Irish Mortgage Brokers Blog

I hope you enjoyed the first round of economic history from 2008 to 2011, I think it is time for round 2.

Alan Greenspan was on CNBC last week and his interview is a very interesting take on Europe - which happens to be the first thing he looks at every day (European Bond Markets). Meanwhile Lloyds are reporting that the risk of a 2nd recession in the UK are higher at c. 25-30%.

Greece is the crisis that just keeps giving, The Telegraph has the usual Eurosceptic line but it isn’t about being smug any more. The Greek referendum call of recent days came out of left field and while it may never actually occur the political optics show that the Aegean issues are far from solved, along with the replacement of military officials (the interpretation being the fear of a coup).

And German joblessness is higher for the first time in 2 years, standing now at 7%. The rate of inflation in Germany is currently 2.6% (HICP at 2.86%), having remained over 2% since January 2011. The issue with that (and unemployment that wasn’t growing) is that it lead to a ‘Goldilocks delusion’ where not cutting rates and fiscally conservative policy was considered best. It seems now that Germany has not decoupled from the rest of Europe.

Growing resentment about profligate EU members along with some fear inducing inflation as well as rising unemployment make for a very grumpy Germany, it does not bide well for negotiations. Perhaps hindsight will equally not bide well for the Germany that handled the Great Recession so well (from an employment perspective) either?

Of course at home here in Ireland we are about to pay €700,000,000.00 to speculative/junk rated bond holders who in any normal circumstances would be jumping for joy at a 50% haircut. Politicians are walking out of the Dail due to the lack of discussion, and bingo halls being raided by cops [irrelevant but a sign of the times!].

The Central Bank of Italy (Banca d’Italia) €-Coin ‘one figure for all European GDP’ statistic is also showing a sharp down-trend at present, negative for the first time since September 2009. Italy, with the worlds 3rd largest debtor at €1.9 trillion Euro, and winner of ’scary chart of the day’ almost every day regarding their bond spreads v.s Germany.

I don’t know of any model that can capture and create metrics out of the information flying around at present. There are interesting twitter based investment tools that use crowd sourced information to imply the trajectory of the markets, but I’m not privy to being under the hood on those.

What I am trying to say is that all of this news doesn’t paint a pretty vista, and in this analysts opinion the October/November 2011 period will be another big turning point or cusp. I last made a call like this in January of 2008 (and while it seemed grim at the time it was understated in retrospect), and during that time I went entirely to cash and advised all of our private clients to do the same until late 08′ early 09′.

Today I am repeating that call - to stay out of the markets for a while and see what comes of this all. You might miss out on the Spring 09′ moment, but you won’t face the burn on the road that gets you there. The news flow is simply too negative at present for confidence to go any other way than down, capital preservation remains key.

Until Central Banks step up to the plate (and it our long held belief that they must and will -they are already our lifeline) with the multi-trillion multi-lateral approach there is no reason to do anything other than earn interest.

I had a wonderful debate today on Newstalk where we discussed the rental market, Threshold sent in their Chairperson Aideen Hayden. The debate was very informed, in particular Aideen was very sharp in the area of tenancy laws, I learned a lot during this interview.

Naturally there are always a few corrections - she corrected me twice; once on sub-letting and again on a statistic that I took from the PRTB annual report (going so far as to mention that she is on the board of the PRTB and that therefore I was wrong).

Alas, I have to offer a correction in return to a PRTB board member & chairperson of Threshold who is currently undergoing her PhD in Housing and who has a degree in Economics (all of these things were mentioned to me in backing up her argument [on and off air]); see the graph below - taken from page 33 of the PRTB 2009 annual report.

This is not advanced mathematics, just add up the Green and Blue parts of the chart and you get the 65% that I mentioned that I mentioned where part or all of the deposit was kept by the landlord. At the same time her take on the matter was that I was wrong/inaccurate and that in fact in over 70% of cases the deposit is refunded in full or in part.

This is merely taking your figures starting at different ends of the number line.

I did mention this after the show and she still insisted I was giving misleading information and that due to holding a degree in Economics that she didn’t need to converse on the topic any further. My impression of her is that I was both highly impressed with her encyclopaedic knowledge in her field of expertise but dismayed at the lack of engagement when challenged on simple numbers by a practitioner - because the point made was both fair and accurate depending on which side of the fence you read it from - I actually tried to raise this as we were leaving studio (about the blue part of the chart being a crossover in both stat’s) but it was not taken up.

The other correction was when I said that you can’t just sub-let a property, I write this condition is written into leases based upon my interpretation of the 2004 Act. Aideen said that this was not true that you could sublet if you wish. Which brings us to (2004 Act S16 sub section k)  Tenant may not assign or sub-let the tenancy without the written consent of the landlord (which consent the landlord may, in his or her discretion, withhold).

My interpretation was that this had to be written into the lease as a clause for them to be able to do it automatically [or they would need permission] - in this case (quoting law) it shows that you cannot just go ahead and do this without consent.

I have to admit, I don’t often walk away from such debates disappointed, in fact they are often a great education (even if it comes at the expense of being wrong a lot of the time!), but Aideen’s statements that my points are wrong/invalid simply do not hold when challenged, and as both a board member of the PRTB and Chairperson of Threshold I would have expected more.

We felt compelled to seek an explanation of the change in rules surrounding Section 23 properties in the recent budget.

This is effectively retrospective taxation and the changes were never set out or implied in the original contracts for the properties.

Changing tax law after the fact is generally considered bad policy, and in some cases it may even be unconstitutional.

A copy of our letter to Kevin Cardiff (pictured inset) is below.

—————————————————-

Kevin Cardiff
Secretary General
Department of Finance
Government Buildings
Upper Merrion Street
Dublin 2

16th December 2010,

Regarding changes made to Section 23 allowances in the 2011 Budget.

Dear Mr. Cardiff,

Section 23 was set out to encourage urban renewal, which was duly provided and paid for by willing investors in return for certain contractual tax incentives which would have an effect of reducing an investors Case V tax bill in return.

The removal of this before the 10yr deadline and ring-fencing of same is effectively breaking a contract with the people who supported the Urban Renewal schemes. While we accept that they may have been continued for too long, we equally believe that reneging on this is flawed policy, sadly, flawed policy has tended to extend far beyond the scope of this latest tax grab, but that is an aside.

It was never set out in the conditions of a Section 23 contract that it was open to the types of changes that were introduced in Budget 2011, we therefore are asking for a return letter outlining the basis upon which this was enacted, not from Department of Finance perspective of being able to enact whatever policy they see fit, but from the perspective of the actual contract which was agreed upon in a Section 23 property.

Any reference to your own policy making abilities is obviously welcome, but not the core request of this letter.

We have a professional obligation to the many clients we have who took out mortgages on these properties to obtain these answers; your swift response will be appreciated.

Sincerely,

Karl Deeter
Operations Manager

We have been talking about this for a while (28/01/09, 11/03/09, 23/04/09), it was a popular topic on this blog in 2009 but well covered and for that reason we have not revisited it much, but the alignment of the stars warrants a look at the symptoms of the disease because now they are ever more present than before. At this point we can see a clearer path; which is still leading to a bond bust destination.

It has also becoming a mainstream topic, recently it showed up in an article titled ‘Currency, the weapon of choice in a world of lower demand‘.

If something can’t happen it won’t, and what can’t happen is a world in which we see century bonds (bonds with 100yr terms) becoming commonplace, they will probably be (as is the benefit with all hindsight) the poster-boy of the time when the bond market was in full insanity. To give an Irish context we can all relate to: property prices mid 2006, that’s where bonds are now.

Investors are not stupid, it could also be the case that we see a world of deflation and they will be able to sell these centuries at a profit, but when you consider the counter trends it doesn’t scream ‘deflation’ to the same degree.

Take a look at some of the offerings (signs):

Goldman Sachs 50yr bond issuance-longest bond issued in their history.

Mexico issued at century and it cleared. Note: ‘cleared’, and this is from the same country that suffered two currency crises and one sovereign default in the last 30 years!

Norfolk Southern - “NEW YORK (Dow Jones)–Norfolk Southern Corp.’s (NSC) reopening of its 100-year bond, first issued in March 2005, has launched at 5.95%, inside price talk of 6%, according to a person familiar with the sale. The sale has also been upsized to $250 million from original guidance of around $100 million”. So they not only issued a century, but they more than doubled the debt issued and it was ALL bought!

Rabobank also issued a 100yr bond. It’s great that they have a triple-A rating (today) but in 100 years will that still be the case? This is a bank let us not forget, and anybody who can see 100yrs out in banking is either a liar or deluded.

They said on their company site that “Until now only a few rail roads and power stations have conducted a bond issue of this type. It’s a real confirmation of the strength of the credit, and obviously, it’s borrowing 100-year money at historically low levels,” I’d go a step in the other direction - it’s a sign that investors are yield hungry and making mistakes, the market doesn’t lie but it equally doesn’t create winners only - time will tell but when a bank issues and clears a 100yr bond it means something isn’t right.

TIPS trading negative 0.55% - this is a bond that has inflation protection built in, it is a proxy for inflation expectation in the same way that gold is (more on that later). People are literally willing to buy in at a loss in order to get that insurance. That is a sure fire sign that inflation is expected

History is interesting, in 1910 nobody was backing the Wright brothers, they were backing the makers of airships, yes, airships, the same craft which spawned such maxims as ‘lead balloon’ and ‘it’ll fly like a lead Zeppelin’, and some awful tragedies as well such as the Hindeburg Disaster, a lot can change in a year, never mind 100 years! The hunt for yield is relentless, but at the same time you have these inflation indicators screaming out (TIPs & Gold) so somebody somewhere is going to get badly burned.

Inflation? Yes, it will be artificial, because QE will bring it about, the latest approach seems to be a currency play-ground tactic along the lines of ‘if you print a trillion then I’LL print a trillion too!’ . Sad but true, and it is being done both as a competition and for competition.

Gold, yes, the boring metal of a decade ago that is now back in the halcyon vogue it enjoyed in the late 70’s. Will it last (this time)? Comfortably trading over $1,300 the difference now versus then is the structural movement of the metal. It isn’t to say this trend can’t die, but it is a slower build up, and broadly in line with the massive increase in money supply that has been a hallmark of the last thirty years.

When the bond market falls it will fall ugly, even on the municipal bond front, the stalwart of private investors, there is trouble brewing, recently Meredith Whitney authored a 600 page report titled “The Tragedy of the Commons” stating “Municipalities receive one-third of their revenue from the states. If the states hold back that money for their own stricken budgets, towns and cities won’t have the funds to make their interest payments. “It has to happen,” says Whitney. “The states will secure their own shortfalls, and leave the cities to fend for themselves.” It’s all about inter-dependency, she says, with the federal government aiding the states, and the states funding the last and most vulnerable link, the municipalities”.

Combine that forecast with the fact that the insurers who (apparently) back it up are no longer high investment grade material, The public finance market no longer has a triple-A rated bond insurer. Bond Buyer lead with this story yesterday - “Standard & Poor’s on ­Monday downgraded Assured Guaranty Ltd.’s two insurer platforms to AA-plus with a stable outlook from AAA with a ­negative ­outlook. Stock in the parent company fell 8.3% to $19.52, but response in the ­municipal market was muted”.

So if things go wrong, their assurance is about as good as the mono-liners who backed sub-prime mortgages! Everything is falling into place for a proper bond market blow out. It doesn’t have to happen, but when all of the dominoes are in place it would be stranger if it didn’t.

I waited a long time for a conversation with Tony Boeckh, his newsletters are a must read for anybody looking to keep a finger on the pulse of the markets both in the USA and internationally, you can sign up for free at the homepage.

Tony’s career has spanned over 40 years and during the entire time he has focused on banking and credit, starting in the Canadian central bank, then taking over the helm at the industry stalwart publication Bank Credit Analyst. His recent book ‘The Great Reflation‘ is a culmination of thoughts on the future of finance and what trends we can expect, and perhaps more importantly, the trends that investors can profit from.

My questions are in bold.

You look at the world in a very macro sense, what indicators, given the span of your career, have you found to be the best guides? Interest rates? flow of funds?

“That’s a never ending question, I am every eclectic, and look at a number of things, liquidity and the rate of change of liquidity in particular is important and that is what drives markets, but how do you measure it? There are different ways to do that, but it is a slippery concept and the measurements are subject to difficult constraints, data can be wrong, or the financial system evolves in ways that your old harvesting methods don’t pick up”.

So what do you watch for in liquidity?

“For what are banks doing with their assets and liabilities, watching the banks gives you a much better handle on what is happening in the system because, at least years ago, banks were the main part of the financial system 70% or more but that is reducing so we have had to constantly change our approach. Corporate liquidity matters as well so we look at liquid assets to total assets, for market measures a good one is the US Treasury yield curve”.

“When it is very steep it tends to be a good indicator, flat or inverting means there is trouble coming”. He focuses on the Treasury Yield curve, or the commercial paper/corporate sector yield curve, believing that generally they tend to give a similar answer, but that any one measure on its own can be very deceptive, he used to look at the debit/loan ratio [cheques cashed against bank deposits], but that is no longer possible.

“in 1930 the debit loan ratio showed the economy was getting worse. Then the Fed stopped publishing that series which was a real pity because it took a key metric out of the market. A lot of people look at money supply and from time to time that has been a good thing to watch, but which measure do you look at? M0 (monetary base), or M2 then M3/M4? Money supply can be misleading, and often random”. For the most part he is a big fan of looking at the asset side of the bank balance sheet and looking at what they do with their money.

“Bank holdings of securities as a percentage of total bank assets is important, if they are adding to liquid assets its an indication the system is becoming liquid and is good for financial markets, on the lending side, if institutions are selling securities to expand loans it means money is getting tighter, if the Fed is lagging behind on rate movements they may not be raising rates but the system is getting tighter, and that shows up in liquidity long before it is evident anywhere else”.

Banks in Ireland are more likely to sit on bonds and make better returns than they are to extend lending at lower margins, what do you think of that?

“Sitting on paper after a recession is typical, so they [banks] buy bonds instead of extending loans, they increase the least risky assets, that is actually a bullish indication, the system is becoming more liquid, after a time lag they start lending. Liquidity is a leading indicator, some forecast by taking a view on the economy, but don’t forget: the market forecasts the economy not the other way around, that is the biggest issue that people face in trying to understand the economy”.

So is there a danger in trusting economists too much?

“Absolutely, a lot of people are pure economic forecasters, and some are very good but the good ones look at different things: talk to David Rosenberg sometime- he is brilliant (and also Canadian!) he has moved back to Canada and he’s a very good economist, but he stayed bearish during the entire recovery over the last 18 months. I think he did this because economic indicators are only one side of the market, he may yet be right, but he missed a huge rally that was staring liquidity watchers in the face”.

“The stock market, ultimately is determined by profits, which is driven by the economy but catching the cyclical swings makes you late if you watch the economy only. Don’t worry about where the stock market is, worry about where profits are, watch that and you are watching the real indicator”.

O.K. but where do you look for that?

“Bank balance sheets, household balance sheet, corporate sector balance sheets. A series of indicators relate to liquidity, sometimes the reading is good, other times it is confusing”, then he looks at other sets, valuation as an adjunct to other things, but he readily admits that it doesn’t always tell you about turning points.

“Negative changes in liquidity with market decreasing means you’ll want to pull the plug a lot faster. The fourth key thing is psychological factors, which tell you a lot about risk. At the bottom of the market in 09′ the valuation was good, the psychology was as bearish as possible and liquidity was going straight up while the technicals looked washed out… That was a screaming ‘buy’!”

Is the reflation going to be monetary? If so how is gold in a bubble at the same time?

“Nobody knows how this will play out, the great reflation is an experiment. Private debt became public debt and now we are in act 2, Greece is the canary in the coal mine, it told the world what happens when you have too much debt, there is a huge shift toward austerity and that is happening to different degrees in different countries. If we get the fiscal restraint required it will put huge downward pressure on the economy, and that impacts on monetary policy, with a ZIRP you can’t go lower so government’s can buy debt to drive down interest rates which will ultimately lead to much higher inflation. Gold bugs who have been forecasting this see it as the buy signal”, but he thinks that the risk is much further down the road, the big threat is deflation and will remain so for some time. “Gold might come through eventually, but for now its a crowded trade”.

Do you believe in locomotion? where large economies recovering will pull smaller economies with them.

“It is happening, in particular in developing countries, the balance of power is shifting and doing so rapidly, that is going to continue, there is no way around that, western countries will be at 1-1.5% growth a year. most of Asia will be at 7-8%, the Chinese are trying to diversify into real assets with their dollars, they are buying companies, mining, energy, so if the US goes the inflation route then the Chinese will ride that wave up indirectly”.

“There is an unspoken dance between to the two nations (US and China), the US might devalue but China will hold companies and assets that benefit from that, ultimately it is political, if it wasn’t they’d (the USA) let unemployment go to 20% go back to fiscally orthodox solution, but politically they can’t do that.

Was the crisis was driven by the ex ante expectations of bailouts for ‘too big to fail’ institutions?

(This is a very economics based question which was put forward by Trinity College maestro Constantin Gurdgiev, so in plain-speak it is as follows: was the crisis partly created by a belief beforehand that investors were sure that even if things went wrong, that the government would intervene with a rescue or bailout package for financial institutions and therefore it gave them the confidence to take bigger levered risks)

“The moral hazard factor… ‘Yes’ and it has been building for 30 or 40 years, there has been a progressive pattern of governments bailing out the economy, after the Great Depression the government was perceived to have responsibility for full employment, there was even a full employment act in 1946. Since then during every recession they run in, pump money and run deficits. The deficits started in the 60’s, Penn Central, then Franklin National Bank were saved, in the seventies it was car maker Chrysler, so it was evident that the government would bail everything out, then in 87′ Greenspan pumped the markets. This trend has been building, meaning people took on more and more risk, the recessions became shallow and that made people think the system was stable so it was o.k. to take more risk, it all falls down and what do they do?… The biggest bailout in history”.

How will balance be restored in the world? My belief is that the USA will eventually rip off china via a devaluation which will drive up exports and reduce deficits, it cures all ills and has hegemony to back it - what do you think?

“Ultimately the rubber meets the pavement on China and the USA, at the moment there is a ‘balance of financial terror’, the US are saying ‘don’t like our currency? don’t hold it! The Chinese don’t want devalued Dollar but then Euro collapses, so now they think ’should we hold yen or sterling? At the same time Russia is buying Canadian dollars for reserves, China can’t do that (they missed the boat so to speak) so they are stuck with the USA and they have all these dollars and they can’t dump them, if the dollar tanks then China tanks.

“Currently Dollar is the best looking horse in the glue factory. This is the fascinating issue; ‘how does this play out?’. The international monetary system and how governments approach them are THE story, the developed countries economies are going to be gravitating toward 1-1.5% GDP growth. With low growth and real interest rates of 2-2.5% the debt/gdp ratios are hard to control”.

“When you try inflating away the debt the average term to maturity gets shorter and shorter, at present its around 4 years, in a fiscal orthodoxy they should be issuing long term bonds, that is the sensible idea, it also gives them protection against inflation, the shorter the term and the more the perception of inflation the quicker it inflates interest rates and that is where you get the death spiral. The US government won’t go there willingly, central banks don’t inflate because they want to, they do it when it is the least bad alternative. If the US goes for orthodox policies while unemployment is going up then you have a big problem, debt monetization etc. In 2009 they started that but they will have to go back and do it again”.

How closely linked or correlated do you believe the housing cycle and business cycle to be?

“In the past they were closely correlated, but that seems to have broken down, the US one is not very different from that in Spain and Ireland, some are more extreme, it will take years to bring that out of the system, then you have demographics working against the housing market, so many people bought homes based on rising prices and now they are under water, pension funds are down, and there is nowhere to bounce from, people will start selling their home earlier in this scenario to raise money because their pensions are not worth what they expected them to be, supply will swamp demand for a long long time, we  simply overbuilt”.

If you could give three golden rules to people who wanted to delve into the kind of inisight you have what would they be?

“That’s a tricky one, I suppose in terms of early training- work at a central bank, that is the best way to learn how the financial system works”. His training at Bank of Canada was invaluable. “Be eclectic and flexible, the business of analysing and forecasting is more of an art than a science”, he has always been sceptical of people building models, he wasn’t into the quantification/quantitative systems but people tend to accept them or believe them because modelling is hart to refute, but equally it just doesn’t work in real life, hence his profound belief that its an art, not a science. “The different schools of economic thought matter, Keynesian’s, Austrians, Monetarists, but you must apply the best of each one depending on what is happening at the time, and never under estimate the stupidity of central bankers and government officials, the paradox is that these people are bright, high IQ’s, PHDs, and they can make the biggest blunders you can think of. the Federal Reserve is a great example”, he catalogues their mistakes in his book, “the only periods when it worked well was by luck”.

“Politicians also have huge capacity to do stupid things, and work out of self interest. It’s like they (the USA) have a permanent minority government, nothing ever gets done until there is a crisis”, Churchill once said ‘You can count on the yanks to do the right thing, but only after they have exhausted the other possibilities’. “Go on what they do not what they say, ignore the verbal noise, for investors you have to be the CEO of your own portfolio, don’t run with the herd”.

Do you find any economic school of thought represents the lunatic fringe?

“The core of the Austrian view is solid but the supporters can sometimes be a little out there, the problem with Keynsians or Monetarists is that they never look at the balances sheet. Supply side guys can also be crazy”. He also thinks that (especially in the US) the system is flexible, that below the surface there are hard working americans looking to correct things, get efficient, looking for new opportunities, the micro can be far better than you think, don’t ever dismiss the micro or anecdotal. “The best thing the government can do is not screw it up”.

ENDS

I didn’t get to type everything Tony said, the conversation lasted about 45 minutes and was a really interesting one to be part of, getting a world view from such a well known analyst, and in particular some insight into how he thinks is a huge benefit for a practitioner and I hope that to some degree that I have shared that with our readers. His book ‘The Great Reflation’ will be reviewed here in the near future.