Global Capital Asset Death Spiral

About a year ago the US market started seeing large asset write downs in the housing and financial markets. Since then, this crisis has spread to almost every asset class in the US. Auction Rate Securities [ARS], like student loans back fully by the US government that can't be sold. The Auctions for these cash equivalent assets have no bids. The same is true for all types of structured investment vehicles [SIV], like packaged mortgage securities [CMOs] and debt securities [CDOs]. Homes prices have falling over 10% on a national basis, the most since the great depression. Equities all over the world have fallen 20% or more.

Money is not rotating in and out of different asset classes. We are seeing a global Capital Asset Death Spiral [CADS]. As the FASB rules require firms to mark to market assets in markets that have no bids or liquidity such as ARSs, CDOs, and CMOs, these firms must write down their asset bases. Many of these financial firms will now be forced to sell assets - good and bad, for whatever price they can get - 20, 30, 40% of book value. So now good and bad assets have very low prices set on them forcing other firms with similar assets to also write down their asset bases, on and on and on...

Firms need to sell assets at reasonable prices to raise cash - not borrow money or dilute shareholders

Recent news of the Freddie (FRE) and Fannie (FNM) government takeover does little to stop the CADS. Institutions around the world are being forced to raise capital since their asset bases are being destroyed since there is no market for previously liquid assets. These firms do not need cash, they need to sell their assets(at, or near current book) for cash. If this asset death spiral continues, the US will move from a recession to a 1930's type depression.

One could argue that we need to allow free markets to solve this problem. I would agree with this if the asset death spiral were caused by free market systems. As I will explain, the previous credit bubble and current asset death spiral were caused to a great degree by actions and inactions of the federal government.

The large credit bubble created from 2003-2007 and CADS had the following causes:

1) Historic low 1% fed funds rate
2) Poorly targeted tax cuts for the wealthy
3) No lending oversight or evaluation
4) FASB mark to market rules

My theory is fairly simple. Too much liquidity chasing an ever shrinking yield. After the US depression in 2001-2002 the federal government lowered the funds rate to 1% and kept it there. Wealthy investors were stumped. With short and long term risk free yields at pathetic low levels cash was getting very hard to invest. Investors were still hurt from the stock market crash, so these investor would not put their cash in equity markets. Then the US gave large tax breaks to these wealthy investors, giving them even more cash per year to handle. What to do with all this cash?

The combination of historic low yields, fear of equities, and a poorly targeted tax cut had created a HUGE increase in the demand for a stable return on all this cash. Can you say SIV, or CMO? Where you have demand supply will not be far behind. The larger banks and investment firms increased the creation of these SIVs with CMO and, CDOs to satisfy the large increase in demand for yield. A 5-6% yield will do just fine in this now low yield environment. Banks would now bundle 1000's of mortgages to create these new higher yielding financial vehicles.

To satisfy this large increase in supply of SIVs, lending standards had to fall. There is no other way to meet this new demand for yield, much to the glee the home builders, mortgage lenders, house flippers, etc.

The US solution - The Asset Investment Fund

We need a resolution trust type fund to invest in the US economy. An original funding of 300 - 500 billion would be needed. This fund would buy CDOs, CMOs, ARSs, developed land, raw real estate, and foreclosed property. These assets would be help the the government 5-7 years then slowly sold back into the market, probably at a profit for the US taxpayer.

The US can borrow money very cheaply , below 4% currently. Our trading partners such as Saudi Arabia, Russia, China, Canada, etc. would help as a strong US economy is in their best interest as well. The average yield of the assets purchased by the US investment fund would be greater than 6%. A positive spread of 2% could be realized for the US. Remember the money needed for this fund will be borrowed cheaply, not come from taxpayers directly.

By investing in these assets, the US will initiate market liquidity and create stable pricing environments for capital assets. This will help the US avoid having to infuse billions of dollars in GSE bailouts and avoid the many FDIC insured bailouts in the future. By investing 300 billion upfront, the US could avoid over 300 billion in bailouts over the next 2 years!

But what about the poor US taxpayer?

I can already hear the fear mongers. A US investment/bailout will just hurt the US taxpayer. If the asset death spiral continues, the US will not have many taxpayers left. State and local municipalities will not be able to raise funds as bonds can't be sold and home prices continue to fall. We will continue to see local government declare bankruptcy along with many regional banks. The remaining banks will be unable to fund ANY projects, even ones with solid cash flows. With no financing available jobs will continue to be lost, creating more home foreclosures and the death spiral continues....

This investment fund will restart the financial systems and help create jobs and insure a solid taxation revenue base for the future. This is the definitive issue in the US economy.

Authors note: I first published this article on Seeking Alpha on Sept 9th, 2008 - before any US bailout was announced.

Fear, greed and loathing in Las Vegas - The US Housing market - then and now.

I have always been very interested in economics. The interpretation of the behavior of millions of individuals all making decisions simultaneously is fascinating. Macroeconomics is incredibly complex, but if we can glean some trends, above average returns in equities are possible. First, I will present my theory of how we have arrived at today's housing economy.

Las Vegas - circa 2004

I visit Vegas many times every year. I only live a few hours away, and the drive is quite pleasant. Sometime in 2004, I was having dinner at a PF Changs. I always go right to the bar since I hate waiting to eat, and I meet some real characters while dinning. On this particular evening, there were 3 young kids(anyone below 30 gets my kid moniker) eating and drinking next me. They were all boasting of there latest real estate deals and profits. As a former slum lord, Having bought and sold many rental properties, I was keenly interested in there discussions.

Not to my surprise, they were very willing to tell me about there recent killings in the Vegas real estate market. These young Turks were buying several new homes at the same time, then flipping within a few months for 50K profits per home. These guy were fun, and I enjoyed our conversations. I have found that ground level info on the economy is very valuable - our government should try this approach. On my drive back into the desert, I dismissed there claims as just some lying, and one upping each other.

Las Vegas - circa 2005 - 2006

I'm back in Vegas, at the same PF Changs. The bar is packed - in fact Vegas is packed and vibrant. I can't believe the amount of desert being scrapped for more boxes - this can not continue I scream! I am wrong. At the PF's bar, I meet more 20-30 somethings and everyone is talking real estate. Everyone is a flipper and dealer - Can everyone be lying? I start to investigate. I am surprised to find people buying more than one property at the same time. This was done years ago, before the computerized records age. Banks would know real time that people are lying on there mortgage applications - right? HM I guess not.

These new homes are not rentals. These buyers had very little cash, and their jobs were fairly low paying - they could not even qualify for one of these homes - but they were buying 2 or 3 at a time..... The tools used by our house flippers: ALT A, subprime, interest only, negative amortization, teaser rate loans, and basically ZERO due diligence from lenders. This was when I started buying puts on some of the home builders. I picked KB Homes as my target for a hedge against my long portfolio.

How could this happen? a Macro interpretation

I started to analyze this crazy home financing system. My theory is fairly simple. Too much liquidity chasing an ever shrinking yield. After the US depression in 2001-2002 the federal banks lowered the funds rate to 1% and kept it there. Wealthy investors were stumped. With short and long term risk free yields at pathetic low levels - cash was getting very hard to invest.

Investors were still hurt from the stock market crash, so these investor would not put their cash in equity markets. Then the US gave a large tax break to these wealthy investors, giving them even more cash per year to handle - what to do with all this cash? The combination of historic low yields, fear of equities, and a poorly targeted tax cut had created a HUGE increase in the demand for a stable return on all this cash.

Can you say SIV, or CMO? Where you have demand - supply will not be far behind. The larger banks and investment houses increased the creation of these SIV's with CMO and, CDO's to satisfy the large increase in demand for yield. 5-6% yield will do just fine in this now low yield environment. Banks would bundle 1000's of mortgages to create these new higher yielding financial vehicles.

To satisfy this large increase in supply of mortgages, lending standard had to fall - there is no other way to meet this new supply - much to the glee of my box flipping buddies back at the PF Chang bar in Vegas.....

Year of reckoning - 2008

Where is the US economy today? We are in a recession, and it may be a longer than average one. Housing is not the main issue - it is the credit collapsing due to the lending system finally falling apart. In conclusion, the US government has helped create the current housing bubble, and the current credit meltdown. As far as housing, my calculations show that home prices have already fallen back to base affordability levels. The measure to use is simple - the monthly mortgage amount for new homes adjusted for sq. footage versus monthly incomes.

Rates are close to historic lows, and the sq. footage of new homes are at historic highs, and incomes are still rising. Will home prices continue to fall? Probably. Lenders are still trying to raise capital, not lend, and US consumers do not wish to buy an asset that is still falling.

Future US economy 2008 - 2009: what's next?

I know many love to hate the home builders and related stocks. Many traders have made hefty profits shorting this industry over the past 6 months. The days of making easy money with these shorts are over in my opinion. We will get at least one US housing bailout package before the end of the year.

The US housing bailout could be as follows. 300-500B of lower level tranches of CMO debt to be purchased and held by the US government. Also the GSE's need to lend money - 5.5% 30 yr, to refinance the weaker loans with 2006-2007 vintages, and slow down the foreclosure process.

The third leg of the bailout would be the Federal government helping states and cities raise bond funds to purchase distressed homes in hard hit communities and take them off the market - maybe affordable housing. Even without a bailout, making additional money on shorting the home builders will be increasingly difficult.

To value any equity, one needs to look at 15 years of future cash flows discounted back into today dollar. Contrary to popular belief, There will be another housing up cycle.

This is an election year, and the politicians will be tripping over each other to show how much they care about us. If the US economy is a weak as I suspect, and as weak as all the bears on wall street think, then this above housing bailout will probably happen. And if the economy is really not as bad as we think - no bailout, but no more profits for shorts either way.

Baseline economic projection is a recession for most of 2008, followed by slow but steady recovery in 2009. I think the recession started in Dec. 2007.

Authors note: I first published this article on an equity web site called CAPS in Motley fools in Feb. of 2008.

Peak Oil Economics

Oil prices, US oil independence and basic economics

I just listened to the another politician screaming about opening up ANWR for oil development.

Implementing Pickens Plan for Public Energy Policy

First, let me applaud T. Boone Pickens for putting all this energy, time and money into a very important issue. His plan is to use wind power to replace 20% of the US electric grid, freeing up natural gas to be used in the US transportation fleet. First lets recap a few points of Pickens' to ponder:

• US oil production peaked in the 1960s and 1970s.

• US oil production is now at 5 million barrels a day, the lowest output in over 50 years despite record real prices - the US consumes over 20 million barrels per day.

• The US consumes 25% of the world's oil, with only 4% of its population.

• The US will send $700 billion dollars out of the country per year to buy oil.

• Projected over the next 10 years, the cost for oil imports will be $10 trillion — the greatest transfer of wealth in the history of mankind.

• World oil production peaked in 2005 at about 85 million barrels per day.

Much of the $700 billion the US spends to buy foreign oil does not go to unstable countries. Canada and Mexico are two of our largest suppliers. But billions of dollars do go to countries that may fund anti-US activities. Bottom line: $700 billion is leaving the US economy.

How has the US boxed itself into this nasty oil corner? The answer is the power of the monopoly. Over the past 100 years the US has built (with tax payer dollars), an enormous vehicle transportation infrastructure based on only one energy source - oil. This oil infrastructure monopoly will not allow competition, as the barrier for entry is just too high.

Free market systems no longer work with a publicly funded monopoly in place. We already have many cheaper alternatives to the oil based vehicle. One can fill up a natural gas vehicle for under $2 a gallon. Electric vehicles cost less than $1.50 to charge.

Eventually economics will force the US energy vehicle infrastructure to move away from oil, but during this time we are putting ourselves at a huge national security and economic risk. A small conflict in the Middle East could close the Straits of Hormuz for months. This would not only create huge price jumps in oil products but create fuel shortages and rationing that would send the US into a long-lasting depression.

We can not dig or drill ourselves out of this problem

T. Boone Pickens has been saying this for over a year. The only result will be a bigger to crawl out of. Almost every drilling rig is in use. Drillers can't find workers to work on their existing projects. Listening to many energy conference calls, I hear the same thing: There are no workers available for this type of work. Here are some recent comments from Stacy Locke, CEO of Pioneer Drilling, a San Antonio-based contract land drilling company:

The labor market is extremely tight for all energy personnel. It is extremely challenging. You can't just hire a truck driver and make him a tool pusher.

A tool pusher, the top hand on a drilling rig who supervises the crew, is the worker most in demand. In the past, it could take a rig worker 10 years to rise to the tool pusher's job. Working up from floor hand to derrickman to driller could take five years.

The crux: more oil exploration, or real investment in alternatives for oil?

We are now at the crux. The US could try and build new rigs, train new workers, and spend huge amounts of money for more oil infrastructure, or the US could spend that money and focus to move vehicles away from oil, and create the infrastructure for renewable energies such as solar, wind, biofuels, and non-oil infrastructure creating American jobs and stop sending $700 billion to foreign countries.

Should the US open up more offshore areas for oil and gas exploration? This should be on the table as part of a REAL US energy policy. But as discussed above, this will have almost no effect on global oil prices as we do not have any more spare oil infrastructure to increase supply. Another reason more drilling in the US will not effect pricing are the concepts of net reserves, and well to wheel efficiencies.

Concept of net reserves

This is very important. Everyone should watch the move "There will be blood". It depicts how digging for oil works in a free market system. The easy oil gets sucked dry first. Back then, oil would just explode into the sky. Now we need to pump millions of gallons of water down the hole to bring up an ever shrinking amount of oil. It takes a lot of energy to pump water around.

60 years ago, it may have taken 1 boe(barrel of oil equivalent) to bring up 100 barrels of oil. That a 99% energy efficiency drill ratio. So the net reserve of that well would be 99% of the total recoverable amount. Now to get that 100 barrels out of the ground it may take 50-100 boe to extract, a 50% or less ratio. So actually reserves figures are meaningless, its the net reserves after you calculate the boe to extract the oil.

I am actually worried about negative energy drill ratio's. It is very possible we will see more energy used than the energy content of what is extracted. How can this be? Simple - natural gas is used to drill, and pump for oil. Since the price of NG is less than 50% of the price of oil based on energy content, we could be losing energy and still making economic profits. This scenario is devastating for the US energy picture, as we could be throwing away a precious US resource - natural gas.

Well to wheel efficiencies

This is an important concept when discussing a comprehensive US energy policy. In most studies, the electric engine is twice as efficient(full cycle) as the oil based combustion engine. This means the US will use half as much total energy, and reduce pollution by half if we move to electric engines. With the above economics of net oil reserves discussed above, this huge efficiency benefit from alternative engine types(electric, and NG) will continue to increase, as oil extraction requires more and more energy.

Pickens' plan implementation

His plan calls for natural gas vehicles, but electric vehicles may be an even better idea. From a free market approach, the US should not try and pick which alternative engine will be used. The US should just make it so the current oil based engine is not used, and let economics decide which is the best replacement. There are two methods that could work in a 10-15 year time frame.

US mandate

A simple mandate could be as follows. By the year 2015, no new vehicles with oil based propulsion systems, are sold in the US. By the year 2022: no vehicle oil based fuel at filling stations. During this time, the US could start a vehicle recycling program to help lower income drivers switch to the new vehicles.

The energy consumption tax approach

Shift away from income taxation into energy taxation. This would actually be a tax reduction plan. Income tax avoidance is growing, and now is 20% of the economy in my opinion. This 20% illegal underground economy currently pays very little in taxes. These tax cheaters will now pay more taxes.

By shifting to gasoline taxes - US workers will have more disposable income after paying these new energy taxes, since their wage taxes would be reduced by more then they pay in new consumption taxes. The US could set the gas tax as follows:

Set minimum gasoline prices:

• 2009 - $5.5
• 2010 - $6.0
• 2011 - $7.0
• 2012 - $8.0

To offset the regressive nature of consumption taxes, the US could change the wage tax structure. Currently, low income earners pay 15.3% SS wage tax, and since the tax stops at around 100K, high wage earners pay a much smaller %. A new structure could be the first 12K of w-2 with a zero SS tax rate, then 15% up to 150K of w-2 income. With the above consumption tax revenue, the income tax rates could be lower at all levels.

I think the US should use both methods concurrently. With the new minimum gas prices, the alternatives would finally be funded from the private sector. The fear of the oil infrastructure, and lower oil and gas prices once these alternative get funded has stop any real funding in the past, and will continue to do so in the future. By setting the minimum price to the consumer, new companies will be funded, and stimulate the economy.

Authors note:
I first published this article on Seeking Alpha on July 16th, 2008