A Depression With Benefits: The Macro Case For mREITs

by: Lance Brofman

An old economics joke is "A recession is when you are out of work. A depression is when I am out of work." However, the differences between a recession and a depression are not simply how many people are unemployed. It is important for investors to recognize and understand the significance of the differences between recessions and depressions

The key difference between a recession and a depression is that a recession can be ended by monetary policy alone.

If every few years you got the flu and now you had a strep throat it would be incorrect and possibly dangerous to think that you just had a bad case of the flu this year. Over the last hundred years there have been numerous recessions but only two depressions, the depression of 1929-1941 and the depression that began in 2007. The symptoms of strep throat and scarlet fever may be similar to that of the flu or common cold. However, causes of the former are the streptococcus bacteria while influenza is viral. Hence, strep throat and scarlet fever require antibiotics which are useless against viruses. Likewise, believing that the depression that started in 2007 is just a severe recession is quite dangerous to both investors and policy makers. As long as many policy makers appear not to realize the distinctions between recessions and depressions, investors ignore those distinctions at their peril.

The effects of the 2007 depression are much less severe than the 1929-41 depression because of safety-net benefits now provided. Consider the horrendous, though not uncommon situation of a household in 1932 comprised of elderly grandparents being supported by their working-age children with young children of their own, when the breadwinners became unemployed. The 1932 family would be destitute. Today the grandparents would have social security and Medicare benefits. Their working-age children could now collect unemployment benefits for up to 99 weeks. Additionally, the entire family could also be eligible for food stamps, Medicaid, rent subsidies, heating fuel subsidies, free school lunches and other benefits. The 1932 family might also have had a bank account in one of the many banks that failed and lost their savings. Today, Federal Deposit Insurance protects such bank accounts. You might say we are now in a depression with benefits.

The difference between a depression and a severe recession are not just semantic. Recessions occur when the Federal Reserve raises interest rates in an effort to slow down an overheated economy. Most importantly, recessions end when the Fed lowers interest rates. In a recession the pent-up demand for housing and durable goods means that monetary policy alone can cure the recession. Just as antibiotics can be effective against bacterial infections but not against viruses, monetary policy alone cannot end a depression. Furthermore, modest fiscal stimulus and the automatic stabilizers that can hasten the end of recessions cannot end a depression. There can be ups and downs in the unemployment rate during a depression. However, the unemployment rate remains elevated. It was 14.5% in 1940 and 9.7% in 1941.

If we are in a recession, economic activity will fully resume just from the monetary and fiscal stimulus that has already occurred. Ultimately interest rates will rise. However, if we are in a depression, even one with safety-net benefits that mitigate the hardships, interest rates will remain relatively low for decades as was the case in Japan and the USA of the 1930s, where only World War II ended the depression. The ideal investment for an extended period of low interest rates is agency mREITs.

Depressions occur after investment bubbles burst. In free-market capitalism, capital generates income for the owners of the capital which in turn is used to create additional capital. This is very good. Sometimes, it can be actually too good. As capital continues to accumulate, its owners find it more and more difficult to deploy it efficiently. The business sector generally must interact with the household sector by selling goods and services or lending to them. When capital accumulates too rapidly, the productive capacity of the business sector can outpace the ability of the household sector to absorb the increasing production.

The capitalists, or if you prefer, job creators use their increasing wealth and income to reinvest, thus increasing the productive capacity of the business they own. They also lend their accumulated wealth to other businesses as well as other entities after they have exhausted opportunities within the business they own. As they seek to deploy ever more capital, excess factories, housing and shopping centers are built and more and more dubious loans are made. This is overinvestment. As one banker described the events leading up to 2008 - First the banks lent all they could to those who could pay them back and then they started to lend to those could not pay them back. As cash poured into banks in ever increasing amounts, caution was thrown to the wind. For a while consumers can use credit to buy more goods and services than their incomes can sustain. Ultimately, the overinvestment results in a financial crisis that causes unemployment, reductions in factory utilization and bankruptcies all of which reduce the value of investments.

If the economy was suffering from accumulated chronic underinvestment, shifting income from the non-rich to the rich would make sense. Underinvestment would mean there was a shortage of shopping centers, hotels, housing and factories were operating at 100% of capacity but still not able to produce as many cars and other goods as people needed. It might not seem fair, but the quickest way to build up capital is to take income away from the middle class who have a high propensity to consume and give to the rich who have a propensity to save (and invest). Except for periods in the 1950s and 1960s and possibly the 1990s when tax rates on the rich just happened to be high enough to prevent overinvestment, the economy has generally suffered from periodic overinvestment cycles.

It is not just a coincidence that tax cuts for the rich have preceded both the 1929 and 2007 depressions. The Revenue acts of 1926 and 1928 worked exactly as the Republican Congresses that pushed them through promised. The dramatic reductions in taxes on the upper income brackets and estates of the wealthy did indeed result in increased savings and investment. However, overinvestment (by 1929 there were over 600 automobile manufacturing companies in the USA) caused the depression that made the rich, and most everyone else, ultimately much poorer.

Since 1969 there has been a tremendous shift in the tax burdens away from the rich and onto the middle class. Corporate income tax receipts, whose incidence falls entirely on the owners of corporations, were 4% of GDP then and are now less than 1%. During that same period, payroll tax rates as percent of GDP have increased dramatically. The overinvestment problem caused by the reduction in taxes on the wealthy is exacerbated by the increased tax burden on the middle class. While overinvestment creates more factories, housing and shopping centers; higher payroll taxes reduces the purchasing power of middle-class consumers.

In an interview about the proposed "Buffett Rule", T.J. Rogers the CEO of Cypress Semiconductor Corporation (NASDAQ:CY) inadvertently illustrated the potential perils of overinvestment for an economy. Warren Buffett the CEO of Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) had proposed the "Buffett Rule" which would impose a minimum tax of 30% on incomes above one million dollars. Rogers explained to Larry Kudlow on CNBC's Kudlow Report on May 16, 2012, why he opposed the Buffett Rule. Rogers said that he spends less than 1% of his income on his living expenses and invests the other 99% in creating new businesses and increasing the productive capacity of the businesses he already owns. If he had to pay taxes pursuant to the Buffett Rule he would not be able to invest as much. Clearly, someone who invests 99% of their income will see his wealth grow exponentially as long as his investments are at all productive. It would not take too many members of the top 1% investing 99% of their income before they would be unable to deploy their capital productively. This would be a classic example of capital accumulating faster than consumers' incomes. Consumers would not be able to buy all the goods and services produced by the over investment.

For investors, the factor that most clearly distinguishes a depression from a recession is the extremely low level of treasury-bill rates that persists in a depression. The rates on 3-month t-bills are now as close to zero as in the 1930s. In a recession the Federal Reserve can keep lowering interest rates until the economy rebounds. Once interest rates are near zero they cannot be reduced further and monetary policy becomes mostly powerless to end the depression.

Could some new fiscal policy end the recession? Absolutely. Will it happen? Highly unlikely. We know that the 1929-1941 depression only ended with the massive deficits that accompanied World War II. What would end the depression now is policy with the fiscal impact of a WWII, hopefully without the blood and gore. For many reasons, not the least of which is political, the fiscal policies which could end the depression would have to be accomplished mainly if not entirely on the tax side rather than the spending side. In any case such policies are unlikely to occur any time soon.

There are various policies that could end the depression. The most important thing that the Federal Reserve could do would be to stop paying interest on reserves. As I discussed in my article, "Federal Reserve Actually Propping Up Interest Rates: What This Means For mREITs," absent that policy, the rate on T-bills would be actually negative. The slight artificial increase in interest rates caused by the Federal Reserve paying interest on reserves by itself does not depress economic activity much. However, policies preventing t-bill rates from being negative may be dissuading congress and the administration from undertaking the magnitude of fiscal stimulus that could end the depression. With negative t-bill rates the deficit could be partially a profit center rather than totally a cost item.

No monetary policy alone can end the depression. It would take fiscal policy as well. One way to do it would be to make the Federal tax structure as progressive as it was in 1969. Today, the wealthiest 3% of the people pay 50% of the federal taxes and the other 97% pay the other 50%. The marginal propensity to consume of the top 3% is around 0.4 while for the other 97% it is probably about 0.98. If taxes on the top 3% were increased by 50% and those on the bottom 97% were reduced by 50%, it would initially be revenue neutral. However, it would ultimately increase GDP by about 3% and reduce the unemployment rate to around 5%. That change in relative tax burdens would bring the degree of progressivity in the tax structure back to where it was in 1969.

Another way to end the depression would be massive tax cuts for the middle class. The 10% and 15% Federal tax brackets could be temporarily reduced to zero. For married taxpayers this would exempt all net income below $72,500 from taxation. This would be a $9,982 tax cut for all couples with taxable incomes of $72,500 or more and less for others with less taxable incomes. Additionally, all personal payroll taxes could be suspended. As with the recently eliminated 2% payroll tax cut, the treasury would make the trust funds whole. This would put $6,120 in the pockets of a household that had $80,000 in wages. These steps would provide a total of about $15,000 to the typical middle class family. It would increase the deficit. However, with the current levels of interest rates and the possible profits made by issuing t-bills at negative rates, the long-term costs will be less than they were in WWII as a percentage of GDP.

When Obama was campaigning for president he called for a $1,000 middle class tax-cut. On the day he took office the correct amount to end the depression was probably close to $15,000. Congress passed an $800 middle class tax-cut as part of the stimulus package.

There are various reasons why I think it highly unlikely that policies which could end the depression will be enacted. Most relevant to investors in mREITs like Annaly Capital (NYSE:NLY) and American Capital Agency Corp. (NASDAQ:AGNC) and the baskets of mREITs such as ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (NYSEARCA:MORL), Market Vectors Mortgage REIT ETF (NYSEARCA:MORT) and iShares Mortgage Real Estate Capped ETF (NYSE:REM) is the fact that most policy makers don't think we are in a depression. Recently, better economic statistics have convinced some that monetary stimulus can be withdrawn earlier rather than later.

There can be periods of vigorous economic growth and significant declines in unemployment during depressions. Unemployment fell from 24.75% in 1933 to 14.18% in 1937 but then rose to 18.91% in 1938. The 14.45% unemployment rate in 1940 was higher than the 1937 level. That unemployment has come down from the peak, as is the case today, does not mean the depression is over now any more than it did in the 1930s.

Even if the depression were to end, mREITs could still do well over a longer period. A scenario that might still be favorable to mREIT investors longer term would be for the current depression to end and interest rates rise somewhat. This could cause short-term and even intermediate term pain to holders of mREITs. However, as long as the relatively regressive tax structure remains intact, the cycle of overinvestment will bring on another period of weak economic conditions and corresponding low interest rates. As with the agency inverse floaters in the 1990s, mREIT investors would ultimately do very well, although possibly after some amount of pain. See: Are mREITs The New Inverse Floaters?

One reason why the depression could persist for decades, as is the case in Japan, is that a depression with benefits is not so bad for most people. Even those unemployed receive safety-net benefits which mitigates much of their suffering. On a psychological level a depression is not frightening when the media does not say we are in a depression. Most people do not use my definition of a depression, namely a condition where monetary policy alone cannot restore the economy to full employment and short-term risk-free interest rates are at the zero lower bound. When people are not calling it a depression there is less impetus to take action to remedy the situation.

It is unlikely that policies will be adopted which could permanently eliminate the overinvestment cycle anytime soon. Many who have been vociferous in criticizing income and wealth inequality such as Paul Krugman and Joseph Stiglitz have not pointed to the increase income inequality as the cause of the depression. Those on the left who might be the natural proponents of a more progressive tax system have not connected the dots. They have a different theory as to the cause of the depression. They are adherents to the regulatory fallacy, the belief that the depression was caused by insufficient regulation.

To determine if someone is an adherent of the regulatory fallacy ask this question: Do you believe that given the degree that the tax burden was shifted from the rich to the middle class, was there any type of regulatory policy which would have prevented the financial crisis and subsequent depression? If they answer yes, they are adherents to the regulatory fallacy

In Paul Krugman's 2012 book "End this Depression Now!" he comes heartbreakingly close to connecting the dots between the reduction in the progressivity of the tax system and the cycle of overinvestment that caused the depression. He states that the book is much less concerned with the cause of the depression than what should be done to end it. His prescription is fiscal stimulus focused on the spending side that has even less of a chance of being enacted than the tax cuts suggested above.

Those on the right have their own version of the regulatory fallacy. They blame the government sponsored enterprises Federal National Mortgage Association Fannie Mae (OTCQB:FNMA) and Federal Home Loan Mortgage Corp. (OTCQB:FMCC) and the Community Reinvestment Act. According to their theory, regulation such as the Community Reinvestment Act resulted in a vast increase in subprime mortgage lending that caused the financial crisis. Possibly the non-bank private entities that originated and securitized most of the subprime loans mistakenly thought the Community Reinvestment Act applied to them.

A slight variation on the regulatory fallacy is the financial innovation fallacy. As with the regulatory fallacy, both left and right versions, there is a miniscule grain of truth to it. Financial innovations such as credit default swaps and regulatory changes like repeal of the Glass-Steagall Act slightly affected the exact timing of the onset of the depression. However, once the tax burden was shifted from the rich to the middle class it was just a matter of time before middle-class consumers became unable to absorb the increased production and service the debt that accompanied the overinvestment. Different regulatory policies might have shifted the bubble more towards commercial real estate rather than residential real estate or vice-versa but the outcome would have been similar.

Blaming regulatory policies and financial innovation for the depression is like blaming the armaments manufacturers and soldiers for World War II. In order for the war to occur there had to some weapons made and some soldiers to fight. If those particular armaments manufacturers and soldiers were not available, others would have taken their place.

Equally unhelpful in terms of addressing the income and wealth inequality which results in the overinvestment cycle that caused the depression are those who emphasize various non-tax factors. Issues such as globalization, free trade, unionization, problems with our education system and infrastructure can increase the income and wealth inequality. However, these are extremely minor when compared to the shift of the tax burden from the rich to the middle class. It is the compounding year after year of the effect of the shift away from taxes on capital income such as dividends over time as the rich get proverbially richer which is the prime generator of inequality.

Even if it was widely understood that the shift of the tax burden from the rich to the middle class was the cause of the depression, it would still be extremely difficult to remedy the situation. The enormous shift in tax policy favoring the rich has been a world-wide phenomenon going on for many years. After the Socialist party candidate François Hollande won the presidential election, France enacted tax laws that gave France the most progressive tax system among the 20 largest industrial nations. However, world-wide the tax systems have become so much less progressive in the past decades, that if the tax code that France has today were applied to France in 1969, France would have had the most regressive tax system among the 20 countries in 1969.

A major component of the shift of the tax burden from the rich onto the middle class involves the corporate income tax, whose incidence falls entirely on the owners of corporations. Corporate income taxes were 4% of GDP in 1969 and are now less than 1%. The reduction in corporate taxes has not necessarily been the result of political power on the part of corporations. Rather it was part of an international "bidding war" among countries to induce corporations to move from one country to a jurisdiction with a lower corporate tax. Even if it were politically feasible, the United States could not unilaterally reinstate the corporate income tax back to 1969 levels.

That it would take the cooperation of more than twenty nations to give up some of their sovereignty and agree on reinstating corporate income taxes illustrates just how difficult it would be to adopt tax policies that could overcome the cycle of overinvestment. Furthermore, even if the depression ends, capital will soon again accumulate too rapidly. Then the productive capacity of the business sector will again outpace the ability of the household sector to absorb the increasing production. This will bring on another period of weak economic conditions and corresponding low interest rates. Alternately, we will see a Japan-like period of extended low interest rates as the current depression, as I define it, lasts indefinitely. Both of these outcomes would be favorable for interest-rate-spread driven investments such as mREITs.

The mathematics of leveraged mREITs is fascinating. One calculation that many will find hard to believe, suggests that an investor who made a single one-time investment in MORL at the all-time high price of $32.25 on April 12, 2013 with the intention of holding for ten years and reinvesting all dividends during that period, could in a sense be better off now as a result of the carnage in the mortgage markets. This is completely counter-intuitive since MORL closed today, July 10, 2013 at $19.79.

To understand this amazing result consider a thought experiment where an investor who bought $10,000 of MORL at the all-time high price of $32.25 on April 12, 2013 is now given a choice by some omnipotent force of having universe 1 or universe 2. In universe 1 MORL behaves as the investor presumably expected when the purchase was made on April 12, 2013. At a price of $32.25 and an annualized dividend based on the trailing three months of $5.86. That represented a simple yield of 18.2% and an effective compounded yield of 19.8%. If the investor chooses universe 1 all the unpleasantness in the mortgage market that occurred since April 12, 2013 never happened and the investor receives the expected return based on the price and yield on April 12, 2013. Thus, by April 12, 2023 the investor's $10,000 has grown to $60,749.13. Effectively, in universe 1 MORL remains at the price of $32.25 and the dividend remains at the previous level.

In universe 2 everything that actually happened since April 12, 2013 occurs. The price of MORL falls to $19.79. AGNC and NLY, the largest components of MORL cut their dividends so that the annualized dividend based on the trailing three months of MORL is now down to $5.39. In universe 2 the investor still made his single one-time investment in MORL at the all-time high price of $32.25 on April 12, 2013 with the intention of holding for ten years and reinvesting all dividends during that period. He has a large unrealized loss on July 10, 2013. In universe 2, from today on, the investor receives the expected return based on the actual price and yield today, throughout the rest of the period until April 12, 2023.

Intuitively, one would assume that if an mREIT investor who bought at the top on the April 12, 2013 could magically make everything that occurred since then disappear, they would do so. However, even though the hypothetical investor's account had fallen from $10,000 on April 12, 2013 to $6,477.17 today, the investor is still better off by choosing universe 2. That is because at today's price of $19.79 and an annualized dividend based on the trailing three months of $5.39, MORL now has a simple yield of 27.2% and an effective compounded yield of 30.9%. That means that in universe 2 the account value at the end of the 10-year period April 12, 2023 is $89,281.29.

Obviously an investor who intended to make periodic additions to his account rather than a single one-time investment on April 12, 2013 would do even better in universe 2 and would view the recent carnage in the mREITs as a great buying opportunity.

Disclosure: I am long MORL, AGNC, CYS, ARR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.