Truth, and Consequences

As I write this, the Dow is up more than 400 points because G7 leaders met ever so briefly to pledge they'd capitalize their respective countries' banks, and because Henry Paulson announced that's what he'll do with the TARP money.

A. We got a similar rally when Congress first began talking about "doing something." Remember what happened since then?

B. Paulson started hinting last week that he'd deploy the TARP money by directly infusing capital into banks. What's new?

C. All this demonstrates is that the guy in charge of righting the ship can't make a sound decision. And this instills confidence in the markets? I guess it also demonstrates that when stock traders want a rally, they'll produce one.

But make no mistake: this is a dead-cat bounce.

True, last week's massive sell-off was, in part, fear-induced. But the fears were well-founded. They were the fear of a recession that is inevitable no matter how many fingers Hank is able to put in the dike, and the fear of what a trillion dollar deficit will do to the US dollar, tax rates and interest rates.

President Bush has been trying to jawbone the fears away, much as FDR did in his inauguration speech in 1933, when he famously said, "We have nothing to fear but fear itself."

I agree. But I have to point out that his words didn't change much. The US economy and the stock market ultimately recovered in 1946.

Okay, let's turn our attention to consequences. I want to hit on several things that the Chicken Littles have been crying for in begging the government to "do something." I'll couch each in terms of paraphrased quotes that represent things we've all been hearing, unless we've kept our TVs and radios off for the last month (in which case, kudos to you).

"We can't let home prices keep falling."
First, I'm sympathetic to the notion of a family losing their home to foreclosure. What a terrible experience that would be. I wouldn't want it to happen to me.

That's why, when I bought a house, I saved a reasonable down payment first, researched the market, got a fixed-rate loan with payments I could afford, and made sure I didn't spend so much money on other stuff that I couldn't make the mortgage payment first and foremost.

That's why, if my home price did decline below my mortgage balance, I'd recognize that it's still my home, and not an investment, and that if I continue paying the mortgage down, the home price will eventually recover, and I'll once again own more than I owe. Because I know that, just as home prices can't go up forever, they can't go down forever either.

And that's why, if I did lose my job, I'd sell everything else I had, work two or three jobs if I had to, to be able to continue making my mortgage payment on time.

I recognize that not everyone is in my situation. And I also believe that the expansion of homeownership is a worthwhile goal, both economically and socially. But here's a simple fact: about 65% of Americans can actually afford to be homeowners. The only way we can expand homeownership above that number is by some kind of financial artifice.

That's exactly what happened in the subprime fiasco: a perfect storm of regulatory pressure, credit scoring, financial "innovation," Wall Street risk-parsing, and dubious marketing.

And, in the end, we did no favors shoe-horning a renter into a home he or she could not afford, letting them live in it for a few years, then taking it away from them.

(It kind of reminds me of how the S&L regulators enticed healthy thrifts to take over sick ones by letting them book "goodwill" as capital, then, after a few years, they took away the "goodwill," declared them insolvent, and shut them down, too.)

Here's how markets work: they go up, and they go down. Why? Because the sometimes go up at a pace above their long-term sustainable rate of growth. In housing, that should be roughly akin to the rate of inflation, discounting extreme supply and demand factors in certain markets like Manhattan. And that rate is about 3-4%.

Well, home prices went up by double digits for several years due to the subprime frenzy and the speculative excess it spawned. Everywhere. Not just in places like Manhattan, but in places where there's plenty of buildable land.

That is a classic example of a bubble. And every bubble demands a correction.

Here's a little exercise for you. Look at the S&P/Case-Shiller Home Price Index for each of the 20 metro markets it covers. Go back to before the housing bubble began, and plot the trendline at the long-term sustainable growth rate for that particular market, whatever it happens to be. Trace it all the way out to the end of 2008.

And you'll find that home prices still have not fallen to where they should be.

"Stop home prices from falling further?" Go ahead and try. Home prices have to fall further, to reach market equilibrium. How is Washington going to stop that from happening? Fix home prices? Say, "You have to buy a house this year, and you have to pay no less than X?"

The day they start doing that, color me gone.

It is both a truth and a consequence that home prices are going to fall further.

"People are losing money in their 401(k)s - we have to do something about that."
I find this almost comical. It was Washington, influenced by businesses, that led the grand exodus from defined benefit to defined contribution retirement plans to begin with. In doing so, they placed the risk directly on the shoulders of the employees.

We took that risk. We make money in the good times, and, unless we successfully rebalance, we lose money in the bad times.

On paper.

Look, if you were planning to retire next year, and now can't, I truly sympathize. I'm sorry you continued to expose yourself to too much risk for your age and life situation, and that you now face the consequences.

But I've had at least two retirees call me to ask if they should move their money. When I asked them what they were invested in, they said they were in a balanced lifestyle fund targeted to their age, invested mostly in bonds, and that it was returning around 4.75% year-to-date.

I told them if they were making money in this environment, they were fine.

But what about the guy who's 30, and fully allocated to equities?

Well, by the time he retires, he'll likely earn the long-term, sustainable historical average that stocks have returned, of about 11%. If he's diversified somewhat into bonds, maybe 8%.

That's more than twice the inflation rate. That should allow any diligent saver to retire comfortably. Only greed could make us expect higher returns than that.

Oh, but we do, because we are indeed greedy. We see those bubbly 25% returns for a couple of years, and it gets good to us. We think it'll go on forever.

See, this is the same story as housing. Only here, the long-term sustainable growth rate is, as I said, about 11%. So let's try the same exercise we tried above.

Go back to before the dot-com bubble, which was inflated by easy money beginning in late 1998, when Greenspan bailed out the Long-Term Capital Management hedge fund (important lesson: bailouts inflate bubbles, and bubbles burst, creating severe corrections). Plot the long-term sustainable growth rate of stock prices - pick any index - from about 1982, when the long-term bull market began, through year-end 2008.

You'll find that when the dot-com bubble began, stocks appreciated at a rate well above what could be sustained. Then it corrected from 2000 to 2002 - hard. But it didn't get all the way down to where it needed to be. Why?

Government intervention. A bailout, again in the form of too-easy money, again courtesy of Alan Greenspan, and again igniting a fresh bubble. This time, in housing.

You'll also find that, even with last week's carnage, the stock market still has not corrected to where its long-term sustainable growth rate would peg it. That level is around 7-8,000 on the Dow, or about 700 on the S&P, or about 1,400 on the NASDAQ.

So we're fairly close. The bad news is, the way corrections work, the market may fall below that mark, then rebound to it.

In the case of stock prices, it is theoretically easier for the government to intervene in a way that props them up, than it is for house prices.

They can simply keep pumping federal money into the economy until growth resumes, and stock prices go up on the prospects for that growth.

But for one thing, that only creates a new bubble. And three massive bubbles in a row, within a relatively short time frame, would totally destroy the US economy, and take the rest of the world with it.

And for another, the theory doesn't work when you're facing a trillion dollar deficit, and when your national debt is approaching 100% of GDP.

You then become a net-debtor nation, and in order to finance all that spending, you have to a) raise taxes by a massive amount, which further depresses spending and investment and causes further economic decline, as happened when Hoover raised taxes in 1932, and b) pay much higher interest rates on government debt you issue, in order to entice foreign investors, who hold the bulk of it, to buy more.

Folks, that is already happening. The ten-year Treasury yield has been rising since the last rate cut. Why? The ten-year note, since it matures in ten years, anticipates future events. A ten-year note trades like a strip of ten one-year bills. And if investors think that bill yields will go higher over the next ten years, they demand higher rates on the ten-year note.

What happens when those rates go up? Well, for one thing, 30-year fixed-rate mortgages are priced off the ten-year. So mortgage rates will go up, even if the Fed cuts the funds target to zero. That won't help solve the housing-led crisis we're in.

Another consequence is that the government has to print even more money, because it's now paying even more in interest - money it doesn't have, because it's still deficit spending. So the deficit gets wider, and that drives rates higher, in a never-ending inflationary spiral.

And they might as well buy every man, woman and child in the country a wheelbarrow in which to take their worthless US dollars to the grocery store.

So here's another truth, and another consequence: when you've enjoyed well-above-trend returns on your 401(k) for several years, you have to expect well-below-trend returns - and probably losses - for a while to get you back on trend. You should plan on the trend, take the good times with a grain of salt, and not worry through the bad times. And, as you near retirement, get out of the risky stuff to an increasing degree.

"We have to keep people from losing their homes."
This is closely related to the home price issue, and I've addressed it before, so I won't belabor it. But here's one important point.

Let's say we're going to pursue the McCain solution of refinancing all the "bad" mortgages into 30-year, fixed rate mortgages at 5.25%. Besides the near-impossible task of finding who now owns all those mortgages, piecing the tranches back together into whole loans, and buying them up - and besides the fact that most of those mortgagors won't be able to make the payments even at 5.25% now - here's the fundamental flaw:

Who will hold the mortgages? Banks won't. They're currently getting more than 5.25% on the mortgages they make. And they're through with making loans to people with impaired credit, who probably won't pay them back.

Investors won't either, for the same reasons. Their risk appetite has waned considerably. And they're back to pricing risk appropriately. So they won't pay par for a 5.25% mortgage-backed bond with a ton of credit risk.

That leaves Uncle Sam - you and me. And that's just what's being proposed. They say we'll ultimately make money on this.

So we're going to accept a 5.25% return on mortgages in a 6%-plus market, with rates sure to rise even further. And suffer eventual default rates that are about what they currently are on the subprime ARMs we're replacing.

Tell me again how we make money on that trade?

Fact is, we don't. We lose on the subsidized yield, we lose even more in a rising rate environment, and we suffer principal losses when they default - which, by the way leads to another glut of foreclosed homes on the market, which creates another overall housing slump.

And the ultimate direct cost to the taxpayer alone will be much, much more than $300 billion.

So, once more, it is both a truth and a consequence that more people are going to lose their homes.

"If we don't do something, people are going to lose their jobs."
Guess what? They already are. And that happens in every recession. Is the government proposing to guarantee that everyone has a job? (Perhaps - the trial balloon of resurrecting the WPA has already been floated .)

Furthermore, about 800,000 people have already lost their jobs since January. If the government spends a ton of money ensuring, somehow, that no one will lose their job going forward, how do they explain the timing of their actions to the guy or gal that got canned in January?

Truth and consequence: more people are going to lose their jobs.

"If we don't act now, more banks will fail."
How many new banks and bank branches have cropped up on every street corner over the past ten years? Can't we live with a few less banks?

Look, bank growth exploded during the housing bubble, because everybody wanted to get into the hyper-profitable lend-and-sell loan game. So it is only a natural consequence that the number of banks will contract when the demand for credit drops sharply.

During the S&L crisis, 747 institutions failed. Thus far in this debacle, 15 have gone down.

The truth is, we have a long, long way to go before we get back to equilibrium.

"We have to un-freeze the credit markets so people will start borrowing again."
Why are so many people whose ARM rates, and thus their mortgage payments, risen, defaulting on the loans?

Because they can't afford the higher mortgage payments when they already have two six-year car loans on brand-new luxury cars they bought with no money down, and several maxed-out credit cards, which combined eat up all of their take-home pay.

As with the banks, we need less credit right now. It is a natural and healthy cleansing of a system that got bloated with greed and excess, which was unnatural and unhealthy. So let's purge it.

More borrowing is not the answer. It's like a glutton who becomes obscenely obese, to the point that he becomes diabetic and has a heart attack.

So the doctors put him in the hospital and work to regulate his blood sugar and do a triple bypass. But they say, "Why, he's become so accustomed to his three milkshakes a day and his quart of ice cream at bedtime - we can't deprive him of that!" So they continue to gorge him. What eventually happens?

Again, I am totally sympathetic to the notion of people losing their jobs, their homes, and a portion of their retirement savings. A big part of the problem, though, is that we focus on those things, and place our faith in dollar-denominated things.

We have survived recessions before. Some of us have lived in poverty. Some of us have survived even worse: the Holocaust, ethnic cleansing in Eastern Europe or Africa, etc.

The key word is "survive." Many who have made it through bad experiences unscathed have been able to do so by placing our faith in the only One that can ultimately sustain us.

But in a nation that increasingly attempts to separate itself from the Creator it acknowledged at its birth, we're becoming increasingly reliant on government - man - to fix things.

And they can't.

The more they try, the worse it gets. So please, Washington, get the message: go home. Visit your constituents. Listen to them, not to your pals on Wall Street. Pay attention when they tell you, "Enough, already!" Then go on a nice junket or whatever you do on your lengthy recesses.

Because the more you spend, the worse it ultimately gets.

The fundamental message is, "We do not have faith in you."