...to a new website -- well, truth is I already have. On July 23, I launched Scala Volpe Capital, at www.scalavolpe.com. It represents the fulfillment of a goal I'd had for a while to take this blog and expand the format into a full website, complete with my blog as well as other offerings regarding insight into my investment portfolio, multimedia presentations, breaking news from Wall Street, and more. This site, austrianschool.blogspot.com, will remain active for now, although I'll occasionally re-post some of my past Austrian School articles at Scala Volpe when I feel it's pertinent to the discussion.
I wanted to post once more at this site in order to thank all of the people who supported my efforts here at Austrian School. I assure you I'll continue to champion free markets, capitalism, and the liberty these ideals ensure our citizenry. Please come visit me at www.scalavolpe.com and let me know what you think of the new site.
Thanks again, and best regards to all of you,
Christopher Anastasio
Tuesday, August 24, 2010
Saturday, July 3, 2010
Like The Matrix’s Spoon, There is No Recovery
In the 1999 film The Matrix, there's a scene in which the main character Neo encounters a child who is seen bending a spoon simply by staring at it. Neo, confused by what he's witnessing, asks the child how this manipulation of reality is accomplished. The child offers guidance to Neo, with the conclusion being "there is no spoon." Neo recognizes that what he has been conditioned to believe to be true is not necessarily so.
This analogy brings us to our topic. Yesterday’s non-farm payroll numbers came in, and were about as disappointing as anyone had expected. Approximately 125,000 jobs had been shed, with much of the fluctuation attributed to the release of the temporary Census workers. Private employers added a modest 83,000 jobs instead of the 110,000 or so anticipated. In addition, the 9.7% unemployment figure fell to 9.5%.
What does this all mean? First off, we need to clarify the unemployment figure and why it dropped. The government’s unemployment figure unfortunately incorporates two oddities: the exclusion of the “underemployed” people in the country, and the “birth-death” ratio. To explain:
First, the underemployment aspect: this basically refers to the fact that if people are working less hours than they want to (they’re in a part time job but are seeking full time employment), they aren’t considered unemployed, just underemployed. Also, if they’ve been searching for work and have given up the search due to discouragement, lack of opportunity, or whatnot, they are no longer considered unemployed.
With respect to the birth-death ratio, what this essentially means is that when companies go out of business, the government automatically assumes all affected workers are hired thereafter, unless reported otherwise (such as when the individuals themselves report to the unemployment office). Of course, in reality, we know that in such economic times as we’re experiencing now, it’s foolish to assert that laid-off workers are able to immediately secure follow-on employment.
So you can see why it makes more sense to pay attention to the underemployment figure, which yesterday fell by a tenth of a percent, from 16.6 to 16.5%. Hardly anything to celebrate. Moreover, the anemic private sector job growth underscores the ineffectiveness of government economic policy.
So aside from this statistical nonsense that the government engages in to pad the numbers, the real question is, if we were supposed to be in a recovery, where are the jobs? The answer to this is simple: there is no recovery. The small amount of positive data that filtered in during early 2010 is anomalous, and suggests that during the lull in the housing market crisis and run-up to the European debt crisis (see my May 24 post), the maligned economy got a breather and some small measure of relief. But that relief is steadily disappearing.
Think of it this way: each dollar the government has spent (and here I’m mostly referring to the stimulus package begun in February 2009) is one less dollar available to the private sector. It’s important to understand that when the government spends money above and beyond what’s readily available to it in the way of taxes and so forth, it must borrow it or print it – neither of these activities comes without a cost to our economy, businesses and individual citizens. This is because the government’s spending brings ill side effects such as new and higher taxes, inflation, and misallocation of capital resources into ventures that are often less productive than those that might be accomplished by the private sector.
The fundamental question that is rarely asked is this: how many more jobs could we create if the capital reallocated by the government were instead available to the private sector? Every time a government official touts the latest job growth (or downplays the latest job losses), I ask myself “at what expense?” The simple fact is that as government has grown and thus become more costly to maintain, it is crowding out businesses and requiring more and more capital to operate. Obviously, this is money no longer available to companies to re-invest into their businesses and expansion of their workforces.
Simply put, the recovery isn’t over; it never was. There is much more hardship remaining in this economic climate. The next wave of the housing crisis is right around the corner, as new and pending home sales have plummeted with the removal of government subsidies, combined with looming mortgage defaults stemming from the Option ARM and Alt-A mortgages on so many banks’ balance sheets. The European debt crisis is in its infancy, with several more nations due to declare bankruptcy, introduce austerity measures, and request fiscal aid from the EU, IMF, US or whomever else might be willing to provide relief. China’s unsustainable economic growth will eventually slow down, producing a ripple effect across its trade partners and upsetting its internal economic (and perhaps even political) dynamics. Given all this, we must be prepared for continued difficulty in the growth of jobs and the economic recovery as a whole. Now that the administration has taken credit for the supposed recovery, it will be interesting to see who gets the blame for the second (and likely far deeper) dip in this recession.
This analogy brings us to our topic. Yesterday’s non-farm payroll numbers came in, and were about as disappointing as anyone had expected. Approximately 125,000 jobs had been shed, with much of the fluctuation attributed to the release of the temporary Census workers. Private employers added a modest 83,000 jobs instead of the 110,000 or so anticipated. In addition, the 9.7% unemployment figure fell to 9.5%.
What does this all mean? First off, we need to clarify the unemployment figure and why it dropped. The government’s unemployment figure unfortunately incorporates two oddities: the exclusion of the “underemployed” people in the country, and the “birth-death” ratio. To explain:
First, the underemployment aspect: this basically refers to the fact that if people are working less hours than they want to (they’re in a part time job but are seeking full time employment), they aren’t considered unemployed, just underemployed. Also, if they’ve been searching for work and have given up the search due to discouragement, lack of opportunity, or whatnot, they are no longer considered unemployed.
With respect to the birth-death ratio, what this essentially means is that when companies go out of business, the government automatically assumes all affected workers are hired thereafter, unless reported otherwise (such as when the individuals themselves report to the unemployment office). Of course, in reality, we know that in such economic times as we’re experiencing now, it’s foolish to assert that laid-off workers are able to immediately secure follow-on employment.
So you can see why it makes more sense to pay attention to the underemployment figure, which yesterday fell by a tenth of a percent, from 16.6 to 16.5%. Hardly anything to celebrate. Moreover, the anemic private sector job growth underscores the ineffectiveness of government economic policy.
So aside from this statistical nonsense that the government engages in to pad the numbers, the real question is, if we were supposed to be in a recovery, where are the jobs? The answer to this is simple: there is no recovery. The small amount of positive data that filtered in during early 2010 is anomalous, and suggests that during the lull in the housing market crisis and run-up to the European debt crisis (see my May 24 post), the maligned economy got a breather and some small measure of relief. But that relief is steadily disappearing.
Think of it this way: each dollar the government has spent (and here I’m mostly referring to the stimulus package begun in February 2009) is one less dollar available to the private sector. It’s important to understand that when the government spends money above and beyond what’s readily available to it in the way of taxes and so forth, it must borrow it or print it – neither of these activities comes without a cost to our economy, businesses and individual citizens. This is because the government’s spending brings ill side effects such as new and higher taxes, inflation, and misallocation of capital resources into ventures that are often less productive than those that might be accomplished by the private sector.
The fundamental question that is rarely asked is this: how many more jobs could we create if the capital reallocated by the government were instead available to the private sector? Every time a government official touts the latest job growth (or downplays the latest job losses), I ask myself “at what expense?” The simple fact is that as government has grown and thus become more costly to maintain, it is crowding out businesses and requiring more and more capital to operate. Obviously, this is money no longer available to companies to re-invest into their businesses and expansion of their workforces.
Simply put, the recovery isn’t over; it never was. There is much more hardship remaining in this economic climate. The next wave of the housing crisis is right around the corner, as new and pending home sales have plummeted with the removal of government subsidies, combined with looming mortgage defaults stemming from the Option ARM and Alt-A mortgages on so many banks’ balance sheets. The European debt crisis is in its infancy, with several more nations due to declare bankruptcy, introduce austerity measures, and request fiscal aid from the EU, IMF, US or whomever else might be willing to provide relief. China’s unsustainable economic growth will eventually slow down, producing a ripple effect across its trade partners and upsetting its internal economic (and perhaps even political) dynamics. Given all this, we must be prepared for continued difficulty in the growth of jobs and the economic recovery as a whole. Now that the administration has taken credit for the supposed recovery, it will be interesting to see who gets the blame for the second (and likely far deeper) dip in this recession.
Monday, May 24, 2010
That Light at the End of the Tunnel is a Train Coming
This blog post focuses on the next round of shock waves that are heading straight for the US economy. It examines the causes, symptoms, and consequences of the next crisis – a crisis that will make you wish for the pleasantries of the Fall 2008 economic crash.
But before we get into that, it is useful to step back for a moment and apply some scrutiny to what is already a bad situation, irrespective of what the next crisis might be. Once you digest the enormity of the fiscal challenges we currently face, you will inevitably gain an even greater understanding of why the next round of crises will be so catastrophic. In actuality, you will realize that even if we don’t have another crisis like 2008 in the short term (which I severely doubt), we are still in for an economic tsunami nonetheless (it will just arrive later). Heads you lose; tails you lose even worse.
Let’s assume for a moment that the current economic climate – 10% unemployment, stock market correction completed, relatively stable consumer prices – continues just as it is. Establishing that, let’s look ahead to some of the metrics regarding our national debt (how much total monies we owe to all our creditors combined) and the national deficits (the annual differential between what our economic activity brings into the country, and what we spend); note that the figures cited have been rounded off:
Debt = $12,000,000,000,000
Deficit for FY11 = $1,800,000,000,000
Projected Debt for FY15 = $24,000,000,000,000
Projected Debt for FY20 = $36,000,000,000,000
Current interest rate on our Debt = approx 3%, equating to:
Annual Debt Interest payment (current) = $300,000,000,000 (12 trillion x 0.03)
Let’s stop there for a moment. Think about all the taxes, fees, hidden taxes, benefits costs, et cetera that you pay now, in order to help Uncle Sam service its $300 billion interest payment. As it stands, this is not too pleasant for most middle class families, which are hit the hardest by most (if not all) of these taxes. (If you’re wealthy, you barely notice your tax payments because either you have a lot of money and the taxes don’t hamper your lifestyle, and/or you can afford the best accountants to hide your money from the IRS and thus pay less tax than people earning a fraction of what you earn. If you’re poor, you pay little to no taxes because you don’t earn enough [of course, if you’re poor you have other problems]. So the middle class suffers the worst from the tax code, and don’t let any government propaganda dissuade you from this fact. When the “wealthy” see tax increases, it’s really time for the middle class to turn its collective pockets inside out.)
So, if $300 billion interest payments don’t feel so great for the average middle class family, what will it feel like when those interest payments Uncle Sam owes start to rise? Let’s look at some more figures and analysis:
Assume our interest rate on the Debt starts to increase, as just about everyone following this situation expects. Why is it going to increase? Because as our dollar remains weak and grows weaker, it buys less, which means our creditors need more in the way of interest payments coming in to balance out the loss of their purchasing power with the US dollar. So let’s assume that by the year 2015, the interest rate we pay on the Debt has doubled to 6% (a modest figure considering it would happen gradually over the course of 5 years):
Debt in 2015 = $24,000,000,000,000
Interest rate on the Debt in 2015 = 6%
Interest Owed = $1,400,000,000,000 (24 trillion x 0.06)
So you can see, our interest payment approximately 5 years from now under the above stated conditions would climb to $1.4 trillion, or nearly a 500% increase from what we owe today. What do you think would happen to you economically if Uncle Sam needed 5 times the amount of tax revenue from you compared to what it takes today? I dare say this would be unsustainable for the average middle class family. But wait, it gets better…
Now let’s say that by 10 years from now, the current interest rate has tripled to 9%, and we then calculate what’s owed in interest based in the debt/interest metrics for the year 2020:
Debt in 2020 = $36,000,000,000,000
Interest rate on the Debt in 2020 = 9%
Interest Owed = $3,240,000,000,000 (36 trillion x 0.09)
So in 2020, under the stated conditions, the government would owe $3.24 trillion in interest, or nearly 1100% more than today. What would happen to you financially if the government required 11 times the tax revenue from you compared to today? Obviously, nothing good could come of this for the average American.
But unfortunately, the picture I just painted was intentionally semi-inaccurate, because I left out one major item: all of our entitlement programs. Let’s take a look at those:
All entitlements = approx $43,000,000,000,000 (based on 2008 figures), comprised of the following component expenses:
Social Security = $6,600,000,000,000
Medicare/Medicaid/Medicare Part D (prescription drugs for seniors) =$36,300,000,000,000
So the calculations I made earlier were actually devoid of the other $43 trillion dollar bill the government has racked up for the three major promises it made to us in the Social Security and Medicare/Medicaid programs. All of these programs begin to kick in earnestly around the 2017-18 time frame, and the spending just skyrockets from there. Needless to say, when you factor these conditions into the prior calculations, you get some very bad news if you happen to be a taxpayer in this country.
Suffice it to say before we move on the next part of this post, that the Congress’ orgiastic spending spree has bankrupted the country – you just don’t notice it yet because the bankruptcy is mostly on paper…for now. The fiscal challenge I outlined above is not speculation; it’s going to happen, the only questions are, how soon, and what agonizingly painful remedies will be instituted?
Having said all the above, we now move to the more short term crisis that looms ahead. There are a variety of factors that will/could potentially contribute to this crisis, but the most likely triggers lie (once again) in the now-familiar area of the housing market, and a new problem, that being the European debt crisis.
The European situation, which warrants greater analysis than I provide here, looks bad now, but has only just begun. The bailing out of Greece alone took abundant gnashing of teeth and then a $1 trillion aid package…all that for one country. What will happen in Europe and the global markets when Portugal, Italy, Ireland and Spain require similar treatment?
Pair that bleak picture with the US housing market. Recall for a moment that in 2008, the softening and then collapsing housing market was a major contributor to the economic misery that followed. At that time, one of the primary instigating factors was the subprime mortgage market, which comprised approximately 2% of all mortgages on the balance sheets of various banks. However, today there are other insidious categories of mortgages that are about to become popular in the news: the Alt-A and Option ARM (adjustable rate mortgage). These kinds of mortgages comprise closer to 30-40% of all the mortgages on the banks’ balance sheets (depending on whose estimates you read). Obviously, considerably more exposure lies in these kinds of mortgages versus the subprime variety. (There's $2.4 trillion tied up in Alt-A mortgages alone.)
Let’s take a closer look at Alt-A and Option ARMs. What are they? Essentially, they are less reliable than “prime” loans, made to the most financially stable customers, and more reliable than “sub-prime” loans, made to the least financially stable individuals. In both cases, the key aspect for the sake of our discussion in these mortgages is the fact that the interest rate attached to the loan is variable (a “teaser rate”), and at some future date, will reset to a new amount, depending on the prevailing interest rates at the time and/or the conditions of the original mortgage agreement. (In many cases, the whole point of these loans was to lure an individual into the agreement with a low interest rate, and then make up for the abnormally low interest later by raising the interest rate – hence the term “teaser rate”). Most of these loans were made in the 2005-06 time frame, with resets occurring around the 5 year mark. Therefore, these loans will see their interest rates reset in 2010-11.
Essentially, this means that at some point, the mortgage holder will see his or her mortgage amount increase at some point in the future. If you are an average middle class family, holding one of these mortgages, and your monthly mortgage rises from $1500 to $2000 or higher, what will this do both to your finances and to the overall economy? Well, from the family finances standpoint, the increased amount will obviously impact the remainder of the budget, and may be prohibitive to pay in and of itself. On top of this fact, if you’re already under water on your home (you owe more than the house is worth), you may very well be incentivized to simply walk away from your home and instead choose to rent. (Estimates abound that by 2011 at least half of US homeowner will be under water. Just last week data came in showing 1 in 7 homeowners is underwater and may be headed for foreclosure.) If you did this, you would effectively be telling the bank that lent you the money (and then possibly packaged your loan into an overall securitized investment and sold it to some other financial institution/investor) that you would be defaulting on the loan and no longer planned on sending in anymore mortgage payments. Clearly, this would quite negatively impact the banks, particularly if it occurred on a nationwide scale.
The other impact that this higher mortgage payment will have lies in the external consequences to the overall economy. If 30-40% of US families holding these resettable mortgages suddenly experiences a spike in their monthly mortgage obligation, it translates into a decreased degree of spending elsewhere. (Post-2008 crisis, it’s likely most families will not opt to continue spending on credit, as they’ve experienced a shift in mindset from the last time this happened and taken to increased saving habits.) This decrease in spending will send ripples through the rest of the US economy, which is based heavily (approximately 70%) on consumer spending and service-oriented industries (versus industries that create items to be sold/exported, such as manufacturing).
Thus, as the housing market softens and possibly collapses (again), and banks begin to witness mounting losses on their balance sheets in the mortgage area, and the consumer once again tightens his belt to deal with the crisis, the economy will experience a massive seizure based on the inability of banks to lend or extend credit and the service sector of the economy experiences large scale reductions in spending, thus reducing profit margins and creating waves of layoffs. This vicious cycle would clearly result in higher unemployment, deflated prices and business profits, and an imploding housing market and banking system. In essence, from a fractal perspective it would look like the 2008 crisis, but the actual implications financially and economically would be far more devastating. (Nassim Taleb discusses the use of fractals in understanding potential black swan events in his book The Black Swan – definitely worth reading.)
Combine the above prognostication with the beginning portion of this post. What if the crisis of 2010-11 occurs as I described (or something close to it), but at the same time the US government is in the middle of an accelerating debt crisis and needed to raise more revenue through taxes? The pairing of an economy in freefall with rising taxes is simply unconscionable, as it would be the final coup de grace for any semblance of the standard of living we enjoy today. If the government didn’t raise this money through taxes, it would only have one other place to get the money (assuming that borrowing more and thus raising the debt/interest payments higher was no longer a viable option): inflation (printing money). Unfortunately, the amount of inflation required to pay this bill is so incredibly high, there is almost no conceivable way it wouldn’t produce massive inflation, and possibly hyperinflation, leading to prices soaring astronomically (see 1920’s Germany for the endless examples of buying a loaf of bread for millions of German marks, etc).
As you can see, the road ahead is bleak for the US, no matter what permutation of specific scenarios you use. Somewhere along the line, and that sometime is in less than 10 years, taxes must be raised a lot, or government spending has to be reduced to spendthrift levels (is that even possible for this reckless Congress?) and entitlements must be reduced substantially (is that politically possible in this country?), or some moderate combination of both. But all of these attempted remedies carry great consequences, and would absolutely demand that an American people now used to the government caring for it in old age/retirement/unemployment would be left holding the bag. Losses of retirement, medical, and unemployment benefits due to the worsening economy and reduced government spending would exacerbate the problem by leaving more Americans jobless and no longer spending their money in an economy that requires spending to function (recall the 70% figure). In other words, the effects produced by these economic realities are exponential and have a cascading dimension to them, which means each year the situation could become drastically worse than the year before (making 2012 much worse than 2011; 2013 making 2012 look enjoyable; 2014 making 2013 look like an economic paradise…you get the picture).
But before we get into that, it is useful to step back for a moment and apply some scrutiny to what is already a bad situation, irrespective of what the next crisis might be. Once you digest the enormity of the fiscal challenges we currently face, you will inevitably gain an even greater understanding of why the next round of crises will be so catastrophic. In actuality, you will realize that even if we don’t have another crisis like 2008 in the short term (which I severely doubt), we are still in for an economic tsunami nonetheless (it will just arrive later). Heads you lose; tails you lose even worse.
Let’s assume for a moment that the current economic climate – 10% unemployment, stock market correction completed, relatively stable consumer prices – continues just as it is. Establishing that, let’s look ahead to some of the metrics regarding our national debt (how much total monies we owe to all our creditors combined) and the national deficits (the annual differential between what our economic activity brings into the country, and what we spend); note that the figures cited have been rounded off:
Debt = $12,000,000,000,000
Deficit for FY11 = $1,800,000,000,000
Projected Debt for FY15 = $24,000,000,000,000
Projected Debt for FY20 = $36,000,000,000,000
Current interest rate on our Debt = approx 3%, equating to:
Annual Debt Interest payment (current) = $300,000,000,000 (12 trillion x 0.03)
Let’s stop there for a moment. Think about all the taxes, fees, hidden taxes, benefits costs, et cetera that you pay now, in order to help Uncle Sam service its $300 billion interest payment. As it stands, this is not too pleasant for most middle class families, which are hit the hardest by most (if not all) of these taxes. (If you’re wealthy, you barely notice your tax payments because either you have a lot of money and the taxes don’t hamper your lifestyle, and/or you can afford the best accountants to hide your money from the IRS and thus pay less tax than people earning a fraction of what you earn. If you’re poor, you pay little to no taxes because you don’t earn enough [of course, if you’re poor you have other problems]. So the middle class suffers the worst from the tax code, and don’t let any government propaganda dissuade you from this fact. When the “wealthy” see tax increases, it’s really time for the middle class to turn its collective pockets inside out.)
So, if $300 billion interest payments don’t feel so great for the average middle class family, what will it feel like when those interest payments Uncle Sam owes start to rise? Let’s look at some more figures and analysis:
Assume our interest rate on the Debt starts to increase, as just about everyone following this situation expects. Why is it going to increase? Because as our dollar remains weak and grows weaker, it buys less, which means our creditors need more in the way of interest payments coming in to balance out the loss of their purchasing power with the US dollar. So let’s assume that by the year 2015, the interest rate we pay on the Debt has doubled to 6% (a modest figure considering it would happen gradually over the course of 5 years):
Debt in 2015 = $24,000,000,000,000
Interest rate on the Debt in 2015 = 6%
Interest Owed = $1,400,000,000,000 (24 trillion x 0.06)
So you can see, our interest payment approximately 5 years from now under the above stated conditions would climb to $1.4 trillion, or nearly a 500% increase from what we owe today. What do you think would happen to you economically if Uncle Sam needed 5 times the amount of tax revenue from you compared to what it takes today? I dare say this would be unsustainable for the average middle class family. But wait, it gets better…
Now let’s say that by 10 years from now, the current interest rate has tripled to 9%, and we then calculate what’s owed in interest based in the debt/interest metrics for the year 2020:
Debt in 2020 = $36,000,000,000,000
Interest rate on the Debt in 2020 = 9%
Interest Owed = $3,240,000,000,000 (36 trillion x 0.09)
So in 2020, under the stated conditions, the government would owe $3.24 trillion in interest, or nearly 1100% more than today. What would happen to you financially if the government required 11 times the tax revenue from you compared to today? Obviously, nothing good could come of this for the average American.
But unfortunately, the picture I just painted was intentionally semi-inaccurate, because I left out one major item: all of our entitlement programs. Let’s take a look at those:
All entitlements = approx $43,000,000,000,000 (based on 2008 figures), comprised of the following component expenses:
Social Security = $6,600,000,000,000
Medicare/Medicaid/Medicare Part D (prescription drugs for seniors) =$36,300,000,000,000
So the calculations I made earlier were actually devoid of the other $43 trillion dollar bill the government has racked up for the three major promises it made to us in the Social Security and Medicare/Medicaid programs. All of these programs begin to kick in earnestly around the 2017-18 time frame, and the spending just skyrockets from there. Needless to say, when you factor these conditions into the prior calculations, you get some very bad news if you happen to be a taxpayer in this country.
Suffice it to say before we move on the next part of this post, that the Congress’ orgiastic spending spree has bankrupted the country – you just don’t notice it yet because the bankruptcy is mostly on paper…for now. The fiscal challenge I outlined above is not speculation; it’s going to happen, the only questions are, how soon, and what agonizingly painful remedies will be instituted?
Having said all the above, we now move to the more short term crisis that looms ahead. There are a variety of factors that will/could potentially contribute to this crisis, but the most likely triggers lie (once again) in the now-familiar area of the housing market, and a new problem, that being the European debt crisis.
The European situation, which warrants greater analysis than I provide here, looks bad now, but has only just begun. The bailing out of Greece alone took abundant gnashing of teeth and then a $1 trillion aid package…all that for one country. What will happen in Europe and the global markets when Portugal, Italy, Ireland and Spain require similar treatment?
Pair that bleak picture with the US housing market. Recall for a moment that in 2008, the softening and then collapsing housing market was a major contributor to the economic misery that followed. At that time, one of the primary instigating factors was the subprime mortgage market, which comprised approximately 2% of all mortgages on the balance sheets of various banks. However, today there are other insidious categories of mortgages that are about to become popular in the news: the Alt-A and Option ARM (adjustable rate mortgage). These kinds of mortgages comprise closer to 30-40% of all the mortgages on the banks’ balance sheets (depending on whose estimates you read). Obviously, considerably more exposure lies in these kinds of mortgages versus the subprime variety. (There's $2.4 trillion tied up in Alt-A mortgages alone.)
Let’s take a closer look at Alt-A and Option ARMs. What are they? Essentially, they are less reliable than “prime” loans, made to the most financially stable customers, and more reliable than “sub-prime” loans, made to the least financially stable individuals. In both cases, the key aspect for the sake of our discussion in these mortgages is the fact that the interest rate attached to the loan is variable (a “teaser rate”), and at some future date, will reset to a new amount, depending on the prevailing interest rates at the time and/or the conditions of the original mortgage agreement. (In many cases, the whole point of these loans was to lure an individual into the agreement with a low interest rate, and then make up for the abnormally low interest later by raising the interest rate – hence the term “teaser rate”). Most of these loans were made in the 2005-06 time frame, with resets occurring around the 5 year mark. Therefore, these loans will see their interest rates reset in 2010-11.
Essentially, this means that at some point, the mortgage holder will see his or her mortgage amount increase at some point in the future. If you are an average middle class family, holding one of these mortgages, and your monthly mortgage rises from $1500 to $2000 or higher, what will this do both to your finances and to the overall economy? Well, from the family finances standpoint, the increased amount will obviously impact the remainder of the budget, and may be prohibitive to pay in and of itself. On top of this fact, if you’re already under water on your home (you owe more than the house is worth), you may very well be incentivized to simply walk away from your home and instead choose to rent. (Estimates abound that by 2011 at least half of US homeowner will be under water. Just last week data came in showing 1 in 7 homeowners is underwater and may be headed for foreclosure.) If you did this, you would effectively be telling the bank that lent you the money (and then possibly packaged your loan into an overall securitized investment and sold it to some other financial institution/investor) that you would be defaulting on the loan and no longer planned on sending in anymore mortgage payments. Clearly, this would quite negatively impact the banks, particularly if it occurred on a nationwide scale.
The other impact that this higher mortgage payment will have lies in the external consequences to the overall economy. If 30-40% of US families holding these resettable mortgages suddenly experiences a spike in their monthly mortgage obligation, it translates into a decreased degree of spending elsewhere. (Post-2008 crisis, it’s likely most families will not opt to continue spending on credit, as they’ve experienced a shift in mindset from the last time this happened and taken to increased saving habits.) This decrease in spending will send ripples through the rest of the US economy, which is based heavily (approximately 70%) on consumer spending and service-oriented industries (versus industries that create items to be sold/exported, such as manufacturing).
Thus, as the housing market softens and possibly collapses (again), and banks begin to witness mounting losses on their balance sheets in the mortgage area, and the consumer once again tightens his belt to deal with the crisis, the economy will experience a massive seizure based on the inability of banks to lend or extend credit and the service sector of the economy experiences large scale reductions in spending, thus reducing profit margins and creating waves of layoffs. This vicious cycle would clearly result in higher unemployment, deflated prices and business profits, and an imploding housing market and banking system. In essence, from a fractal perspective it would look like the 2008 crisis, but the actual implications financially and economically would be far more devastating. (Nassim Taleb discusses the use of fractals in understanding potential black swan events in his book The Black Swan – definitely worth reading.)
Combine the above prognostication with the beginning portion of this post. What if the crisis of 2010-11 occurs as I described (or something close to it), but at the same time the US government is in the middle of an accelerating debt crisis and needed to raise more revenue through taxes? The pairing of an economy in freefall with rising taxes is simply unconscionable, as it would be the final coup de grace for any semblance of the standard of living we enjoy today. If the government didn’t raise this money through taxes, it would only have one other place to get the money (assuming that borrowing more and thus raising the debt/interest payments higher was no longer a viable option): inflation (printing money). Unfortunately, the amount of inflation required to pay this bill is so incredibly high, there is almost no conceivable way it wouldn’t produce massive inflation, and possibly hyperinflation, leading to prices soaring astronomically (see 1920’s Germany for the endless examples of buying a loaf of bread for millions of German marks, etc).
As you can see, the road ahead is bleak for the US, no matter what permutation of specific scenarios you use. Somewhere along the line, and that sometime is in less than 10 years, taxes must be raised a lot, or government spending has to be reduced to spendthrift levels (is that even possible for this reckless Congress?) and entitlements must be reduced substantially (is that politically possible in this country?), or some moderate combination of both. But all of these attempted remedies carry great consequences, and would absolutely demand that an American people now used to the government caring for it in old age/retirement/unemployment would be left holding the bag. Losses of retirement, medical, and unemployment benefits due to the worsening economy and reduced government spending would exacerbate the problem by leaving more Americans jobless and no longer spending their money in an economy that requires spending to function (recall the 70% figure). In other words, the effects produced by these economic realities are exponential and have a cascading dimension to them, which means each year the situation could become drastically worse than the year before (making 2012 much worse than 2011; 2013 making 2012 look enjoyable; 2014 making 2013 look like an economic paradise…you get the picture).
Tuesday, February 9, 2010
Further Reading on Black Swan Conjecture and Nassim Taleb
In dialogue with one of my readers, I discovered a website that he maintains containing an exceptional degree of information on Nassim Taleb and his black swan conjecture. This site is called The Black Swan Report; you can visit it at www.blackswanreport.com.
The site has articles, video clips, and Twitter updates from Taleb. Specifically, I encourage readers to check out the following on The Black Swan Report site:
-- The February 6 post, which contains a link to a video clip of Taleb at The Russia Forum 2010 this month, where he gives specifics on which trades he’d consider making for the current economic climate (shorting US Treasuries, out of the money put options betting on hyperinflation, shorting the S&P 500, etc). (Also, see my February 1 post for a discussion on a proposed black swan protection protocol investment approach, similar to what Taleb discusses in this video clip.)
-- The January 31 post, which contains a video clip of Taleb at The New Yorker Summit in May 2009. Still worth watching despite being nine months old.
-- The January 26 post, in which Taleb lists six problems regarding Ben Bernanke and his performance as Fed Reserve Chairman.
The site has articles, video clips, and Twitter updates from Taleb. Specifically, I encourage readers to check out the following on The Black Swan Report site:
-- The February 6 post, which contains a link to a video clip of Taleb at The Russia Forum 2010 this month, where he gives specifics on which trades he’d consider making for the current economic climate (shorting US Treasuries, out of the money put options betting on hyperinflation, shorting the S&P 500, etc). (Also, see my February 1 post for a discussion on a proposed black swan protection protocol investment approach, similar to what Taleb discusses in this video clip.)
-- The January 31 post, which contains a video clip of Taleb at The New Yorker Summit in May 2009. Still worth watching despite being nine months old.
-- The January 26 post, in which Taleb lists six problems regarding Ben Bernanke and his performance as Fed Reserve Chairman.
Monday, February 1, 2010
Black Swan Protection Protocol: An Approach for Weathering the Storm (continued)
In my August 12, 2009 post, I indicated that there was a separate approach I was undertaking for shielding the money I had no desire to lose – I referred to this approach as “black swan protection protocol.” The genesis of this term lies in the writings of Nassim Nicholas Taleb, and specifically, his 2007 best seller The Black Swan: The Impact of the Highly Improbable. Let me state clearly that this blog post does not suffice for conveying the importance and material significance of Taleb’s conjecture. Nonetheless, I was sufficiently motivated by his insights to fashion a rough outline here of how I plan to follow his advice and why.
If you read my July 15 post regarding Taleb’s ideas, the following may sound a bit redundant, but it’s worth exploring before moving into the details of the actual investment approach. The term “black swan” refers to the discovery in the 17th century of the first non-white swans, invalidating centuries of assumption that all swans were white. Thus, when Taleb speaks of black swan events, he is referring to an event which has the following attributes:
1) the event is completely unexpected
2) it is highly impactful
3) it is retrospectively distorted; that is, afterward it is rationalized as if it was or could have been expected
(IF YOU PREFER TO SKIP TO THE ACTUAL IMPLEMENTATION APPROACH FOR BLACK SWAN PROTOCOL, SCROLL DOWN SEVERAL PARAGRAPHS.)
One of the central themes of the book focuses on the following: the concept of two different realms of existence for humans: Mediocristan and Extremistan. An illustration works best for explaining these concepts.
Take 1,000 individuals randomly from society, tabulating their weight and averaging it out. Then take the 1,001st individual, who is the heaviest individual in the world (say roughly 1,000 pounds for the sake of argument). The average weight for these 1,001 individuals will not have changed substantially with the addition of the 1,001st’s weight to the total. This is Mediocristan.
Now take 1,000 individuals randomly from society and tabulate their net worth, then average it out. Take the 1,001st individual, who happens to be the richest individual in the world: Bill Gates, approximate net worth of $80 billion. What will happen to the average net worth? Rise dramatically, obviously. In other words, the addition of just one individual’s net worth changes the entire complexion of the situation instantaneously. This is Extremistan.
Here’s the basic point: human beings do not intrinsically recognize the kind of world we live in; we think we are living in Mediocristan, when we are actually living in Extremistan. In this sense, we underestimate the impact and importance of unforeseen, significant scale events. Evidence that we are living in Extremistan abounds: see 9/11, the 2008 financial collapse, the 1987 market crash, and so on and so forth. Whether it is due to human nature or evolutionary programming (or lack thereof), the simple fact is we do not effectively recognize the role and impact of randomness and black swan style events in our lives.
Taleb does an excellent job of exploring why this is the case in some depth, with one of the prime reasons being what he calls the “Platonic fold.” Essentially, this is the differential between what we know and what we think we know. When we act on what we think we know, rather than grasping the notion that we are treading into territory that we cannot possibly predict or explain adequately, we invite disaster or at the very least, a severe under-appreciation for the consequences or implications of a particular event.
Another key concept Taleb discusses is what he calls the “confirmation bias.” This refers to the fact that, because we do not see an event occur over a period of time, we assume it is not possible (if we can even imagine its possibility to begin with). Taleb uses this great analogy: a turkey is fed and well-cared for by its owner throughout the year, and the turkey comes to believe the owner has its best interest at heart; then, in late November, the turkey is slaughtered by the owner for Thanksgiving. The turkey experienced a confirmation bias, in that every day it was well-treated, it confirmed the notion that the owner had the turkey’s interest at heart. Obviously, this misconception is suddenly clarified, with tragic consequences for the turkey.
The real question becomes, what can we do about these conditions? As Taleb offers in his book, we can only attempt to build a more robust system that is less susceptible to the devastating effects of negative black swans. His prime example of this from a finance perspective resides in the notion that our banking system is severely over-leveraged and, by carrying the amount of debt that we currently have, as well as speculating in complex derivative financial products, simply begging for some catastrophic perturbation to occur to the system.
But the added problem here is that the banking and overall financial system has become increasingly interconnected in a global sense, thus vastly increasing the complexity of the system itself. A problem at one node, or bank, within the system, can quickly propagate throughout the entire system, causing distress to the system and turbulence in the financial markets. This kind of complexity must be countered with a more robust approach to the kinds of financial products and rule sets that are employed by the institutions themselves. In other words, the less complexity, the less the impact of the failure of a banking or financial institution on the overall system.
Again, I implore readers of this blog to read the book in order to gain a full appreciation of why Taleb’s conjecture is so critical to the health of one’s financial portfolio. There is simply no substitute for his insights.
(BELOW THIS POINT I BEGIN TO EXPLAIN THE THEORETICAL FINANCIAL APPROACH FOR EMPLOYING BLACK SWAN PROTOCOL.)
In deploying black swan protection protocol for my portfolio, I begin by identifying the money I have that I do not wish to subject to the risks of the marketplace; in other words, money I absolutely do not want to lose. Next, I identify the amount of money that I want to deploy for the active component of the black swan protection protocol (I’ll explain what this component is momentarily). These two figures comprise the bookends of what Taleb calls the barbell strategy: extreme conservatism at one end, extreme risk taking at the other.
On the conservative end, taking the amount of money I cannot afford to lose, I invest it into the safest securities available: CDs, money market accounts, and other savings vehicles (as safe as these can be given the overall tenability of the financial system). (One possibility here that Taleb mentions, though I would not personally choose, is the Treasury bond. Bonds will be the basis for the third and final financial bubble that is forming right before our eyes; however, to avoid digressing, I will save that topic for another post.) By investing in these extremely conservative positions, I have achieved the primary objective of capital preservation. While I will very well be subjected to purchasing power erosion due to inflation, that’s where the other end of the barbell approach comes into play, as we will examine now.
The central instrument behind the extreme risk end of the barbell strategy, and where the potential for significant gains resides, is the option. Investopedia describes options as follows: “A financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).” It is crucial here to note that, in general, the further away the date of the option, the more expensive the option will be. For example, if I bought an option in February 2010 that assumed Microsoft’s stock price would rise $2 by April 2010, this option would be less costly to me than if I bought an identical option with an expiration of February 2011. This is due to the fact that the underlying contract price has more time to fluctuate. (As a side note, for terminology sake, the options that are further out on the calendar can be referred to as “long-dated.”) Conversely, the more far-fetched the outcome implied by the option (the further it is "out of the money"), the less expensive it will be. For example, if I bought an option in February 2010 that assumed Microsoft’s stock price would rise $22 by April 2010, this option would be less costly to me than if I bought an option assuming the price would rise by $2. (Option prices are calculated using an esoteric, opaque formula called Black Scholes, but the above pricing assumptions will suffice for this post.)
Thus, on the riskier end of the barbell, I would begin accumulating various options, including short-dated, long-dated and out of the money options, that positioned me for extreme events. For example, as of the date of this blog post, the Dow is around 10000. So I might buy options for this time next year (Feb 2011) indicating that the Dow would be at 9000, 8000, 7000, 6000, and 5000. Another example would be as follows: given my firm belief that the dollar will continue to be devalued through the reckless money-printing of the US government, I would purchase options for 2010 and perhaps 2011 assuming that gold prices would reach $2000, $3000, and even $4000 per ounce.
You might be reading the above examples and thinking that these are extremely untenable investment choices…and you might very well be right. But that is the point. The options I described above – which I must reiterate are only examples for the sake of illustration – would do one of two things: if they do not materialize for me, I’ve lost a couple of hundred dollars; if they do materialize, I’ve made tens or perhaps hundreds of thousands. As I continue to analyze the market and macroeconomic trends, identifying these kinds of potential black swan events, I continue purchasing the options I believe may materialize and rolling them forward further into the calendar years. For example, in 2010 I’d be buying 2011, 2012, and 2013 options; in 2011 I’d buy 2012, 2013 and 2014 options, and so on and so forth.
What’s created through this barbell approach is a method for preserving the bulk of your capital (say 80-90% on average) through conservative investments, and a method for realizing enormous gains through black swan protocol, with about 10-20% of the portfolio dedicated towards option purchases. The 3-10% a year lost to inflation in the conservative category is made up by the triple digit percentage gains in the second. Using the real world example of Taleb’s fund, portfolios would have lost some real value to inflation throughout the mid-2000’s, until 2008 when they gained 50-110% during the financial collapse. Thus, if you’d given that kind of fund $1,000,000 in 2005 (assuming 5% inflation), you might have dropped to $950,000 real value in 2006, $902,500 real value in 2007, then risen to anywhere between $1.35M and $1.8M at the conclusion of 2008. Your overall return after 3 years would be between 35% and 80%.
Again, the approach outlined here is basic in nature, and should be carefully considered for one’s tolerance toward enduring steady but relatively small losses with the anticipation of infrequent yet sizable gains. In addition, the use of options as investments requires some education and understanding, or the help of a financial adviser or broker. But in essence, the black swan protection protocol is in many respects the perfect hedge to a more traditional approach involving the purchase and holding of stocks, bonds, and other securities. After the 2008 financial crisis, it is fair to say that such traditional investments do not necessarily equate to safe investments.
If you read my July 15 post regarding Taleb’s ideas, the following may sound a bit redundant, but it’s worth exploring before moving into the details of the actual investment approach. The term “black swan” refers to the discovery in the 17th century of the first non-white swans, invalidating centuries of assumption that all swans were white. Thus, when Taleb speaks of black swan events, he is referring to an event which has the following attributes:
1) the event is completely unexpected
2) it is highly impactful
3) it is retrospectively distorted; that is, afterward it is rationalized as if it was or could have been expected
(IF YOU PREFER TO SKIP TO THE ACTUAL IMPLEMENTATION APPROACH FOR BLACK SWAN PROTOCOL, SCROLL DOWN SEVERAL PARAGRAPHS.)
One of the central themes of the book focuses on the following: the concept of two different realms of existence for humans: Mediocristan and Extremistan. An illustration works best for explaining these concepts.
Take 1,000 individuals randomly from society, tabulating their weight and averaging it out. Then take the 1,001st individual, who is the heaviest individual in the world (say roughly 1,000 pounds for the sake of argument). The average weight for these 1,001 individuals will not have changed substantially with the addition of the 1,001st’s weight to the total. This is Mediocristan.
Now take 1,000 individuals randomly from society and tabulate their net worth, then average it out. Take the 1,001st individual, who happens to be the richest individual in the world: Bill Gates, approximate net worth of $80 billion. What will happen to the average net worth? Rise dramatically, obviously. In other words, the addition of just one individual’s net worth changes the entire complexion of the situation instantaneously. This is Extremistan.
Here’s the basic point: human beings do not intrinsically recognize the kind of world we live in; we think we are living in Mediocristan, when we are actually living in Extremistan. In this sense, we underestimate the impact and importance of unforeseen, significant scale events. Evidence that we are living in Extremistan abounds: see 9/11, the 2008 financial collapse, the 1987 market crash, and so on and so forth. Whether it is due to human nature or evolutionary programming (or lack thereof), the simple fact is we do not effectively recognize the role and impact of randomness and black swan style events in our lives.
Taleb does an excellent job of exploring why this is the case in some depth, with one of the prime reasons being what he calls the “Platonic fold.” Essentially, this is the differential between what we know and what we think we know. When we act on what we think we know, rather than grasping the notion that we are treading into territory that we cannot possibly predict or explain adequately, we invite disaster or at the very least, a severe under-appreciation for the consequences or implications of a particular event.
Another key concept Taleb discusses is what he calls the “confirmation bias.” This refers to the fact that, because we do not see an event occur over a period of time, we assume it is not possible (if we can even imagine its possibility to begin with). Taleb uses this great analogy: a turkey is fed and well-cared for by its owner throughout the year, and the turkey comes to believe the owner has its best interest at heart; then, in late November, the turkey is slaughtered by the owner for Thanksgiving. The turkey experienced a confirmation bias, in that every day it was well-treated, it confirmed the notion that the owner had the turkey’s interest at heart. Obviously, this misconception is suddenly clarified, with tragic consequences for the turkey.
The real question becomes, what can we do about these conditions? As Taleb offers in his book, we can only attempt to build a more robust system that is less susceptible to the devastating effects of negative black swans. His prime example of this from a finance perspective resides in the notion that our banking system is severely over-leveraged and, by carrying the amount of debt that we currently have, as well as speculating in complex derivative financial products, simply begging for some catastrophic perturbation to occur to the system.
But the added problem here is that the banking and overall financial system has become increasingly interconnected in a global sense, thus vastly increasing the complexity of the system itself. A problem at one node, or bank, within the system, can quickly propagate throughout the entire system, causing distress to the system and turbulence in the financial markets. This kind of complexity must be countered with a more robust approach to the kinds of financial products and rule sets that are employed by the institutions themselves. In other words, the less complexity, the less the impact of the failure of a banking or financial institution on the overall system.
Again, I implore readers of this blog to read the book in order to gain a full appreciation of why Taleb’s conjecture is so critical to the health of one’s financial portfolio. There is simply no substitute for his insights.
(BELOW THIS POINT I BEGIN TO EXPLAIN THE THEORETICAL FINANCIAL APPROACH FOR EMPLOYING BLACK SWAN PROTOCOL.)
In deploying black swan protection protocol for my portfolio, I begin by identifying the money I have that I do not wish to subject to the risks of the marketplace; in other words, money I absolutely do not want to lose. Next, I identify the amount of money that I want to deploy for the active component of the black swan protection protocol (I’ll explain what this component is momentarily). These two figures comprise the bookends of what Taleb calls the barbell strategy: extreme conservatism at one end, extreme risk taking at the other.
On the conservative end, taking the amount of money I cannot afford to lose, I invest it into the safest securities available: CDs, money market accounts, and other savings vehicles (as safe as these can be given the overall tenability of the financial system). (One possibility here that Taleb mentions, though I would not personally choose, is the Treasury bond. Bonds will be the basis for the third and final financial bubble that is forming right before our eyes; however, to avoid digressing, I will save that topic for another post.) By investing in these extremely conservative positions, I have achieved the primary objective of capital preservation. While I will very well be subjected to purchasing power erosion due to inflation, that’s where the other end of the barbell approach comes into play, as we will examine now.
The central instrument behind the extreme risk end of the barbell strategy, and where the potential for significant gains resides, is the option. Investopedia describes options as follows: “A financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).” It is crucial here to note that, in general, the further away the date of the option, the more expensive the option will be. For example, if I bought an option in February 2010 that assumed Microsoft’s stock price would rise $2 by April 2010, this option would be less costly to me than if I bought an identical option with an expiration of February 2011. This is due to the fact that the underlying contract price has more time to fluctuate. (As a side note, for terminology sake, the options that are further out on the calendar can be referred to as “long-dated.”) Conversely, the more far-fetched the outcome implied by the option (the further it is "out of the money"), the less expensive it will be. For example, if I bought an option in February 2010 that assumed Microsoft’s stock price would rise $22 by April 2010, this option would be less costly to me than if I bought an option assuming the price would rise by $2. (Option prices are calculated using an esoteric, opaque formula called Black Scholes, but the above pricing assumptions will suffice for this post.)
Thus, on the riskier end of the barbell, I would begin accumulating various options, including short-dated, long-dated and out of the money options, that positioned me for extreme events. For example, as of the date of this blog post, the Dow is around 10000. So I might buy options for this time next year (Feb 2011) indicating that the Dow would be at 9000, 8000, 7000, 6000, and 5000. Another example would be as follows: given my firm belief that the dollar will continue to be devalued through the reckless money-printing of the US government, I would purchase options for 2010 and perhaps 2011 assuming that gold prices would reach $2000, $3000, and even $4000 per ounce.
You might be reading the above examples and thinking that these are extremely untenable investment choices…and you might very well be right. But that is the point. The options I described above – which I must reiterate are only examples for the sake of illustration – would do one of two things: if they do not materialize for me, I’ve lost a couple of hundred dollars; if they do materialize, I’ve made tens or perhaps hundreds of thousands. As I continue to analyze the market and macroeconomic trends, identifying these kinds of potential black swan events, I continue purchasing the options I believe may materialize and rolling them forward further into the calendar years. For example, in 2010 I’d be buying 2011, 2012, and 2013 options; in 2011 I’d buy 2012, 2013 and 2014 options, and so on and so forth.
What’s created through this barbell approach is a method for preserving the bulk of your capital (say 80-90% on average) through conservative investments, and a method for realizing enormous gains through black swan protocol, with about 10-20% of the portfolio dedicated towards option purchases. The 3-10% a year lost to inflation in the conservative category is made up by the triple digit percentage gains in the second. Using the real world example of Taleb’s fund, portfolios would have lost some real value to inflation throughout the mid-2000’s, until 2008 when they gained 50-110% during the financial collapse. Thus, if you’d given that kind of fund $1,000,000 in 2005 (assuming 5% inflation), you might have dropped to $950,000 real value in 2006, $902,500 real value in 2007, then risen to anywhere between $1.35M and $1.8M at the conclusion of 2008. Your overall return after 3 years would be between 35% and 80%.
Again, the approach outlined here is basic in nature, and should be carefully considered for one’s tolerance toward enduring steady but relatively small losses with the anticipation of infrequent yet sizable gains. In addition, the use of options as investments requires some education and understanding, or the help of a financial adviser or broker. But in essence, the black swan protection protocol is in many respects the perfect hedge to a more traditional approach involving the purchase and holding of stocks, bonds, and other securities. After the 2008 financial crisis, it is fair to say that such traditional investments do not necessarily equate to safe investments.
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