Thursday, October 9, 2008

...And the Kitchen Sink. Part II

Why am I reminded of the movie "The Money Pit" as I watch our economy fall apart piece by piece? Probably because what looked good from the outside was really rotten to the core. It's clear now that what is moving the market is sheer contagion. The DOW is down around 20+% over the last month, with no signs of slowing down. The other day I was speaking with an older economist who felt the need to help me understand that I will never see this type of environment again in my lifetime. I wasn't sure what to make of that.

So I have just a few random thoughts to share, nothing too heavy.

1. I expect to turn out like my Grandpa. Those of us who had Grandparents that grew up in the depression are very familiar with the tireless rantings where our Grandpa/Grandma would espouse the virtues of savings accounts, CD's, no debt, and hiding money under the mattress. Now, I don't think that's such a bad way to go. Although, some savings accounts aren't even THAT safe these days. I truly believe this crisis will have a profound effect on the younger generation in respect to how they view long-term savings and their appetite for risk.

2. The most troubling statistic of the week. Earlier this week MSN reported that 1 in 6 Homeowners owe more than their house is worth. That's almost 20 million homes. If 25% walk away (likely to be much higher) then that means banks will own 5 million homes. That means more fire sales which will decrease the value of existing homes even further. And don't forget about the already existing inventory sitting on the market. Indeed, it is difficult to believe housing will recover anytime soon. Think at least five years out. My solution? Burn the home. This accomplishes two things. First, it decreases the supply of homes for sale, thus bringing the demand/supply curve into closer equilibrium. Second, it prevents a fire (no pun intended) sale from bringing down housing prices even further, preserving the current value for existing homeowners. Or you could donate it to Habitat for Humanity (I think they could use a solid pre-built home).

3. Regarding the recent rate cut by the Fed and European Central Banks. This was a fascinating development. On Monday the Fed decreased the federal funds rate another half-a-percent. At the same time, Central Banks in Europe also decreased their interbank lending rates. Why did they do it together? I think there are two reasons. First, I believe they want to demonstrate a very united front. European Banks started to slide and at least a dozen had to be bailed out. The message is SUPPOSED to be "Hey, we are serious about taking action and will do so on a global scale." However, I think it had the opposite effect. Most Americans, and, from the reaction of the market, most people worldwide, took the Central Bank's action as meaning "Yep, it's much worse than we thought and we don't know what else to do," which in turn served to confirm everyone's fears. Perhaps in this case, inaction is the best solution. But there is a more technical reason why the Central Banks cut rates in concert. They are worried about capital flight out of their countries. If interest rates in the U.S. drop, then, if I'm China, I pull my money out of the U.S. and invest it in another country that is paying higher interest. But if all major central banks cut rates together, and maintain the same relative relationship, then the economic incentive to pull your money is severely diminished.

4. The importance of Commercial Paper. The Fed also announced this week that they would begin to buy Commercial paper. Why is that significant? Commercial paper is short-term debt (usually with a maturity anywhere from 1 to 270 days) that a corporation will issue to fund operating cash flow. Think of it as a very short term loan. For example, if I'm Microsoft I issue commercial paper for $1 million dollars at 4% interest with a 30 day maturity. A money market fund will buy it from Microsoft because, after all, Microsoft is highly rated and the Money Market Fund can earn 4% interest over 30 days rather than 3% in the bank. At the same time, Microsoft can use the money to pay salaries or fund other assets. Now the problem is no one is buying this Commercial Paper from Microsoft because they don't trust them. Only highly rated companies are allowed to issue commercial paper. The fact that Money Market funds in particular don't trust them, even over a very short period of time, speaks volumes regarding the uncertainty in the market. The Fed stepped in because they recognize businesses depend on this financing to operate on a daily basis.

Hot Investment Tip of the Week. Residential homes in Houston, Texas. Some rather astute real estate investors have indicated that Houston has a bright future as a place to invest in a home. These professionals cite the low cost of living, and favorable population demographics based, in part, on the growth of the Energy sector which is getting ready to boom with the energy demands of the global middle class.

On the bright side, Alan Greenspan did say he thought the economy would turn around in the first quarter of next year. I think that sounds about right. I'm not sure though, I think I'll go ask my Grandpa.


James said...

To your #2:

Even more troubling is that demand for much of the type of housing constructed (urban fringe McMansions) is not likely to increase for two reasons. First, the price of gas...obvious. Second, and less obvious is the trend toward "walkable urban" development in many (but not all) metro areas. This type of urban development is likely to define the next 50 years much like the suburbs defined the previous 50 years. If you want more bad news, one expert on housing and demographics recently stated that we will only need 1 million new single family homes to meet future demand over the next 30 years. In other words, the single family home market is already almost at saturation. These powerful social and geographic trends aren't often on many people's radar when considering the overall real estate market OR individual decision-making. In other words, depressed housing values in many places will be slower to recover than most people think, and in some places won't come back at all.

Jenga said...

Good point.

perfectwagnerite said...

Great summary of things-as-they-are-now. But do really believe that this will prove to be the great financial upheaval of this century or just a passing economic migraine? --Brandon

Jenga said...

Your tone is one of peace amidst the storm. If only I could be more like you. However, I also think you should have the decency to panic.

Difficult to say whether or not this will be the big one for the rest of the century, seeing how we still have 92 years left. But this crisis will be significant based on what's at stake, namely:

1. This COULD be the first of many steps leading to the demise of the dollar as a reserve currency which would create elevated inflation levels that would be difficult to control. Get ready for an xbox costing $1500 dollars and flat screen T.V.'s routinely running $10,000. You may say, "there's no way that will happen!" You're right, the black market will be in full tilt in the U.S. by that time.

2. Implicit in number 1, the U.S. will not be the financial or consumer hub of the world, which role has aided many aspects of U.S. politics, not the least of which is foreign policy and various free-trade agreements.

3. Precedent set by both the Fed and the Treasury will increase scope of mandate going forward.

4. New regulations making it more difficult for financial institutions to do business with/in the U.S. which will result in more high-paid jobs going overseas (also special thanks to Sarbanes-Oxley for the same effect).

5. The potential demise of U.S. Real Estate as an investment for the foreseeable future (excluding a few key areas, but no surprise to any Michigan residents).

6. Overall risk aversion on behalf of the lending "system" (defined as anyone lending money) which, if not remedied, could squash "entreprenuerism" to the detriment of American innovation and Real GDP.

Clearly, if the contagion continues, it could get ugly. I don't believe all the above will happen, I'd like to think our politicians recognize the long-term effects of their decisions. And I don't think the U.S. and Europe are alone in this mess. Look for other countries to distance themselves from the U.S. economy over the next 10 years or so.

Jessica said...

So, how do you explain the DOW's rebound today?

perfectwagnerite said...

I'm feeling better knowing that this probably most likely in all foreseeable ways isn't the end of our financial world as we know it--we hope. I'm with you, I think things will continue to be rough for the next couple of years and what we can expect is a long, slow decline of American influence on international economic affairs. By the end of the century, that title will belong solely to China.(?) What do you think?

By the way, I love the what-do-you-think-now-Mr.-Smarty-Pants tone of your wife's comment. There's no respect these days, is there? Oh, what has become of the patriarchy along with the economy? :)

Jenga said...

No kidding, I get no respect. In response the DOW's rebound yesterday (up 11% in one day, which, is a record) it only validates my claim that this is a historic moment. The only thing I'm predicting is that the DOW will continue to swing wildly over the next month. Then, I think it will bump along for the next four months (some up, some down) but not to the same magnitude as the last month. The fourth quarter is historically the best quarter of the year. If there is a time for optimism, it's when the hot chocalate is flowing and there are college bowl games to watch.

Regarding the new world power. Some predict China will replace the U.S. Others think India will hold the crown. But most of these claims are based solely on the fact that both countries have more people than us. Yes, you must have economies of scale. But the real problem for both countries is harnassing the purchasing power of the population. There are huge income disparities between the upper and lower classes in China and India. One thing any challenger will need is a strong middle class (see Mexico). How do you get that? Access to debt. Or an influx of very high paying jobs. Neither of those have yet materialized in either China or India. I think what we're more likely to see is a "group" of nations leading the way. I think the days of a global hegemon are gone.