The Bubble Years and Beyond

Did you get burned on housing, Fannie (FNM) or Freddie (FRE)? Did you not buy Altria (MO) in 2000, yielding over 9%, and miss out on 24% a year since? If you did, it is because you have not read James Grant's Interest Rate Observer or, if you did, you ignored it at your own peril.

First the boilerplate stuff:

Collected from speeches and editorials by Grant, the editor of Grant's Interest Rate Observer, these essays are remarkable for their prescience: two years before subprime mortgages collapsed, the author described them as "not one borrower left behind" and when other analysts were worried about the effect of a Fed interest rate increase, he foresaw that the "risk to house prices lies not with interest rates but with lending standards."

Other chapters attack bubbles in stocks and the dollar with erudition and wit ("Economics, mistaking itself for physics, is wont to turn up its nose at history, but the past has much to teach"; "as dress on Wall Street has become more casual, so have the monetary arrangements... the gold standard and swallowtail coats have given way to Greenspan and open-neck shirts"). It's hard to imagine reading any other investment newsletter even a week after publication. Grant's is the exception; it paints on a larger canvas and is infused with the author's generous spirit and rich sense of humor. (Nov.) --Publishers Weekly

The book:
Grant is a scathing critic of the Fed and its now decade-long use of low interest rates to prop up economic growth. In the mid 1990s Grant predicted, almost to a T, the current situation we find ourselves in today. Article after article warned of the tenuous (at best) situation at Fannie and Freddie and described in detail how gluttonous subprime lending, caused by irresponsibly low interest rates (and government mandate) was going to cause a collapse of the housing market, and then due to securitization, a banking crisis. Anyone read the papers lately?

Grant avoids the common thread today of laying blame on a political party or a particular person. He instead lays the majority of it at the feet of the Fed. Grant argues, successfully I think, that massive Fed liquidity injections and 1% interest rates, causing an actual negative real rate of interest (the interest you receive minus the rate of inflation) led to yield hunting. The easiest way to accomplish it was to lend the money to hungry home buyers and owners. When the AAA rated buyers were exhausted, yield hunters moved down the credit chain.

When they reached the bottom of the yield chain, they moved on to alternate mortgages (interest only, no money down, no verification etc.). All the while, the loans were being combined, sliced and diced into CDOs, MBSs and a whole litany of cryptic letter denominated securities. These were sold to other yield hunters and provided more cash for additional lending.

Grant argues that much of what we are experiencing today may have been avoided had we accepted 3% plus GDP growth was not a mandate, kept interest rates at more of a sane level, fought inflation rather than accepting it and kept the dollar from depreciating.

For over a decade, Grant laid out a thesis that doing the above would avoid the mess we find ourselves in today. Now, agree or not with what he says, it would be hard to believe and make a convincing argument he was this right for all the wrong reasons.

When you put this book down you will say what I did 1/4 of the way through: "Had I only read James Grant 10 years ago..." You could have made a bundle, or, more importantly, saved one.

Comments

[Suziclue:]

Yes I did miss on buying MO stock and instead I bought two property. Things looked real good at first but things have been sour lately. I'm hoping the trend would stop soon but I'm not too optimistic when I check the home price trend at this site weekly. It seems to be going down on a weekly basis in Riverside, CA.

www.homepricetrend.com

2008 Nov 08 05:07 AM

[Dr. O:]

James Grant in among the elite in the financial world. Portrayed as a skeptic, or a bear, he merely analyzes the mathematics and draws conclusions therefrom. Realists like Jim Grant cannot tell you when thing will turn sour, but he can tell you what to expect and why.

Frankly, once the "Grant" or "Fleckenstein" scenario begin playing itself out earlier this year, I sold what wasn't already in cash in June and have been in cash ever since.

The good folks at Minyanville.com, especially Todd Harrison, Bennet Sedecca, and Mr. Practical have also proven invaluable in giving both big picture and real time information on the economic crisis as it has unfolded this year.

2008 Nov 08 08:02 AM

[jse17:]

Agreed, how can any reasonable investor not appreciate Jim Grant. With this said, IMHO, all investors will remain lost in space unless they absorb, not read, Naomi Klein’s, “The Shock Doctrine - Disaster Capitalism”.

If an investor does not appreciate “Shock” in context of the past 8-years geopolitical and resulting economic disaster, that investor is mandated to limit his/her exposure to a pass book savings account. Jim Grant understands the Milton Friedman Chicago School of Economics tragedy and the Neocon’s self-serving embrace of its horrifically flawed tenets. Naomi conveys this message seamlessly to the open minded masses without Wharton MBA degrees!

If we are to survive the current debacle, the Jim Grants, Naomi Kleins, and a very few enlightened others must lead the way!

2008 Nov 08 11:21 AM

[cyclingscholar:]

Take all this bubble stuff and shove it.

The first step of the scientific method is DEFINITION AND MEASUREMENT. Exactly where--exactly ANYwhere---in this bubble bullsh*t do we have an operating definition of what constitutes a market bubble? Are all bubblebuttheads using the same definition of bubble?

Trivial concern? NOT IN THE LEAST. Without an agreed upon working definition of what constitutes a bubble, all this 'research' is crap...junk science to rate with the best of global warmingism, peak oilism, and end of historyism.

We are in a severe bear market. It happens. Get over it.

cyclingscholar

2008 Nov 08 11:32 AM

[Pipo:]

Buffett is buying and sees no bubble at all.

warrenbuffettstocks.bl.../

2008 Nov 08 01:39 PM

[Ray Lopez:]

I like Grant, always have, but keep in mind he's a bit of a permabear. He's been saying this since the 1980s. As for Naomi Klein, she's a journalist, looking for an audience, but, unlike Grant, she has little credibility with me.

2008 Nov 08 02:00 PM

[moonbat1775:]

"Exactly where--exactly ANYwhere---in this bubble bullsh*t do we have an operating definition of what constitutes a market bubble? " cyclingman

Well, how about when real interest rates (nominal - inflation) are NEGATIVE? What sensible person is going to watch his savings get eaten up by inflation without being tempted to speculate? Hence, bubbles.

2008 Nov 08 02:43 PM

[maelstrom:]

Todd thanks for another helpful article

2008 Nov 08 04:13 PM

[dw57:]

while part of his thesis might be true. I don't think the GSE"S had that much of an impact. They weren't writing the notes. They just made the stupid decision to buy notes that didn't originally meet their standards. had they not bought them, some body else would have so they same scenario would have happened. I think there are two causes. One wages have never recovered from the last recession, causing a consumer based economy to live on credit. The other was a really stupid group think, house prices had to go up, they never ever go down.

2008 Nov 08 04:35 PM

[Magnum:]

In this 28th edition of the GEAB, LEAP/E2020 has decided to launch a new global systemic crisis alert. Indeed our researchers anticipate that, before next summer 2009, the US government will default and be prevented to pay back its creditors (holders of US Treasury Bonds, of Fanny May and Freddy Mac shares, etc.). Of course such a bankruptcy will provoke some very negative outcome for all USD-denominated asset holders. According to our team, the period that will then begin should be conducive to the setting up of a « new Dollar » to remedy the problem of default and of induced massive capital drain from the US. The process will result from the following five factors studied in detail further in this GEAB:

1. The recent upward trend of the US Dollar is a direct and temporary consequence of the collapse of stock markets

2. Thanks to its recent « political baptism », the Euro becomes a credible « safe haven » value and therefore provides a « crisis » alternative to the US dollar

2. The US public debt is now swelling uncontrollably

3. The ongoing collapse of US real economy prevents from finding an alternative solution to the country’s defaulting

4. « Strong inflation or hyper-inflation in the US in 2009? », that is the only question.

Studying the case of Iceland can give an idea of the upcoming stages of the crisis. That is what our team has been doing ever since the beginning of 2006. This country indeed provides a good illustration of what the US and the UK should be expecting. It can be considered – and that is what most Icelandic people do today – that the collapse of Iceland’s financial system came from the fact that it was disproportionate to the size of the country’s economy.

Inflation in Iceland - 2003-2008 - Source Central Bank of Iceland

Financially speaking, Iceland thought of itself as UK [1], in the same way as, financially speaking, UK thought of itself as the US and the US thought of themselves as the entire world. It is therefore quite useful to study the case of Iceland [2] in order to understand the course of events that London and Washington will follow in the next 12 months [3].

What we see today is a double historical phenomenon:

. on the one hand, since September 2008 (as anticipated in the February 2008 edition of the GEAB - N°22), the whole planet has become aware that a global systemic crisis is unfolding, characterised by the collapse of the US financial system and its contagion to the rest of the world.

. on the other hand, a growing number of global players are beginning to act on their own, in reaction to the ineffectiveness of the measures advocated or implemented by the US though they are the centre of this global financial system. What happened with this first Euroland (or Eurozone) summit which took place on Sunday, October 12, 2008, and whose decisions, by their scope (close to 1,700-billion EUR) and their nature [4], resulted in a regain of confidence on financial markets from all over the world, is typical of the « post-September 2008 world ».

Map of deposit insurances in the EU - Source AFP - 10/09/2008

Indeed there is such a thing as a « post-September 2008 world ». According to our team, it is now clear that this past month will remain in the history books of the whole planet as the month when the global systemic crisis started; even if what is really at play is its decanting phase, the last of a series of four phases of the crisis described by LEAP/E2020 as early as June 2006 [5]. As always when it comes to large human groups, the perception of change among the general public only occurs when change is already far on its way.

As a matter of fact, September 2008 is the month when the « financial detonator » of the global systemic crisis exploded. According to LEAP/E2020 indeed, this second semester 2008 is the time when « the world dives into the heart of the impact phase of the global systemic crisis » [6]; which means for our researchers that, at the end of this semester, the world enters the « decanting phase » of the crisis, i.e. a phase when the outcome of the shock settles down. This phase is the longest (from 3 to 10 years, according to the country) and the one affecting the largest number of people and countries. It is also the phase when the components of new global equilibriums will start to appear, two of them being already described by LEAP/E2020 in this 28th edition of the GEAB in the graphic illustrations below [7].

Therefore, as we repeated it on and on since 2006, this crisis is far more important, in terms of impact and outcome, than the 1929 crisis. Historically, we are the very first players, witnesses and/or victims of a crisis affecting the whole planet, in a situation of unprecedented interdependence of countries (resulting from twenty years of globalisation) and people (the level of urbanization - and related dependence for all the basic needs – water, food, energy… - is also unprecedented). However, the 1929 experience and all its dreadful outcome, is still vivid enough in our collective memories to hope, if citizens are vigilant and leaders clear-sighted, that we will be spared from a « remake » leading to major conflagration(s).

Europe, Russia, China, Japan,... are certainly the collective players who can make sure that the unfolding implosion of today’s world power, i.e. the United States, does not drive the planet into a disaster. Indeed, except for Gorbachev’s USSR, empires have a tendency to strive in vain to reverse the course of History when they realize their might is escaping them. It then belongs to partner-powers to channel the process peacefully, as well as it belongs to the citizens and rulers of the concerned country to be clear-sighted and face the difficult times they are about to cross.

2008 Nov 08 05:32 PM

[sheople:]

Cyclingscholar, Severe bear market is an understatement!

2008 Nov 08 08:50 PM

[Bill Herbert:]

Grant is one of the best, for sure. Maybe the best overall economic analyst there is today.

Puts a fraud-job like Greenspan to shame, where he belongs. Ditto for most of the other whackjobs that we collectively refer to as the "Federal Reserve"

2008 Nov 08 11:09 PM