative universe that centers around Manhattan."

Sources

Jane Sasseen, "Taxing the 'Not-So-Rich' Rich," BusinessWeek, June 5, 2008

Tim Harford, "A Secret Tax on Teenagers," Slate, May 31, 2008

What's With the Spike in Unemployment?

Mark Zandi had it exactly right on Squawk Box this morning (nine and a half minutes into this clip). As we wrote back in January and February, whether we're in a "recession" or not is sort of a silly question--because people are feeling recessionary (even stagflationary) conditions all around them.

Which might help us understand how the May NFP report could show a relatively modest decline of 49,000 jobs and a 0.5% rise in the unemployment rate to 5.5%. Seasonal factors may account for some of the sharp rise in the reported unemployment rate. But we suspect there's another factor in play here: American households, increasingly squeezed by stagnant wages, a weak job market, and rising prices for food and energy are sending people back into the job-seeking workforce out of economic necessity. Indeed, the BLS reported a jump of 577,000 workers in the civilian labor force between April and May.

It would be comforting to think that this is just a bunch of teenagers looking for work at the local waterpark this Summer. Or that people are re-entering the labor force because they're so bullish on their job (and earning) prospects that they can't help but go back to work. Alas, we fear the reality is a little less sanguine here.

Chart of the Day

In light of today's Flow of Funds report from the Fed, which showed a substantial decline in U.S. household wealth in the most recent quarter, we thought the data presented below (courtesy Investment News) were as timely as ever. Note that for the first time in the post-war period, Americans own less than half of the estimated value of their residential real estate.

 

This chart is the inevitable product of declining prices and massive equity withdrawals. Which makes us think of Maxed Out, a documentary on Americans' ever-expanding indebtedness and some of the less savory business practices that have helped us along on that path. We recommend it--though maybe not on a full stomach.

Sources

Carlos Torres, "U.S. Household Net Worth Fell the Most in 5 Years Last Quarter," Bloomberg, June 5, 2008

"Owners' equity in household real estate, 1945-2007," Investment News, June 2, 2008

Housing and Long-Term Competitiveness

Every day brings new data on the real estate market, most of it discouraging to the realists in the crowd. The latest evidence suggests that commercial real estate is following residential into the tank. All but the most willfully obtuse Pollyannas now acknowledge that the real estate picture is bad...and likely to get worse before it gets better. Of course the universal caveat applies: Local markets will vary.

As we've written repeatedly in this space (most recently three weeks ago in this item), the mad scramble to prop real estate up may or may not be effective, but regardless of its efficacy, its wisdom is doubtful at best.

So we were pleased to see Yves Smith pass along a summary of Nouriel Roubini's recent roundtable on broad financial and economic circumstances. Here's the relevant passage from Smith's post (emphasis added in bold):

One speaker (I cannot recall which one) argued that the push for more affordable housing was to mask the political impact of stagnant wages. "We needed to show some form of economic progress to meet social goals." Yet channeling so much investment capital into housing has certainly not helped, and probably weakened US competitiveness, thus in the end making workers worse off in the long haul.

That last sentence should be distributed immediately to every member of Congress, with helpful bullet-point explanations of the difference between productivity-enhancing and productivity-draining investments.

As always, none of this should obscure the substantial dislocations (i.e., pain) caused by the bursting of the lending and real estate bubbles. But the extent of the pain this time makes an appropriate policy response that much more important--to minimize the pain next time.

Thinking About Housing

Some say a recession has arrived. Some say it hasn't yet but will. Some say it never will.

Notwithstanding all the disagreement about where we are not, we've detected near-unanimity on the need for the housing market to stabilize (or "bottom") before the economy stages any kind of meaningful recovery. Which, as far as it goes, is almost certainly true. But the argument has assumed a normative dimension, with many observers claiming that it would be an affirmatively good thing for housing to bottom. Alas, this a question that gets too little attention in the current debate: Should we make extraordinary efforts to force the bottom into place right here, right now?

We think the answer is a definitive no. In the long run, the U.S. economy would be better-served if home prices fell further--much further in some markets, a little further in others--in order to reach market-clearing levels without short-term gimmicks and unsustainable subsidies.

After all, the big problem these days is that too many Americans became overleveraged to acquire (or, more accurately, occupy) unproductive assets. This, we think, is a gross mis-allocation of public and private resources. And all this so Americans could stake partial/leveraged claims to an asset class that historically has been a relatively poor performer.*

Three caveats:

1. We are not of the "let them eat cake" school of economics. Not at all. But the castles-in-the-sky fantasies of the last few years served Americans of moderate means very poorly. These are people whose real wages are lower now than they were when we embarked on this outrageous real estate bubble. So bringing real estate prices back to some reasonable level of affordability, for all the dislocations it will cause in the short run, is very much in the long-term interests of working- and middle-class America.
2. We aren't reflexively anti-government. By its very existence, government "intervenes" in markets...by creating them!** We do think that extraordinary interventions should have clearly stated objectives and plausible likelihoods of achieving those objectives. But we do think it's entirely legitimate for government to try to smooth out the roughest edges, and mitigate the negative externalities, of market cycles.
3. We freely and fully acknowledge that falling home prices do and will hurt in the short run. But we'd rather take the responsible position of focusing on the long-term requirements of economic growth than just applying an expensive short-term salve to the wounds created by the last bubble.

And what are those requirements of growth? Here we'll focus on just one: A higher rate of domestic saving. By slashing interest rates, the Fed has punished saving (of which we need more) and encouraged borrowing (of which we need less). These days, the marginal spent dollar is the marginal borrowed dollar. They're the same thing!***

Only in the most short-sighted sense is a bottom in housing (which we intend to mean a stabilization in the price of residential real estate) necessary or good. A further purging of the truly perverse excesses that have barnacled the American economy over over the last few years would serve us all better in the long run. Less leverage. More affordability. Higher savings rates. More discretionary income for other stuff. More productivity.

No self-respecting elected official will touch this argument, and we understand why. But let's be honest: That doesn't make it any less compelling.

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* Thanks in part to exceptionally high "expense ratios." If we included the true costs of homeownership (interest payments, property taxes, maintenance, &c.), the return on equity from residential real estate would, in all but the most unusual circumstances (of the sort we witnessed from 2000 to 2005), be remarkably low, even negative in many instances. That doesn't mean real estate is inherently a "bad investment." For several reasons, economic and otherwise, we like the idea of homeownership as much as anyone. But it does mean that as an investment per se, residential real estate isn't especially attractive.

** Through the establishment and preservation of physical and intellectual property rights, the enforcement of contracts, and the maintenance of infrastructure and public safety, among other things. 

*** Those stimulus checks now flying toward a mailbox near you? Those are borrowed too, and the feds want you to spend 'em.

Sources

Alison Vekshin, "U.S. House Passes Anti-Foreclosure Bill Facing Bush Veto Threat," Bloomberg, May 9, 2008