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Past Commentaries

Current Commentary: The Prices We Pay
August 19, 2011

To my Clients, Friends & Observers:

The WSJ headline on June 29, 2011 was “BofA Nears Huge Settlement” referring to a payment of $8.5 billion to “a group of high-profile investors who lost money on mortgage-backed securities purchased before the U.S. housing collapse.” The deal would settle claims against Bank of America for mortgage-backed securities (MBS) originally valued at $105 billion. Prominent among the investors was the Federal Reserve Bank of New York. Intrigued, I went to the Federal Reserve Statistical Releases H.4.1.

On the September 24, 2008 statement the total assets of the Federal Reserve Banks were $1.2 trillion and there was no line item for MBS owned by the FRB. (Treasury Secretary Timothy Geithner was then president of the FRB of New York.) On the July 6, 2011 statement the total assets of the FRB were $2.9 trillion, of which $908 billion were line-item MBS. Of those, $423 billion were held at the New York Fed. Those MBS are footnoted as follows: “Guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. Current face value of the securities, which is the remaining principal balance of the underlying mortgages.” (sic)

On August 10, 2011 the WSJ headline read “BofA Sells Part of Mortgage Portfolio to Fannie Mae.” In the story it is revealed that the purchase price is “more than $500 million” and it gives Fannie the rights to process and collect payments on a pool of 400,000 loans with unpaid principal balance of $73 billion.

Further, “the bank decided to sell the portfolio at a loss because its value is expected to deteriorate further. The loans have a 13% delinquency rate” ($9.5 billion - so far) “and more than half of the loans are in troubled U.S. real-estate markets” where, I will add, 60% of home values are below the mortgage balances owed and the delinquency rate will be far more than 13%.

I have yet to see any objection to this, and I read a lotta lot. Is anyone paying attention? Does anybody care? Lousy mortgages, worth maybe 40 cents on the dollar, written by Bank of America (Countrywide/Merrill Lynch) have been and continue to be securitized and sold to the Federal Reserve and Fannie Mae, paid with currency printed by the Treasury, which devalues the dollars everybody else uses to pay their mortgages. The mortgages are guaranteed by Fannie Mae/Freddie Mac, which are themselves implicitly guaranteed as federal government sponsored entities. You and I and our progeny are being yoked to a debt created by a cast of characters who may or may not be greedy, predominantly wealthy, incompetents, and/or miscreants who might or might not have gamed the system, either deliberately, unintentionally or maliciously.

Imagine for a moment that, in good if misplaced faith, you have given check-writing authority to a spendthrift lunatic who is writing bad checks on your three accounts and kiting deposits from one to the other to try and cover up. Eventually, YOU will have to cover the bad debts. Clear?

There is no benefit to the commonwealth for bailing out the Bank of America. There is nothing that BofA does at a retail level that cannot be performed more effectively and efficiently by any one of the legions of smaller, local, profitable community banks all over the country. The U.S. is the most over-banked nation in the world. And the investment banking and trust company functions of BofA are utterly disposable or replaceable.

The price of real estate

I’ve received many queries about my negative outlook for real-estate, which is that a recovery may not occur for a generation and that prices have a lot further to fall. And they really must if our own children are ever going to be able to afford a first home. Talk of discontinuing the mortgage interest deduction is disconcerting. That is what really allows young people to get started accumulating some equity in life. Here is why the housing market will stay depressed.

In 1998 the economist Ed Yardeni published a superb white paper titled “The Baby Boom Chartbook.” I still refer to it occasionally. It is a fine analysis of the baby boom demographic that is moving like a pig through a python. There are not enough of the baby busters, the baby boomlet, or the genexers to pick up the slack in demand that follows.

The baby boomers are defined as being ages 45 to 64 in 2010. According to the 2010 U.S. Census that group was 81.5 million. The population of those over 65 was 40.3 million. Total 45 and up was 121.8 million, representing 39.4% of the total U.S. population. Those ages 25 to 44 years totaled 82.1 million, or 26.6% of the population. The baby boomers and their elders are, by either downsizing or dying, adding 39.7 million to the supply of living accommodations above and beyond the needs of the generations that succeed them.

Measured by other Census Bureau data, in 2009 the number of “heads of households” ages 45 and up was 69.3 million; the number 44 and under was 47.9 million, excess supply of 21.4 million. Wherever, however and in whatever accommodations these people are living, there is far more supply than demand and there is no place for real estate prices to go but down. It is a market in a perfect storm: a bubble of speculation, fed by abuses in mortgage underwriting and securitization, resulting in overbuilding and bad financing, and finally doomed by its demographics. Prices are inevitably just, whether we like them or not.

The Price of China, Oil, and War

A body in motion tends to stay in motion; a body at rest tends to stay at rest. Nothing changes until a force is applied to make a change. I submitted the following to my elected federal representatives and I hope others share these opinions.

  1. Trade with China is not “fair trade.” Manufacturing Chinese goods requires millions of Chinese employees. Printing treasury bonds requires none. China does not “buy” anything when it “buys” treasury bonds; in so doing, China simply lends the U.S. money to buy more Chinese goods. China has accumulated a trade surplus with the U.S. of $3 trillion. The Chinese yuan is 40% undervalued against the dollar. The price paid for this undervaluation is American jobs exported to China. There are not enough goods and services available in the U.S. to correct this imbalance. If the U.S. were to manage a $30 billion annual trade surplus with China, it would still take 100 years to reach equilibrium. A trade war would be of far greater consequence to China than America because China is the greater exporter by far. The longer the balance of trade issue with China remains unaddressed, the more serious it becomes – to all parties. Any additional domestic economic stimulus only allows America to consume more Chinese manufactured goods.

  1. OPEC is a too-obvious affront to fair trade. It is an oligopoly of mostly undemocratic nations whose interests are generally antithetical to the United States. This price-fixing cartel should be broken and condemned, diplomatically at the U.N., and with real, unilateral, trade sanctions. There are eight OPEC members which are also members in good standing of the World Trade Organization. They are Angola, Ecuador, Kuwait, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela. If the WTO means anything, and to the extent of the United States’ influence at the WTO, these OPEC nations should be expelled – a suggestion offered by Mrs. Clinton during her nomination run. America has the cleanest environment of any developed nation in the world and it continues to progress in this regard, but significantly lower oil prices would create immediate and substantial economic relief more effectively than any other action could.

  1. There is no issue about which “we the people” should be more directly engaged than war: it carries the highest, and the ultimate, price. In consideration of that price may I suggest a special war tax, imposed at any time U.S. military forces are engaged anywhere. The tax ought to be universal and highly progressive. If such a tax were in place in 2000, the vote to permit the Iraq invasion might not have passed, and in any case, the $3 trillion cost of the Afghanistan, Iraq and Libya pursuits would have been funded. Presidents must be restrained from their free discretionary exercise of the military. It is debilitating.

The Price of Government

A client (a PhD scientist) sent me this illustration recently.

The U.S. Congress sets a federal budget every year in the trillions of dollars. Few people know how much money that is so we created a breakdown of federal spending in simple terms. Let's put the 2011 federal budget into perspective:

U.S. income:  $2,170,000,000,000

 *   Federal budget: $3,820,000,000,000
 *   New debt: $ 1,650,000,000,000
 *   National debt: $14,271,000,000,000
 *   Recent budget cut: $ 38,500,000,000 (about 1 percent of the budget)

It helps to think about these numbers in terms that we can relate to.   Therefore, let's remove eight zeros from these numbers and pretend this is the household budget for the fictitious Smith family:

 *   Total annual income for the Smith family: $21,700
 *   Amount of money the Smith family spent: $38,200
 *   Amount of new debt added to the credit card: $16,500
 *   Outstanding balance on the credit card: $142,710
 *   Amount cut from the budget: $385

Pricing Indexes and Averages

In May we raised significant cash in most portfolios in anticipation of a sell-off. The market is clearly discounting a recession. As the Euro tenaciously has held its value against the dollar despite the PIIGS, I would rationalize that the E.U. has Germany. The U.S. does not have a Germany. But German GDP slowed to .1% for the last quarter, so a recession may be indicated on both sides of the pond. Here in the states, the administration’s economic management has been ineffectual and in many cases (as above) appears nonsensical. The nation has no trade policy, no industrial policy, no fiscal policy and an incomprehensible monetary policy.

Economist David Malpass, writing of the “Weak Dollar, Weak Economy” in the WSJ 8/5/11:

“By choosing to pay savers nearly nothing, the Fed discourages thrift and limits income growth…Much of the private sector feels stuck in the mud, yet Wall Street and Washington are booming. They are the middle-men in the wealth transfer from savers to debtors and foreigners, creating thousands of millionaires each year trading currency volatility and inflation hedges. The profits are immense, but it’s a zero-sum game in which the losers are the millions of Americans who work and save in dollars.”

In June we reviewed the systematic risk of every client portfolio and adjusted to reflect a 20% decline in the S&P 500 Index. While raising cash, which yields nothing, I don’t want to sacrifice good and growing dividends. We can tolerate periods of share price declines so long as dividends are consistent and increasing. Over the last 28 years the market has dropped approximately 15% of the time. We make our best returns by allocating out of declining assets and re-positioning on the way back up. The best currency available, I continue to say, is multinational corporate stock. Perhaps I don’t trust Greece, Italy or the U.S.; I do trust Chevron, Caterpillar, Eaton and IBM.

The former President of the Federal Home Loan Bank of Chicago, Alex J. Pollack, puts it this way: “From an overall financial perspective, it is perfectly logical to think that internationally diversified, cash-generating, well-managed companies with low leverage are better credit risks than nationally concentrated, negative cash flow, poorly managed, highly leveraged governments.”

Kind regards
Dennis M. O’Connor