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Seven Varieties of Deflation

A Little Chronic Deflation
John Mauldin
October 13, 2012



One of the questions I (and other analysts) get asked most frequently is whether I think there is deflation or inflation in store for the US. My quick answer is “Yes.” A brief answer is that we are in a deflationary period and have been for over 30 years, but like all cycles it will come to an end. A great deal of the “when” depends on how the US deals with its deficit following the election. If we put the US on a realistic glide path to a balanced budget (over time) then that deflationary impulse will last longer than most observers think, even given QE3+++. If we do not deal with the issue, and try once again to kick the can to the next election, inflation could be a very real problem.

But one of the definitive experts on the question, and someone who has taught me a great deal over the years, is Dr. Gary Shilling, who has literally written the book (several, actually) on deflation. This week he summarizes a recent client letter for our Outside the Box, and I think you’ll will find stimulating. His is not the consensus view, but it’s one we need to understand.

You can subscribe to Gary Shilling’s Insight for the special introductory rate of $275 for Outside the Box readers (email delivery) and get a copy of the full Insight report excerpted here plus a copy of Gary’s latest book, Letting Off Steam, a collection of his commentaries on matters great and small, complex and mundane, serious and frivolous.

Gary will be writing about the details of who will be winners and losers in the Fed’s QE3 program, how overseas economies are faring, and what it all means for US stocks and the American economy. To subscribe to Insight call them at 888-346-7444 or 973-467-0070 and be sure to mention you read about the offer here.

This has been an interesting week. I was supposed to speak at a client meeting for Common Sense Investments at noon on Wednesday in Portland. Kyle Bass of Hayman Advisors was also speaking, so he graciously offered to let me fly with him in his plane rather than catching a redeye the night before. I got up early and made it to the hangar, but the plane had a mechanical problem. A quick call to American Airlines and a mad dash to the airport got me on a scheduled flight that would have gotten me in on time. Except that flight too had issues and the other flights were booked solid. An extremely helpful staff member at American somehow sorted it out and got me onto a full flight (with wifi!) and into Portland in time to let me give a speech as the “closer” for the day. Meanwhile, Kyle was in Chicago and found another way to get to Portland. The other speaker had a personal tragedy to deal with and couldn’t make it; so I called my old friend Ed Easterling, who lives not far from Portland, and he kicked the meeting off with his usual dynamic presentation while the rest of us figured out how to get there.

The next day, the founder of Common Sense Investments, Jim Bisenius, took us to his 36,000 acre ranch (and wildlife preserve) in Eastern Oregon to do a little hunting and fishing. It is a rather amazing place. He is such a gracious host and has a gift for getting people to tell their stories. Kyle brought along a young man who had been Special Operations in Iraq and who now carries around about four pounds of metal from a IED that can’t be gotten out of him. He’s in quite a lot of chronic pain but is rather cheerful and can tell some pretty amazing stories. It makes me humble to realize what sacrifices people make for our freedoms. The courage he and his brethren display on a regular basis is inspiring. I simply stand in awe and gratitude.

I was able to hitch a ride back to Dallas, got in late, got up the next morning, taped videos and read some emails, and then hopped another plane to Houston, where I am getting ready to go to my 40th Rice University class reunion. I am sure it will be another night of old friends and great stories, so I think I will hit the send button and go on to the party. Have a great week!

Your rather amazed at how much fun I get to have analyst,

(Even more amazing is that I get paid for this!)

John Mauldin, Editor
Outside the Box

Seven Varieties of Deflation

By Dr. A. Gary Shilling

Inflation in the U.S. has historically been a wartime phenomenon, including not only shooting wars but also the Cold War and the War on Poverty. That’s when the federal government vastly overspends its income on top of a robust private economy—obviously not the case today when government stimulus isn’t even offsetting private sector weakness. Deflation reigns in peacetime, and I think it is again, with the end of the Iraq engagement and as the unwinding of Afghanistan expenditures further reduce military spending.

Chronic Deflation

Few agree with my forecast of chronic deflation. They’ve never seen anything but inflation in their business careers or lifetimes, so they think that’s the way God made the world. Few can remember much about the 1930s, the last time deflation reigned. Furthermore, we all tend to have inflation biases. When we pay higher prices, it’s because of the inflation devil himself, but lower prices are a result of our smart shopping and bargaining skills. Furthermore, we don’t calculate the quality-adjusted price declines that result from technological improvements in many big-ticket purchases. This is especially true since many of those items, like TVs, are bought so infrequently that we have no idea what we paid for the last one. But we sure remember the cost of gasoline on the last fill-up a week ago.


Furthermore, many believe widespread deflation is impossible and that rampant inflation is assured in future years because of continuing high federal deficits, regardless of any long-run budget reform. And annual deficits of over $1 trillion are likely to persist in the remaining five to seven years of deleveraging, as I explain in my recent book, The Age of Deleveraging. The 2% annual real GDP growth I see persisting is well below the 3.3% needed to keep the unemployment rate stable. So to prevent high and chronically rising unemployment, any Administration and Congress—left, right or center—will be forced to spend a lot of money to create a lot of jobs.

But big federal deficits are inflationary only when they come on top of fully-employed economies and create excess demand. That’s obviously not true at present when large deficits are reactions to private sector weakness that has slashed tax revenues and encouraged deficit spending. Indeed, the slack in the economy in the face of persistent trillion dollar-plus deficits measures the huge size and scope of the offsetting deleveraging in the private sector, as noted earlier.

The deleveraging, especially in the global financial sector and among U.S. consumers, will be completed in another five to seven years at the rate it is progressing. At that point, the federal deficit should fade quickly, assuming a war or other cause of oversized government spending doesn’t intervene. The resumption of meaningful economic growth will reduce the pressure for economic stimuli and rising incomes and corporate profits will spur revenues. Serious work on the postwar baby-related bulge in Social Security and Medicare costs will also depress the deficit.

Good Deflation

A decade ago in my two Deflation books, I distinguished between two types of deflation—the Good Deflation of excess supply and the Bad Deflation of deficient demand. Good Deflation is the result of important new technologies that spike productivity and output even as the economy grows rapidly. Bad Deflation results from financial crises and deep recession, which hype unemployment and depress demand.

I’ve been forecasting chronic good deflation of excess supply because of today’s convergence of many significant productivity-soaked technologies such as semiconductors, computers, the Internet, telecom and biotech that should hype output. Ditto for the globalization of production and the other deflationary forces I’ve been discussing since I wrote the two Deflation books and The Age of Deleveraging. As a result of rapid productivity growth, fewer and fewer man-hours are needed to produce goods and services. The rapid productivity growth so far this decade is likely to persist (Chart 1).

While I’ve consistently predicted the good deflation of excess supply, I said clearly that the bad deflation of deficient demand could occur—due to severe and widespread financial crises or due to global protectionism. Both are now clear threats.

My forecast is that the unfolding global slump will initiate worldwide chronic deflation. A number of indicators point in that direction. Sure, much of the recent weakness in the PPI and CPI has been due to falling energy and food prices. Excluding these volatile items, prices are still rising but at slowing rates (Charts 2 and 3). Consumer price inflation is also falling abroad in the U.K. and the eurozone.


5 Theories Why Romney Won’t Release His Tax Records

Invictus here.

Mitt Romney didn’t have a very good week. When the Romney Campaign releases his 2011 taxes as a subject-changer, it’s a safe bet that things haven’t been going swimmingly.

Let’s oblige them by wading into this tax story.

Here is what we know: GOP candidate Mitt Romney has released his two most recent tax returns. According to Politifact, that’s far fewer than most presidential candidates disclose. As an example, Romney’s father, George, had released 12 years of tax returns. He has steadfastly refused to release the rest, despite being goaded by many players — not just Democrats and media pundits, but by members of the GOP establishment as well. Regardless, he has not been very forthcoming.

Why has he refused? There are no good answers, only speculations. Given that not releasing additional tax docs has cost Romney politically only increases the arm chair hypothesizing. All summer, the incumbent has battered the challenger on this (and related issues). Romney’s approval ratings have been hurt. His refusal is helping to coalesce a detrimental media narrative: There are different rules for people of privilege than for the rest of the country, and Romney has taken advantage of them. These week’s 47% gaffe only plays into that same narrative.

While the Obama ads have been politically effective, it’s been even more surprising that there has not been a successful counter from the GOP candidate. Romney was even vetted as a Veep candidate in 2008 by the McCain camp, where they ostensibly saw his tax records. McCain himself said Romney provided 20 years of records, and has paid his taxes . . . but then again, he passed over Romney for Sarah Palin as Veep.

The Obama campaign has offered to drop the issue if Romney releases just 5 years of tax docs. Still, the Romney camp has refused.

All of these minor sleights and unanswered accusations have led to a cottage industry of imagining what secrets might be hidden in these tax records. We do not know, but we can use some deductive reasoning to come up with some reasonable theories as to why Romney won’t share with voters what he showed the McCain camp (or perhaps, what took place post-McCain).

Here are our 5 top contenders:

1) 0% Tax Rates: The released tax documents show a very low tax rate, and Romney has said he never paid less than a 13% rate over the past 10 years. However, its not inconceivable that through a combination of aggressive tax planning, use of Trusts, earned income carry forwards and use of tax havens like Switzerland, Lichtenstein, Cayman Islands and Bermuda, Romney may have paid no taxes whatsoever in 2009 and years prior. His advisors may have correctly surmised this would be fatal to his Presidential aspirations.

Since I began composing this post, the Romney campaign has released a letter from his accountants to the effect that, over the period reviewed, the Romneys’ lowest tax rate was 13.66 percent (though there was a bit of numerical gymnastics to make that true in 2011). Note that Romney’s letter from PricewaterhouseCoopers discusses “adjusted gross income” — not total income; this subtle difference has already been debunked.

Not surprisingly in the post-Enron, post-WorldCom world, the word of an accountant ain’t worth the pixels used to write it. And, if it’s true, why not just get them out there and be done with with?

Well, maybe it’s:

2) Voter FraudThe Guardian and others came up with an even simpler theory: That Romney has voted in a state in which he was not technically a resident (i.e. voting in Massachusetts when he was actually a resident of California).

I first saw this in Forbes, which mentioned that “Romney appears to have escaped relatively unsinged from the apparently unrelated revelation that he may have committed voter fraud in January 2010, when – despite not owning a house in Massachusetts and having given every appearance of having moved to California…”

3) Broken Tax Laws: Personally, I assign this a very low to moderate probability. However, without releasing his returns, Romney leaves himself open to speculation that he may perhaps have crossed a line and submitted returns that are somehow numerically fraudulent and/or otherwise illegal (separate and apart from the aforementioned address issue).

BR has raised the issue of Romney’s IRA. William Cohan at Bloomberg has also wondered how he was able to legally amass $102 million in his individual retirement account — tax free! — during the 15 years he was at Bain Capital, despite contribution limits that would seem to make that all but impossible. What sort of rate of return is that, anyway?

Regarding the IRA contributions, Victor Fleischer, Professor of Law at University of Colorado is rather blunt: “Bottom line: Mitt Romney has not paid all the taxes required under law.”

Beyond that, it’s possible he is:


Mankiw’s Ode to the Governmental Competition that Made Romney Wealthy

Mankiw’s Ode to the Governmental Competition that Made Romney Wealthy
By William K. Black




This is the second part of my discussion of N. Gregory Mankiw’s column asserting that governmental competition is desirable for the same reason that private competition is.  Mankiw was Chairman of President Bush’s Council of Economic Advisors from 2003-2005.  He was one of the principal architects of the perverse incentive structures that proved so criminogenic and drove the ongoing financial crisis.  He gave no useful warnings of the necessity for containing the developing crisis – even after the FBI’s September 2004 warning that mortgage fraud was become “epidemic” and would cause a financial “crisis” if it were not contained.  He is now Mitt Romney’s principal economic advisor.  His column favors the “competition” argument that led him to support crippling financial regulation even as private sector competition led to endemic fraud.  Mankiw is a moral failure as well as a failed economist.  His infamous response to Akerlof and Romer’s 1993 paper (“Looting: the Economic Underworld of Bankruptcy for Profit”) was that it would be “irrational” for CEOs not to loot “their” corporations.  He ignored all of the prescient warnings we made about how accounting control fraud drove our crises and he continues to ignore those warnings and the reality of our recurrent, intensifying financial crises.  He wants the U.S. to move even more rapidly downward in the “competition in regulatory laxity” that is driving those crises.


Mankiw is serving as Romney’s propagandist in chief.  He is writing columns trying to defend Romney’s vulnerabilities, e.g., claiming that Romney should pay a marginal income tax rate that is lower than the marginal rate his secretary pays.  In the column I am responding to, Mankiw chose this frame for his analysis:  “SHOULD governments — of nations, states and towns — compete like business rivals?” (The capitalization is in the original.)  He answered his question in this self-referential manner.

“[K]nowing that I have to keep up with the Paul Krugmans and the Glenn Hubbards of the world keeps me on my toes. It makes me work harder, benefiting the customers — in this case, students. The upshot is that competition among economics textbooks makes learning the dismal science a bit less dismal.

For much the same reason, competition among governments leads to better governance.”

The title of Mankiw’s article reflects his claim:  “Competition Is Healthy for Governments, Too.”

It is inevitable that Mankiw thinks that competition makes his textbook superior.  I leave analysis of that claim to future columns to be written with the aid of readers.  I am announcing a competition among readers of our New Economic Perspectives blog at UMKC.  I will provide “Mankiw Mendacity and Morality” t-shirts to the providers of the three top suggestions from readers of our blog (and Mankiw’s textbook) for the worst predictive and policy follies contained in that textbook.  See details on our website.

Suffice it to say here that Mankiw’s belief that his ability to sell a textbook famous for its failed predictions and theories demonstrates the success of private markets in helping students learn actually constitutes proof of the market’s folly.

This column represents the second part of my discussion of his claim that the public and private sectors are sufficiently similar that competition in both sectors benefits the public.  All three premises are overstated and frequently false.  It is not true that competition in the private sector is unambiguously socially desirable.  It is not true that completion in the public sector is typically desirable.  (That will be the subject of the third part of my discussion of Mankiw’s ode to governmental competition.)  It is not true that the public and private sectors are typically sufficiently comparable that they should be run under the same governance principles.  Mankiw also ignores the destructive interaction effects of encouraging unrestrained public and private sector competition.  (Those claims will be the subject of the fourth and fifth parts of my discussion.)  I argue that competition in the public sector is generally a grave error and that competition in the private sector has become increasingly harmful because regulation and law enforcement has been crippled by Mankiw’s policy of encouraging “competition in laxity.”

Mankiw conflates “choices” with “competition” when he discusses government.  We may benefit from the ability of a federal system to have what Justice Brandeis referred to as laboratories for experimentation.  The competitive dynamic, however, is frequently harmful in government.

Government is not just like business and governmental competition is often harmful


Determining whether competition among governments is desirable as Mankiw argues requires us to examine the areas and manners in which governments compete.  I start with a fundamental duty of government (as many governmental leaders have conceived the task) – national security and conquest.  Some governments seek to conquer other nations or regions and seize wealth, people, and power.  Each of the nations that is currently a major power, and was previously a major power over the last 300 years has engaged in conquest as a major function.  Nations (and, in civil wars, rival governments) engaged in armed struggle are engaged in the ultimate form of competition.  Even when wars are fought with restraints they are vicious.  The explicit goal in less restrained wars is to ensure that the competition ends.  The rival nation and people are destroyed.  Carthago delenda est (Carthage must be destroyed) is the famous cry.  (Mankiw’s version of Cato the Elder’s murderous demand would be “financial regulation must be destroyed.”)  The “competitor’s” people are annihilated in a genocidal fury or their cities razed and their populations sold into slavery.  Terror is a common tactic of governments, failed states such as Afghanistan under the Taliban, and would be-state actors such as the IRA “competing” with nation states.   Woman and children are often targets.  Rape is common and sometimes a deliberate tactic.  Torture and atrocities are common.  Mass deaths and maiming are expected.

Competition in the run-up to war, or the effort to deter war, is also typically destructive from an overall societal standpoint.  We engage in arms races and battleship races that lead to a waste of resources whether or not the war occurs.  The opportunity costs of taking many of our brightest thinkers and skilled engineers out of inventing, developing, and manufacturing useful goods and services and diverting them to figuring out clever means to maim and kill is severe.

Some nations and proto-national movements engage in warfare by non-traditional means.  They launch cyber attacks, counterfeit other nation’s currencies, and kidnap foreign nationals to trade them for cash and weapons.  They sell illegal drugs or counterfeit goods to fund their efforts.

Governmental military competition is a leading cause of death and misery.  This competition can be seen as essential from the standpoint of individual nations, but it is, net, a social catastrophe.  It threatens our survival as a species given weapons of mass destruction.  It is not “healthy.”

Economic “War”

Some nations compete economically by theft.  One form is the theft of intellectual property by conventional means, but nations also use their intelligence services to steal trade secrets and learn about other nations’ secret international trade bargaining positions.  They suborn foreign nationals as secret assets who will betray their nation’s interests.   Another form of economic warfare is factory fishing.  This can produce over-fishing and habitat destruction that can permanently destroy other nations’ traditional fishing industries.  Nations and their businesses compete with other nations and their businesses (an example of the interaction of public and private competition) for exports by bribing foreign nationals (particularly government officials).


Charles Munger: A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business

I’m going to play a minor trick on you today because the subject of my talk is the art of stock picking as a subdivision of the art of worldly wisdom. That enables me to start talking about worldly wisdom—a much broader topic that interests me because I think all too little of it is delivered by modern educational systems, at least in an effective way.

And therefore, the talk is sort of along the lines that some behaviorist psychologists call Grandma’s rule after the wisdom of Grandma when she said that you have to eat the carrots before you get the dessert.

The carrot part of this talk is about the general subject of worldly wisdom which is a pretty good way to start. After all, the theory of modern education is that you need a general education before you specialize. And I think to some extent, before you’re going to be a great stock picker, you need some general education.

So, emphasizing what I sometimes waggishly call remedial worldly wisdom, I’m going to start by waltzing you through a few basic notions.

What is elementary, worldly wisdom? Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ’em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form.

You’ve got to have models in your head. And you’ve got to array your experience—both vicarious and direct—on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You’ve got to hang experience on a latticework of models in your head.

What are the models? Well, the first rule is that you’ve got to have multiple models—because if you just have one or two that you’re using, the nature of human psychology is such that you’ll torture reality so that it fits your models, or at least you’ll think it does. You become the equivalent of a chiropractor who, of course, is the great boob in medicine.

It’s like the old saying, “To the man with only a hammer, every problem looks like a nail.” And of course, that’s the way the chiropractor goes about practicing medicine. But that’s a perfectly disastrous way to think and a perfectly disastrous way to operate in the world. So you’ve got to have multiple models.

And the models have to come from multiple disciplines—because all the wisdom of the world is not to be found in one little academic department. That’s why poetry professors, by and large, are so unwise in a worldly sense. They don’t have enough models in their heads. So you’ve got to have models across a fair array of disciplines.

You may say, “My God, this is already getting way too tough.” But, fortunately, it isn’t that tough—because 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person. And, of those, only a mere handful really carry very heavy freight.

So let’s briefly review what kind of models and techniques constitute this basic knowledgethat everybody has to have before they proceed to being really good at a narrow art like stock picking.

First there’s mathematics. Obviously, you’ve got to be able to handle numbers and quantities—basic arithmetic. And the great useful model, after compound interest, is the elementary math of permutations and combinations. And that was taught in my day in the sophomore year in high school. I suppose by now in great private schools, it’s probably down to the eighth grade or so.

It’s very simple algebra. It was all worked out in the course of about one year between Pascal and Fermat. They worked it out casually in a series of letters.

It’s not that hard to learn. What is hard is to get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it’s fundamental truth. So you simply have to have the technique.

Many educational institutions—although not nearly enough—have realized this. At Harvard Business School, the great quantitative thing that bonds the first-year class together is what they call decision tree theory. All they do is take high school algebra and apply it to real life problems. And the students love it. They’re amazed to find that high school algebra works in life….

By and large, as it works out, people can’t naturally and automatically do this. If you understand elementary psychology, the reason they can’t is really quite simple: The basic neural network of the brain is there through broad genetic and cultural evolution. And it’s not Fermat/Pascal. It uses a very crude, shortcut-type of approximation. It’s got elements of Fermat/Pascal in it. However, it’s not good.

So you have to learn in a very usable way this very elementary math and use it routinely in life—just the way if you want to become a golfer, you can’t use the natural swing that broad evolution gave you. You have to learn—to have a certain grip and swing in a different way to realize your full potential as a golfer.

If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an asskicking contest. You’re giving a huge advantage to everybody else.

One of the advantages of a fellow like Buffett, whom I’ve worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations….

Obviously, you have to know accounting. It’s the language of practical business life. It was a very useful thing to deliver to civilization. I’ve heard it came to civilization through Venice which of course was once the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention.

And it’s not that hard to understand.

But you have to know enough about it to understand its limitations—because although accounting is the starting place, it’s only a crude approximation. And it’s not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn’t make it anything you really know.

In terms of the limitations of accounting, one of my favorite stories involves a very great businessman named Carl Braun who created the CF Braun Engineering Company. It designed and built oil refineries—which is very hard to do. And Braun would get them to come in on time and not blow up and have efficiencies and so forth. This is a major art. And Braun, being the thorough Teutonic type that he was, had a number of quirks.

And one of them was that he took a look at standard accounting and the way it was applied to building oil refineries and he said, “This is asinine.”

So he threw all of his accountants out and he took his engineers and said, “Now, we’ll devise
our own system of accounting to handle this process.” And in due time, accounting adopted a lot of Carl Braun’s notions.
So he was a formidably willful and talented man who demonstrated both the importance of accounting and the importance of knowing its limitations.

He had another rule, from psychology, which, if you’re interested in wisdom, ought to be part of your epertoire—like the elementary mathematics of permutations and combinations.

His rule for all the Braun Company’s communications was called the five W’s—you had to tell who was going to do what, where, when and why. And if you wrote a letter or directive in the Braun Company telling somebody to do something, and you didn’t tell him why, you could get fired. In fact, you would get fired if you did it twice.

You might ask why that is so important? Well, again that’s a rule of psychology. Just as you think better if you array knowledge on a bunch of models that are basically answers to the question, why, why, why, if you always tell people why, they’ll understand it better, they’ll consider it more important, and they’ll be more likely to comply. Even if they don’t understand your reason, they’ll be more likely to comply.

So there’s an iron rule that just as you want to start getting worldly wisdom by asking why, why, why, in communicating with other people about everything, you want to include why, why, why. Even if it’s obvious, it’s wise to stick in the why.

Which models are the most reliable? Well, obviously, the models that come from hard science and engineering are the most reliable models on this Earth. And engineering quality control—at least the guts of it that matters to you and me and people who are not professional engineers—is very much based on the elementary mathematics of Fermat and Pascal:

It costs so much and you get so much less likelihood of it breaking if you spend this much. It’s all elementary high school mathematics. And an elaboration of that is what Deming brought to Japan for all of that quality control stuff.

I don’t think it’s necessary for most people to be terribly facile in statistics. For example, I’m not sure that I can even pronounce the Poisson distribution. But I know what a Gaussian or normal distribution looks like and I know that events and huge aspects of reality end up distributed that way. So I can do a rough calculation.

But if you ask me to work out something involving a Gaussian distribution to ten decimal points, I can’t sit down and do the math. I’m like a poker player who’s learned to play pretty well without mastering Pascal.

And by the way, that works well enough. But you have to understand that bellshaped curve at least roughly as well as I do.

And, of course, the engineering idea of a backup system is a very powerful idea. The engineering idea of breakpoints—that’s a very powerful model, too. The notion of a critical mass—that comes out of physics—is a very powerful model.

All of these things have great utility in looking at ordinary reality. And all of this cost-benefit
analysis—hell, that’s all elementary high school algebra, too. It’s just been dolled up a little bit with fancy lingo.

I suppose the next most reliable models are from biology/ physiology because, after all, all of us are programmed by our genetic makeup to be much the same.

And then when you get into psychology, of course, it gets very much more complicated. But it’s an ungodly important subject if you’re going to have any worldly wisdom.

And you can demonstrate that point quite simply: There’s not a person in this room viewing the work of a very ordinary professional magician who doesn’t see a lot of things happening that aren’t happening and not see a lot of things happening that are happening.

And the reason why is that the perceptual apparatus of man has shortcuts in it. The brain cannot have unlimited circuitry. So someone who knows how to take advantage of those shortcuts and cause the brain to miscalculate in certain ways can cause you to see things that aren’t there.

Now you get into the cognitive function as distinguished from the perceptual function. And there, you are equally—more than equally in fact—likely to be misled. Again, your brain has a shortage of circuitry and so forth—and it’s taking all kinds of little automatic shortcuts.

So when circumstances combine in certain ways—or more commonly, your fellow man starts acting like the magician and manipulates you on purpose by causing your cognitive dysfunction—you’re a patsy.

And so just as a man working with a tool has to know its limitations, a man working with his cognitive apparatus has to know its limitations. And this knowledge, by the way, can be used to control and motivate other people….

So the most useful and practical part of psychology—which I personally think can be taught to any intelligent person in a week—is ungodly important. And nobody taught it to me by the way. I had to learn it later in life, one piece at a time. And it was fairly laborious. It’s so elementary though that, when it was all over, I felt like a fool.

And yeah, I’d been educated at Cal Tech and the Harvard Law School and so forth. So very eminent places miseducated people like you and me.

The elementary part of psychology—the psychology of misjudgment, as I call it—is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly complicated. But the guts of it is unbelievably important.

Terribly smart people make totally bonkers mistakes by failing to pay heed to it. In fact, I’ve done it several times during the last two or three years in a very important way. You never get totally over making silly mistakes.

There’s another saying that comes from Pascal which I’ve always considered one of the really accurate observations in the history of thought. Pascal said in essence, “The mind of man at one and the same time is both the glory and the shame of the universe.”

And that’s exactly right. It has this enormous power. However, it also has these standard misfunctions that often cause it to reach wrong conclusions. It also makes man extraordinarily subject to manipulation by others. For example, roughly half of the army of Adolf Hitler was composed of believing Catholics. Given enough clever psychological manipulation, what human beings will do is quite interesting.


Is Decoupling Possible in a Global Economy?

Factors and their impact on Monetary Policy
the Economy, and Financial Markets
Investment letter – January 13, 201


Is Decoupling Possible in a Global Economy?

An improvement in U.S. economic data in the fourth quarter has convinced many investment strategists that the U.S. will continue to grow 2% to 3% in 2012, absent a Lehman Brothers type of crisis in Europe. After all, U.S. GDP growth likely exceeded 3% in the fourth quarter, while Europe was slipping into recession, and China’s growth throttled down 8% to 9%. Further evidence can be found in how equity markets performed around the world in 2011. In the U.S., the DJIA was up 5.5%. In Europe: Germany -14.6%, France -16.9%, Italy -25.2%, Spain -13.1%, Portugal -27.6%, Greece -51.8%. In Asia: South Korea -10.9%, Australia -14.5%, Singapore -17.0%, Japan -17.3%, Hong Kong -19.9%, China -21.6%, India -24.6%. In South America: Brazil -18.1%.

Hardly a day passes that a strategist or expert on a financial news broadcast doesn’t remind viewers that the stock market is always looking out six to twelve months, which is why it is a discounting mechanism. We’re told the market anticipates events like recessions, recoveries, and decoupling far better than we mere mortals. If the market does indeed peer into the fog of the future, the U.S.’s outperformance in 2011 should provide investors comfort about the next six to twelve months, right? As we have discussed on a number of occasions, we do not believe the stock market is a discounting mechanism, which anticipates economic events, i.e. recessions and recoveries. For instance, in March 2000, was the Nasdaq Composite telling us that the New Paradigm in technology would continue, so there was no need to worry, just be happy? At the top in October 2007, were the market’s tea leaves suggesting that the credit crisis would be contained, so there would be no recession, as most strategists and advisors believed? And, in March 2009, when the market indicated that the sky was indeed falling, were most strategists and advisors justified in being negative, because the market was plumbing new lows?

The majority of strategists and advisors who believe the ‘market is a discounting mechanism’ axiom can be compared to car drivers who navigate their way by looking in the rear view mirror. If the markets are consistent in at least one facet, it is they always take the long and winding road. When a majority of drivers peer into their rearview mirror and reflect on how lovely the drive has been, they won’t notice their car has left the road until it is airborne and in free fall. Of course, the opposite occurs at market bottoms. Drivers only see potholes and ditches in the rearview mirror, and feel as if they’ve been driving in the Baja 500 without shock absorbers forever. At every market top and bottom, the market is wrong. Not convinced? Just ask all those folks who bought condos in Florida, Nevada, and Arizona in 2006! For all our intelligence, we humans are too often induced to become herded by the newest craze, or an investment that seems to offer a sure fire path to riches. Whenever a herd mentality takes over, i.e. technology stocks in 2000 or housing in 2006, separating from the crowd is really difficult. But that’s what makes contrary opinion, one of the more powerful investment tools, and far more valuable than believing the market is a discounting mechanism.


Germany is the largest economy in the European Union and derives more than 35% of its GDP from exports. In the last five years, more than half of its growth in GDP has come from a surge in exports. This growth was largely the result of productivity gains relative to other countries in the EU. In effect, as the low cost producer, Germany became the China of the European Union.

This productivity edge has lowered Germany’s unemployment rate from 9.6% at the end of 2006, to 6.8% in December, the lowest since 1991. In contrast, since the end of 2006, the rate of unemployment in France has risen to 9.8% from 8.9. The combined unemployment rate for the 10 periphery countries has soared from 7.4% at the end of 2006 to 15.2% in October. Italy’s unemployment rate reached 8.6% in November, but for those under age 24 it was over 30%. Greece’s overall unemployment rate is over 18%, and in Spain it is almost 23%.

The differential in unemployment rates between members of the European Union underscores one of the major structural problems that will be painful to correct, and potentially socially unacceptable. Labor comprises 60% to 70% of the cost of goods. In order for the countries with high unemployment rates to be able to compete with Germany and globally, they must lower their production costs by 10%, 20% or even 30%. If the Italian Lira was still Italy’s currency, Italy could devalue the Lira by 20% and immediately lower its cost of production and increase its competitiveness within the E.U. and worldwide. This option is not available since Italy’s currency is the Euro. For Italy, and every other EU member country that has a cost of goods problem, the Euro is an albatross. In order to increase their competiveness, the workers in each country must accept a significant decline in wages in order to lower their country’s cost of production. This ‘internal devaluation solution’ not only creates a burden for the workers involved, but it also creates social and budgetary problems for Italy, Greece, and any other country in the E.U. that is uncompetitive. If a worker has less income, they have less income to spend and will pay less in taxes. In order for Greece and Italy to reduce their excessively high debt to GDP ratios, they need strong economic growth, and more workers paying taxes on rising wages. Obviously, this austerity ‘solution’ will not work, as workers unite, and launch labor strikes that will result in more social disorder in coming years.

The flags represent the US, Japan, Germany, France, Britain, Portugal, Italy, Ireland, Greece, and Spain.

The diminishing level of productivity in Greece and Italy over the last five years is a bit like rust. And, as we all know, rust never sleeps. Like many other developed nations, Italy was also affected by China’s emergence, and a lack of energy independence that became more costly as oil prices rose. Rather than adopting policies to address their weaknesses, both countries borrowed money on the back of low borrowing costs afforded members of the European Union, made even cheaper by a strengthening Euro. Greece is small enough to force private holders of its debt to accept a ‘voluntary’ haircut of 50% on their Greek bond holdings. This could lower Greece’s total indebtedness of $450 billion by about 30%. This will help. But, given Greece’s cost of borrowing and its shrinking economy, a default seems a foregone conclusion. There is also the possibility that some of the private holders of Greek bonds will not go along with the 50% haircut, since the ECB is scheduled to receive the full face value of their Greek bonds. Should private holders not go along with the current ‘voluntary’ haircut plan, a default by Greece could be triggered by March 20.


Changing the Rules in the Middle of the Game

Changing the Rules in the Middle of the Game
By John Mauldin
November 25, 2011


Changing the Rules
When Even Germany Fails
European Inverted Yield Curves
Time to Review the Bang!Moment
The Risk of Contagion in the US
Time to Start Watching China
New York, China, and Some Links

Angela Merkel is leading the call for a rule change, a rewiring of the basic treaty that binds the EU. But is it both too much and too late? The market action suggests that time is indeed running out, and so we’ll look at the likely consequences. Then I glance over the other way and take notice of news out of China that may be of import. Plus a few links for your weekend listening “pleasure.” There is lots to cover, so let’s get started.

Changing the Rules

I have been writing for a very long time about the changes needed to the EU treaty if Europe is to survive. Specifically, last week I noted that Angela Merkel has made it clear that the independence of the ECB must not be compromised. This week Sarkozy and the new prime minister of Italy, Mario Monti, agreed to stop their public calls for such changes (at least until their own crises get even worse, would be my guess). And Merkel has called for a new, stronger union with strict control of budgets as the price for further German aid for those countries in crisis. In seeming response:

“The European Commission on November 23 proposed a new package including budget previews at EU level, the establishment of independent fiscal councils and growth forecasts, closer surveillance of bailout recipients and a consultation paper on Eurobonds. There is also a growing consensus among EU policy makers on the need for the adoption of fiscal rules in national legislation. However, it is far from clear whether EU countries would accept the implicit loss of sovereignty this would involve and agree to treaty changes enshrining legally enforceable fiscal oversight at EU level. The German Chancellor, Angela Merkel, is willing to support a change in Germany’s own constitution if the EU Treaty change to that effect is agreed first.” (

But this means a major treaty change that must be approved by all member countries. Note that Merkel wants the treaty change first, or at least the language, before she takes it to German voters, which will certainly be required, since what she is suggesting is not allowed by the present German constitution. Without the changes stated clearly and explicitly in advance, it is unlikely, as I read the polls, that German voters will go along. Merkel has made it clear that any proposed changes will be limited to fiscal issues and central control and not touch on the ECB’s independence. She is adamant against eurozone bonds and putting the German balance sheet at risk (see more below).

But will the rest of Europe go along with what would be a major alterations of their own individual sovereignty and their ability to adjust their own budgets, no matter what? And agree to all this in time to deal with the current crisis? Such changes will be controversial, to say the least. And they would require, if I understand, the yes votes of all 27 European Union members, or at a minimum the 17 eurozone members.

That is problematical. Will even German voters give up their independence and listen to an EU commission tell them what they can and cannot do with their own budget? A budget that is in theory controlled by the rest of Europe? The answer depends on whom you listen to last, as the answers range all over the board.

When Even Germany Fails

Let’s get back to the German balance sheet. This week the markets were greeted with a failed German bond offering. The German central bank had to step in and buy German bunds, at a recent-series-high rate. And while the “trade” has been to buy German bunds as a hedge, Germany is not precisely a model of balance and austerity, with high (above 4%) deficits and a rising debt-to-GDP ratio. And the market senses the contradictions here. When even German bond auctions fail, whither the rest of Europe?

As a quick aside, notice that German yields are not higher than those of UK debt at some points. The market is clearly signaling that the lack of a national central bank with a printing press is an issue. Go figure. But that is a story for another letter at another time.

Let’s look at some recent headlines. Greek 2-year bonds are now at 116%. You read that right. “Bond yields on short-term Italian debt rose above 8 per cent on Friday as Rome was forced to pay euro-era-high interest rates in what analysts called an ‘awful’ auction. A peak of 8.13 per cent was reached on three-year bonds, according to Reuters data, as Italian debt traded deeper into territory associated with bail-outs of Greece, Portugal and Ireland in the past 18 months.

“Italy raised its targeted €10bn in an auction of two-year bonds and six-month bills but at sharply higher yields. ‘Rates have skyrocketed. It’s simply not sustainable in the long run,’ said Marc Ostwald, strategist at Monument Securities in London.

“Investors demanded a yield of 7.81 per cent for the two-year bond, up from 4.63 per cent last month. The six-month bills saw yields of 6.50 per cent, up from 3.54 per cent. That was significantly higher than Greece paid for six-month money earlier this month when it issued bills at 4.89 per cent.” (Reuters)

Spanish bond yields are slightly lower but not by much, with both countries paying more for short-term debt than Greece.

And no one is really talking about Belgium, which I have been pointing to for some time. Belgium debt yield on its ten-year bonds went to 5.85%. Notice the recent trend, in the chart below. It looks like Greece in the not-very-distant past. (Chart courtesy of and Reuters data)

European Inverted Yield Curves

Let’s rewind the tape a little bit. Both the Spanish and Italian bond markets are close to or already in an “inverted” state. That is when lower-term bonds yield higher than longer-term bonds, which is not a natural occurrence. Typically, when that happens, the markets are sending a signal of something. (Charts below courtesy of my long-suffering Endgame co-author, Jonathan Tepper of Variant Perception, who lets me call him up late for data like this.)

Note that Greece (especially) and Portugal inverted when they began to enter a crisis. And shortly thereafter they went into freefall. Why did it happen so suddenly?


European Summit: A Plan with No Details

European Summit: A Plan with No Details
By John Mauldin
October 29, 2011


A Definite Plan (Minus Those Sticky Details)
Dear Mario
When Leverage Is the Kind-of Answer
Meanwhile Back in Portugal
Let’s Just Change the Rules
San Francisco, Kilkenny, Atlanta, DC … and the World Series Loss


Where is the peace dividend that was supposed to come after the end of the Cold War? Where are the fruits of the amazing gains in efficiency that technology has afforded? It has been eaten by the bureaucracy that manages our every move on this earth. The voracious and insatiable monster here is called the Federal Code that calls on thousands of agencies to exercise the police power to prevent us from living free lives.

It is as Bastiat said: the real cost of the state is the prosperity we do not see, the jobs that don’t exist, the technologies to which we do not have access, the businesses that do not come into existence, and the bright future that is stolen from us. The state has looted us just as surely as a robber who enters our home at night and steals all that we love.

– William “Bill” Bonner

Exactly what happened in Europe yesterday? The market reacted like it was the Second Coming of the Solution to End All Solutions. No problem here! The European debt crisis is solved! But if you look deeply (almost always dangerous when it comes to Europe) there is more to the market “melt-up” than simple euphoria and relief. What you find is a very disturbing unintended consequence that will come back to haunt us, as, sadly, I have written about in the past. The finger points to our old friends derivatives and credit default swaps. This week, as I recover from a rather nasty bug, we look at gamma and delta and other odd entities that may be behind the real reason for the market response, as we march inexorably toward the final chapters of the Endgame. Let’s see how far out on a limb I can go.

But first an important announcement. I am very excited to be able to introduce my readers to a mutual fund offered by my friends at Altegris Investments. This special fund is a blend of five commodity trading advisors, or CTAs. Normally, to access a CTA you be to be an accredited investor, with all the net-worth requirements and limited liquidity. But Altegris has figured out how to wrap a mutual fund around CTAs and create a fund of commodity traders with all the usual aspects of a mutual fund (daily pricing, liquidity, etc.).

I have long been involved in the commodity-trading advisor space (some 20 years) and am a proponent of CTAs as a way to diversify portfolio risk. I have written a detailed report on this fascinating sector in relation to the fund, and it is available for free, along with more information on the fund (including the offering memorandum and important risk disclosures, which are also included at the end of this letter).

The fund has been very well received since its launch and has grown rapidly to almost $1 billion. There has been very active interest in the professional community, as advisors and brokers are looking for simple and realistic ways to diversify their clients’ portfolio risk in a manner that is truly noncorrelated to typical stock funds and many other asset classes. Whether you are a professional or individual, you really should take the time to research what I think is a very solid fund. My partners at Altegris have decades of experience in the CTA space, with the largest available database of CTAs and long-term relationships with many of the managers (I actually started my investment career in the commodity fund space, so I have more than a passing knowledge of the arena). Given the potential for volatility in the global markets, I think it makes sense to have some exposure to funds that can go both long and short (depending on their models). I urge you to read my report here.

A Definite Plan (Minus Those Sticky Details)

Tonight there are so many moving parts it is hard to know where to start, so in the interest of time we will briefly scan a number of facts and opinions and see if we can come to something like a conclusion.

First, let’s look at what came out of Europe. Before the summit, German Chancellor Angela Merkel went before her parliament and, in an impassioned speech, basically declared that unless the parliament approved the expansion and leverage of the EFSF the European Union would collapse, along with the decades-long peace that has prevailed. And the Bundestag went along with her – with an important caveat. They made their approval conditional on the European Central Bank continuing to comply with Article 123 of the Treaty of Lisbon, which says that the ECB cannot print money (or words to that effect). The Germans are obsessed with an independent ECB that will maintain the value of the euro – something to do with Weimar being embedded in their collective psyche.


An Irish Haircut

An Irish Haircut
By John Mauldin
October 8, 2011


Two Insights from Ireland
The Irish Chamber of Commerce
An Irish Haircut
New York, South Africa, Back to Ireland … and Pushups

Just as only four short years ago it was All Subprime, All the Time, and then it was the Credit Crisis, now it is Europe. (When) will Greece default and which banks will implode as a result? Is there another banking crisis in our future? I just came back from a whirlwind four-country visit to Europe, and I will try to offer a few insights. This week we start with Ireland, move to the problem of Europe at large and, if we’re not out of space (and your patience!), we’ll visit some last-minute data points. There is a lot to cover, so let’s jump right in.

Two Insights from Ireland

This was my first visit to Ireland, but it won’t be my last. In an odd way, I felt more at home than I do in some US cities. And the views! I was charmed enough to agree to go back next month to speak at one of the most unusual economic “festivals” I have ever been to, when the last thing I want to do is get on another plane. More on that at the end.

First off, even though we think of Ireland as a country, it is in reality a nice-sized city. Ireland is a little under 4.5 million in population (with another 1.8 million in Northern Ireland). I was lucky, in that I have a number of readers in Ireland who offered to introduce me to people. Remember the old game of six degrees of separation (from Kevin Bacon, the actor)? In Ireland it is more like two degrees. It turns out they all had cousins or mates who knew someone I should see. No one was less than a few introductions away.

I spent a great deal of time going from one meeting to the next, gathering impressions and data. Literally dozens of meetings. I met with officials of government pension funds, the new chairman of the Anglo Irish Bank, former prime ministers, politicians of all types (both front and back benchers), established economists and rogue economists, businessmen at all levels, regular people in pubs, investors, and the fabled Irish ne’er-do-wells. And only got to a fraction of the potential meetings. With such a potpourri of people, you might think it would be hard to draw any conclusions, but I came away with two main impressions (and lots of smaller ones), which I think offer us insight into the world and European situations at large.

But before we get to those, let’s review a little history. Ireland is noted throughout the world for its troubles and the Diaspora. Famines, rebellions, and tales of woes. The Irish have emigrated almost everywhere. The Irish pub was created as a way for people to gather when it was against the laws to assemble in public. And they exported their pubs around the world. What city can you go to and not find an Irish pub? (Well, some in Asia, perhaps, though my editor tells me there’s a great one in Kyoto.) And in all of them they’ll sing about some kid that was killed in the war, which was of course in 1618, or whenever.

I have always loved Celtic music, so I was delighted when I went to some local pubs and, sure enough, heard the music I was so familiar with, complete with the lilting Irish voices. The Irish are nothing if not a social people, wherever they gather. And the local pub is still the center of local communication (more on that later).

The first night I was there, I had the fortune to be invited by David McWilliams to attend the opening night of a classic and much-loved Irish play by Sean O’Casey, at the Abbey Theatre, first staged at the same theatre for its premier in 1924. The play is set in the working-class tenements of Dublin during the Irish Civil War of the early 1920s. It is a comic tragedy on so many levels, and was an interesting introduction to Ireland.

It is those centuries of woes that set the stage for the recent economic crisis in Ireland. For a number of reasons, Ireland began a “miracle” growth period in the 1980s and soon became “the Celtic Tiger.” The mood of the country changed from downtrodden to optimistic. And that translated into a construction boom. They ended up believing that “this time is different” and went crazy buying and building homes. Which are now down some 65%.

Ireland is an interesting contrast to Greece. Greece used its access to low rates that came along with the euro to borrow and increase the wages of government workers, until the Greek train system, for instance, had €100 million in revenue and €400 million in salaries, with another €300 million in expenses. A government-sponsored retirement plan for some 600 different “hazardous” jobs (like hairdressing and radio work) was available at 50 years of age.

Greek banks are going to go bankrupt not because they lent money to finance too many homes but because they lent money to the Greek government. That is the opposite of Irish banks, which, while they bought modest amounts of Irish government debt, facilitated a construction boom of epic proportions – a bubble that imploded.

I have written about Irish housing woes. They built 300,000 too many homes, which would correspond to about 15 million too many homes in the US (we “merely” overbuilt by 2.5 million). The resulting crash in building has been a monstrous drag on the Irish economy. And the same happened in commercial construction – a taxi driver took some delight, once he knew I was a financial writer, in pointing out buildings that were empty. “But they are probably a good buy now!”

And the construction boom helped finance a huge boost in government revenues. In 2004, the Irish Home Builders Association calculated that 40% of the price of a house went straight to the government in taxes. You can find details on their calculations in this newspaper article. The government of that time protested that the figure was only 28%!

And the Irish willingly took on the debt of banks that went bankrupt. If Anglo Irish Bank were a US institution, the equivalent debt would have been about $3.5-4 trillion (depending on the exchange rate). Can you imagine trying to get a bailout for ONE bank for that much? And in Ireland there were three of them (!), though the other two were somewhat smaller. The Irish government guaranteed the bank debt for ECB loans, which money then went to European banks that had loaned the Irish banks the money in the first place.

Michael Lewis, in his just published book Boomerang! (I saw several people reading it on the plane coming back – soon to be downloaded to my iPad), noted that he thought it was interesting that the Irish people did not seem all that aware of the rather crushing nature of the debt they had assumed. He also commented on that in an interview with Charlie Rose. More on that bank debt below.

Before we get to my two impressions from Ireland, a few things we should keep in mind. First, I heard time and time again that Ireland is different from Greece and other Mediterranean countries. The Irish willingly undertook an austerity program, without major public protests, and have actually begun reforms. They cut public salaries (around 15%), pensions, and other “untouchables.” (Try that in the US! Wisconsin went berserk over cuts that were a fraction of what the Irish did.) Other government budgets were slashed. And they acknowledge the need for even more cuts. That being said, a clear backlash is beginning to brew over cuts to government social programs. (I should note that even though this is about the Irish, I hear this complaint everywhere in Europe and the US.)

This is from the Irish paper The Independent:

“A LABOUR senator has questioned the need for massive social welfare payments to many families after revealing yesterday that some are receiving €90,000 a year. Senator Jimmy

Harte highlighted the case of one family who are being paid €1,763 per week. The unemployed married couple, who have four children and live in Dublin, claim a range of social welfare benefits.

“Mr. Harte, who received the information from Department of Social Protection officials, said €50,000 is more than enough for a family to survive on. The Donegal-based senator told the Irish Independent yesterday that he believed the figure was far too much to be handed to a family in support payments.

“The family are doing nothing illegal but the system is wrong when a couple are able to receive €90,000 per year for doing nothing. I don’t think this sort of payment is acceptable in the good times, never mind the bad times we find ourselves in now…. There are married couples in this country with two good jobs, working very hard and are not receiving anything like this. As well as receiving €90,000, they will not have to pay property tax or water charges. That is just wrong. You would need to be earning close to €140,000 to take that sort of money home after tax.


Still Home Sick

Still Home Sick
By John Mauldin
May 16, 2011


Everyone is curious about the state of housing in the US. My friend Gary Shilling recently did a lengthy issue on housing as it is today. I asked him to give us a shorter version for Outside the Box, and he graciously did. And you want to know what Gary thinks, because he is one of the guys who really got it right early, from subprime to the bubble and the price collapse, and has been right all along. No one is better. This very readable edition is full of charts and fast reasoning.The quid pro quo for getting him to give us something that is normally behind a velvet rope is that I put a link in to let you subscribe to his wonderful monthly letter. He really is one of the better analysts out there. He has spoken at my conference the last two years and is one of our highest-rated speakers.

You can subscribe and mention the OTB and get 13 issues for the price of 12, plus Gary’s January 2011 report laying out his investment strategies for the year. $275 is the price via e-mail. Call them at 1-888-346-7444 or e-mail

And for those in the Dallas area, it is now my intention to meet some friends at the Zaza after the Tuesday night Mavericks-Thunder game, so drop on by.

Your living the internet-driven life analyst,

John Mauldin, Editor
Outside the Box

Still Home Sick

(Excerpted from the May 2011 edition of A. Gary Shilling’s INSIGHT)

All may be well. That’s what many housing optimists proclaimed a year ago when prices appeared to have stabilized, indeed, started to recover from their collapse (Chart 1). As Insight readers are well aware, we emphatically disagreed. We pointed out that the earlier extremes in the housing market made rapid revival—or any revival for that matter—extremely difficult. In the earlier salad days, housing was propelled by low mortgage rates, lax or nonexistent underwriting standards, securitization of mortgages that passed seemingly creditworthy and highly-rated but really toxic assets on the unsuspecting buyers, laissez-faire regulation, and most of all, almost universal conviction that house prices never fall on a nationwide basis—which they hadn’t since the 1930s.

But housing activity remains at post- World War II lows (Chart 2).

The Administration’s Home Affordable Modification Program (HAMP) was a bust. Tightening lending standards, the renewed decline in house prices, fears of job loss as unemployment remains high and the drying up of mortgage securitization have handily offset the positive effects of low mortgage rates and new homeowner tax credits. Indeed, the jumps in home sales in anticipation of the tax credit expiration first in November 2009 and then in April 2010 were promptly retraced and followed by still-weaker sales (Chart 3).

Mortal Enemy

Most of all, in making the case for continuing housing weakness, we’ve continually hammered home the ongoing negative effect of excess inventories on house sales, prices, new construction and just about every other aspect of residential real estate. In housing, as in every goods-producing sector, excess inventories are the mortal enemy of prices. It’s that simple. Lower prices are needed to unload surplus inventory, but in turn lower prices bring forth more inventory from anxious sellers. And the anxiousness of house sellers and reluctance of buyers is enhanced by the realization that house prices can fall, and are falling for the first time in 70 years.

Just how big are excess house inventories and how long will it take to absorb them? As discussed in many past Insights, we measure excess house inventories by the excess over the earlier trendless norm of about 2.5 million (Chart 4). We consider 2.5 million to be the normal working level for total existing units and new single-family houses (new multi-family inventories are not reported). Notice that this flat pattern, except for the recent extreme volatility, matches the equal trendless patterns of housing starts and completions over time. Note also that total inventories jumped to 5 million as housing collapsed, and still equals 4 million, or 1.5 million over and above the norm.

Hidden House Inventory

But wait! There’s more! The Census Bureau, in its estimate of housing inventory, lists a category called “Held off the market for other reasons”— very descriptive! This category leaped by over 1 million between the first quarter of 2006 and the first quarter of this year. It includes unspecified numbers of houses that have been foreclosed but not yet sold and units that people want to sell—first or second homes—but have not listed due to current market conditions. Of course, if those in foreclosed houses and those who want to sell finally do so and move into other abodes, they’re still occupying housing units and total inventories don’t change. But if they’re unloading extra and vacant houses or doubling up with family and friends, additional excess inventories are created. Many are now beginning to give up hope of higher prices as they continue to fall and throwing their houses on the market for whatever they will bring.

How Long?

Our total estimate of 2 million to 2.5 million excess house inventories, then, may well rise with further foreclosures that will be spurred by falling prices. This surplus is already huge since in the long run the U.S. builds about 1.5 million houses per year (Chart 2). To forecast the length of time to work off this excess inventory, we need to project supply and demand for residential units. New conventional construction of single-family house and apartment units plus manufactured home shipments is running about 700 thousand at annual rates. There’s no reason to expect this rate to change in the next few years, given falling prices excess inventories and other constraining factors. About 300,000 of these units are offset each year by dilapidated houses that are torn down, houses converted to nonresidential purposes and other factors that remove them from the housing stock. So the net supply will probably continue to average about 400,000 annually.

On the demand side, house sales data, especially existing house sales reported by the National Association of Realtors, appear to be overstated. Well, what did you expect? Did you ever meet a residential realtor who isn’t wildly optimistic about house sales and prices? The NAR uses models to expand its actual survey to national total sales numbers. With the collapse in housing activity, many of the multi-listing services that trade group samples have consolidation so the sales of those remaining expanded because their area of coverage has grown. Since the NAR doesn’t correct for this, the sales numbers are likely overstated. Also, the NAR doesn’t sample but estimates the share of sales by owners that don’t go through multi-listing services. That segment of the market collapsed with the housing bust but the NAR has not subsequently adjusted its estimates downward.

In contrast, CoreLogic measures sales by checking property transfer records at local court houses and reports that its data covers about 85% of all house sales. Its numbers are consistently lower than the NAR numbers (Chart 5). In 2010, NAR reported 4.9 million in sales, down 5.7% from 5.2 million in 2009. But CoreLogic recorded only 3.3 million in 2010, a drop of 10.8% from 3.7 million in 2009. So the NAR data may overstate home sales by a third.

If so, and if house inventory data reported by the NAR are correct, it will take much longer to unload excess inventories at current sales rates. In March, NAR reported inventories of existing houses would take 8.4 months to sell at the trade group’s reported sales rate. That’s down from 12.5 months in July of last year but still almost about twice the level of healthy markets. And if NAR sales data are overstated by a third, the month’s supply is still back in double digits.

Household Formation

Because of the NAR’s likely overstatement of sales and for other reasons, we prefer to rely on household formation data gathered by the Census Bureau to forecast housing demand. Now, there’s a lot of misunderstanding about household formation numbers. Many assume that there is a one-to-one relationship between the growth in the population and the number of new households formed. With population growing around 1% per year, or by about 3 million, then with an average 2.77 people per household, 1.08 million new households will be formed, the reasoning goes. But the link between demographics and household formation is at best a very tenuous one, especially in a cyclical time frame.

In the 2001-2010 decade, household formation averaged 888.5 thousand per year. Since those years included boom and bust years, this average, about 900 thousand per year, seems like a reasonable, probably optimistic forecast for the years ahead, given the likely further fall in house prices, high unemployment and declining real incomes in the years ahead. So if demand is averaging 900 thousand per year while supply runs 400 thousand, about 500 thousand of the excess housing inventory will be absorbed per annum. Consequently, it will take four or five years to absorb the 2 million to 2.5 million housing units, over and above normal working inventory, that we believe exist at a minimum.

Prices Down Another 20%

Four or five years is plenty of time for the inventory overhang to depress prices another 20% as we’ve been forecasting. Prices, after reviving somewhat with the new homeowner tax credit, are now essentially back to their April 2009 lows (Chart 1). Another 20% drop would bring the total decline from the peak in April 2006 to 45% and take them back to their longrun flat trend (Chart 6). In that graph, median single-family house prices are corrected for two types of inflation. The first is general inflation affecting all goods and services. The second is the tendency over time of houses to get bigger and, therefore, intrinsically more expensive. As living standards rise, people want more bathroom, fancier kitchens, etc. in their homes. A further 20% price drop may be an optimistic forecast since declines tend to overshoot on the downside just as bubbles expand to the stratosphere.

Other forecasters are coming into agreement with our forecast, dire as it is. The Dallas Federal Reserve Bank states that a 23% decline is needed to return house prices to their long-run trend. Prof. Robert Shiller of Yale says there is a “substantial risk” of another 15% or 20% decline in house prices. The NAR’s March survey of members revealed that 42% of everoptimistic realtors expect home prices in their areas to fall in the next 12 months. Starting last year, Shiller’s firm, Macro Markets LLC, asked us and 110 other housing experts to forecast house prices over the next five years. Since that survey commenced, we have consistently forecast a 20% cumulative decline for 2011-2013, with an 11% drop this year. Last June, the average forecast was a 1.3% price rise this year, but the last survey in early March reported a 1.4% drop.

There are other reasons to expect house prices to fall sharply in coming quarters. Now that the moratoria while mortgage modifications were attempted and during the robo-signing flap are over, foreclosures are likely to resume in earnest. And, as noted earlier, lenders and servicers tend to dump foreclosed houses on the market for quick sales, regardless of prices. These fire-sale prices put more homeowners under water and lead to more foreclosures, but they do attract investors looking for cheap houses who often pay all cash.


Many underwater homeowners, of course, still are committed to service their financial obligations, or want to stay in their abodes. Some are even doing cash-in refinancing, the reverse of the cash-outs of yesteryear, and contributing money from other sources to reduce their mortgage balances. A total of $1.1 trillion was withdrawn in 2006 and 2007, and at the peak of the housing bubble in 2006, cash-outs ran $80 billion per quarter and accounted for 90% of refinancings. By the fourth quarter of 2010, however, cash-outs dropped to 16% of refinancings and cash-ins jumped to 33%.

Homeowner deleveraging through cash-ins reduces the vulnerability to further house price declines, but they also reduce the funds available for other investments and current spending. So, too, do the higher downpayments lenders are requiring on house purchases, which also freeze out many potential buyers and otherwise discourage home ownership. Regulators are proposing 20% downpayments for high-quality new mortgages underwritten by private lenders, and Wells Fargo, the country’s largest mortgage lender, has suggested 30%.

For these loans, borrowers will also need to maintain 75% loans-to-market value ratios, 75% for refinancings and 70% for cash-out refinancings. Borrowers can’t have missed two consecutive payments on any consumer debt within two years. Mortgage-related debt payments can be no more than 28% of income and total debt service can’t exceed 36% of income. And mortgage loans must be fully amortizing—no interest-only borrowing. According to CoreLogic, 46% of all mortgagors at the end of 2010 had less than 20% equity in their homes.

Mortgages that don’t meet these standards will be subject to 5% retention by the original lender if they are sold to others or securitized. In other words, regulators intend to end the days when subprime mortgages were packaged as securities by the original lender and sold with no further recourse. Buy them, securitize them, sell off the securitized tranches and forget them was the strategy.

In fact, median downpayments on conventional mortgages already were 22% last year in nine major U.S. cities, according to an analysis by, up from 4% in the fourth quarter of 2006. Those cities are Chicago, Stockton, Calif., Las Vegas, Los Angeles, Miami-Fort Lauderdale, Phoenix, San Diego, San Francisco and Tampa. To be sure, private lenders are now making very few mortgages, with most initiated by Government-Sponsored Enterprises (Chart 7). The Federal Housing Administration, which required only 3.5% up front, accounted for 23.4% of residential mortgages last year. In contrast, in 1950, the median downpayment for FHA first mortgages was 35%, for Veterans Administration first mortgages, 8%, and 35% for non-government conventional first mortgages. Underwriting standards have tightened, but are still loose by those earlier standards.

The elimination of home equity for most mortgages will no doubt have severe detrimental effects on consumer sentiment and spending. It also will magnify the mortgage delinquencies and defaults, and severely depress the value of existing mortgages and derivatives backed by them In recent quarters, banks have booked profits as they reduced their reserves against potential loan losses, but that process will be dramatically reversed. And it goes without saying that mortgage lenders and servicers will severely tighten their mortgage underwriting standards with a further 20% drop in house prices. The top 10 mortgage servicers account for the majority of the market and include the nation’s largest banks.

Needless to say, another big decline in house prices almost guarantees another recession because of its financial impact. At the same time, further declines in residential construction won’t matter much to the overall economy. It was 6.3% of GDP at its peak in the fourth quarter of 2005, but plummeted to a mere 2.2% in the first quarter of this year.

No Help to the Economy

Conversely, we don’t look for any revival of homebuilding in the years ahead that will boost the economy. The housing collapse prevented residential construction from serving its usual role in spurring economic recovery from the recession. Rather than contribute meaningfully, residential construction actually declined in the first seven quarters of recovery. The ongoing housing crisis will probably continue to trouble financial markets, depress consumer spending and keep residential construction depressed for years.

Keep ‘Em Out – Or In?

From a regulator standpoint, tighter controls will continue to discourage homeownership. The Dodd-Frank financial overhaul law requires banks to retain 5% of the credit risks on lower-quality residential mortgages that are securitized and sold to others. These new rules will obviously discourage mortgage loans to all but the most creditworthy borrowers. Also, since Fannie Mae and Freddie Mac are backed by the U.S. government, they are exempt from the retention rules, which therefore will drive mortgage loans to these Government-Sponsored Enterprises. Still, their fates are uncertain.

Government attitudes toward homeownership also appear to have shifted with the housing collapse. On Oct. 15, 2002, when the housing boom was inflating, President George W. Bush said at the White House Conference on Increasing Minority Homeownership, “We want everybody in America to own their own home. That’s what we want…An ownership society is a compassionate society.”

In contrast, in February 2011, the white paper released by the Treasury Department and Department of Housing and Urban Development, which addressed the future of Fannie and Freddie, also stated that homeownership isn’t for every American. “The Administration believes that we must continue to take the necessary steps to ensure that Americans have access to an adequate range of affordable housing options. This does not mean, however, that our goal is for all Americans to become homeowners. Instead, we should make sure that all Americans who have the credit history, financial capacity, and desire to own a home have the opportunity to take that step. At the same time, we should ensure that there are a range of affordable options for the 100 million Americans who rent, whether they do so by choice or necessity.”

“Become Renters Again”

The statement echoes the muchmaligned comments by then-Treasury Secretary Henry Paulson of the Bush Administration in the midst of the housing collapse. He said in a December 2007 online Q&A session: “And let me be clear—we will not avoid all foreclosures. Borrowers who are struggling even with the lower initial ARM rate are unlikely to be eligible for assistance, and likely will become renters again.”

Furthermore, Congressional Republicans are proposing the end of tax deductibility of mortgage interest, which would further reduce the appeal of owning abodes. This is the largest of the “tax expenditures” and will cost the federal government $600 billion from 2009 to 2013, according to the Congressional Joint Committee on Taxation. Whether this tax break aids homeowners is questionable, however. In the European Union, where mortgage interest is not tax deductible, the homeownership rate is 75% compared with the earlier U.S. peak of 69%. Furthermore, lack of mortgage interest deductibility may encourage homeowners to pay off their loans faster, and avoid that false assumption that owning an abode is cheaper than renting.

At the same time, homeownership continues to be very political powerful, and many recent government actions can certainly be viewed as an unstated attempt to keep people in their homes, even those who clearly can’t afford to own them. The reality that many foreclosures have tossed homeowners out is powerful not only to those affected directly, but also to many others in and out of Washington. Our friend and superb housing analyst Tom Lawler has taken a hard look at the numbers and worked his way through the many assumptions needed to determine the number of homeowners who lost their homes to foreclosure last year. He concludes it was about 1 million. Tom goes on to point out that many others have really lost their homes but not technically since foreclosures are not yet completed. These “owners” may still be living in those houses— rent-free, by the way!

There’s also sympathy for the many who, despite concerted efforts, have been unable to reduce their mortgage and other debts such as auto, student and credit card loans. Their total debt in relation to disposable personal income (after-tax income) peaked in the third quarter of 2007 at 131%. Debt itself peaked three quarters later in the second quarter of 2008. From then through the fourth quarter of 2010, mortgage debt dropped $517.9 billion and consumer (other) debt has fallen $174.6 billion for a total decline of $691.5 billion.

No Debt Repayment

But in those same 10 quarters, $542.2 billion in mortgage debt was charged off and $333.8 billion in consumer debt for an $875.9 billion total. As shown in the last three columns, after accounting for charge-offs, mortgage debt actually rose a bit, $24.2 billion to $10 trillion, consumer debt climbed $159.2 billion to $2.4 trillion and the total rose $183.4 billion to $12.4 trillion. The rise in mortgage debt ex charge-offs is so small that it’s merely a rounding error, but it’s surprising that it didn’t fall significantly. Perhaps financially stressed homeowners who didn’t lose their homes to foreclosure have not been able to reduce their mortgage debt.

To encourage home-buying, Washington enacted tax credits for new homeowners, which initially expired in November 2009 and then was renewed until April 2010. HAMP’s goal is to stave off foreclosures for underwater homeowners by making their mortgage payments more affordable. The government essentially told major mortgage lenders and servicers to forestall foreclosures while HAMP modifications were being attempted. More recently, 14 large financial institutions have been ordered by regulators to revise their mortgage servicing practices to encourage more successful modifications and speed up foreclosures. Those 14 have until mid-June to establish their plans and then 60 days to implement them.

Among other things, the mortgage servicers will be required to have a single point of contact for borrowers to avoid their being bounced from one servicer employee to another and getting lost in the shuffle. They also must set “appropriate deadlines” for deciding whether borrowers can qualify for a loan workout, and have enough staff to deal with the multitude of troubled mortgages. The goal is to get servicers to contact borrowers earlier and more frequently after one missed payment in order to have a better chance of modifying troubled loans.

Fannie and Freddie

The U.S. Treasury-HUD white paper cited earlier indicates that the Administration, like many other Democrats as well as Republicans, wants a significantly smaller role for government in housing finance, including a “winding down” of Fannie and Freddie and a smaller role for the FHA. House Republicans want Fannie and Freddie eliminated and only the FHA left as a source of federal backing. Currently, federal agencies including Fannie and Freddie guarantee 87% of new mortgages.

As discussed in our new book, The Age of Deleveraging, back in mid-2008, many FDIC-insured institutions were heavily leveraged but still had an average capital-to-asset ratio of 7.9%. In contrast, Freddie and Fannie had less than 2%, so for each buck of capital, they owned or guaranteed $50 in mortgages. Lobbyists from the two convinced Congress that they didn’t need more capital since defaults would be tiny as house prices rose forever. But when the housing sector nosedived, Fannie and Freddie’s houses of cards fell apart. So in September 2008, both were seized by the government in a legal structure called conservatorship. They are regulated, indeed controlled, by the Federal Housing Finance Agency. Initially, each had up to $200 billion backing from the Treasury, but it later was made open-ended through 2012.

Washington regarded Freddie and Fannie as part of the government. Assistant Treasury Secretary Michael Barr said that because they are “owned by the taxpayers in the biggest housing crisis in 80 years, it is logical that they be used to stabilize the housing market.” But since the two technically remain private corporations, their finances remain off the federal budget and their huge prospective losses from sour mortgages don’t need to be counted in the federal deficit. It’s ironic that the government is using Fannie and Freddie as the biggest off-balance-sheet financing vehicles in the economy at the same time it blasted banks for using off-balance-sheet entities in earlier years.

Also, by using these GSEs to support housing, with an open credit line to the Treasury, the Administration doesn’t have to approach Congress for funding bit by bit. The Treasury simply injects enough money, quarter by quarter, to cover their losses. As of Feb. 25, 2011, that was $153 billion for the pair, and the Congressional Budget Office estimates the losses through 2020 at almost $400 billion. Treasury Secretary Timothy Geithner in March 2010 said, “There is a quite strong economic case, quite strong public policy case for preserving, designing some form of guarantee by the government to help facilitate a stable housing finance market,” even after Fannie and Freddie are restructured or unwound.

More Private Capital

Nevertheless, the February 2011 white paper advocated a number of short-term measures to attract private capital into the mortgage market—with higher costs for house financing and its detrimental effects on home ownership. These include allowing the maximum loan limits to fall to $625,000 from $729,750 as scheduled on October 1, increasing downpayments on Fannie and Freddie guaranteed loans to 10%, and increasing FHA insurance premiums, which subsequently was announced to rise by 0.25 percentage points on 30- and 15-year loans to 1.15% on low downpayment loans.

The Administration believes that given the fragile state of the housing sector, it will take at least five to seven years to move to a longer term structure of housing finance. It offered in the white paper—but did not discuss in detail—three options, which no doubt will be hotly debated going into the 2012 elections.

The first is a privatized system with Fannie and Freddie eliminated. Their $1.5 trillion combined mortgage portfolio, out of the $10 trillion mortgage market, is already set to fall 10% per year. Government financial support would be confined to FHA and VA loans, which accounted for 23% of mortgages last year, targeted to help narrow borrower groups. Private lenders would originate and securitize mortgages without government guarantees. Interestingly, small banks oppose this option because they believe it would concentrate the business in the hands of large lenders, much to their detriment.

The second option would create a mostly private mortgage market as well as FHA/VA involvement, with a government “backstop mechanism to insure access to credit during a housing crisis.” Option three involves a privatized market as well as FHA-VA participation. New, privately-owned companies would buy mortgages from lenders and securitize them. Those securities would be guaranteed by the government as long as they met standards. These new private entities would essentially replace Fannie and Freddie.

Regardless of how government legislation and regulation unfold, the nation’s zeal for homeownership may be weakening outside as well as inside Washington. Homeowners have learned the hard way that for the first time since 1930s, house prices nationwide can and do fall. Zeal for a sound home financing system involves measures that discourage homeownership. And the likely leap in the percentage of renters and falling portion who own their abodes will reduce the power of homeownership advocates.

More Renters

Homeownership is falling, as the earlier boom and quick route to riches in a loose-lending environment has been replaced with collapsing prices, tight underwriting requirements, more regulation and horror stories of huge homeowner equity losses. As homeownership slides, the flip side, the renter population grows. Of course, many former and current homeowners are really renters with an option on their house’s price appreciation. They put little if anything down and planned to refinance with cash-out before their mortgage rates reset upward or, in some cases, even before they skipped enough monthly payments to be foreclosed.

Homeownership bulls, naturally, argue that owning a house has never been cheaper. In calculating this index, the NAR assumes that a family with median income buys a median-priced single-family house with 20% down and financed at the current 30-year fixed mortgage rate. The collapse in house prices and decline in mortgage rates in recent years have more than offset the weakness in median family income that, according to the NAR, dropped from $63,366 in 2008 to $61,313 in 2010.

Nevertheless, comparisons between the current attractiveness of buying a home and that in the 1990s and early 2000s is like comparing an octopus to an ant. Back then, incomes were growing; now they’re weak. Unemployment rates were lower; now they’re high. House prices were rising as they had been since the 1930s; now they’re falling and even the stabilization last year has given way to renewed declines. Financing a mortgage was easy with little or nothing down and spotty credit; now it takes 20% or more in downpayments and sterling credit scores. Back then, the prospects of huge house price declines and massive foreclosures weren’t even the subject of horror films; now they’re the real, everyday reality.

Rents Still Cheaper

Despite the collapse in house prices, they are still expensive relative to rentals, even as apartment rental rates rise and vacancies decline. Those rent rises are having an interesting effect on the CPI. In the total index, 32% is weighted for shelter including 5.9% for the rental of primary residences. But an additional 24.9% is “owners’ equivalent rent of residences.” The idea is that homeowners rent their abodes from themselves at market rental rates. Of course they don’t, but this creates an odd situation where house prices are falling, but owners’ equivalent rent is rising.

This, in effect, overstates the recent rise in the CPI. Chart 8 shows the year-over-year change in the core CPI, which excludes the volatile food and energy components, and the core excluding the shelter component, which is dominated by owners’ equivalent rent. That component is 32.3% of the core index and total shelter is 41.5%.

Notice that without shelter, the year-over-year core index rose 0.8%, or 0.4 percentage points less than the 1.2% rise in the total core. Back in 2007 and early 2008 before housing collapsed, owners’ equivalent rent was rising considerably faster than other prices in the core index, as shown by the gap in Chart 8 and in Chart 9. The fall in rent rates in 2008-2009 pushed the year-over-year change in shelter costs into negative territory.

The price index for personal consumption expenditures, which we and the Fed prefer to the CPI, also uses homeowners’ equivalent rent, but only weights it at 15% of the total index and 17.5% of the core. Partly as a result of this lower weighting, the core index in March rose 0.9% from a year earlier compared to 1.2% for the core CPI.

Homeownership Downtrend

The fall in the homeownership rate has been swift, but probably understated. The overall rate in the first quarter, 66.4%, was down from the 69.2% peak in the fourth quarter of 2009 and was the same as in the fourth quarter of 1998. But Tom Lawler wrote on April 27 that “if the Q1/2011 homeownership rate by age group were ‘correct,’ but the age distribution of households had been the same last quarter as it was in 1998, then the homeownership rate last quarter would have been 65.1%, or 1.4 percentage points lower than in 1998!”

In any event, continuing the rate of fall since its peak will bring the total homeownership rate back to its earlier base level of 64% in the fourth quarter of 2016 from 66.4% in the first quarter of this year. That’s a return to trend. And we are strong believers in reversion to trend. Continuing the average annual growth in households over the last decade of 888.5 thousand increases the total number of households by 5.1 million from the first quarter to the fourth quarter of 2016. This is enough to increase the number of new homeowners by 608 thousand even with the drop in the homeownership rate to 64%.

But it also means the addition of 4.5 million new renters, or 782.7 thousand at annual rates. That’s a lot, but we’re not alone in this forecast. Greenstreet Advisors believes that a drop to 65% homeownership in the next five years will produce 4.5 million new rental households. Some of those people will no doubt rent cheap single-family houses, but most will probably be in rental apartments. In the longer run, only about 300 thousand multi-family units have been produced per year, or less than half our projected increase in renters. Apartment construction may again boom after the absorption of current vacancies pushes rental rates up enough to justify new building.

Our Theme

As we hope you’re well aware, we’ve been advocates of rental apartments as an investment theme for some time. It’s one of our long-term “buy” themes in The Age of Deleveraging. We also listed it as an investment strategy for 2011 in our Jan. 2011 Insight. In addition to all the reasons covered in his report, we noted in our January issue that rental apartments will benefit from the separation that Americans are beginning to make between their abodes and their investments. The two used to be combined in owner-occupied houses back when owners believed house prices never fall. So they bought the biggest homes they could finance. The collapse in house prices has shown them otherwise. Further weakness in the prices of singlefamily houses and condos due to the depressing effects of excess inventories (Chart 4) will add fat to the fire.

Contrary to general belief, a single-family house, excluding the effects of increasing size and general inflation, has been a flat investment for over a century (Chart 6). It does provide a place to live, but that value is offset, at least in part, by maintenance, taxes, utilities, real estate commissions and other costs. Furthermore, even with the tax deductibility of mortgage interest, renting a single-family house or apartment is cheaper than home ownership, absent price appreciation. Our repeated analyses over the years have shown this to be true, and even more so in the period of deflation we foresee when nominal house prices will probably fall on average.

Over time, houses have sold for about 15 times rental income. But that’s in the post–World War II years when owners of rental properties expected inflation to enhance their 6.7% return—before the costs of income tax–deductible maintenance and property taxes. When we were young and house price appreciation was not expected in the aftermath of the 1930s, the norm for rentals was 10% of the house’s value. If we’re right about our outlook for slow economic growth and falling house prices, houses and apartments may sell for closer to 10 times rentals than 15 times, much less the 20 times rental income in the housing boom days.

The separation of abodes from investments should work to the advantage of rentals in future years. We’re not suggesting that Americans will give up on single-family owneroccupied housing. The idea of a singlefamily home of your own is just too deeply embedded in the American culture. But many who have no pride of home ownership and who would vastly prefer to yell for the “super” (New York-ese for the building superintendent) than to apply a wrench to a leaky pipe have bought houses and apartments in past decades only to participate in capital appreciation.

The Old And The Young

They’ll be more inclined in future years to occupy rental apartments. This might be especially true of empty-nesters who don’t like to mow their lawns and who decide to unload their suburban money pits—especially because these homes are no longer appreciating rapidly but rather falling in price. At the front end of the life cycle, young couples may decide that because houses are no longer a great investment, there’s no reason to strain their financial, physical, and emotional resources to buy big, expensive houses as soon as possible. So they’ll stay in rental apartments a bit longer and wait until their kids are of the age that a single-family house makes sense.

Reinforcing our earlier analysis of the future demand for rentals is the surprisingly small shift in housing patterns it will take to make a big difference in the demand for and construction of rental apartments. Today, there are 131 million housing units in the U.S., including vacancies, of which 42 million are rentals. If only 1% of the total 112 million households decided to move to rentals, the demand for apartments would increase by over one million, most of which would need to be newly built after current vacancies are absorbed. This is a big number compared to new apartment starts of about 300,000 on average in the past. Rental apartments will also appeal to the growing number of postwar babies as they retire, downsize, and want less responsibility and more leisure time.

Like other REITs, apartment REITs rose rapidly last year (Chart 10) and may have over-anticipated the performance of the underlying investments in coming quarters. Direct ownership and other forms of investment in rental apartments may be more rewarding in the near future.

Rental apartments are not without their problems for investors. Prices haven’t risen dramatically lately compared to office and industrial buildings, but capitalization rates are relatively low, indicating that prices are high. Also, multi-family mortgage delinquencies and foreclosures are a problem, especially for Fannie, which with Freddie bought apartment loans in 2007 and 2008 as private lenders withdrew. Their share of multi-family loan purchases jumped to 85% in 2009 from 29% two years earlier. They own or guarantee 40% of the $325 billion multi-family mortgage market. Nevertheless, rental apartments are likely to be an attractive investment area for years as the joys and profitability of homeownership continue to fade.

Kyle Bass: The Cognitive Dissonance of It All

The Cognitive Dissonance of It All
By John Mauldin
March 6, 2011


I get a lot of client letters from various managers and funds, as you might imagine. I read more than I should. But one that shows up every quarter or so makes me stop what I am doing and sit down and read. It is the quarterly letter from Hayman Advisors, based here in Dallas. They are macro guys (which I guess is part of the magnetic attraction for me), and they really put some thought into their craft and have some of the best sources anywhere. So today we take a look at their latest letter, where they cover a wide variety of topics, with cutting-edge analysis and sharp insight. I really like these guys, and suggest you take the time to read the entire letter.

Today (Tuesday) is the day I want you to start buying Endgame. The early reviews on Amazon are quite gratifying – writing a book is damn hard work, so when people say nice things it just feels good. Have a great week! Now let’s jump into the Hayman client letter.

John Mauldin, Editor
Outside the Box

The Cognitive Dissonance of It All

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

– Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds

Dear Investors:

We continue to be very concerned about systemic risk in the global economy. Thus far, the systemic risk that was prevalent in the global credit markets in 2007 and 2008 has not subsided; rather, it has simply been transferred from the private sector to the public sector. We are currently in the midst of a cyclical upswing driven by the most aggressively procyclical fiscal and monetary policies the world has ever seen. Investors around the world are engaging in an acute and severe cognitive dissonance. They acknowledge that excessive leverage created an asset bubble of generational proportions, but they do everything possible to prevent rational deleveraging. Interestingly, equities continue to march higher in the face of European sovereign spreads remaining near their widest levels since the crisis began. It is eerily similar to July 2007, when equities continued higher as credit markets began to collapse. This letter outlines the major systemic fault lines which we believe all investors should consider. Specifically, we address the following:

• Who Is Mixing the Kool-Aid? (Know Your Central Bankers)

• The Zero-Interest-Rate-Policy Trap

• The Keynesian Endpoint – Where Deficit Spending and Fiscal Stimulus Break Down

• Japan – What Other Macro Players Have Missed and the Coming of “X-Day”

• Will Germany Go All-In, or Is the Price Too High?

• An Update on Iceland and Greece

• Does Debt Matter?

While good investment opportunities still exist, investors need to exercise caution and particular care with respect to investment decisions. We expect that 2011 will be yet another very interesting year.

In 2010, our core portfolio of investments in US mortgages, bank debt, high-yield debt, corporate debt, and equities generated our positive returns while our “tail” positions in Europe contributed nominally in the positive direction and our Japanese investments were nominally negative. We believe this rebound in equities and commodities is mostly a product of “goosing” by the Fed’s printing press and are not enthusiastic about investing too far out on the risk spectrum. We continue to have a portfolio of short duration credit along with moderate equity exposure and large notional tail positions in the event of sovereign defaults.

Who Is Mixing the Kool-Aid?

Unfortunately, “academic” has become a synonym for “central banker.” These days it takes a particular personality type to emerge as the highest financial controller in a modern economy, and too few have real financial market or commercial experience. Roget’s Thesaurus has not yet adopted this use, but the practical reality is sad and true. We have attached a brief personal work history of the US Fed governors to further illustrate this point. So few central bankers around the world have ever run a business – yet so much financial trust is vested with them. In discussing the sovereign debt problems many countries currently face, the academic elite tend to arrive quickly at the proverbial fork in the road (inflation versus default) and choose inflation because they perceive it to be less painful and less noticeable while pushing the harder decision further down the road. Greenspan dropped rates to 1% and traded the dot com bust for the housing boom. He knew that the road over the next 10 years was going to be fraught with so much danger that he handed the reins over to Bernanke and quit. Central bankers tend to believe that inflation and default are mutually exclusive outcomes and that they have been anointed with the power to choose one path that is separate and exclusive of the other. Unfortunately, when countries are as indebted as they are today, these choices become synonymous with one another – one actually causes the other.

ZIRP (Zero Interest Rate Policy) Is a TRAP

As developed Western economies bounce along the zero lower bound (ZLB), few participants realize or acknowledge that ZIRP is an inescapable trap. When a heavily indebted nation pursues the ZLB to avoid painful restructuring within its debt markets (household, corporate, and/or government debt), the ZLB facilitates a pursuit of aggressive Keynesianism that only perpetuates the reliance on ZIRP. The only meaningful reduction of debt throughout this crisis has been the forced deleveraging of the household sector in the US through foreclosure. Total credit market debt has increased throughout the crisis by the transfer of private debt to the public balance sheet while running double-digit fiscal deficits. In fact, this is an explicit part of a central banker’s playbook that presupposes that net credit expansion is a necessary precondition for growth. However, the problem of over indebtedness that is ameliorated by ZIRP is only made worse the longer a sovereign stays at the ZLB – with ever greater consequences when short rates eventually (and inevitably) return to a normalized level.

Consider the United States’ balance sheet. The United States is rapidly approaching the Congressionally mandated debt ceiling, which was most recently raised in February 2010 to $14.2 trillion dollars (including $4.6 trillion held by Social Security and other government trust funds). Every one percentage point move in the weighted-average cost of capital will end up costing $142 billion annually in interest alone. Assuming anything but an inverted curve, a move back to 5% short rates will increase annual US interest expense by almost $700 billion annually against current US government revenues of $2.228 trillion (CBO FY 2011 forecast). Even if US government revenues were to reach their prior peak of $2.568 trillion (FY 2007), the impact of a rise in interest rates is still staggering. It is plain and simple; the US cannot afford to leave the ZLB – certainly not once it accumulates a further $9 trillion in debt over the next 10 years (which will increase the annual interest bill by an additional $90 billion per 1%). If US rates do start moving, it will most likely be for the wrong (and most dire) reasons. Academic “research” on this subject is best defined as alchemy masquerading as hard science. The only historical observation of a debt-driven ZIRP has been Japan, and the true consequences have yet to be felt. Never before have so many developed western economies been in the same ZLB boat at the same time. Bernanke, our current “Wizard of Oz”, offered this little tidbit of conjecture in a piece he co-authored in 2004 which was appropriately titled “Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment”. He clearly did not want to call this paper a “Hypothetical Assessment” (as it really was).

Despite our relatively encouraging findings concerning the potential efficacy of non‐standard policies at the zero bound, caution remains appropriate in making policy prescriptions. Although it appears that nonstandard policy measures may affect asset prices and yields and, consequently, aggregate demand, considerable uncertainty remains about the size and reliability of these effects under the circumstances prevailing near the zero bound. The conservative approach — maintaining a sufficient inflation buffer and applying preemptive easing as necessary to minimize the risk of hitting the zero bound — still seems to us to be sensible. However, such policies cannot ensure that the zero bound will never be met, so that additional refining of our understanding of the potential usefulness of nonstandard policies for escaping the zero bound should remain a high priority for macroeconomists.

–Bernanke, Reinhart, and Sack, 2004. (Emphasis Added) It is telling that he uses the verb “escaping” in that final sentence – instinctively he knows the ZLB is dangerous.