Usually things are easier to understand looking backwards, rather than looking forward. So let´s look “backwards” at the last 15 years, using 2015 as our point of departure. In our viewpoint from 2015, we have absolute knowledge of many things happening in the years from 2000 to 2015.
People in 2015 will say the following:
1. The market crash in tech stocks in 2000 led the Federal Reserve to “fix” the problem by lowering interest rates to stimulate the economy. This action led to a bubble in real estate, based on the low interest rates and easy access to borrowed funds. Additionally, the bankers created ways to get unlimited amounts of money for real estate loans through new financial instruments such as collateralized loan obligations. This policy led to highly inflated housing prices and a collapse of the ability of the homeowners to pay their mortgages. This ended in a collapse of the residential mortgage market in 2006 and 2007. This policy led to the creation of enormous mortgage loan obligations that were not collectible, even though many of them had high credit ratings from the rating agencies.
2. This situation caused the Fed to “fix” the problem in 2007 and 2008 in its traditional way: Lowering interest rates to nearly zero and making money more available. We call this strategy “kicking the can down the road,” since it worsens the ultimate problem/solution, but it momentarily makes the problem appear less dangerous. A further effort to fix this was the government TARP plan, a $700 billion effort to fix the financial system. While most of the TARP money was repaid in 2010 and the banks declared safe, the reality was that most of the bad loans were still there and the losses still waiting to be taken at the end of 2010. Rather than fix the problem, the government “kicked the can down the road."
3. President Obama agreed with the Republicans in Dec. 2010 to both extend tax credit to all citizens and, at the same time, make enormous new payments and social benefits to the needy in the United States. This Republican/Democrat compromise is a profoundly risky decision to give more benefits today with the hope that we have time to deal with our fundamental financial problems later; this is the ultimate kicking the can down the road. This type of decision-making puts at risk the ultimate solvency of the United States. It raises questions about the sustainability of the western world's democratic processes, if elected governments cannot face challenges equally dangerous as an attack from a military enemy intent on conquering our nation.
4. In 2011 to 2014, our economic world began to fall apart. “Kicking the can down the road” ceased to work and simultaneously we had to deal with problems that have existed for years, but now we are forced to face directly and urgently:
a.) The housing market took another big fall, particularly in the U.S., England and Spain. Here is a Cullen Roche article on this, showing why housing prices will likely decline in the U.S. in 2011. There are few buyers, and even fewer who can qualify for credit. The mortgage foreclosure issue creates a supply of houses for sale for which there are no adequate buyers. Banks that had been holding back properties subject to foreclosure are now forced, by their own weak condition, to liquidate what they can. Recognizing the renewed bankruptcy of Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB) became unavoidable.
b.) Cash is king in the private sector. Up through 2010, banks could argue they were okay because their balance sheets were okay. Starting in 2011, people stopped believing in balance sheets with their uncertain asset valuations and only believed in cash. This mentality revealed bank balance sheets stuffed with assets whose carrying value was much greater than their true market value. To put this idea in a numerical context, JP Morgan (JPM) has estimated $1.9 trillion of defaults and $1.1 trillion of net losses to be written off just from the residential loans made from 2005 to 2007. When we include residential loans prior to 2005 and commercial real estate loans, we are nearing $2 trillion in losses -- an amount which exceeds all stimulus provided by the government. At the end of 2010, most of these losses still had to be recognized and continued on bank balance sheets as if they were real assets.
c.) Citibank (C) and Bank of America (BAC) failed as banks. They became government-owned banks basically used for deposits and payments, as opposed to all the merchant banking operations, proprietary trading and other high-profit but high-risk businesses they had been in, including collateralized loan obligations and credit default swaps. Both JP Morgan and Wells Fargo (WFC) were tottering. While JP Morgan was the best-run of the big banks, its large real estate portfolio made it uncertain how it would all end. Strong regionals with limited real estate exposure began to strengthen their market share of American banking. Approximately half of the smaller banks went broke due to their primary dependence on residential and commercial real estate lending. At 2015, we are still not sure if the FDIC (i.e. the U.S. government, since the FDIC ran out of money in 2009) will be able to honor all it commitments to pay depositors of failed banks. During this period, we had a new crash a la 2007-08 affecting hedge funds and commercial banks with proprietary trading. This time the damage was more severe and much longer lasting. Hedge funds and large banks, based on a new law and commercial lending practices enacted in 2014, will not again be allowed excessive leverage for decades to come. While some expected this excessive leverage problem to be solved by new laws in 2010, the new problems of 2011 through 2014 showed the 2010 laws were not enough to protect the public from credit losses related to excessive loan leverage.
d.) Cash is also king in the public sector. This cash-only mentality revealed the major western world governments to have dubious credit. This gradual recognition forced the western governments to pay significantly higher interest to be able to place their national debts with third parties. A minor increase in the cost of borrowings meant that the entire income of Japan went to paying the interest of its foreign debt. A significant rate increase in U.S. government borrowing costs meant that the entire tax revenues of the U.S. went to pay the interest on its debt. The European Common market faced the fact that Germany would not pay or guarantee the unwise spending of the southern country members. Furthermore, Ireland and the southern ECM members found devaluation, which is not possible as a member of the ECM, more attractive than balancing their budgets from inside the ECM. Most of these Southern countries and Ireland defaulted on their debt.
e.) The United States has much higher debt payments, but is starting to put its house in order by 2015. While the cost of medium- and long-term bonds has skyrocketed, short-term U.S. Treasury bills pay negative interest; i.e., you pay a small amount to hold a short-term bill because it is the money you most trust in an untrustworthy world.
f.) The transition has started whereby the U.S. shares its place as a world economic leader with a group of countries including China, Brazil and India. Russia’s non-democratic tendencies have precluded it from being an insider in this group.
g.) All those who thought inflation was the risk find themselves fooled. The problem of the world was deflation, not inflation. In 2015, it is clear that the write-downs in the banks' and individuals' personal wealth led to the loss of value for everything but hard currency. It turned out that the price run-up of commodities, including gold and oil, at the end of 2010 was simply another Fed-induced asset bubble. Likewise, the mini-boom of IPOs such as GM's (GM) and the enormous increase in buyouts were simply bad companies being bought at high prices. The alleged synergies in businesses being purchased were a fiction. The truth was that major business leaders couldn't´t resist increasing their empire, because it looked like it was a no brainer with such cheap money available through the Fed stimulus policy.
h.) The U.S. Fed is considered a principal cause of the U.S. depression. While the Fed did not make the problem originally, it did not take William McChesney´s advice as a former Fed president to “take the punch bowl away just when the party gets going” during the 15-year period we are looking at here. The Fed policy was short-term stimulus and “kicking the can down the road.” We now view this as a tragic policy mistake by the Fed and the U.S. government, including both the executive and legislative branches of government.
5. Where are we in 2015?
a.) Over 90% of the people think that stock markets are dead, that life is horrible and that there is no reason to be optimistic. Depression exists in Japan and the western countries. A staggering amount of wealth has disappeared through the deflationary process.
b.) Yet the good news is that we are nearing the end of the economic downturn, probably sometime between 2015 and 2018. The Fed-induced excesses have largely been wrung out of the economy, and we are nearing the time when the economic cycle will revert from decline to growth. The time is approaching when investors should buy everything in sight – real estate, stock shares and bonds that continue to be paid on a timely basis. The recovery will be slow -- perhaps even slower than after the 1929 debacle. But it will happen.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
