Old bulls versus younger bears. This could be entirely coincidental. Has anyone noticed that bullish sentiment seems correlated with age?
Bullish and Buying
The most prominent U.S. stock market bull to surface in recent days is highly respected Mr. Buffett, who was born in 1930 and grew up during the Great Depression years. If as a child he was too young to comprehend the hard times and economic turmoil of the era, we can at least presume that, in his early adult years as a student of Ben Graham, Buffett absorbed the first-hand lessons garnered by his teacher, who had lost everything during the stock market crash of 1929, which apparently was the life-changing event that led Graham to formulate his well-known value-investing methodology. Quoting from Buffett's op-ed piece in the New York Times:
Warren Buffett (age 78): October 16, 2008. "Buy American. I am."
"The financial world is a mess, both in the United States and abroad. So . . . I’ve been buying American stocks. . . . I previously owned nothing but United States government bonds. If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities."
Also notable is so-called "perma-bear" Grantham, whose switchover into the bullish camp can be considered significant, since he spent the past couple of decades marauding with the bears:
Jeremy Grantham (age 69): October 18, 2008. "Silver Linings and Lessons Learned"
We "have moderately cheap U.S. and global equities for the first time in 20 years. . . . We at GMO [Grantham's investment management company] are already careful buyers. We are reconciled to buying too soon, but we recognize that our fair value estimate of 975 on the S&P 500 is, from historical precedent, likely to overrun on the downside by 20% to 40%, giving a range of 585 to 780 on the s&P as a probable low."
I am not sure how much weight Glickenhaus's opinion carries today in the investor community, but he is said to be the lone voice who boldly spoke out when stocks fell 23% on Black Monday in 1987, confidently calling a market bottom and the start of the next bull market. FOX Business has interviewed Glickenhaus twice during the past few weeks, highlighting the relevance of his experience of having lived through the stock market crash of 1929 and seen how the government's actions (or inaction) impacted the severity of the Great Depression:
Seth Glickenhaus (age 94): October 27, 2008. "On the Verge of a New Bull Market. . . "
"We are making a painful but meaningful low. . . . This is a rare opportunity to buy stocks at substantially below their intrinsic values. . . . We are on the verge of a new bull market beginning within a week or two. . . ."
(Note: On October 15, 2008, on Neil Cavuto's show on FOX Business, Glickenhaus indicated that a new bull market would start "next week." That day, the S&P 500 closed at 908. Today, a week and a half later, the S&P 500 closed at 849, a fresh, new five-and-a-half-year low.)
Bearish and Avoiding Stocks
As might be expected, so-called "Dr. Doom," Marc Faber, sees the U.S. and world mired in a serious recession that will last a few years. However, he also sees potential for a near-term rally within the longer-term bear market:
Marc Faber (age about 60?): October 20, 2008. "Stocks May Rally, Won't Reach Records"
"We're extremely oversold at the present time. The market is in a position to rebound." However, Faber holds only a small equity position: "stocks make up 7 or 8 percent of his holdings, with cash, bonds and gold, his biggest position, accounting for the rest." Also, his opinion on the U.S. economy remains gloomy: "To rebuild economic health in the United States, you need a serious recession that will last several years. The patient that got drunk on credit growth needs to go into rehabilitation. To give him more alcohol, the way the Fed and the Treasury propose to do, is the wrong medicine."
Next, here's the opinion of a firmly committed, unwavering bear, who is calling for a significantly lower bottom:
Gary Shilling (age in 60s): October 22, 2008. "We Haven't Seen the Worst Yet"
"The economy hasn't hit bottom yet. Neither, in all likelihood, have stocks. . . . If you're an equity investor with a long-only portfolio, it's not too late to take some money off the table. Remember 777--not the airliner but the low that the Standard & Poor's 500 hit in 2002. That's 21% beneath where we are today, but if it's breached, then all the stock rise of the last six years will have been but a bear market rally, and the bear market that started in March 2000 will still be with us."
Finally, representative of the diversity of opinion, here's a market commentator who is one of the few courageous enough to state publicly that Buffett is, whether we like it or not, just plain wrong this time around:
Diane Francis (age in 40s): October 27, 2008. "Buffett Is Wrong: Avoid Stocks"
"Far be it from me to contradict one of the world's greatest stock sages and business analysts. But I will. Seems to me that we are in uncharted territory with this panic until the U.S. election is staged on November 4 and until the global community demonstrates that it is going to appoint sheriffs to patrol the global economy and stop the kind of jurisdictional arbitrage that led to the casino-ization of banking. . . . For me, buying and selling should not be an option at least until the U.S. election and probably until January 2009."
Does Age Matter?
Admittedly, based on a sample size of just three opinions from each camp, we have at hand little more than anecdotal evidence and, consequently, cannot draw any conclusion that comes even close to being statistically significant. However, with the bull opinions coming from investors in approximately the 70-to-90 age group, versus the bear opinions from a younger cohort in the 40-to-60 age group, I suspect that investor age might be an indicator of stock market sentiment.
One interpretation is that the older generation, having closer first-hand experience with the crash of 1929 and economic hard times during the 1930s, have a deeper appreciation for today's unprecedented government efforts to stem the current financial crisis before it reaches depression-era proportions. If the bulls end up being correct, we will in a few years' time look back upon today and have to acknowledge that the older seers professed a certain "market wisdom" that the less experienced, younger generation lacked. On the other hand, if the bears win the battle and the actual market bottom turns out to be much lower, I can already almost hear the youthful crowd "writing off" the elderly bulls as having "gone senile," being "out to pasture," or at least being "out of touch" with these ever so "modern" times of ours.
For the sake of global economic stability, I certainly hope the old bulls really are the wiser. However, on days like today, with the market closing at a new low, we have to fear that the younger bears could be right in the short run.
Older Bulls Wiser than Younger Bears? Maybe
Old bulls versus younger bears. This could be entirely coincidental. Has anyone noticed that bullish sentiment seems correlated with age?
Bullish and Buying
The most prominent U.S. stock market bull to surface in recent days is highly respected Mr. Buffett, who was born in 1930 and grew up during the Great Depression years. If as a child he was too young to comprehend the hard times and economic turmoil of the era, we can at least presume that, in his early adult years as a student of Ben Graham, Buffett absorbed the first-hand lessons garnered by his teacher, who had lost everything during the stock market crash of 1929, which apparently was the life-changing event that led Graham to formulate his well-known value-investing methodology. Quoting from Buffett's op-ed piece in the New York Times:
Warren Buffett (age 78): October 16, 2008. "Buy American. I am."
"The financial world is a mess, both in the United States and abroad. So . . . I’ve been buying American stocks. . . . I previously owned nothing but United States government bonds. If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities."
Also notable is so-called "perma-bear" Grantham, whose switchover into the bullish camp can be considered significant, since he spent the past couple of decades marauding with the bears:
Jeremy Grantham (age 69): October 18, 2008. "Silver Linings and Lessons Learned"
We "have moderately cheap U.S. and global equities for the first time in 20 years. . . . We at GMO [Grantham's investment management company] are already careful buyers. We are reconciled to buying too soon, but we recognize that our fair value estimate of 975 on the S&P 500 is, from historical precedent, likely to overrun on the downside by 20% to 40%, giving a range of 585 to 780 on the s&P as a probable low."
I am not sure how much weight Glickenhaus's opinion carries today in the investor community, but he is said to be the lone voice who boldly spoke out when stocks fell 23% on Black Monday in 1987, confidently calling a market bottom and the start of the next bull market. FOX Business has interviewed Glickenhaus twice during the past few weeks, highlighting the relevance of his experience of having lived through the stock market crash of 1929 and seen how the government's actions (or inaction) impacted the severity of the Great Depression:
Seth Glickenhaus (age 94): October 27, 2008. "On the Verge of a New Bull Market. . . "
"We are making a painful but meaningful low. . . . This is a rare opportunity to buy stocks at substantially below their intrinsic values. . . . We are on the verge of a new bull market beginning within a week or two. . . ."
(Note: On October 15, 2008, on Neil Cavuto's show on FOX Business, Glickenhaus indicated that a new bull market would start "next week." That day, the S&P 500 closed at 908. Today, a week and a half later, the S&P 500 closed at 849, a fresh, new five-and-a-half-year low.)
Bearish and Avoiding Stocks
As might be expected, so-called "Dr. Doom," Marc Faber, sees the U.S. and world mired in a serious recession that will last a few years. However, he also sees potential for a near-term rally within the longer-term bear market:
Marc Faber (age about 60?): October 20, 2008. "Stocks May Rally, Won't Reach Records"
"We're extremely oversold at the present time. The market is in a position to rebound." However, Faber holds only a small equity position: "stocks make up 7 or 8 percent of his holdings, with cash, bonds and gold, his biggest position, accounting for the rest." Also, his opinion on the U.S. economy remains gloomy: "To rebuild economic health in the United States, you need a serious recession that will last several years. The patient that got drunk on credit growth needs to go into rehabilitation. To give him more alcohol, the way the Fed and the Treasury propose to do, is the wrong medicine."
Next, here's the opinion of a firmly committed, unwavering bear, who is calling for a significantly lower bottom:
Gary Shilling (age in 60s): October 22, 2008. "We Haven't Seen the Worst Yet"
"The economy hasn't hit bottom yet. Neither, in all likelihood, have stocks. . . . If you're an equity investor with a long-only portfolio, it's not too late to take some money off the table. Remember 777--not the airliner but the low that the Standard & Poor's 500 hit in 2002. That's 21% beneath where we are today, but if it's breached, then all the stock rise of the last six years will have been but a bear market rally, and the bear market that started in March 2000 will still be with us."
Finally, representative of the diversity of opinion, here's a market commentator who is one of the few courageous enough to state publicly that Buffett is, whether we like it or not, just plain wrong this time around:
Diane Francis (age in 40s): October 27, 2008. "Buffett Is Wrong: Avoid Stocks"
"Far be it from me to contradict one of the world's greatest stock sages and business analysts. But I will. Seems to me that we are in uncharted territory with this panic until the U.S. election is staged on November 4 and until the global community demonstrates that it is going to appoint sheriffs to patrol the global economy and stop the kind of jurisdictional arbitrage that led to the casino-ization of banking. . . . For me, buying and selling should not be an option at least until the U.S. election and probably until January 2009."
Does Age Matter?
Admittedly, based on a sample size of just three opinions from each camp, we have at hand little more than anecdotal evidence and, consequently, cannot draw any conclusion that comes even close to being statistically significant. However, with the bull opinions coming from investors in approximately the 70-to-90 age group, versus the bear opinions from a younger cohort in the 40-to-60 age group, I suspect that investor age might be an indicator of stock market sentiment.
One interpretation is that the older generation, having closer first-hand experience with the crash of 1929 and economic hard times during the 1930s, have a deeper appreciation for today's unprecedented government efforts to stem the current financial crisis before it reaches depression-era proportions. If the bulls end up being correct, we will in a few years' time look back upon today and have to acknowledge that the older seers professed a certain "market wisdom" that the less experienced, younger generation lacked. On the other hand, if the bears win the battle and the actual market bottom turns out to be much lower, I can already almost hear the youthful crowd "writing off" the elderly bulls as having "gone senile," being "out to pasture," or at least being "out of touch" with these ever so "modern" times of ours.
For the sake of global economic stability, I certainly hope the old bulls really are the wiser. However, on days like today, with the market closing at a new low, we have to fear that the younger bears could be right in the short run.
Bullish and Buying
The most prominent U.S. stock market bull to surface in recent days is highly respected Mr. Buffett, who was born in 1930 and grew up during the Great Depression years. If as a child he was too young to comprehend the hard times and economic turmoil of the era, we can at least presume that, in his early adult years as a student of Ben Graham, Buffett absorbed the first-hand lessons garnered by his teacher, who had lost everything during the stock market crash of 1929, which apparently was the life-changing event that led Graham to formulate his well-known value-investing methodology. Quoting from Buffett's op-ed piece in the New York Times:
Warren Buffett (age 78): October 16, 2008. "Buy American. I am."
"The financial world is a mess, both in the United States and abroad. So . . . I’ve been buying American stocks. . . . I previously owned nothing but United States government bonds. If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities."
Also notable is so-called "perma-bear" Grantham, whose switchover into the bullish camp can be considered significant, since he spent the past couple of decades marauding with the bears:
Jeremy Grantham (age 69): October 18, 2008. "Silver Linings and Lessons Learned"
We "have moderately cheap U.S. and global equities for the first time in 20 years. . . . We at GMO [Grantham's investment management company] are already careful buyers. We are reconciled to buying too soon, but we recognize that our fair value estimate of 975 on the S&P 500 is, from historical precedent, likely to overrun on the downside by 20% to 40%, giving a range of 585 to 780 on the s&P as a probable low."
I am not sure how much weight Glickenhaus's opinion carries today in the investor community, but he is said to be the lone voice who boldly spoke out when stocks fell 23% on Black Monday in 1987, confidently calling a market bottom and the start of the next bull market. FOX Business has interviewed Glickenhaus twice during the past few weeks, highlighting the relevance of his experience of having lived through the stock market crash of 1929 and seen how the government's actions (or inaction) impacted the severity of the Great Depression:
Seth Glickenhaus (age 94): October 27, 2008. "On the Verge of a New Bull Market. . . "
"We are making a painful but meaningful low. . . . This is a rare opportunity to buy stocks at substantially below their intrinsic values. . . . We are on the verge of a new bull market beginning within a week or two. . . ."
(Note: On October 15, 2008, on Neil Cavuto's show on FOX Business, Glickenhaus indicated that a new bull market would start "next week." That day, the S&P 500 closed at 908. Today, a week and a half later, the S&P 500 closed at 849, a fresh, new five-and-a-half-year low.)
Bearish and Avoiding Stocks
As might be expected, so-called "Dr. Doom," Marc Faber, sees the U.S. and world mired in a serious recession that will last a few years. However, he also sees potential for a near-term rally within the longer-term bear market:
Marc Faber (age about 60?): October 20, 2008. "Stocks May Rally, Won't Reach Records"
"We're extremely oversold at the present time. The market is in a position to rebound." However, Faber holds only a small equity position: "stocks make up 7 or 8 percent of his holdings, with cash, bonds and gold, his biggest position, accounting for the rest." Also, his opinion on the U.S. economy remains gloomy: "To rebuild economic health in the United States, you need a serious recession that will last several years. The patient that got drunk on credit growth needs to go into rehabilitation. To give him more alcohol, the way the Fed and the Treasury propose to do, is the wrong medicine."
Next, here's the opinion of a firmly committed, unwavering bear, who is calling for a significantly lower bottom:
Gary Shilling (age in 60s): October 22, 2008. "We Haven't Seen the Worst Yet"
"The economy hasn't hit bottom yet. Neither, in all likelihood, have stocks. . . . If you're an equity investor with a long-only portfolio, it's not too late to take some money off the table. Remember 777--not the airliner but the low that the Standard & Poor's 500 hit in 2002. That's 21% beneath where we are today, but if it's breached, then all the stock rise of the last six years will have been but a bear market rally, and the bear market that started in March 2000 will still be with us."
Finally, representative of the diversity of opinion, here's a market commentator who is one of the few courageous enough to state publicly that Buffett is, whether we like it or not, just plain wrong this time around:
Diane Francis (age in 40s): October 27, 2008. "Buffett Is Wrong: Avoid Stocks"
"Far be it from me to contradict one of the world's greatest stock sages and business analysts. But I will. Seems to me that we are in uncharted territory with this panic until the U.S. election is staged on November 4 and until the global community demonstrates that it is going to appoint sheriffs to patrol the global economy and stop the kind of jurisdictional arbitrage that led to the casino-ization of banking. . . . For me, buying and selling should not be an option at least until the U.S. election and probably until January 2009."
Does Age Matter?
Admittedly, based on a sample size of just three opinions from each camp, we have at hand little more than anecdotal evidence and, consequently, cannot draw any conclusion that comes even close to being statistically significant. However, with the bull opinions coming from investors in approximately the 70-to-90 age group, versus the bear opinions from a younger cohort in the 40-to-60 age group, I suspect that investor age might be an indicator of stock market sentiment.
One interpretation is that the older generation, having closer first-hand experience with the crash of 1929 and economic hard times during the 1930s, have a deeper appreciation for today's unprecedented government efforts to stem the current financial crisis before it reaches depression-era proportions. If the bulls end up being correct, we will in a few years' time look back upon today and have to acknowledge that the older seers professed a certain "market wisdom" that the less experienced, younger generation lacked. On the other hand, if the bears win the battle and the actual market bottom turns out to be much lower, I can already almost hear the youthful crowd "writing off" the elderly bulls as having "gone senile," being "out to pasture," or at least being "out of touch" with these ever so "modern" times of ours.
For the sake of global economic stability, I certainly hope the old bulls really are the wiser. However, on days like today, with the market closing at a new low, we have to fear that the younger bears could be right in the short run.
Potential secret weapon to battle our financial crisis: A trillion dollar debt-to-equity swap
While heavily indebted American consumers struggle to make mortgage and credit card payments, a larger shift is underway. News from Tokyo indicates that politicians in Japan, America's "friendly" creditor nation, are beginning to consider investing the country's massive horde of foreign reserves, to "take advantage of the opportunities opening up around the world" during this global financial crisis we are in.
The largest foreign exchange reserves are held by China with $1.9 trillion and Japan with $1.0 trillion, followed by Eurozone countries and Russia, each with about $550 billion. Almost all of these largely U.S. dollar-denominated reserves are invested in conservative fixed-income instruments like U.S. Treasury bonds. However, as noted already in a 2005 article by Andrew Rozonov, who first used the term "sovereign wealth fund," the practical distinction between foreign exchange reserves and their more equity-like sovereign wealth fund counterpart has begun to blur.
In the earlier part of the subprime crisis, we saw high-profile investing of $21 billion by sovereign wealth funds (Singapore, Kuwait and South Korea) into U.S. financial institutions (Citi and Merrill). This week's closing of Mitsubishi UFJ's $9 billion capital infusion into Morgan Stanley is a private sector version of the same type of foreign investment. Given the, not billion, but trillion dollar scale of the foreign exchange reserves that China and Japan have amassed, any decision on their part to swap even a small portion of their fixed-income funds into equity-like investments will have a tremendous impact on the U.S. equity market.
Ponder this: The investments last January by smaller sovereign wealth funds in U.S. financial institutions helped to boost capital, but nevertheless Merrill is now being acquired by Bank of America and Citi's balance sheet is still under pressure. The U.S. government coordinated JPMorgan's acquisition of faltering Bear Stearns in March, but that did not prevent Lehman from going bankrupt in September. After an unprecedented $85 billion government lifeline to AIG last month, AIG needed another $38 billion just last week. Also, despite heightened government intervention in recent weeks--Paulson's $700 billion bank rescue plan signed into law on October 3, coordinated global rate cuts by many G-7 members and other countries last week, and the government's "no objections allowed" infusion of $125 billion capital into JPMorgan, Bank of America, Citi, Wells Fargo, Goldman, Morgan Stanley and other financial institutions announced on Monday--the economic outlook grows bleaker, people worry more about their jobs and retirement and cut back on consumption, and the stock market resumes its downward spiral while real estate prices sag further.
In short, each and every policy measure to date, however unprecedented and seemingly "radical" at implementation, has failed to stem the economic bleeding.
So, where do we turn at this juncture? Well, recall the proverbial "rich uncle," who is perennially forthcoming with money gifts when you are a kid, lends you the extra money you need for a down payment when buying your first house, and provides half the capital you need to start a new business. As our financial crisis runs its course, we Americans as owners of over-leveraged assets in our increasingly distressed U.S. economy really have only one place to go for the capital we so badly need. Because there is not enough capital internally within our national borders, the much-needed equity capital to stabilize our economy and restore confidence of consumers and among financial institutions must come from abroad.
Like it or not, for equity capital rather than just debt, American financial institutions, large corporations and our U.S. equity markets as a whole need to tap into the trillions of dollars of foreign exchange reserves on the books of governments throughout the world, and particularly the trillion dollar balances of each of China and Japan. Back in March, the House held a hearing on the role of foreign government investment in the U.S. economy and financial sector. More along these lines is needed.
My guess is that our equity markets will not find a firm bottom until cross-border government-level deals are struck to convert from debt to equity significant portions of the U.S. dollar-denominated foreign exchange reserves sitting overseas in Asia. How about a trillion dollar swap out of Treasuries and into a broad-based equity index like the S&P 500?
A substantial increase in foreign ownership of the American economy is probably a lot closer than we think.
The largest foreign exchange reserves are held by China with $1.9 trillion and Japan with $1.0 trillion, followed by Eurozone countries and Russia, each with about $550 billion. Almost all of these largely U.S. dollar-denominated reserves are invested in conservative fixed-income instruments like U.S. Treasury bonds. However, as noted already in a 2005 article by Andrew Rozonov, who first used the term "sovereign wealth fund," the practical distinction between foreign exchange reserves and their more equity-like sovereign wealth fund counterpart has begun to blur.
In the earlier part of the subprime crisis, we saw high-profile investing of $21 billion by sovereign wealth funds (Singapore, Kuwait and South Korea) into U.S. financial institutions (Citi and Merrill). This week's closing of Mitsubishi UFJ's $9 billion capital infusion into Morgan Stanley is a private sector version of the same type of foreign investment. Given the, not billion, but trillion dollar scale of the foreign exchange reserves that China and Japan have amassed, any decision on their part to swap even a small portion of their fixed-income funds into equity-like investments will have a tremendous impact on the U.S. equity market.
Ponder this: The investments last January by smaller sovereign wealth funds in U.S. financial institutions helped to boost capital, but nevertheless Merrill is now being acquired by Bank of America and Citi's balance sheet is still under pressure. The U.S. government coordinated JPMorgan's acquisition of faltering Bear Stearns in March, but that did not prevent Lehman from going bankrupt in September. After an unprecedented $85 billion government lifeline to AIG last month, AIG needed another $38 billion just last week. Also, despite heightened government intervention in recent weeks--Paulson's $700 billion bank rescue plan signed into law on October 3, coordinated global rate cuts by many G-7 members and other countries last week, and the government's "no objections allowed" infusion of $125 billion capital into JPMorgan, Bank of America, Citi, Wells Fargo, Goldman, Morgan Stanley and other financial institutions announced on Monday--the economic outlook grows bleaker, people worry more about their jobs and retirement and cut back on consumption, and the stock market resumes its downward spiral while real estate prices sag further.
In short, each and every policy measure to date, however unprecedented and seemingly "radical" at implementation, has failed to stem the economic bleeding.
So, where do we turn at this juncture? Well, recall the proverbial "rich uncle," who is perennially forthcoming with money gifts when you are a kid, lends you the extra money you need for a down payment when buying your first house, and provides half the capital you need to start a new business. As our financial crisis runs its course, we Americans as owners of over-leveraged assets in our increasingly distressed U.S. economy really have only one place to go for the capital we so badly need. Because there is not enough capital internally within our national borders, the much-needed equity capital to stabilize our economy and restore confidence of consumers and among financial institutions must come from abroad.
Like it or not, for equity capital rather than just debt, American financial institutions, large corporations and our U.S. equity markets as a whole need to tap into the trillions of dollars of foreign exchange reserves on the books of governments throughout the world, and particularly the trillion dollar balances of each of China and Japan. Back in March, the House held a hearing on the role of foreign government investment in the U.S. economy and financial sector. More along these lines is needed.
My guess is that our equity markets will not find a firm bottom until cross-border government-level deals are struck to convert from debt to equity significant portions of the U.S. dollar-denominated foreign exchange reserves sitting overseas in Asia. How about a trillion dollar swap out of Treasuries and into a broad-based equity index like the S&P 500?
A substantial increase in foreign ownership of the American economy is probably a lot closer than we think.
Potential secret weapon to battle our financial crisis: A trillion dollar debt-to-equity swap
While heavily indebted American consumers struggle to make mortgage and credit card payments, a larger shift is underway. News from Tokyo indicates that politicians in Japan, America's "friendly" creditor nation, are beginning to consider investing the country's massive horde of foreign reserves, to "take advantage of the opportunities opening up around the world" during this global financial crisis we are in.
The largest foreign exchange reserves are held by China with $1.9 trillion and Japan with $1.0 trillion, followed by Eurozone countries and Russia, each with about $550 billion. Almost all of these largely U.S. dollar-denominated reserves are invested in conservative fixed-income instruments like U.S. Treasury bonds. However, as noted already in a 2005 article by Andrew Rozonov, who first used the term "sovereign wealth fund," the practical distinction between foreign exchange reserves and their more equity-like sovereign wealth fund counterpart has begun to blur.
In the earlier part of the subprime crisis, we saw high-profile investing of $21 billion by sovereign wealth funds (Singapore, Kuwait and South Korea) into U.S. financial institutions (Citi and Merrill). This week's closing of Mitsubishi UFJ's $9 billion capital infusion into Morgan Stanley is a private sector version of the same type of foreign investment. Given the, not billion, but trillion dollar scale of the foreign exchange reserves that China and Japan have amassed, any decision on their part to swap even a small portion of their fixed-income funds into equity-like investments will have a tremendous impact on the U.S. equity market.
Ponder this: The investments last January by smaller sovereign wealth funds in U.S. financial institutions helped to boost capital, but nevertheless Merrill is now being acquired by Bank of America and Citi's balance sheet is still under pressure. The U.S. government coordinated JPMorgan's acquisition of faltering Bear Stearns in March, but that did not prevent Lehman from going bankrupt in September. After an unprecedented $85 billion government lifeline to AIG last month, AIG needed another $38 billion just last week. Also, despite heightened government intervention in recent weeks--Paulson's $700 billion bank rescue plan signed into law on October 3, coordinated global rate cuts by many G-7 members and other countries last week, and the government's "no objections allowed" infusion of $125 billion capital into JPMorgan, Bank of America, Citi, Wells Fargo, Goldman, Morgan Stanley and other financial institutions announced on Monday--the economic outlook grows bleaker, people worry more about their jobs and retirement and cut back on consumption, and the stock market resumes its downward spiral while real estate prices sag further.
In short, each and every policy measure to date, however unprecedented and seemingly "radical" at implementation, has failed to stem the economic bleeding.
So, where do we turn at this juncture? Well, recall the proverbial "rich uncle," who is perennially forthcoming with money gifts when you are a kid, lends you the extra money you need for a down payment when buying your first house, and provides half the capital you need to start a new business. As our financial crisis runs its course, we Americans as owners of over-leveraged assets in our increasingly distressed U.S. economy really have only one place to go for the capital we so badly need. Because there is not enough capital internally within our national borders, the much-needed equity capital to stabilize our economy and restore confidence of consumers and among financial institutions must come from abroad.
Like it or not, for equity capital rather than just debt, American financial institutions, large corporations and our U.S. equity markets as a whole need to tap into the trillions of dollars of foreign exchange reserves on the books of governments throughout the world, and particularly the trillion dollar balances of each of China and Japan. Back in March, the House held a hearing on the role of foreign government investment in the U.S. economy and financial sector. More along these lines is needed.
My guess is that our equity markets will not find a firm bottom until cross-border government-level deals are struck to convert from debt to equity significant portions of the U.S. dollar-denominated foreign exchange reserves sitting overseas in Asia. How about a trillion dollar swap out of Treasuries and into a broad-based equity index like the S&P 500?
A substantial increase in foreign ownership of the American economy is probably a lot closer than we think.
The largest foreign exchange reserves are held by China with $1.9 trillion and Japan with $1.0 trillion, followed by Eurozone countries and Russia, each with about $550 billion. Almost all of these largely U.S. dollar-denominated reserves are invested in conservative fixed-income instruments like U.S. Treasury bonds. However, as noted already in a 2005 article by Andrew Rozonov, who first used the term "sovereign wealth fund," the practical distinction between foreign exchange reserves and their more equity-like sovereign wealth fund counterpart has begun to blur.
In the earlier part of the subprime crisis, we saw high-profile investing of $21 billion by sovereign wealth funds (Singapore, Kuwait and South Korea) into U.S. financial institutions (Citi and Merrill). This week's closing of Mitsubishi UFJ's $9 billion capital infusion into Morgan Stanley is a private sector version of the same type of foreign investment. Given the, not billion, but trillion dollar scale of the foreign exchange reserves that China and Japan have amassed, any decision on their part to swap even a small portion of their fixed-income funds into equity-like investments will have a tremendous impact on the U.S. equity market.
Ponder this: The investments last January by smaller sovereign wealth funds in U.S. financial institutions helped to boost capital, but nevertheless Merrill is now being acquired by Bank of America and Citi's balance sheet is still under pressure. The U.S. government coordinated JPMorgan's acquisition of faltering Bear Stearns in March, but that did not prevent Lehman from going bankrupt in September. After an unprecedented $85 billion government lifeline to AIG last month, AIG needed another $38 billion just last week. Also, despite heightened government intervention in recent weeks--Paulson's $700 billion bank rescue plan signed into law on October 3, coordinated global rate cuts by many G-7 members and other countries last week, and the government's "no objections allowed" infusion of $125 billion capital into JPMorgan, Bank of America, Citi, Wells Fargo, Goldman, Morgan Stanley and other financial institutions announced on Monday--the economic outlook grows bleaker, people worry more about their jobs and retirement and cut back on consumption, and the stock market resumes its downward spiral while real estate prices sag further.
In short, each and every policy measure to date, however unprecedented and seemingly "radical" at implementation, has failed to stem the economic bleeding.
So, where do we turn at this juncture? Well, recall the proverbial "rich uncle," who is perennially forthcoming with money gifts when you are a kid, lends you the extra money you need for a down payment when buying your first house, and provides half the capital you need to start a new business. As our financial crisis runs its course, we Americans as owners of over-leveraged assets in our increasingly distressed U.S. economy really have only one place to go for the capital we so badly need. Because there is not enough capital internally within our national borders, the much-needed equity capital to stabilize our economy and restore confidence of consumers and among financial institutions must come from abroad.
Like it or not, for equity capital rather than just debt, American financial institutions, large corporations and our U.S. equity markets as a whole need to tap into the trillions of dollars of foreign exchange reserves on the books of governments throughout the world, and particularly the trillion dollar balances of each of China and Japan. Back in March, the House held a hearing on the role of foreign government investment in the U.S. economy and financial sector. More along these lines is needed.
My guess is that our equity markets will not find a firm bottom until cross-border government-level deals are struck to convert from debt to equity significant portions of the U.S. dollar-denominated foreign exchange reserves sitting overseas in Asia. How about a trillion dollar swap out of Treasuries and into a broad-based equity index like the S&P 500?
A substantial increase in foreign ownership of the American economy is probably a lot closer than we think.
The Survival of the Longest
A specter is haunting the world — the specter of gold, while the old fiat money has lost all its powers. Gold is now the only safe and sensible asset, because only gold will survive apocalyptic scenario that is about to unfold. Those who thought “this time will be different” are about to be proven right. Only a few of the most respected authorities of the market predicted elements of the unfolding demise. As, one after another, these predictions come true, we will see the financial markets gradually unravel.
In August of last year I forecast a target of 800 for the S&P, which is about to be tested. This was an easy target to establish, since it represented the low of the 2001-2003 bear market. Last week’s heroic performance – what traders call a “dead cat bounce” - was a temporary respite from the market’s downward spiral. I now doubt 800 will be the bottom for this bear market. There may be more dead cat bounces, but there is no support in sight once 800 is decisively broken. My ultimate target is 400-500 for the S&P (or 4,000-5,000 for the Dow) which will be reached by the end of 2010. The timing of the 2010 bottom is consistent with what was given by Wharton professors Andrew Abel and Jeremy Siegel in 2001 in their “baby boomer cashing out” scenario discussed below.
My pessimism is based on my belief that neither government actions nor unnatural market mechanisms, such as circuit breakers and banning short sales, are capable of arresting this bear market. Many believe this bear market will recover quickly, like it did in 1987. This will not happen. After the one-day 20% drop in the market in 1987, circuit breakers were introduced to limit daily declines. But the market has adapted and selling pressure is distributed over longer time intervals, and the net effect is the same. Regulators could install additional market holidays, like they did in the 1930s, but the market will continue to adapt.
Jeremy Grantham’s Predictions
Earlier this year, Jeremy Grantham of GMO predicted in an interview with Barron’s that the S&P 500 would drop to 1,100 by end of 2010. A lot of people just laughed at him. Was this crazy old man out of his mind? Now, to quote Hamlet, “All the rest is silence.” We always should listen to an old man who experienced the so-called “Nifty Fifty” losing 80% of their market value in 1970s and has extensively studied the Great Depression of the 1930s. He probably regrets now that his 1,100 target was too conservative.
Jeremy derived his 1,100 prediction with a P/E of 11-12 as a norm for a long-term capital market. With a more representative bear market P/E value of 6-7, the forecast comes out in the 600-700 range. At the extreme of this bear market a few years down the road, the S&P 500 might very well overshoot and drop all the way to 4-500. That was the launch pad for last leg of the bull market that followed the recession of the early 1990s. Everything could go back to square one, while 20 years of bull market returns turn out to be in vain.
How long will this bear market last? Well, the Great Depression caused a bear market lasting over two decades, from 1929 to 1952. Only in 1958 did that market come back to the old 1929 peak, nearly three decades later. The 1970s were not much better—the bear market lasted 14-16 years from 1966 or 1968 to 1982. Even though that bear market ended more quickly, it still took until 1992 — 24 years later — to return to the markets’ 1968 peak.
My most optimistic forecast is this bear market will last another 4-5 years, which is overall actually about 12 years if we count 2000 as the starting point. If we use Jim Rogers’ commodity super-cycle, which usually runs opposite to the general equity market, this will be the latest two-decade bear market for equities, he predicts, lasting until 2020. When will the S&P 500 be back to last October’s peak? No sooner than 2024.
Another reason this bear market differs from 1987 is that, in 1987, the fundamentals were strong, stocks were trending upward, and the market didn’t have its economic lifeline of credit severed. There is another fundamental factor now suggesting we face a longer-lasting bear market than the 1970s. It is demographic. Baby boomers are not comfortable with the market turmoil of the past year, and they want to lock in their nest eggs and cash out. Their withdrawals have in turn caused more baby boomers to do the same. They don't want to take the risk of sitting through this credit crisis and bear market, since no one knows how long it will last.
What happens if it lasts as long as two decades? Time is not on boomers’ side. How can we blame them? With the real estate market freefalling with no bottom in sight, it is only natural for them to protect their only remaining nest eggs. And they will likely never get back into the stock market again once they cash out, since profiles grow more risk-averse with increasing age. Their overriding concern is to protect their cash. This is why you see US Treasuries, the so-called safe haven vehicle, with infinitesimally low yields. Boomers will not be tempted by equities even if they reach “undervalued” levels of 50% of book value, 70% of intrinsic value, P/E ratios of 6, etc. Inflation will gradually eat their money away with negative real interest rates, and they will worry about that later when inflation reaches double digits.
The above discussion about baby boomers is not new. In 2001, Abel and Siegel voiced concern about the potential herd behavior of the baby boomer generation — that their cashing out simultaneously could cause a stock market meltdown around 2010.. What an accurate prediction that is. They only missed by two years! Who wants to get caught holding the bag as the last one to cash out at the lowest price in 2010?
Good for Buffett but Bad for Common Shareholders
As the market dives, Warren Buffett’s investment in both GE and Goldman Sachs deserve discussion. Perpetual preferred stocks are usually a good way to invest in good businesses, as long as the firms survive, and obviously Buffett thinks both will. I tend to agree. But even if both GE and Goldman survive, such investments come at a large cost to the existing common shareholders.
In GE’s case, GE is using Buffett’s name and investment to raise $12 billion in a separate public offering, diluting their common shares. That’s not counting on the $3 billion of GE warrants, which could potentially cause more dilution. Almost all GE industrial units are doing fine since they are usually #1 or #2 in their respective sectors and have some monopoly pricing power. The biggest risk for GE is their GE capital unit, which never reveals the illiquid assets through loan and mortgage securitization and OTC derivatives in its portfolio, as is also the case with investment banks. And, unfortunately, it accounts for half of GE’s earning power. If GE Capital is in the same trouble as Wall Street investment banks, GE will likely have to shut down this division, write down large losses for its portfolio, and they will lose half of their earning power and an important vehicle to smooth their earnings every quarter. But as a conglomerate, they will still survive. The problem is that in an economic depression, with decreasing revenue and a shrinking profit margin, GE’s earnings will be depressed substantially. But it will still have to honor its large interest payment to Buffett on the new preferreds before common shareholders see any dividends.
Goldman is a much riskier investment than GE. The largest expense for investment banks is compensation, and they always issue many new shares, on top of cash bonuses, to retain talent every year as part of their incentive program. In an economic depression, there are likely no banking deals, not much trading activity, and especially no more highly profitable structured products like before. Goldman’s net income could be running less than $1 billion in its worst years (like Morgan Stanley is today). But they have to pay Buffett $500 million —10% interest on his $5 billion investment — every year. What is left for common shareholders with Buffett’s annual payout and increasingly diluted shares? The incentive program becomes demoralizing. Both deals are really bad for common shareholders.
Bailouts and the Unraveling of Private Equity
There are many angry investors around the country, causing the House to defeat the $700 billion bail out plan initially. Without Wall St.’s innovations on structured products, the subprime crisis could have been easily contained, even in the face of widespread abusive lending practices. The problem is for every $1 of subprime mortgages, Wall St. created $10 CDO products, then the math geeks at structured product groups used those to create another $100 of OTC derivatives out of thin air (for more on this, refer to my previous article Why Wall St. Needed Credit Default Swaps?). Now, suddenly, a $700 billion default of subprime loans would cause a $7 trillion default in CDOs and $70 trillion in CDS losses, a crisis 100 times larger than it should be. Now you know why Wall St. is so profitable, because in the past 5-10 years, they have already sucked the blood and “profit” of not only this generation but the next. If Washington is serious about a bailout, its size will need to measured in tens of trillions instead of trillions.
Not long ago, with a market for CDOs virtually nonexistent, Merrill was forced to sell CDOs at 20 cents on the dollar. That alone sounds bad enough, but Merrill had to finance 15 cents out of the 20 itself, suggesting that those CDOs may really only have been worth 5 cents. In response, banks devalued CDOs in their portfolios, but the markdown was to 20 cents, not 5. The clear implication is that their portfolios are still shored up to more than they are really worth. But any asset writedown has to be matched by equity, and even with the CDOs propped up at 20 cents on the dollar, there is really no more equity to write down for many banks, and no way to raise new equity, leaving liquidation of the firm as the only option. Since debt stays the same, debt-to-equity ratios have to be reduced in the current deleveraging process. As a result, each writedown causes more writedowns, and it becomes a death spiral and a “no way out” situation.
In the summer of 2007, Jeremy Grantham predicted half of hedge funds will get wiped out, and more than half of all private equity firms will vanish. Let us just look at the private equity sector, which, in boom years, can achieve a 50% return easily.
Let us look at a hypothetical deal: PE Firm A, with a 2+20 fee structure, purchased Company B for $4 billion. It did so by borrowing $2 billion at 6% interest, netting $1 billion in 2 years by IPO — a very typical deal in the good old days. It yields a 50% return ($1 billion on a $2 billion investment) for the PE firm (partners only). But for you as a PE investor, your share of that return is: $1B profit - $0.08B fee (2%*$2B*2 yr) - $0.2B PE profit cut - $0.24B interest ($2B*6%*2 yr) = $0.48B, or 24% return ($0.48B/$2B). The same deal that seems to achieve a 50% return (for the firm partners) has a real return for its clients that is only half that.
Now let us use the same example above, but let us say the equity market enters a couple of years of bear market like we are facing now. The same deal now takes 5 years instead of 2 years to spin off in an IPO. What would the return for PE clients be?
The answer is zero. It is: $1B profit - $0.2B fee (2%*$2B*5 yr) - $0.2B PE profit cut - $0.6B interest ($2B*6%*5 yr) = zero. Five years for nothing. The extra 3 years of interest payments and the excessive 2+20 fee structure eat all of the remaining profit. For all corporate pension funds, state and local government retirement funds, endowment funds and foundations rushing to invest 10-20% of their resources in private equities: Do they realize investing in 5%-per-year US treasury bonds (27% over 5 years compounding) would actually offer better return and carry no risk at all (except the risk of holding the US dollar)?
In the above calculation, I didn’t even factor in a long recession with a decade long bear market, the reduced revenues and deteriorating profit margins that would result, or potentially large losses for businesses the PE firm may have purchased. This is why Jeremy was so confident about his prediction, even though he was still in the middle of the bull market last year — predicting only half of them dead was conservative. Now, with the clock ticking, no credit for financing, and no equity market for IPOs to cash out and dump the risk to the public, it’s likely that the whole private equity sector will get wiped out by the end of 2010, just like the investment bank sector.
Diminished Returns Across US Industries
For a decade-long recession and likely depression, the only firms that will survive are those preserving cash by cutting their workforce; stopping capital expenditures, R&D and IT investments; cutting dividends, including preferred dividends; and discontinuing stock buybacks. Things will get very nasty. Only firms that can still manage to generate net cashflow during a depression will emerge as survivors, as in 1930s and 1970s. Newer companies with experimental technologies will be vulnerable and regarded as nonessential, and undercapitalized private firms will be in trouble since the IPO window will be shut for the unforeseeable future. Venture capital firms will have to hold on to their investments forever, at least another decade, without any IPOs in sight, until all their cash is burnt out. Many firms relying on bank financing will not survive. The only businesses that will thrive will be cashflow-positive energy firms and mining producers.
Pretty soon, people will realize holding cash in US dollars is also unwise, due to its quick deterioration. The current rise in the US dollar is due to short-term disappearance of the money supply, since banks don’t want to lend money. Once the government socializes the banking industry and floods the system with worthless paper, people will downgrade US Treasuries, since the US government is buying and holding the worst quality mortgages and CDOs dumped by the banks.
In a normal bankruptcy process for investment banks, common stocks, preferreds and subordinated debts get wiped out. Bondholders act as a cushion and suffer some losses, but usually customers and trade partners are protected. The current bailout plan, the previous Bear Stearns bailout, and the AIG bailout all use taxpayer money to bail out the bondholders and the perferreds, which are held mostly by institutions. The bailouts basically wipe out individual investors, then use taxpayers’ money to protect large institutions.
The next thing that will happen is all investors, including foreign central banks, will dump US treasuries and buy the ultimate asset everyone around the world trusts — gold. People will realize this is worse than the 1930s — at least then fiat money was backed by gold. Now the US dollar is backed by the $10 trillion national debt and the larger unfunded obligations of Medicare, Medicaid, Social Security, pensions, and the GSEs. Failures in the banking, auto, and airline industries loom on the horizon. Government can’t socialize only the money losing sectors, and taxpayers and lawmakers have only so much patience. They can’t tolerate this forever. Pretty soon, the government will need to take over a profitable sector, like energy firms, to offset some of its losses. The US is moving down the slippery path of socialism quickly.
There will be a nuclear winter for many years to come. It’s no wonder that many years ago George Soros correctly predicted that there would be the end of globalization and the death of capitalism. This is the payback time for all the abuses select elites have committed against our whole society, but now that it’s here, the public is footing their bills. If the G-7 is serious about bailing out the global economy, the only way to do it is to have double-digit hyperinflation to inflate the whole world out of depression at any cost. And they have to do it now. It can’t be half-hearted either; otherwise it will end up being the worst nightmare of hyperinflation coupled with an immense depression. This means all commodities will skyrocket and currently slumping commodities would provide the best buying opportunity before oil goes to $150 and gold to $2,000. When people lose faith in fiat money, the next thing to happen is barter like in the Weimar Republic, where only commodities, especially gold, are treated as money.
This is the end of an era, one characterized by financial engineering and alchemy, capital distortion, rip-off and cover-up, the flooding of worthless fiat currencies, and the deluge of manipulated paper assets like stocks, bonds and derivatives. It is the beginning of a new, honest and real money era: the gold era.
In this difficult period, do nothing and hold nothing but gold. Only gold, the ultimate asset that has survived the longest in human history, can save us now.
In August of last year I forecast a target of 800 for the S&P, which is about to be tested. This was an easy target to establish, since it represented the low of the 2001-2003 bear market. Last week’s heroic performance – what traders call a “dead cat bounce” - was a temporary respite from the market’s downward spiral. I now doubt 800 will be the bottom for this bear market. There may be more dead cat bounces, but there is no support in sight once 800 is decisively broken. My ultimate target is 400-500 for the S&P (or 4,000-5,000 for the Dow) which will be reached by the end of 2010. The timing of the 2010 bottom is consistent with what was given by Wharton professors Andrew Abel and Jeremy Siegel in 2001 in their “baby boomer cashing out” scenario discussed below.
My pessimism is based on my belief that neither government actions nor unnatural market mechanisms, such as circuit breakers and banning short sales, are capable of arresting this bear market. Many believe this bear market will recover quickly, like it did in 1987. This will not happen. After the one-day 20% drop in the market in 1987, circuit breakers were introduced to limit daily declines. But the market has adapted and selling pressure is distributed over longer time intervals, and the net effect is the same. Regulators could install additional market holidays, like they did in the 1930s, but the market will continue to adapt.
Jeremy Grantham’s Predictions
Earlier this year, Jeremy Grantham of GMO predicted in an interview with Barron’s that the S&P 500 would drop to 1,100 by end of 2010. A lot of people just laughed at him. Was this crazy old man out of his mind? Now, to quote Hamlet, “All the rest is silence.” We always should listen to an old man who experienced the so-called “Nifty Fifty” losing 80% of their market value in 1970s and has extensively studied the Great Depression of the 1930s. He probably regrets now that his 1,100 target was too conservative.
Jeremy derived his 1,100 prediction with a P/E of 11-12 as a norm for a long-term capital market. With a more representative bear market P/E value of 6-7, the forecast comes out in the 600-700 range. At the extreme of this bear market a few years down the road, the S&P 500 might very well overshoot and drop all the way to 4-500. That was the launch pad for last leg of the bull market that followed the recession of the early 1990s. Everything could go back to square one, while 20 years of bull market returns turn out to be in vain.
How long will this bear market last? Well, the Great Depression caused a bear market lasting over two decades, from 1929 to 1952. Only in 1958 did that market come back to the old 1929 peak, nearly three decades later. The 1970s were not much better—the bear market lasted 14-16 years from 1966 or 1968 to 1982. Even though that bear market ended more quickly, it still took until 1992 — 24 years later — to return to the markets’ 1968 peak.
My most optimistic forecast is this bear market will last another 4-5 years, which is overall actually about 12 years if we count 2000 as the starting point. If we use Jim Rogers’ commodity super-cycle, which usually runs opposite to the general equity market, this will be the latest two-decade bear market for equities, he predicts, lasting until 2020. When will the S&P 500 be back to last October’s peak? No sooner than 2024.
Another reason this bear market differs from 1987 is that, in 1987, the fundamentals were strong, stocks were trending upward, and the market didn’t have its economic lifeline of credit severed. There is another fundamental factor now suggesting we face a longer-lasting bear market than the 1970s. It is demographic. Baby boomers are not comfortable with the market turmoil of the past year, and they want to lock in their nest eggs and cash out. Their withdrawals have in turn caused more baby boomers to do the same. They don't want to take the risk of sitting through this credit crisis and bear market, since no one knows how long it will last.
What happens if it lasts as long as two decades? Time is not on boomers’ side. How can we blame them? With the real estate market freefalling with no bottom in sight, it is only natural for them to protect their only remaining nest eggs. And they will likely never get back into the stock market again once they cash out, since profiles grow more risk-averse with increasing age. Their overriding concern is to protect their cash. This is why you see US Treasuries, the so-called safe haven vehicle, with infinitesimally low yields. Boomers will not be tempted by equities even if they reach “undervalued” levels of 50% of book value, 70% of intrinsic value, P/E ratios of 6, etc. Inflation will gradually eat their money away with negative real interest rates, and they will worry about that later when inflation reaches double digits.
The above discussion about baby boomers is not new. In 2001, Abel and Siegel voiced concern about the potential herd behavior of the baby boomer generation — that their cashing out simultaneously could cause a stock market meltdown around 2010.. What an accurate prediction that is. They only missed by two years! Who wants to get caught holding the bag as the last one to cash out at the lowest price in 2010?
Good for Buffett but Bad for Common Shareholders
As the market dives, Warren Buffett’s investment in both GE and Goldman Sachs deserve discussion. Perpetual preferred stocks are usually a good way to invest in good businesses, as long as the firms survive, and obviously Buffett thinks both will. I tend to agree. But even if both GE and Goldman survive, such investments come at a large cost to the existing common shareholders.
In GE’s case, GE is using Buffett’s name and investment to raise $12 billion in a separate public offering, diluting their common shares. That’s not counting on the $3 billion of GE warrants, which could potentially cause more dilution. Almost all GE industrial units are doing fine since they are usually #1 or #2 in their respective sectors and have some monopoly pricing power. The biggest risk for GE is their GE capital unit, which never reveals the illiquid assets through loan and mortgage securitization and OTC derivatives in its portfolio, as is also the case with investment banks. And, unfortunately, it accounts for half of GE’s earning power. If GE Capital is in the same trouble as Wall Street investment banks, GE will likely have to shut down this division, write down large losses for its portfolio, and they will lose half of their earning power and an important vehicle to smooth their earnings every quarter. But as a conglomerate, they will still survive. The problem is that in an economic depression, with decreasing revenue and a shrinking profit margin, GE’s earnings will be depressed substantially. But it will still have to honor its large interest payment to Buffett on the new preferreds before common shareholders see any dividends.
Goldman is a much riskier investment than GE. The largest expense for investment banks is compensation, and they always issue many new shares, on top of cash bonuses, to retain talent every year as part of their incentive program. In an economic depression, there are likely no banking deals, not much trading activity, and especially no more highly profitable structured products like before. Goldman’s net income could be running less than $1 billion in its worst years (like Morgan Stanley is today). But they have to pay Buffett $500 million —10% interest on his $5 billion investment — every year. What is left for common shareholders with Buffett’s annual payout and increasingly diluted shares? The incentive program becomes demoralizing. Both deals are really bad for common shareholders.
Bailouts and the Unraveling of Private Equity
There are many angry investors around the country, causing the House to defeat the $700 billion bail out plan initially. Without Wall St.’s innovations on structured products, the subprime crisis could have been easily contained, even in the face of widespread abusive lending practices. The problem is for every $1 of subprime mortgages, Wall St. created $10 CDO products, then the math geeks at structured product groups used those to create another $100 of OTC derivatives out of thin air (for more on this, refer to my previous article Why Wall St. Needed Credit Default Swaps?). Now, suddenly, a $700 billion default of subprime loans would cause a $7 trillion default in CDOs and $70 trillion in CDS losses, a crisis 100 times larger than it should be. Now you know why Wall St. is so profitable, because in the past 5-10 years, they have already sucked the blood and “profit” of not only this generation but the next. If Washington is serious about a bailout, its size will need to measured in tens of trillions instead of trillions.
Not long ago, with a market for CDOs virtually nonexistent, Merrill was forced to sell CDOs at 20 cents on the dollar. That alone sounds bad enough, but Merrill had to finance 15 cents out of the 20 itself, suggesting that those CDOs may really only have been worth 5 cents. In response, banks devalued CDOs in their portfolios, but the markdown was to 20 cents, not 5. The clear implication is that their portfolios are still shored up to more than they are really worth. But any asset writedown has to be matched by equity, and even with the CDOs propped up at 20 cents on the dollar, there is really no more equity to write down for many banks, and no way to raise new equity, leaving liquidation of the firm as the only option. Since debt stays the same, debt-to-equity ratios have to be reduced in the current deleveraging process. As a result, each writedown causes more writedowns, and it becomes a death spiral and a “no way out” situation.
In the summer of 2007, Jeremy Grantham predicted half of hedge funds will get wiped out, and more than half of all private equity firms will vanish. Let us just look at the private equity sector, which, in boom years, can achieve a 50% return easily.
Let us look at a hypothetical deal: PE Firm A, with a 2+20 fee structure, purchased Company B for $4 billion. It did so by borrowing $2 billion at 6% interest, netting $1 billion in 2 years by IPO — a very typical deal in the good old days. It yields a 50% return ($1 billion on a $2 billion investment) for the PE firm (partners only). But for you as a PE investor, your share of that return is: $1B profit - $0.08B fee (2%*$2B*2 yr) - $0.2B PE profit cut - $0.24B interest ($2B*6%*2 yr) = $0.48B, or 24% return ($0.48B/$2B). The same deal that seems to achieve a 50% return (for the firm partners) has a real return for its clients that is only half that.
Now let us use the same example above, but let us say the equity market enters a couple of years of bear market like we are facing now. The same deal now takes 5 years instead of 2 years to spin off in an IPO. What would the return for PE clients be?
The answer is zero. It is: $1B profit - $0.2B fee (2%*$2B*5 yr) - $0.2B PE profit cut - $0.6B interest ($2B*6%*5 yr) = zero. Five years for nothing. The extra 3 years of interest payments and the excessive 2+20 fee structure eat all of the remaining profit. For all corporate pension funds, state and local government retirement funds, endowment funds and foundations rushing to invest 10-20% of their resources in private equities: Do they realize investing in 5%-per-year US treasury bonds (27% over 5 years compounding) would actually offer better return and carry no risk at all (except the risk of holding the US dollar)?
In the above calculation, I didn’t even factor in a long recession with a decade long bear market, the reduced revenues and deteriorating profit margins that would result, or potentially large losses for businesses the PE firm may have purchased. This is why Jeremy was so confident about his prediction, even though he was still in the middle of the bull market last year — predicting only half of them dead was conservative. Now, with the clock ticking, no credit for financing, and no equity market for IPOs to cash out and dump the risk to the public, it’s likely that the whole private equity sector will get wiped out by the end of 2010, just like the investment bank sector.
Diminished Returns Across US Industries
For a decade-long recession and likely depression, the only firms that will survive are those preserving cash by cutting their workforce; stopping capital expenditures, R&D and IT investments; cutting dividends, including preferred dividends; and discontinuing stock buybacks. Things will get very nasty. Only firms that can still manage to generate net cashflow during a depression will emerge as survivors, as in 1930s and 1970s. Newer companies with experimental technologies will be vulnerable and regarded as nonessential, and undercapitalized private firms will be in trouble since the IPO window will be shut for the unforeseeable future. Venture capital firms will have to hold on to their investments forever, at least another decade, without any IPOs in sight, until all their cash is burnt out. Many firms relying on bank financing will not survive. The only businesses that will thrive will be cashflow-positive energy firms and mining producers.
Pretty soon, people will realize holding cash in US dollars is also unwise, due to its quick deterioration. The current rise in the US dollar is due to short-term disappearance of the money supply, since banks don’t want to lend money. Once the government socializes the banking industry and floods the system with worthless paper, people will downgrade US Treasuries, since the US government is buying and holding the worst quality mortgages and CDOs dumped by the banks.
In a normal bankruptcy process for investment banks, common stocks, preferreds and subordinated debts get wiped out. Bondholders act as a cushion and suffer some losses, but usually customers and trade partners are protected. The current bailout plan, the previous Bear Stearns bailout, and the AIG bailout all use taxpayer money to bail out the bondholders and the perferreds, which are held mostly by institutions. The bailouts basically wipe out individual investors, then use taxpayers’ money to protect large institutions.
The next thing that will happen is all investors, including foreign central banks, will dump US treasuries and buy the ultimate asset everyone around the world trusts — gold. People will realize this is worse than the 1930s — at least then fiat money was backed by gold. Now the US dollar is backed by the $10 trillion national debt and the larger unfunded obligations of Medicare, Medicaid, Social Security, pensions, and the GSEs. Failures in the banking, auto, and airline industries loom on the horizon. Government can’t socialize only the money losing sectors, and taxpayers and lawmakers have only so much patience. They can’t tolerate this forever. Pretty soon, the government will need to take over a profitable sector, like energy firms, to offset some of its losses. The US is moving down the slippery path of socialism quickly.
There will be a nuclear winter for many years to come. It’s no wonder that many years ago George Soros correctly predicted that there would be the end of globalization and the death of capitalism. This is the payback time for all the abuses select elites have committed against our whole society, but now that it’s here, the public is footing their bills. If the G-7 is serious about bailing out the global economy, the only way to do it is to have double-digit hyperinflation to inflate the whole world out of depression at any cost. And they have to do it now. It can’t be half-hearted either; otherwise it will end up being the worst nightmare of hyperinflation coupled with an immense depression. This means all commodities will skyrocket and currently slumping commodities would provide the best buying opportunity before oil goes to $150 and gold to $2,000. When people lose faith in fiat money, the next thing to happen is barter like in the Weimar Republic, where only commodities, especially gold, are treated as money.
This is the end of an era, one characterized by financial engineering and alchemy, capital distortion, rip-off and cover-up, the flooding of worthless fiat currencies, and the deluge of manipulated paper assets like stocks, bonds and derivatives. It is the beginning of a new, honest and real money era: the gold era.
In this difficult period, do nothing and hold nothing but gold. Only gold, the ultimate asset that has survived the longest in human history, can save us now.
Irony of Capitalism in Crisis: The rich lose more, but the poor and middle class suffer . . . and we need more government intervention, not less.
With credit tight and real estate and stocks at multi-year lows, who wins and who loses? Certainly, any trader short the market or long put options is making out like a bandit, while anyone long real estate and stocks is experiencing painful net worth erosion.
But, in the midst of the financial turmoil we're in, how's the "average American" faring? For insight, let's first have a look at household balance sheets.
Household Balance Sheets
According to the Fed's triennial Survey on Consumer Finances (using 2004 data--results of the 2007 survey come out in early 2009), assets owned and debt held by 10% or more of all American families, along with the median dollar value of holdings among the specified percentage of families holding the particular asset or debt, are:
Financial assets:
The Poor, the Middle Class and the Rich
The landscape gets more interesting when we probe one layer deeper, to see who owns what and against how much debt. Taking a look at three distinct groups classified by net worth (again in 2004 dollars), we can list assets and debt commonly held by 40% or more of the households in each group:
The Poor (below 25th percentile): $2k median net worth
Assets:
The Middle Class (50th to 75th percentile): $171k median net worth
Assets:
The Rich (above 90th percentile): $1.43 million median net worth
Assets:
On the asset side of the household balance sheet, the picture that emerges is pretty much as expected: the rich own everything that the poor and middle class do, and have more of everything, item by item. The typical middle class household owns a checking account, car, house and retirement account. By comparison, rich households own what their middle class brethren do, plus a long list of investment assets: stocks, mutual funds or hedge funds, insurance annuities, second homes or investment real estate, and private businesses. At the other extreme, the majority of poor households have only a checking account and a car.
The situation flips, however, when we look at the liability side of the balance sheet: although the rich have higher absolute dollar amounts of debt, their debt-to-assets ratio is the smallest among the three groups. Borrowing is most prevalent among the middle class, where two-thirds of the households have mortgages on their homes, half have car loans, and half carry balances on their credit cards, resulting in typical household leverage of about 0.4. Among the poor, slightly fewer than half have car loans and about four out of ten households have credit card debt. However, it is actually the poor who are most overburdened by debt, with a high debt-to-assets ratio of about 0.8. This trend of the "asset-poor" being the most "debt-rich" can easily be seen by looking at the fraction of car owners in each group who have car loans and other installment debt: the poor (48%/70% = 0.7), the middle class (49%/92% = 0.5), the rich (27%/93% = 0.3).
Weathering the Financial Storm
Who fares best: the over-leveraged poor, the debt-laden middle class, or the asset-endowed rich?
As real estate and stock prices fall, here's how each group is affected:
The recent chain of events is becoming all too familiar: real estate and stock markets fall, investor sentiment (i.e., among the rich) turns negative, headlines carry news of our ensuing financial crisis, smaller investors (i.e., the middle class) either sell out or hesitate to buy, consumers (all groups) spend less on goods and services, businesses earn less, the economy stalls, layoffs begin, sentiment worsens, and market prices fall further, bringing us full cycle--but at a lower level.
If this downward spiral continues, the over-leveraged poor lose their jobs, cars and homes (through foreclosure if they own them, or eviction if they are renters); the debt-laden middle class exhaust their savings and deplete their dwindling retirement accounts trying to stave off foreclosure of their homes (but many lose their homes anyway); and the asset-endowed rich watch their asset values plunge but keep their homes and still own America. While an extended economic recession is definitely not desirable for any group, note that:
Economic pain and suffering is inversely proportional to wealth: the poor suffer the most, the middle class are next, and the rich, well, they become a little less rich.
The public policy implication should be clear: at this point, whatever can be done to stabilize the markets should be done. President Bush distributed cash to families last year through his fiscal stimulus package, which helped the consumer and temporarily kept the economy afloat. The recent moves of the Fed, FDIC and government--in rescuing Bear Stearns and AIG, saving Fannie Mae and Freddie Mac, coordinating orderly takeovers of WaMu and Wachovia, increasing deposit insurance levels from $100k to $250k, preparing to buy $700 billion of "toxic" mortgage-related assets from the banks, and buying commercial paper in the markets today--have all helped.
But, one problem remains: we're not yet on solid ground.
Australia cut rates this morning by 100 b.p., twice as much as anticipated. Pimco's Bill Gross is right to push the Fed for a similar massive rate cut later this month. A coordinated global rate cut is also in order.
For any advocates of laissez faire capitalism, this "visible hand" of persistent government intervention in the markets must be appalling, particularly following the apparent successes of American-style capitalism over Cold War communism during the past few decades. However, we are now in a "leveraged asset" crisis and the only way to stop the bleeding is do what it takes to stabilize asset prices, and the only entity capable of acting on a large enough scale to make a difference is the government.
From Economics 101, we know that the four factors of production are innovation, labor, physical resources and money. Despite this financial crisis we're in, America and the world still have plenty of entrepreneurial ideas, people willing and able to work, and all the (arguably diminishing) natural resources we always have had. What is lacking is capital, and at this point only the government has deep enough pockets to keep the money flowing.
With the U.S. government stepping in so often in recent months and taking ownership (or warrants) in our prime financial institutions, it may be surprising to many that America is involuntarily slipping through some convoluted "looking glass" into a society with increasing government ownership of businesses, where the state, by default, has become the largest market participant.
Such is the irony of modern capitalism, with more government intervention, not less, being needed to keep the ship above water as the economic tide sloshes all around us--poor, middle class and rich alike.
But, in the midst of the financial turmoil we're in, how's the "average American" faring? For insight, let's first have a look at household balance sheets.
Household Balance Sheets
According to the Fed's triennial Survey on Consumer Finances (using 2004 data--results of the 2007 survey come out in early 2009), assets owned and debt held by 10% or more of all American families, along with the median dollar value of holdings among the specified percentage of families holding the particular asset or debt, are:
Financial assets:
- Checking or other transactional account: 91% of families, $4k
- CDs: 13% of families, $15k
- Savings bonds: 18% of families, $1k
- Stocks: 21% of families, $15k
- Mutual funds and other pooled assets: 15% of families, $40k
- Retirement accounts: 50% of families, $35k
- Life insurance products with cash value: 24% of families, $6k
- Car or other vehicle: 86% of families, $14k
- Primary residence: 69% of families, $160k
- Other residential property: 13% of families, $100k
- Business equity: 12% of families, $100k
- Mortgage on primary residence: 48% of families, $95k
- Car loan or other installment loan: 46% of families, $12k
- Credit card balance: 46% of families, $2k
The Poor, the Middle Class and the Rich
The landscape gets more interesting when we probe one layer deeper, to see who owns what and against how much debt. Taking a look at three distinct groups classified by net worth (again in 2004 dollars), we can list assets and debt commonly held by 40% or more of the households in each group:
The Poor (below 25th percentile): $2k median net worth
Assets:
- 75% have checking accounts with median value $1k
- 70% own car(s) with median value $6k
- 48% have car loans or other installment loans with median value $11k
- 40% carry credit card balances with median value $2k
The Middle Class (50th to 75th percentile): $171k median net worth
Assets:
- 98% have checking accounts with median value $6k
- 62% have retirement accounts with median value $34k
- 92% own car(s) with median value $17k
- 93% own their primary residence having median value $159k
- 66% carry a mortgage on their home with median value $97k (60% implied loan-to-value)
- 49% have car loans or other installment loans with median value $13k
- 53% carry credit card balances with median value $3k
The Rich (above 90th percentile): $1.43 million median net worth
Assets:
- 100% have checking accounts with median value $43k
- 63% own stocks with median value $110k
- 47% own mutual funds with median value $160k
- 83% have retirement accounts with median value $264k
- 44% own cash value life insurance products with median value $20k
- 93% own car(s) with median value $31k
- 97% own their primary residence having median value $450k
- 46% own other residential property with median value $325k
- 41% own business equity with median value $527k
- 58% carry a mortgage on their home with median value $186k (40% implied loan-to-value)
On the asset side of the household balance sheet, the picture that emerges is pretty much as expected: the rich own everything that the poor and middle class do, and have more of everything, item by item. The typical middle class household owns a checking account, car, house and retirement account. By comparison, rich households own what their middle class brethren do, plus a long list of investment assets: stocks, mutual funds or hedge funds, insurance annuities, second homes or investment real estate, and private businesses. At the other extreme, the majority of poor households have only a checking account and a car.
The situation flips, however, when we look at the liability side of the balance sheet: although the rich have higher absolute dollar amounts of debt, their debt-to-assets ratio is the smallest among the three groups. Borrowing is most prevalent among the middle class, where two-thirds of the households have mortgages on their homes, half have car loans, and half carry balances on their credit cards, resulting in typical household leverage of about 0.4. Among the poor, slightly fewer than half have car loans and about four out of ten households have credit card debt. However, it is actually the poor who are most overburdened by debt, with a high debt-to-assets ratio of about 0.8. This trend of the "asset-poor" being the most "debt-rich" can easily be seen by looking at the fraction of car owners in each group who have car loans and other installment debt: the poor (48%/70% = 0.7), the middle class (49%/92% = 0.5), the rich (27%/93% = 0.3).
Weathering the Financial Storm
Who fares best: the over-leveraged poor, the debt-laden middle class, or the asset-endowed rich?
As real estate and stock prices fall, here's how each group is affected:
- The poor, who do not typically own real estate, stock or mutual funds, are not immediately affected by falling markets. However, a small yet significant subset (12% in 2004, presumably higher today) of these households in the lowest quartile of net worth are homeowners carrying mortgages and, being the most highly leveraged group, are undoubtedly the most adversely impacted by depressed home prices. Further, having little to no savings, this group is the first to fall behind in loan and credit card payments when job losses escalate as the economic downturn runs its course.
- The middle class comprises the bulk of homeowners with substantial mortgages who are feeling the brunt of the fall of the housing market. These households also have retirement accounts with stock and mutual fund positions that shrink as stock prices slide. In the event of a job loss, most of these families can cover their bills for at least a few months by relying on their savings and, if needed, early withdrawals from their IRAs and 401ks. But, if the downturn lengthens and unemployment rises further, many of these households will unfortunately suffer through home foreclosures and the like.
- The rich experience the fewest financial dislocations, despite the fact that their vast holdings of stocks and real estate are immediately impacted when prices fall, putting downward pressure on the equity in their private businesses as well. Although rich households lose the most money in absolute terms when prices fall, their minimal household leverage (debt-to-assets ratio of just 0.1) makes true financial hardship a foreign concept to most in this group. Because very few of the rich have large mortgages on their homes (and even if they do, they usually have liquid assets they can sell off to reduce leverage), foreclosures among this group will be almost unheard of, however severe the economic downturn becomes.
The recent chain of events is becoming all too familiar: real estate and stock markets fall, investor sentiment (i.e., among the rich) turns negative, headlines carry news of our ensuing financial crisis, smaller investors (i.e., the middle class) either sell out or hesitate to buy, consumers (all groups) spend less on goods and services, businesses earn less, the economy stalls, layoffs begin, sentiment worsens, and market prices fall further, bringing us full cycle--but at a lower level.
If this downward spiral continues, the over-leveraged poor lose their jobs, cars and homes (through foreclosure if they own them, or eviction if they are renters); the debt-laden middle class exhaust their savings and deplete their dwindling retirement accounts trying to stave off foreclosure of their homes (but many lose their homes anyway); and the asset-endowed rich watch their asset values plunge but keep their homes and still own America. While an extended economic recession is definitely not desirable for any group, note that:
Economic pain and suffering is inversely proportional to wealth: the poor suffer the most, the middle class are next, and the rich, well, they become a little less rich.
The public policy implication should be clear: at this point, whatever can be done to stabilize the markets should be done. President Bush distributed cash to families last year through his fiscal stimulus package, which helped the consumer and temporarily kept the economy afloat. The recent moves of the Fed, FDIC and government--in rescuing Bear Stearns and AIG, saving Fannie Mae and Freddie Mac, coordinating orderly takeovers of WaMu and Wachovia, increasing deposit insurance levels from $100k to $250k, preparing to buy $700 billion of "toxic" mortgage-related assets from the banks, and buying commercial paper in the markets today--have all helped.
But, one problem remains: we're not yet on solid ground.
Australia cut rates this morning by 100 b.p., twice as much as anticipated. Pimco's Bill Gross is right to push the Fed for a similar massive rate cut later this month. A coordinated global rate cut is also in order.
For any advocates of laissez faire capitalism, this "visible hand" of persistent government intervention in the markets must be appalling, particularly following the apparent successes of American-style capitalism over Cold War communism during the past few decades. However, we are now in a "leveraged asset" crisis and the only way to stop the bleeding is do what it takes to stabilize asset prices, and the only entity capable of acting on a large enough scale to make a difference is the government.
From Economics 101, we know that the four factors of production are innovation, labor, physical resources and money. Despite this financial crisis we're in, America and the world still have plenty of entrepreneurial ideas, people willing and able to work, and all the (arguably diminishing) natural resources we always have had. What is lacking is capital, and at this point only the government has deep enough pockets to keep the money flowing.
With the U.S. government stepping in so often in recent months and taking ownership (or warrants) in our prime financial institutions, it may be surprising to many that America is involuntarily slipping through some convoluted "looking glass" into a society with increasing government ownership of businesses, where the state, by default, has become the largest market participant.
Such is the irony of modern capitalism, with more government intervention, not less, being needed to keep the ship above water as the economic tide sloshes all around us--poor, middle class and rich alike.
Irony of Capitalism in Crisis: The rich lose more, but the poor and middle class suffer . . . and we need more government intervention, not less.
With credit tight and real estate and stocks at multi-year lows, who wins and who loses? Certainly, any trader short the market or long put options is making out like a bandit, while anyone long real estate and stocks is experiencing painful net worth erosion.
But, in the midst of the financial turmoil we're in, how's the "average American" faring? For insight, let's first have a look at household balance sheets.
Household Balance Sheets
According to the Fed's triennial Survey on Consumer Finances (using 2004 data--results of the 2007 survey come out in early 2009), assets owned and debt held by 10% or more of all American families, along with the median dollar value of holdings among the specified percentage of families holding the particular asset or debt, are:
Financial assets:
The Poor, the Middle Class and the Rich
The landscape gets more interesting when we probe one layer deeper, to see who owns what and against how much debt. Taking a look at three distinct groups classified by net worth (again in 2004 dollars), we can list assets and debt commonly held by 40% or more of the households in each group:
The Poor (below 25th percentile): $2k median net worth
Assets:
The Middle Class (50th to 75th percentile): $171k median net worth
Assets:
The Rich (above 90th percentile): $1.43 million median net worth
Assets:
On the asset side of the household balance sheet, the picture that emerges is pretty much as expected: the rich own everything that the poor and middle class do, and have more of everything, item by item. The typical middle class household owns a checking account, car, house and retirement account. By comparison, rich households own what their middle class brethren do, plus a long list of investment assets: stocks, mutual funds or hedge funds, insurance annuities, second homes or investment real estate, and private businesses. At the other extreme, the majority of poor households have only a checking account and a car.
The situation flips, however, when we look at the liability side of the balance sheet: although the rich have higher absolute dollar amounts of debt, their debt-to-assets ratio is the smallest among the three groups. Borrowing is most prevalent among the middle class, where two-thirds of the households have mortgages on their homes, half have car loans, and half carry balances on their credit cards, resulting in typical household leverage of about 0.4. Among the poor, slightly fewer than half have car loans and about four out of ten households have credit card debt. However, it is actually the poor who are most overburdened by debt, with a high debt-to-assets ratio of about 0.8. This trend of the "asset-poor" being the most "debt-rich" can easily be seen by looking at the fraction of car owners in each group who have car loans and other installment debt: the poor (48%/70% = 0.7), the middle class (49%/92% = 0.5), the rich (27%/93% = 0.3).
Weathering the Financial Storm
Who fares best: the over-leveraged poor, the debt-laden middle class, or the asset-endowed rich?
As real estate and stock prices fall, here's how each group is affected:
The recent chain of events is becoming all too familiar: real estate and stock markets fall, investor sentiment (i.e., among the rich) turns negative, headlines carry news of our ensuing financial crisis, smaller investors (i.e., the middle class) either sell out or hesitate to buy, consumers (all groups) spend less on goods and services, businesses earn less, the economy stalls, layoffs begin, sentiment worsens, and market prices fall further, bringing us full cycle--but at a lower level.
If this downward spiral continues, the over-leveraged poor lose their jobs, cars and homes (through foreclosure if they own them, or eviction if they are renters); the debt-laden middle class exhaust their savings and deplete their dwindling retirement accounts trying to stave off foreclosure of their homes (but many lose their homes anyway); and the asset-endowed rich watch their asset values plunge but keep their homes and still own America. While an extended economic recession is definitely not desirable for any group, note that:
Economic pain and suffering is inversely proportional to wealth: the poor suffer the most, the middle class are next, and the rich, well, they become a little less rich.
The public policy implication should be clear: at this point, whatever can be done to stabilize the markets should be done. President Bush distributed cash to families last year through his fiscal stimulus package, which helped the consumer and temporarily kept the economy afloat. The recent moves of the Fed, FDIC and government--in rescuing Bear Stearns and AIG, saving Fannie Mae and Freddie Mac, coordinating orderly takeovers of WaMu and Wachovia, increasing deposit insurance levels from $100k to $250k, preparing to buy $700 billion of "toxic" mortgage-related assets from the banks, and buying commercial paper in the markets today--have all helped.
But, one problem remains: we're not yet on solid ground.
Australia cut rates this morning by 100 b.p., twice as much as anticipated. Pimco's Bill Gross is right to push the Fed for a similar massive rate cut later this month. A coordinated global rate cut is also in order.
For any advocates of laissez faire capitalism, this "visible hand" of persistent government intervention in the markets must be appalling, particularly following the apparent successes of American-style capitalism over Cold War communism during the past few decades. However, we are now in a "leveraged asset" crisis and the only way to stop the bleeding is do what it takes to stabilize asset prices, and the only entity capable of acting on a large enough scale to make a difference is the government.
From Economics 101, we know that the four factors of production are innovation, labor, physical resources and money. Despite this financial crisis we're in, America and the world still have plenty of entrepreneurial ideas, people willing and able to work, and all the (arguably diminishing) natural resources we always have had. What is lacking is capital, and at this point only the government has deep enough pockets to keep the money flowing.
With the U.S. government stepping in so often in recent months and taking ownership (or warrants) in our prime financial institutions, it may be surprising to many that America is involuntarily slipping through some convoluted "looking glass" into a society with increasing government ownership of businesses, where the state, by default, has become the largest market participant.
Such is the irony of modern capitalism, with more government intervention, not less, being needed to keep the ship above water as the economic tide sloshes all around us--poor, middle class and rich alike.
But, in the midst of the financial turmoil we're in, how's the "average American" faring? For insight, let's first have a look at household balance sheets.
Household Balance Sheets
According to the Fed's triennial Survey on Consumer Finances (using 2004 data--results of the 2007 survey come out in early 2009), assets owned and debt held by 10% or more of all American families, along with the median dollar value of holdings among the specified percentage of families holding the particular asset or debt, are:
Financial assets:
- Checking or other transactional account: 91% of families, $4k
- CDs: 13% of families, $15k
- Savings bonds: 18% of families, $1k
- Stocks: 21% of families, $15k
- Mutual funds and other pooled assets: 15% of families, $40k
- Retirement accounts: 50% of families, $35k
- Life insurance products with cash value: 24% of families, $6k
- Car or other vehicle: 86% of families, $14k
- Primary residence: 69% of families, $160k
- Other residential property: 13% of families, $100k
- Business equity: 12% of families, $100k
- Mortgage on primary residence: 48% of families, $95k
- Car loan or other installment loan: 46% of families, $12k
- Credit card balance: 46% of families, $2k
The Poor, the Middle Class and the Rich
The landscape gets more interesting when we probe one layer deeper, to see who owns what and against how much debt. Taking a look at three distinct groups classified by net worth (again in 2004 dollars), we can list assets and debt commonly held by 40% or more of the households in each group:
The Poor (below 25th percentile): $2k median net worth
Assets:
- 75% have checking accounts with median value $1k
- 70% own car(s) with median value $6k
- 48% have car loans or other installment loans with median value $11k
- 40% carry credit card balances with median value $2k
The Middle Class (50th to 75th percentile): $171k median net worth
Assets:
- 98% have checking accounts with median value $6k
- 62% have retirement accounts with median value $34k
- 92% own car(s) with median value $17k
- 93% own their primary residence having median value $159k
- 66% carry a mortgage on their home with median value $97k (60% implied loan-to-value)
- 49% have car loans or other installment loans with median value $13k
- 53% carry credit card balances with median value $3k
The Rich (above 90th percentile): $1.43 million median net worth
Assets:
- 100% have checking accounts with median value $43k
- 63% own stocks with median value $110k
- 47% own mutual funds with median value $160k
- 83% have retirement accounts with median value $264k
- 44% own cash value life insurance products with median value $20k
- 93% own car(s) with median value $31k
- 97% own their primary residence having median value $450k
- 46% own other residential property with median value $325k
- 41% own business equity with median value $527k
- 58% carry a mortgage on their home with median value $186k (40% implied loan-to-value)
On the asset side of the household balance sheet, the picture that emerges is pretty much as expected: the rich own everything that the poor and middle class do, and have more of everything, item by item. The typical middle class household owns a checking account, car, house and retirement account. By comparison, rich households own what their middle class brethren do, plus a long list of investment assets: stocks, mutual funds or hedge funds, insurance annuities, second homes or investment real estate, and private businesses. At the other extreme, the majority of poor households have only a checking account and a car.
The situation flips, however, when we look at the liability side of the balance sheet: although the rich have higher absolute dollar amounts of debt, their debt-to-assets ratio is the smallest among the three groups. Borrowing is most prevalent among the middle class, where two-thirds of the households have mortgages on their homes, half have car loans, and half carry balances on their credit cards, resulting in typical household leverage of about 0.4. Among the poor, slightly fewer than half have car loans and about four out of ten households have credit card debt. However, it is actually the poor who are most overburdened by debt, with a high debt-to-assets ratio of about 0.8. This trend of the "asset-poor" being the most "debt-rich" can easily be seen by looking at the fraction of car owners in each group who have car loans and other installment debt: the poor (48%/70% = 0.7), the middle class (49%/92% = 0.5), the rich (27%/93% = 0.3).
Weathering the Financial Storm
Who fares best: the over-leveraged poor, the debt-laden middle class, or the asset-endowed rich?
As real estate and stock prices fall, here's how each group is affected:
- The poor, who do not typically own real estate, stock or mutual funds, are not immediately affected by falling markets. However, a small yet significant subset (12% in 2004, presumably higher today) of these households in the lowest quartile of net worth are homeowners carrying mortgages and, being the most highly leveraged group, are undoubtedly the most adversely impacted by depressed home prices. Further, having little to no savings, this group is the first to fall behind in loan and credit card payments when job losses escalate as the economic downturn runs its course.
- The middle class comprises the bulk of homeowners with substantial mortgages who are feeling the brunt of the fall of the housing market. These households also have retirement accounts with stock and mutual fund positions that shrink as stock prices slide. In the event of a job loss, most of these families can cover their bills for at least a few months by relying on their savings and, if needed, early withdrawals from their IRAs and 401ks. But, if the downturn lengthens and unemployment rises further, many of these households will unfortunately suffer through home foreclosures and the like.
- The rich experience the fewest financial dislocations, despite the fact that their vast holdings of stocks and real estate are immediately impacted when prices fall, putting downward pressure on the equity in their private businesses as well. Although rich households lose the most money in absolute terms when prices fall, their minimal household leverage (debt-to-assets ratio of just 0.1) makes true financial hardship a foreign concept to most in this group. Because very few of the rich have large mortgages on their homes (and even if they do, they usually have liquid assets they can sell off to reduce leverage), foreclosures among this group will be almost unheard of, however severe the economic downturn becomes.
The recent chain of events is becoming all too familiar: real estate and stock markets fall, investor sentiment (i.e., among the rich) turns negative, headlines carry news of our ensuing financial crisis, smaller investors (i.e., the middle class) either sell out or hesitate to buy, consumers (all groups) spend less on goods and services, businesses earn less, the economy stalls, layoffs begin, sentiment worsens, and market prices fall further, bringing us full cycle--but at a lower level.
If this downward spiral continues, the over-leveraged poor lose their jobs, cars and homes (through foreclosure if they own them, or eviction if they are renters); the debt-laden middle class exhaust their savings and deplete their dwindling retirement accounts trying to stave off foreclosure of their homes (but many lose their homes anyway); and the asset-endowed rich watch their asset values plunge but keep their homes and still own America. While an extended economic recession is definitely not desirable for any group, note that:
Economic pain and suffering is inversely proportional to wealth: the poor suffer the most, the middle class are next, and the rich, well, they become a little less rich.
The public policy implication should be clear: at this point, whatever can be done to stabilize the markets should be done. President Bush distributed cash to families last year through his fiscal stimulus package, which helped the consumer and temporarily kept the economy afloat. The recent moves of the Fed, FDIC and government--in rescuing Bear Stearns and AIG, saving Fannie Mae and Freddie Mac, coordinating orderly takeovers of WaMu and Wachovia, increasing deposit insurance levels from $100k to $250k, preparing to buy $700 billion of "toxic" mortgage-related assets from the banks, and buying commercial paper in the markets today--have all helped.
But, one problem remains: we're not yet on solid ground.
Australia cut rates this morning by 100 b.p., twice as much as anticipated. Pimco's Bill Gross is right to push the Fed for a similar massive rate cut later this month. A coordinated global rate cut is also in order.
For any advocates of laissez faire capitalism, this "visible hand" of persistent government intervention in the markets must be appalling, particularly following the apparent successes of American-style capitalism over Cold War communism during the past few decades. However, we are now in a "leveraged asset" crisis and the only way to stop the bleeding is do what it takes to stabilize asset prices, and the only entity capable of acting on a large enough scale to make a difference is the government.
From Economics 101, we know that the four factors of production are innovation, labor, physical resources and money. Despite this financial crisis we're in, America and the world still have plenty of entrepreneurial ideas, people willing and able to work, and all the (arguably diminishing) natural resources we always have had. What is lacking is capital, and at this point only the government has deep enough pockets to keep the money flowing.
With the U.S. government stepping in so often in recent months and taking ownership (or warrants) in our prime financial institutions, it may be surprising to many that America is involuntarily slipping through some convoluted "looking glass" into a society with increasing government ownership of businesses, where the state, by default, has become the largest market participant.
Such is the irony of modern capitalism, with more government intervention, not less, being needed to keep the ship above water as the economic tide sloshes all around us--poor, middle class and rich alike.
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