When I was about ten my grandfather gave me a book he had been saving just for me. It was my first book. I don’t remember the title or content but it was a beautiful book, my own book. It had a dust jacket that my grandfather removed and tossed aside to reveal a soft brown leather book with the title and author embossed in 18 carat gold on the cover and spine. Both the cover and spine had been tooled with a beautiful border. I thought the spine especially beautiful. The hide had been glued to a form of cardboard made of cotton fibers and the endpapers of the book itself were glued to the spine with the glue joint covered over with a beautiful hand made gold and green marbled paper. The body of the book had been printed by letterpress in giant 16 page signatures then sewn into a cloth backing with a Smyth Sewing machine. The first signature of the book, only 4 pages, had been printed by engraving and contained the title page with a florid design together with a portrait of the author reminiscent of those found on currency. There was a phantom signature of tissue paper between each of the engraved pages to protect the engravings.
You could tell the book had not been opened and read because the signatures had not been cut. The binding process included folding and gathering the signatures then sewing them into the backing but the resulting signatures were not trimmed as they are today. My grandfather ceremoniously handed me his paper cutter and instructed me to cut the signatures firmly but gently. For him learning how to properly open a book was a sacred right of passage. As I slowly sliced the first signature open I could feel the individual cotton fibers stretch then break as I drew the dull knife upwards. By the time I had cut the last signature the book had become mine. I would be the first person to set eyes on the printed page since they had come off the press. There was magic in that.
When I opened the book and looked at the first page in the first signature I could see the slightly uneven imprint of the type in the soft textured paper. Even without a magnifying glass I could see the needle edge of the types serifs where it cut into the paper carrying with it the carbon black filled ink. It was beautiful.
Books were made this way for several hundred years. Typesetting was a tedious, expensive and challenging work when done by hand and dangerous when done by a linotype machine that cast individual lines or slugs of metal type from negatively shaped type masters and hot molten lead. These slugs were then printed for proofing on small presses called galley presses. When all was well the slugs were then placed in a large 2 x 4 page panel for printing. Two of these were required to print one sixteen page signature. It was a slow tedious labor intensive process.
Before about 1970 fine, hardbound books were only printed by letterpress. I am old enough to remember when the change occurred. Offset printing was considered cheep and not worthy of a fine printed book. By 1980 all hardbound books were printed by offset lithography.
Offset lithography printing uses a flat metal or plastic sheet called a plate that has been photographically prepared so that ink sticks to the image area and is rejected elsewhere. Ink is transferred from the plate to a roller that presses into ink into the paper. One of the drawbacks to offset lithography is that the offset plate cannot carry as much ink to the paper or press as hard as a letterpress. Because of this the paper used in offset printing must be very flat and without the “tooth” that characterizes the “fine” papers used in letterpress. When the thin film of ink on an offset roller is pressed against the very flat paper, fine lines, dots and type serifs tend to spread so serif type faces printed by offset tend to look a little muddy when compared to identical type printed by letterpress. This feature of offset printing lead directly to an explosion in the use of san-serif type faces like Helvetica, Universe and others in book design. One good feature of offset printing is the ability to print photographs with a resolution many times greater than letterpress offers.
In older books photographs were often printed individually then glued or “tipped” into the book or entire signatures of photographs or drawings were printed by etching presses then sewn into the book. The maximum resolution of a letterpress was about 45 dots per inch using newsprint and as much as 85 dots per inch using paper specially prepared for the purpose. This paper was often hard and brittle from the clay used to prepare the paper to take a very sharp image. The harder and flatter the surface the sharper the dots could be. Etching presses or rotogravure, are capable of impressions of up to 200 dots per inch but this process is very expensive and gravure doesn’t print type very well at all. The colorful magazines distributed with Sunday Newspapers were always printed by rotogravure. That was then; today both newspapers and the colorful magazines they contain on Sunday are printed by offset. Because offset printing was an inexpensive way to print both type and art on the same page it became very popular with textbook publishers. It didn’t take long for paperback publishers to switch to offset followed quickly by traditional publishers.
Not only did the switch to offset represent a revolution in printing at the same time there was a revolution in typesetting. Letterpress printing was a part the old industrial revolution characterized by big dirty machines, steam engine technology. Typesetting was a blue-collar profession conducted in the bowls of a factory. Type was literally hot as the liquid lead flowed down open channels to form the slug in a linotype machine. In the late 1960’s “cold type” became popular. Early “cold type” systems came from IBM Selectric ™ Typewriters modified to print real typographers’ fonts onto specially prepared paper and Compugraphic ™ and other brands of machines that composed type onto photographic paper. These galleys would then be used to “paste-up” a dummy of the publication which then was then used to photographically create an offset plate.
Today, of course, hot type and paste-up is a thing of the past because of the multitude of personal computer programs that can electronically paste-up, proof the image on ink jet or laser printers and electronically create an offset plate. Xerox, Hewlett Packard and Kodak all pioneered in the use of ink jet and laser as “page-proof printers” with a quality image that rivaled or bettered that produced by an offset press.
The best offset printers can print images with a resolution of 300 dots per inch at a rate measuring in the thousands of impressions per minute but an offset pressman might have to print as many as 50 sheets to get the inking on a plate exactly right before turning up the press. Because of the tuning required an offset job is cheaper than a proofing press only of the print run exceeds many hundred or thousands of impressions. For many years book publishing has been constrained by the economies of scale in offset printing. For example, printing a 200 page paperback book might cost as much as $2000 to set up and 2 cents per impression. Printing and binding 100 copies could cost $35 or more per book but in quantities of 50,000 the cost falls into the range of pennies per book.
Modern proofing presses, for example Hewlett Packard’s Indigo series of industrial laser printers, are capable of printing an 11” by 17” images in full color with a resolution of 1200 dots per inch at the rate of up to 1000 pages per minute. The quality of the image produced by these printers is superior to almost all offset printing but cost considerably more than offset at its optimum but considerably less than offset in very small quantities. With the introduction of home, commercial and industrial laser printers “printing on demand” was born and “publishing on demand” soon after.
Publishers face two dilemmas: First, Can they sell enough books to make publishing worthwhile? Second, how can publishers keep their back list alive without having to print and stock uneconomical quantities of books? For most mainstream publishers pre- and post-publication costs dictate an initial print run of many thousands of books. These same economics prohibit the publication of books with potentially smaller audiances and prohibit altogether books on the backlist that could have long but active tails. A book by a major publisher that might sell 100 – 300 books a year in perpetuity is quickly marked out of print.
“Publishing on demand,” or POD, is a technology that solves the problem of small press runs. POD marries laser proofing technology with conventional bindery equipment to create a book production system that is as efficient at printing a one-of book as it is 2,000 books. Of course the unit cost is much, much higher and the production rate much lower than offset but back listed books that once would have gone out of print can be quickly and effectively produced by a Lulu or Lightning press one at a time at a cost point guaranteed to earn the publisher a profit.
To a small to medium sized publisher POD is a revolution. Not only does the use of POD eliminate an investment in inventory but the quality of publication is greater or equal to that produced by offset. The simple elimination of large inventories allows smaller publishers to publish more books than they otherwise could and the availability of POD published works guarantees that no book will ever go out of print. The agility of POD will almost guarantee that new and exciting works will flow to those publishers who using POD, will be able to respond quickly and decisively to the market. By reducing the cost to market while maintaining expected quality will insure the publisher using POD will have an advantage over their more conventional competition.
The books my grandfather kept were the classics but in that age and the one immediately after it how many books, good books, were never published because a publisher didn’t think there was a market big enough to make money? Today every book can get published and linger in obscurity until someone finds the gem they were looking for.
Thursday, October 23, 2008
Sunday, October 05, 2008
Roosting Chickens
In 1978 I had the opportunity to buy a house in Cambridge Massachusetts for about $75,000. I turned it down because had I bought it, after paying $10,000 up front for a down payment my mortgage would be $300 a month more than I had been paying to rent the house. If I bought the house I would get a negative return on my investment. Real estate has been immune from that logic for most of my lifetime because of the almost universal belief that all real estate appreciates quickly. The house was sold and I had to move. I drive by it occasionally and realize that at the peek of the real estate boom that ramshackle house could have sold for $900,000.
The problem is that someone did buy that house for a price nearer $900,000 than the $75,000 I had been offered. For the last 50 years the expectation that real estate will appreciate has been proved more or less true. Unless incomes grow at least at the same rate as the price of housing eventually the average person cannot purchase the average home. My guess is that that line was crossed somewhere in the mid 1990’s. Unfortunately bankers, brokers and consumers all assumed that the party would continue forever, that there would always be a greater fool willing to pay just a little bit more but as the prices rose relative to our incomes the number of fools willing to pay absurd prices approached the vanishing point.
Banks recognized the problem they were facing. When a depositor places money in a bank it is a liability. To turn that liability into an asset it must be invested which for a bank means loaning the money out. Because that money is then returned to the bank in the form of a new deposit or liability, it must be loaned out again. Without limits the amount of money “created” could approach infinity. To prevent that from happening a “reserve” of about 20% is held back. This reserve requirement is adjusted by the Federal Reserve Bank to speed up or slow down the economy as it effects the creation of money, it’s a multiplier effect. As the Real Estate market began running out of new suckers, banks began running out of new places to put their money. The banks return on investment began to falter; the rise in the price of Real Estate began to falter. The first part of the Real Estate Bubble was at an end, the second part was just about to begin.
We have become a very short sighted society. Executives are rewarded for what results they got last quarter and their vision rarely extends beyond the next. The “future” has been foreshortened to not much beyond this fiscal year. A mortgage is a 30 year investment, a deposited liability is now. The question became one of how to turn all that liability into high paying short term loans. Some financial genius with an HP-35 calculator realized that the adjustable rate mortgage, or ARM, was a perfect vehicle to keep the good times rolling.
An ARM is based on the notion that a security can be sold based on the cash flow over the life of a loan while low payments at the start mean more people can afford the payments at least initially. For example a loan can have very low payments for the first 24 payments then those payments rise over time with a huge balloon payment at the end. If the bank resells the the loan while the payments are low and still in good standing then the bank is off the hook. A loan priced at 2% then 6% then 25% could average, over the life of the loan as 7%. This financial genius figured the bank could have it both ways:
1. By charging a very low interest rate (or low repayment rate) initially, a lot more people could qualify for loans and since, so the theory went, most people refinance (in 3 years for example on a 30 year note) before the high payments kick in the security was safe. In theory someone could continually refinance a house with an ARM every couple of years forever.
2. Since the sale price of the security is based on the cash flow over the life of the security, 30 years, the bank could bundle thousands of these loans and sell them as “tranches” to large investment banks as well as Fanny Mae and Freddy Mac. Banks typically mix good, bad and mediocre loans in a tranche and sell these to the highest bidder. They need to sell tranches to prevent buyers from cherry picking only the best loans leaving the bank with the trash. We’ll see in a moment what Freddy, Fanny and the investment banks did with these securities that made the situation worse.
The availability of cheep loans jumpstarted the Real Estate market as new “greater fools” flowed into the housing market. Hundreds of thousands of jobs were created as millions of dollars worth of new housing was built. The monster fed on itself as deposits flowed into the banks and unstable loans flowed out.
Greed has no limits. Fanny, Freddie and the investment banks were not happy holding five year notes, much less 10, 15 or 30 year notes. To make these assets liquid, to create even more money, these institutions created “Asset Backed Securities.” An Asset Backed Security is created when an investment bank merges all it’s “tranches” together then splits them into different grades of investment bonds. A new “tranche” of, for example, $100 million worth of mortgages (at present value) is bundled together and bonds created that represent some percent of the total. These ABS’s were then sold on the open market creating new cash, new liabilities. The problem is that in a declining market no one knows what these asset backed securities are worth because they don’t know what the underlying mortgages are worth. It’s a Ponzi scheme, it works only while there is a greater fool willing to buy whatever is being sold.
Again! Unfortunately bankers, brokers and consumers all assumed that the party would continue forever, that there would always be a greater fool willing to pay just a little bit more but as prices rose the number of fools willing to pay idiotic prices approached the vanishing point. Suddenly all those 2, 3, and 5 year ARMS began to come due. A 2% interest rate became, 4% and 4% became 6, 7 or 8%. A mortgage payment of $1000 became $2000 and promised to go to $4000. The greater fools could not refinance their mortgages and the prices began to fall. The monster fed on itself.
Remember that money you deposited in a bank back at the beginning of this story? Let’s say you deposited $100. Given the 20% reserve requirement the bank was able to loan out $80, then $64 then $51.20 …. This creates a total of about $450 in new deposits and about $350 in new loans. If some of those loans go sour then the bank has to either find more money to maintain the reserve requirements or stop making loans while those loans that are still good are paid back.
The way banks find more money is to either sell the assets they have or get new deposits. Here’s the problem: No one is willing to buy these “assets.” Even Fanny and Freddy have suffered terminal indigestion, having purchased enough ABS junk bonds and toxic mortgages that they had to be taken over and resuscitated by the U.S. Government. That leaves option number two: wait until existing loans mature and are paid back. The cash coming in from maturing loans fills the bank’s vault until the reserve requirements are met. In the mean time they don’t have any money to loan out. That is where we find ourselves right now but that’s only half of the story.
It gets worse. We live in a world where we finance everything. No one pays cash for their homes or cars or washing machines. Likewise companies finance as much of their operations as they can get away with. Every automobile dealership finances their inventory and look inside any store and you will see nothing but bank owned inventory, fixtures and infrastructure. Most companies as well as most individuals are “leveraged” to the max. On paper this looks great: Grow with other people’s money. What happened when all this toxic debt began clogging the market is that the whole house of cards started falling. It’s already begun and like the twin towers once the collapse starts no one knows if it can be stopped.
The cards at the top of the pyramid are crumbling: General Motors has tapped out its last $2 billion line of credit. Once that’s spent it will have to live on its cash flow, something it hasn’t been able to do for the better part of a decade. GMAC, GM’s finance arm and a big player in the toxic security market, announced it could no longer finance the inventory of its dealers and almost immediately the largest GM dealership in the US went bankrupt sending thousands of employees to the unemployment lines.
All five of the of the largest investment banks, creators of those toxic Asset Backed Securities, have, one way or another, gone out of business so has the largest insurance company in America, a major buyer of the ABS junk. We may celebrate the demise of incompetence but historically these same investment banks were instrumental in the creation of most of America’s largest companies. In the future it will be foreign investment banks, Chinese, Russian, Arab and European that will dictate the direction America’s economy will go. Almost unnoticed was the largest bank failure in American history when Washington Mutual discovered that it could not raise enough cash to meet its commitments. Then Wachovia, who’s next? This is just the tip of the iceberg.
So the Federal Government is going to bail out the financial system by buying $700+ billion in bogus, toxic, ABS, “derivative” securities. With luck it will work but please note that the Feds aren’t buying the original mortgages, heavens no, they might have some value, rather the Feds are buying the Asset backed Securities created by the now defunct Investment Banks. If (and only if) the Real Estate market “recovers” and somehow still greater fools are found will those ABS ever have value.
If $700 billion is the size of the problem we would be very lucky. $700 billion is only about half the size of the annual Federal Budget, that’s manageable. Fortunately only a small portion of those questionable mortgages were converted into ABS’s, the vast majority of those loans are still on the books of banks and Freddy and Fanny as assets. If the sale price of these assets continue to decline they will poison the balance sheets of more and more banks and cause many to fail. If you don’t like a $700 billion bailout you’ll love the price tag if this bailout doesn’t work. It’s something like $100 trillion or about half of the mortgages out there.
It might be interesting to stop for a moment and look at how and why we got here. We know greed got us here but it was greed at every level, from the most petty real-estate salesman through Wall St. to the Congress and the President of the United States. Greed has many forms and in politics is often disguised as altruistic actions. We want all sorts of services from our government but none of us want to pay for these services. No problem we’ll charge it and leave the debt to another generation. Our national debt, money we have borrowed to run the national government, has grown from $2 Billion in 1980 to $10 Billion today. Historically our debt has been eliminated by monetary inflation. Inflation is a hidden tax shared evenly across the country. Let’s take a look at the last 100 years.
In 1900 the average person earned $300 a year. In 2005 the average person earned over $40,000 per year. Of course in 1900 the average person didn’t have the costly amenities we have today like indoor plumbing and electricity but still the majority of the difference in incomes between 1900 and 2005 is inflation. Inflation is defined as an increase in the amount of money in circulation relative to the goods and services available for sale. It sounds simple and concrete but is really nebulous because as we saw banks can create money simply by making loans.
Economists have a name for different kinds of money much like Eskimos have names for different kinds of snow. Hard currency is called M0, M0 plus bank deposits are M1, M1 plus medium term deposits (like CD’s and savings accounts) are called M2 and M2 plus the longest term deposits (like 2 year treasury notes) are called M3. Most of us treat our real estate investments as part of our personal M3 although most economists don’t count it. In the past we have treated real estate as money since we could always go to the bank and get a loan based on the value of our houses. I would also argue that our 401K plans are also part of our personal M3 since we can dip into them on occasion too. The point of this exercise is that we measure our economy and our salary in money terms measured in dollars but that term has different meanings depending on context. A dollar means different things depending on when and where it’s used so talking about inflation around economists is as slippery as an eel but a change in incomes from $300 to $40,000 speaks for itself.
What happened at the beginning of the Great Depression was almost the same thing that’s happening today. When deposits aren’t reinvested, new money isn’t created and when money is transferred from M3 to M2 (by loan defaults or by paying off loans faster then new loans are made) then to M1 and cash (as confidence in longer term securities dwindles) the combined money supply shrinks. So long as all those ARM’s are not being refinanced the money supply will shrink. When the money supply shrinks prices fall. At the height of the Depression the average price level actually declined, we had deflation.
When Roosevelt came into office the new thinking in economics was to stimulate the economy by increasing the money supply. It did so by purchasing all the bonds issued during the First World War and by buying gold at the, then, unheard of price of $35 an ounce. The national debt was “monetized.” Still it took the demands of the Second World War to put the malaise of the Great Depression behind us, monetary policy wasn’t enough. Fortunately for us a combination of aggressive monetary expansion and an incredibly fast growing economy put the debt of the Second World War behind us very quickly. The cost of Vietnam was different.
There is an old saying that “you can’t have both guns and butter” and during both world wars there were shortages and rationing. Vietnam was different. For the first time in history politicians tried to have it both ways. President Johnson’s “Great Society” combined with a booming post-war economy and a festering and expensive war in Vietnam lead to a relatively massive national debt. The solution the Federal Reserve choose to solve the problem was to monetize the debt to pay for it with “fiat,” invented, money. Of course this lead the wild inflation of the Nixon and Ford and Jimmy Carter years but it solved the problem of the debt. It got rid of it. It also stimulated the economy and the 1980’s were golden years.
This magic potion was not lost on Ronald Reagan who doubled the national debt as well as the size of the federal budget and managed to bankrupt the Soviet Union in an arms race Russia realized they could not win. Unfortunately Reagan also appointed Allan Greenspan to head the Federal Reserve.
Alan Greenspan did two things that made free market economists drool in delight. He attacked inflation with a vengeance by raising interest rates sky high. This made investments in America look very attractive while at the same time removing money (that mysterious M3) from the system. He was so effective in removing money that he caused the recession of 1988-89 which cost George H.W. Bush the presidency and forced President Clinton to create budgets with a surplus. Regains debt could not be paid for with inflation so Clinton had to arrange to pay for it with taxes. Fortunately the end of the cold war reduced the need for military spending. We had a peace dividend and the economy grew and grew and grew. The economy grew because there were more goods and services available to buy since the capacity of our economy to manufacture goods for human consumption rather than military consumption grew. The good times came to an end with George W. Bush.
George thought he could do old Ronald Regain one, maybe two better. After nine-eleven George conjured up the most expensive war in American history. If Regain only doubled the national debt from $2 trillion to $4 trillion, George managed to double it again from $4 trillion to $8 trillion through a combination of tax cuts and uncontrolled spending. Contrary to their political doctrine Republicans have been unable to restrain themselves when it comes to spending your money. With the financial rescue plan in place it is not unreasonable to expect the final bill to push our national debt well over $10 trillion.
So how are we going to solve this problem? This is a ~$30,000 problem for every man woman and child in the US, it’s the cost of a low end luxury car or a year at a middle of the road private college. It is “doable” if any of us really thought that would be the end of it but it would destroy the hopes of retirement for the current generation and hobble the start of the next. Even if we did pay it off in a static economy would it have any effect? Who do we owe this money to anyway?
In the aggregate we owe it to ourselves but the devil is in the details. When Ross Periot sold Electronic Data Systems to General Motors for a couple of billion Dollars he put his money in U.S. Government bonds, he bought part of our national debt. When he ran for President and paid for his campaign “with his own money” he actually paid for it with interest on those bonds. We actually paid for his campaign with that portion of our taxes that pays the interest on the national debt. It’s the very rich of the world, rich individuals, rich corporations and rich countries like Dubai and China that own the promissory notes of the United States. If we default, and default we must, it will be a massive transfer of wealth from the rich to the poor.
Why must we default? Simple, we must default because there is historical precedent for it and in the end there is no other way. Trickle down economics never worked. The rich don’t spend the way you and I do. They invest, they create more money, and they create additional claims on our national productive capacity. They own or have a lean on the means of production and they demand their due. Eventually the economy grinds to a halt as it becomes tied up in servicing its own debt.
I’m not inventing economic theory here, just observing the patterns of history that have been observed in every society since man began recording history. In our own era it has been called long economic wave or Kondratieff Wave after a Soviet era economist who first described a 50-80 year wave of economic growth and contraction in the modern era. Nilolai Kondratieff observed the expansion and contraction of economies and described it as a cycle of strong economic growth followed by a period of debt repudiation and commodity price collapse. The price collapse is a result of the contraction of the money supply brought on by debt repudiation or default.
In earlier times what economists now call the Kondratieff wave was observed as “goldsmith crisises.” Vilfredo Pareto, an economist and early contemporary of Kondratieff was able to isolate data showing signs of long economic waves going back into Roman times. It appears that in societies lasting long enough to observe their internal economics institutionalize their debt repudiation. For example in the Old Testament there is the observation of the “Jubilee Cycle” every 49 years, a feature of which is the forgiveness of debts.
There are many ways to default on the national debt. The most obvious way and the least likely to take place is to simply repudiate the debt, just announce that we will no longer honor the debt. The second way is through monetary inflation. The Federal Reserve adjusts the money supply by buying or selling debt instruments like Treasury Notes. When the Feds buy notes they introduce money into the system, when they sell securities they remove money from the system. What do you think will happen when $700 billion in cash is spent buying up defaulted mortgages and “toxic” securities? A lot of money will be introduced into the system and according to classical (or neo-classical if you like) economic theory one of two things will happen. If there is pent up demand (i.e. if there are people who could qualify to buy a house but can’t because of the mortgage crisis) then the economy will boom as money changes hands again at an accelerating pace. This is called a simple increase in the velocity of money if any of you reading this are economists. If, however, the economy is saturated, if there are no more “greater fools” out there then this sudden increase in the money supply will cause nothing but inflation. This is good!
Why is this good? For one it reignites the housing market as outrageously expensive houses become relatively cheaper. It also allows us to pay down the national debt with inflated dollars. It’s a game of musical chairs where those who hold enormous wealth on paper are least likely to end up with a seat at the table. Still inflation is a hidden tax on all of us that history has shown to be a universal but, ultimately, welcome leveler.
The problem is that someone did buy that house for a price nearer $900,000 than the $75,000 I had been offered. For the last 50 years the expectation that real estate will appreciate has been proved more or less true. Unless incomes grow at least at the same rate as the price of housing eventually the average person cannot purchase the average home. My guess is that that line was crossed somewhere in the mid 1990’s. Unfortunately bankers, brokers and consumers all assumed that the party would continue forever, that there would always be a greater fool willing to pay just a little bit more but as the prices rose relative to our incomes the number of fools willing to pay absurd prices approached the vanishing point.
Banks recognized the problem they were facing. When a depositor places money in a bank it is a liability. To turn that liability into an asset it must be invested which for a bank means loaning the money out. Because that money is then returned to the bank in the form of a new deposit or liability, it must be loaned out again. Without limits the amount of money “created” could approach infinity. To prevent that from happening a “reserve” of about 20% is held back. This reserve requirement is adjusted by the Federal Reserve Bank to speed up or slow down the economy as it effects the creation of money, it’s a multiplier effect. As the Real Estate market began running out of new suckers, banks began running out of new places to put their money. The banks return on investment began to falter; the rise in the price of Real Estate began to falter. The first part of the Real Estate Bubble was at an end, the second part was just about to begin.
We have become a very short sighted society. Executives are rewarded for what results they got last quarter and their vision rarely extends beyond the next. The “future” has been foreshortened to not much beyond this fiscal year. A mortgage is a 30 year investment, a deposited liability is now. The question became one of how to turn all that liability into high paying short term loans. Some financial genius with an HP-35 calculator realized that the adjustable rate mortgage, or ARM, was a perfect vehicle to keep the good times rolling.
An ARM is based on the notion that a security can be sold based on the cash flow over the life of a loan while low payments at the start mean more people can afford the payments at least initially. For example a loan can have very low payments for the first 24 payments then those payments rise over time with a huge balloon payment at the end. If the bank resells the the loan while the payments are low and still in good standing then the bank is off the hook. A loan priced at 2% then 6% then 25% could average, over the life of the loan as 7%. This financial genius figured the bank could have it both ways:
1. By charging a very low interest rate (or low repayment rate) initially, a lot more people could qualify for loans and since, so the theory went, most people refinance (in 3 years for example on a 30 year note) before the high payments kick in the security was safe. In theory someone could continually refinance a house with an ARM every couple of years forever.
2. Since the sale price of the security is based on the cash flow over the life of the security, 30 years, the bank could bundle thousands of these loans and sell them as “tranches” to large investment banks as well as Fanny Mae and Freddy Mac. Banks typically mix good, bad and mediocre loans in a tranche and sell these to the highest bidder. They need to sell tranches to prevent buyers from cherry picking only the best loans leaving the bank with the trash. We’ll see in a moment what Freddy, Fanny and the investment banks did with these securities that made the situation worse.
The availability of cheep loans jumpstarted the Real Estate market as new “greater fools” flowed into the housing market. Hundreds of thousands of jobs were created as millions of dollars worth of new housing was built. The monster fed on itself as deposits flowed into the banks and unstable loans flowed out.
Greed has no limits. Fanny, Freddie and the investment banks were not happy holding five year notes, much less 10, 15 or 30 year notes. To make these assets liquid, to create even more money, these institutions created “Asset Backed Securities.” An Asset Backed Security is created when an investment bank merges all it’s “tranches” together then splits them into different grades of investment bonds. A new “tranche” of, for example, $100 million worth of mortgages (at present value) is bundled together and bonds created that represent some percent of the total. These ABS’s were then sold on the open market creating new cash, new liabilities. The problem is that in a declining market no one knows what these asset backed securities are worth because they don’t know what the underlying mortgages are worth. It’s a Ponzi scheme, it works only while there is a greater fool willing to buy whatever is being sold.
Again! Unfortunately bankers, brokers and consumers all assumed that the party would continue forever, that there would always be a greater fool willing to pay just a little bit more but as prices rose the number of fools willing to pay idiotic prices approached the vanishing point. Suddenly all those 2, 3, and 5 year ARMS began to come due. A 2% interest rate became, 4% and 4% became 6, 7 or 8%. A mortgage payment of $1000 became $2000 and promised to go to $4000. The greater fools could not refinance their mortgages and the prices began to fall. The monster fed on itself.
Remember that money you deposited in a bank back at the beginning of this story? Let’s say you deposited $100. Given the 20% reserve requirement the bank was able to loan out $80, then $64 then $51.20 …. This creates a total of about $450 in new deposits and about $350 in new loans. If some of those loans go sour then the bank has to either find more money to maintain the reserve requirements or stop making loans while those loans that are still good are paid back.
The way banks find more money is to either sell the assets they have or get new deposits. Here’s the problem: No one is willing to buy these “assets.” Even Fanny and Freddy have suffered terminal indigestion, having purchased enough ABS junk bonds and toxic mortgages that they had to be taken over and resuscitated by the U.S. Government. That leaves option number two: wait until existing loans mature and are paid back. The cash coming in from maturing loans fills the bank’s vault until the reserve requirements are met. In the mean time they don’t have any money to loan out. That is where we find ourselves right now but that’s only half of the story.
It gets worse. We live in a world where we finance everything. No one pays cash for their homes or cars or washing machines. Likewise companies finance as much of their operations as they can get away with. Every automobile dealership finances their inventory and look inside any store and you will see nothing but bank owned inventory, fixtures and infrastructure. Most companies as well as most individuals are “leveraged” to the max. On paper this looks great: Grow with other people’s money. What happened when all this toxic debt began clogging the market is that the whole house of cards started falling. It’s already begun and like the twin towers once the collapse starts no one knows if it can be stopped.
The cards at the top of the pyramid are crumbling: General Motors has tapped out its last $2 billion line of credit. Once that’s spent it will have to live on its cash flow, something it hasn’t been able to do for the better part of a decade. GMAC, GM’s finance arm and a big player in the toxic security market, announced it could no longer finance the inventory of its dealers and almost immediately the largest GM dealership in the US went bankrupt sending thousands of employees to the unemployment lines.
All five of the of the largest investment banks, creators of those toxic Asset Backed Securities, have, one way or another, gone out of business so has the largest insurance company in America, a major buyer of the ABS junk. We may celebrate the demise of incompetence but historically these same investment banks were instrumental in the creation of most of America’s largest companies. In the future it will be foreign investment banks, Chinese, Russian, Arab and European that will dictate the direction America’s economy will go. Almost unnoticed was the largest bank failure in American history when Washington Mutual discovered that it could not raise enough cash to meet its commitments. Then Wachovia, who’s next? This is just the tip of the iceberg.
So the Federal Government is going to bail out the financial system by buying $700+ billion in bogus, toxic, ABS, “derivative” securities. With luck it will work but please note that the Feds aren’t buying the original mortgages, heavens no, they might have some value, rather the Feds are buying the Asset backed Securities created by the now defunct Investment Banks. If (and only if) the Real Estate market “recovers” and somehow still greater fools are found will those ABS ever have value.
If $700 billion is the size of the problem we would be very lucky. $700 billion is only about half the size of the annual Federal Budget, that’s manageable. Fortunately only a small portion of those questionable mortgages were converted into ABS’s, the vast majority of those loans are still on the books of banks and Freddy and Fanny as assets. If the sale price of these assets continue to decline they will poison the balance sheets of more and more banks and cause many to fail. If you don’t like a $700 billion bailout you’ll love the price tag if this bailout doesn’t work. It’s something like $100 trillion or about half of the mortgages out there.
It might be interesting to stop for a moment and look at how and why we got here. We know greed got us here but it was greed at every level, from the most petty real-estate salesman through Wall St. to the Congress and the President of the United States. Greed has many forms and in politics is often disguised as altruistic actions. We want all sorts of services from our government but none of us want to pay for these services. No problem we’ll charge it and leave the debt to another generation. Our national debt, money we have borrowed to run the national government, has grown from $2 Billion in 1980 to $10 Billion today. Historically our debt has been eliminated by monetary inflation. Inflation is a hidden tax shared evenly across the country. Let’s take a look at the last 100 years.
In 1900 the average person earned $300 a year. In 2005 the average person earned over $40,000 per year. Of course in 1900 the average person didn’t have the costly amenities we have today like indoor plumbing and electricity but still the majority of the difference in incomes between 1900 and 2005 is inflation. Inflation is defined as an increase in the amount of money in circulation relative to the goods and services available for sale. It sounds simple and concrete but is really nebulous because as we saw banks can create money simply by making loans.
Economists have a name for different kinds of money much like Eskimos have names for different kinds of snow. Hard currency is called M0, M0 plus bank deposits are M1, M1 plus medium term deposits (like CD’s and savings accounts) are called M2 and M2 plus the longest term deposits (like 2 year treasury notes) are called M3. Most of us treat our real estate investments as part of our personal M3 although most economists don’t count it. In the past we have treated real estate as money since we could always go to the bank and get a loan based on the value of our houses. I would also argue that our 401K plans are also part of our personal M3 since we can dip into them on occasion too. The point of this exercise is that we measure our economy and our salary in money terms measured in dollars but that term has different meanings depending on context. A dollar means different things depending on when and where it’s used so talking about inflation around economists is as slippery as an eel but a change in incomes from $300 to $40,000 speaks for itself.
What happened at the beginning of the Great Depression was almost the same thing that’s happening today. When deposits aren’t reinvested, new money isn’t created and when money is transferred from M3 to M2 (by loan defaults or by paying off loans faster then new loans are made) then to M1 and cash (as confidence in longer term securities dwindles) the combined money supply shrinks. So long as all those ARM’s are not being refinanced the money supply will shrink. When the money supply shrinks prices fall. At the height of the Depression the average price level actually declined, we had deflation.
When Roosevelt came into office the new thinking in economics was to stimulate the economy by increasing the money supply. It did so by purchasing all the bonds issued during the First World War and by buying gold at the, then, unheard of price of $35 an ounce. The national debt was “monetized.” Still it took the demands of the Second World War to put the malaise of the Great Depression behind us, monetary policy wasn’t enough. Fortunately for us a combination of aggressive monetary expansion and an incredibly fast growing economy put the debt of the Second World War behind us very quickly. The cost of Vietnam was different.
There is an old saying that “you can’t have both guns and butter” and during both world wars there were shortages and rationing. Vietnam was different. For the first time in history politicians tried to have it both ways. President Johnson’s “Great Society” combined with a booming post-war economy and a festering and expensive war in Vietnam lead to a relatively massive national debt. The solution the Federal Reserve choose to solve the problem was to monetize the debt to pay for it with “fiat,” invented, money. Of course this lead the wild inflation of the Nixon and Ford and Jimmy Carter years but it solved the problem of the debt. It got rid of it. It also stimulated the economy and the 1980’s were golden years.
This magic potion was not lost on Ronald Reagan who doubled the national debt as well as the size of the federal budget and managed to bankrupt the Soviet Union in an arms race Russia realized they could not win. Unfortunately Reagan also appointed Allan Greenspan to head the Federal Reserve.
Alan Greenspan did two things that made free market economists drool in delight. He attacked inflation with a vengeance by raising interest rates sky high. This made investments in America look very attractive while at the same time removing money (that mysterious M3) from the system. He was so effective in removing money that he caused the recession of 1988-89 which cost George H.W. Bush the presidency and forced President Clinton to create budgets with a surplus. Regains debt could not be paid for with inflation so Clinton had to arrange to pay for it with taxes. Fortunately the end of the cold war reduced the need for military spending. We had a peace dividend and the economy grew and grew and grew. The economy grew because there were more goods and services available to buy since the capacity of our economy to manufacture goods for human consumption rather than military consumption grew. The good times came to an end with George W. Bush.
George thought he could do old Ronald Regain one, maybe two better. After nine-eleven George conjured up the most expensive war in American history. If Regain only doubled the national debt from $2 trillion to $4 trillion, George managed to double it again from $4 trillion to $8 trillion through a combination of tax cuts and uncontrolled spending. Contrary to their political doctrine Republicans have been unable to restrain themselves when it comes to spending your money. With the financial rescue plan in place it is not unreasonable to expect the final bill to push our national debt well over $10 trillion.
So how are we going to solve this problem? This is a ~$30,000 problem for every man woman and child in the US, it’s the cost of a low end luxury car or a year at a middle of the road private college. It is “doable” if any of us really thought that would be the end of it but it would destroy the hopes of retirement for the current generation and hobble the start of the next. Even if we did pay it off in a static economy would it have any effect? Who do we owe this money to anyway?
In the aggregate we owe it to ourselves but the devil is in the details. When Ross Periot sold Electronic Data Systems to General Motors for a couple of billion Dollars he put his money in U.S. Government bonds, he bought part of our national debt. When he ran for President and paid for his campaign “with his own money” he actually paid for it with interest on those bonds. We actually paid for his campaign with that portion of our taxes that pays the interest on the national debt. It’s the very rich of the world, rich individuals, rich corporations and rich countries like Dubai and China that own the promissory notes of the United States. If we default, and default we must, it will be a massive transfer of wealth from the rich to the poor.
Why must we default? Simple, we must default because there is historical precedent for it and in the end there is no other way. Trickle down economics never worked. The rich don’t spend the way you and I do. They invest, they create more money, and they create additional claims on our national productive capacity. They own or have a lean on the means of production and they demand their due. Eventually the economy grinds to a halt as it becomes tied up in servicing its own debt.
I’m not inventing economic theory here, just observing the patterns of history that have been observed in every society since man began recording history. In our own era it has been called long economic wave or Kondratieff Wave after a Soviet era economist who first described a 50-80 year wave of economic growth and contraction in the modern era. Nilolai Kondratieff observed the expansion and contraction of economies and described it as a cycle of strong economic growth followed by a period of debt repudiation and commodity price collapse. The price collapse is a result of the contraction of the money supply brought on by debt repudiation or default.
In earlier times what economists now call the Kondratieff wave was observed as “goldsmith crisises.” Vilfredo Pareto, an economist and early contemporary of Kondratieff was able to isolate data showing signs of long economic waves going back into Roman times. It appears that in societies lasting long enough to observe their internal economics institutionalize their debt repudiation. For example in the Old Testament there is the observation of the “Jubilee Cycle” every 49 years, a feature of which is the forgiveness of debts.
There are many ways to default on the national debt. The most obvious way and the least likely to take place is to simply repudiate the debt, just announce that we will no longer honor the debt. The second way is through monetary inflation. The Federal Reserve adjusts the money supply by buying or selling debt instruments like Treasury Notes. When the Feds buy notes they introduce money into the system, when they sell securities they remove money from the system. What do you think will happen when $700 billion in cash is spent buying up defaulted mortgages and “toxic” securities? A lot of money will be introduced into the system and according to classical (or neo-classical if you like) economic theory one of two things will happen. If there is pent up demand (i.e. if there are people who could qualify to buy a house but can’t because of the mortgage crisis) then the economy will boom as money changes hands again at an accelerating pace. This is called a simple increase in the velocity of money if any of you reading this are economists. If, however, the economy is saturated, if there are no more “greater fools” out there then this sudden increase in the money supply will cause nothing but inflation. This is good!
Why is this good? For one it reignites the housing market as outrageously expensive houses become relatively cheaper. It also allows us to pay down the national debt with inflated dollars. It’s a game of musical chairs where those who hold enormous wealth on paper are least likely to end up with a seat at the table. Still inflation is a hidden tax on all of us that history has shown to be a universal but, ultimately, welcome leveler.
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