Comstock Partners, Inc.June 11, 2008
How To Get Out Of This Mess
The Fed will not be successful if they try to micro-manage our economy with a secondary role in controlling inflation. In our opinion, if they continue to attempt to liquidate us out of this mess, it will only postpone the inevitable decline in house prices and lead us into a long deflationary environment just like Japan experienced starting in 1990.
On the other hand, if they allow housing prices to decline to pre-bubble levels, this mess could be over late next year. We have tremendous excess leverage (mostly in real estate) that must unwind without government interference for us to be able to get out of this mess!! In our opinion, we have to let our democracy go through excesses (without extreme government interference) followed by contractions (without extreme government interference).
The summary of the previous report "How We Got Into This Mess", was that in the midst of the correction following the greatest financial mania in history, the Fed swooped in to save the day. Instead of letting the business cycle play out and have the type of cleansing and capitulation that would be required to correct the excesses built up in the late 1990s, the Fed under Alan Greenspan lowered rates from 6.5% to 1% (with 8 half point declines) and kept them at 1% for a year. This easy money was accompanied by the Bush tax reductions just before a major war which resulted in very large budget deficits. The money that was pumped into the economy stopped the market decline and rather than going into a severe recession (which should've and would've happened) we experienced the mildest recession in history. Not only did they ignite a five year bull market in stocks from one of the highest valuation levels in history, they also sparked a gigantic move in single family homes. Home values were at extremely high valuations in 2001, yet after the stimulus started it drove the valuations to outrageous levels. The price of the average home in the U.S. rose 80% from 2001 to 2006 driving the home values relative to median income from a record high of 3 times in 2001 to 5 times in 2006.
Much of this housing mania was spurred on by unethical mortgage lending and repackaging mortgages sold by Wall Street. But, even worse, was the verbal suasion and prompting by the Fed Chairman. We will quote from the special report we wrote in November 2003, "Potential Catalyst-Real Estate- for Deflationary Bear Market---"One of the amazing aspects of the massive refinancing of homes, which is effectively piling on consumer debt at record levels, is the fact that this is being done with the blessings of our esteemed Federal Reserve Chairman, Alan Greenspan. In various testimonies he has stated that borrowing the equity in consumer's homes is helping the economy and he supports it. Imagine the head of the Central Bank of the world's largest economy becoming a cheerleader for individuals to continue borrowing on the equity of their homes while they have already incurred a record amount of debt and the homeowners' equity is falling to record lows. Could the Fed Chairman actually think it is appropriate to use ones' home as an ATM cash machine?"
We would not be so upset about the massive interference in our so called "free market system" if it weren't for the fact that Greenspan definitely knew this was not a good long- term solution. We happened to come across an op-ed article written by Mr. Greenspan in March 1974 when he was President of Townsend-Greenspan & Co.. We will quote from the article, "The Politics of Inflation"--- He started by talking about the U.S. economic instabilities (inflation was taking off at the time) not caused by the Arab Oil embargo or our sale of wheat to Russia. In the article he stated, "they cannot explain the overall inflation-ridden economic climate of recent years. I see inflation as essentially a political, not an economic problem. Political decisions on economic policy are characterized by a focus on short-term benefits at the expense of long-term costs. This leads inevitably to crisis solutions that come to grips only with the immediate manifestations of a problem. Since deficits which are not accompanied by an expansion in the money supply induce sharply rising interest rates which offend the housing constituency, there is a further tendency for the money supply also to expand. The result is a standard fiscal-monetary inflation such as we are now experiencing." These were just various quotes from the article, but the entire article espoused not making politically expedient short-term policies at the expense of long-term results. We are sure, from the op-ed that Mr. Greenspan had respect for Paul Volker when the inflation got so far out of control in the late 1970s that he had to make politically tough decisions in order to control the rampant inflation.
We are now in the process of unwinding the most leveraged asset in the world-- housing. The reason this economy will not respond to the stimulus this time is due to the size of the asset bubble that was driven up by the value of home prices. Home values were close to $21 trillion at the peak in 2006. This deleveraging of $21 trillion of home values will probably wind up around the $15 trillion level or lower before it is over-- and it won't be a pretty decline. Believe it or not, in our opinion, this is the only way to "get out of this mess"-by letting the free markets work. The Fed and administration are trying to stimulate the economy again rather than let the free markets work their own solution. We do not think the tax rebate package and the monetary stimulus just announced will be successful in preventing a significant recession (probably global), continued housing price declines, and a bear market in stocks. Instead, it may just postpone the inevitable decline and make it much worse when it happens.
Don't get us wrong, we understand that sometimes regulation and some government intervention make sense, but most of the time it only postpones what would happen by letting the free markets work. If there were no regulation the only way we would be able to determine if a newly released drug was dangerous would be to wait to see if patients died taking the pill. When it had to be obvious that homes were being sold to people who couldn't afford them, maybe the government should have looked into why this was taking place. Surely, they would have discovered the corruption taking place in this industry. They would have had to have seen that mortgages were being granted to people without jobs or any documentation. And these loans would only be made due to the convoluted process of packaging the loans into Collateral Debt Obligations (CDOs) which were, in turn, sold through Wall Street firms all over the world as a virtually riskless investment due to the diversification. How insane was this!! If these new homeowner's mortgages were kept and serviced at the bank or mortgage company that made the loan, the loan would have never been made. Now, we have Presidential candidates that think putting a cap on mortgage interest payments, suspending foreclosures, or even suspending taxes on gasoline will solve this mess. We sure feel sorry for the new homeowners that got in way over their heads, but we can't see how postponing the inevitable home price decline will help them in the end.
Japan had the same overvaluation problem in their stock and real estate market at the end of 1989. Their real estate market was even more over valued than the U.S. was in 2006 and declined by about 44%. Japan tried to do the same thing we are doing now to alleviate the pain of both asset bubbles bursting. They brought their interest rates down to close to zero, and tried to print their way out. However, by 1991 their money supply collapsed since the banks refused to lend to questionable borrowers and well healed potential borrowers would not bother taking out loans. This is the old concept of "pushing on a string" and the attempt of government intervention dragged out the Japanese deflationary bear market for years. Their stock market declined from 39,000 on the Nikkei Average in late 1989 to about 7,400 in 2003 before doubling since then. Their real estate market is still bouncing around a bottom after declining every year for 18 years (see attached NDR chart).
It may have taken just as long to find a sustainable bottom in the Japanese stock and real estate market if the government just let the bubbles burst without interference but we doubt it. Hopefully, we won't make the same mistake in the U.S. and we should be grateful that our present bubbles were not as outrageous as Japan's.