The Evils of Inflation

So with all the coverage of the housing and credit markets I've been giving lately there may be some readers wondering why the Fed shouldn't just step in en force and flood the market with cheap money. Well, that answer is inflation. Regulating inflation is a big part of the Fed's job, and to rapidly and recklessly cut rates just to bail out the markets would be to turn a blind eye to that aspect of their charter.

Curious why inflation is a big deal? Well, I could spout some hot air, but here's something I was just reading from Warren Buffett's annual letter to Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) shareholders in 1980:

"Unfortunately, earnings reported in corporate financial statements are no longer the dominant variable that determines whether there are any real earnings for you, the owner. For only gains in purchasing power represent real earnings on investment. If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won’t eat richer.

"High rates of inflation create a tax on capital that makes much corporate investment unwise - at least if measured by the criterion of a positive real investment return to owners. This “hurdle rate” the return on equity that must be achieved by a corporation in order to produce any real return for its individual owners - has increased dramatically in recent years. The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil.

"For example, in a world of 12% inflation a business earning 20% on equity (which very few manage consistently to do) and distributing it all to individuals in the 50% bracket is chewing up their real capital, not enhancing it. (Half of the 20% will go for income tax; the remaining 10% leaves the owners of the business with only 98% of the purchasing power they possessed at the start of the year - even though they have not spent a penny of their “earnings”). The investors in this bracket would actually be better off with a combination of stable prices and corporate earnings on equity capital of only a few per cent.

"Explicit income taxes alone, unaccompanied by any implicit inflation tax, never can turn a positive corporate return into a negative owner return. (Even if there were 90% personal income tax rates on both dividends and capital gains, some real income would be left for the owner at a zero inflation rate.) But the inflation tax is not limited by reported income. Inflation rates not far from those recently experienced can turn the level of positive returns achieved by a majority of corporations into negative returns for all owners, including those not required to pay explicit taxes. (For example, if inflation reached 16%, owners of the 60% plus of corporate America earning less than this rate of return would be realizing a negative real return - even if income taxes on dividends and capital gains were eliminated.)

"Of course, the two forms of taxation co-exist and interact since explicit taxes are levied on nominal, not real, income. Thus you pay income taxes on what would be deficits if returns to stockholders were measured in constant dollars.

"At present inflation rates, we believe individual owners in medium or high tax brackets (as distinguished from tax-free entities such as pension funds, eleemosynary institutions, etc.) should expect no real long-term return from the average American corporation, even though these individuals reinvest the entire after-tax proceeds from all dividends they receive. The average return on equity of corporations is fully offset by the combination of the implicit tax on capital levied by inflation and the explicit taxes levied both on dividends and gains in value produced by retained earnings.

"As we said last year, Berkshire has no corporate solution to the problem. (We’ll say it again next year, too.) Inflation does not improve our return on equity."

Click here to read the whole thing.

-AvgJoe

The Cheap Money Jitters

For those of us that haven't seen the throes of a detoxing addict first hand, there have been plenty of TV shows and movies that have let us see roughly what it's like from a safe distance (if you don't know what I'm talking about, rent Trainspotting). The process is nasty, and it applies to whether that person is detoxing from chemicals or some non-chemical addiction such as gambling.

Recently it's been interesting for me to watch the behavior of many of the market participants as they try to swallow the fact that the Fed may not step in to the same extent as it has in the past to bail out those that got in over their head during the past few years. Whether you're talking about Mad Money's Jim Cramer absolutely losing it on the "Stop Trading" segment of CNBC, or the various pundits and executives skewering Fed chief Ben Bernanke for being "too academic," I think the whole scene is reminiscent of an alcoholic having his bottle taken away.

I guess you could also liken it to a kid having his favorite toy snatched from him.

Personally, I think that Bernanke's measured approach to the situation is smart. After all, it was arguably the aggressive and deep cutting of interest rates a few years ago that laid down the tinder for this current mess. Short term pain may be a necessary evil to purge some of the poor loans and lousy risk management that has been dogging the markets. Lenders like Countrywide (NYSE: CFC) and Wells Fargo (NYSE: WFC) as well as some of the i-banks like Lehman (NYSE: LEH) and Bear Stearns (NYSE: BSC) -- among others -- may gripe, but that doesn't mean you do should whatever they say.

The addiction that the market is detoxing from is often referred to as the "Greenspan put." A put option gives the buyer the option to sell a security to another party at a pre-determined price. This is often used as a backstop on a risky or volatile security. For example, if you buy Accredited Home Lenders (Nasdaq: LEND) at the current $8.74 and a buy a put at $6, you can guarantee that you won't lose more than the $2.74 difference plus the cost of the put.

In the case of the Fed, the Greenspan put referred to the fact that many took it for granted that the Fed would bail out the markets at the first sign of trouble. This meant that market participants -- relying on this implied backstop -- were free to pursue riskier opportunities than they otherwise would.

All that said, I wouldn't hope for the Fed to sit on its hands and do nothing. The problem with this situation is that legitimate corrections could lead to high levels of fear and an over-estimate of risk in the market. That, in turn, could lock up certain areas of the market and hurt real economic growth (as opposed to free-money-inspired speculative growth).

Bernanke's approach to the markets creates different implications for the outcome of the September Fed meeting. If the Fed keeps the Federal Funds Rate steady, it would imply that they are comfortable with how the situation is working itself out and they don't see it as a threat to economic growth. However, if they lower the rate, they would in effect be saying that the problems are still very bad and might have an impact on underlying growth. A cut larger than 25 basis points would amplify the concerns.

In other words, assuming Bernanke isn't the dummy that some seem to think he is, no rate cut in September would be the better outcome. Of course, you trying telling the heroin addict that he's really better off without a needle in his arm...

-AvgJoe

But is Subprime Really the Problem?

At this point, the word "subprime" has practically become a four letter word. Mention that word, or any of the companies like New Century, Accredited Home Lenders (Nasdaq: LEND), and Fremont General (NYSE: FMT) that were at the forefront of subprime lending over the past few years and you're likely to draw disgusted looks from people on the street. But I think all the derision begs a question: is there something inherently wrong with subprime lending?

In short, my answer is no.

The broad definition of subprime loans are loans that are made to borrowers that have less-than-perfect credit. These are people that perhaps have a high level of debt already, have a habit of missing payments on other loans, and perhaps even have defaults or bankruptcy in their past.

Lending to this group is obviously much riskier than lending to someone who has little outstanding debt, perfect payment history, and a wad of cash in the bank. However, that risk is studied and in order to take on the incremental risk, lenders charge higher interest rates. The idea is that when everything shakes out over time, the lender will have more defaults/foreclosures, but that will be balanced out by the higher rates that the rest of the group pays.

There is most certainly a market for these loans, and as long as risk is adequately measured, there is no reason that there shouldn't be someone out there serving this part of the market.

The problem currently, though, is that lenders had not adequately cushioned themselves for the default risk that they were going to face. Historical measures of subprime default risk were used at a time when the environment and the loans being made were anything but similar to historical subprime lending. Housing prices were soaring, people were falling over themselves to buy homes, and subprime loans were being made with various features that completely changed the risk profile of the loans.

Now there is a lot more that I can get into here, but I wanted to just briefly focus on what I see as the key issue that has made the word "subprime" sound like "Long Term Capital Management" -- namely, the availability of 100% financing.

I have no problem with 100% financing when you're talking about a big screen TV or maybe a nice sectional, but 100% financing for a home is asking for trouble if you ask me. Even worse is allowing subprime borrowers to use 100% financing. Of course, I'm not just talking about full 100% loan-to-value (LTV) loans, the same applies to the so-called piggy-back loans that provided 100% financing through 80/20 or 90/10 paired loans. And don't even get me started on 110% LTV loans...

Give somebody -- anybody, not just somebody with bad credit -- the ability to buy an asset without risking any of their own money in a highly speculatively environment, and you're asking for them to walk away from the loan if things turn sour.

Coming back around to my original point, though, there's no reason why subprime lending has to disappear. Right now the market has tightened like a vice on those loans and I can guarantee that there is demand just building up -- demand that somebody can and should be serving. It's just crucial that lenders are responsible in how they make those loans and how they project the performance of those loans.

So should subprime go away? Nope. It just needs a little resuscitation and a maybe some plastic surgery to get back on its feet. And given how risky people view those loans as right now, whoever wants to step in and serve that demand should be able to get more than adequately compensated for it.

-AvgJoe

The Fed Minutes and Ensuing Freefall

Yikes! I stepped away from my computer for a bit to have a nice West Coast lunch and I come back to headlines like "Ahhhh, the Fed Minutes!!!! Freefall! We're all going to die!"

Ok, I exaggerate.

But seriously, the Fed Minutes, which usually don't have much of an effect on the market, seriously stomped the market when they were released late in the day today. So here's the quick Average Joe breakdown:

So the Fed Minutes are basically the notes taken when the Fed meets to discuss their target for the Federal Funds Rate. They review what's going on in the economy and discuss the factors that play into deciding whether to raise, lower, or keep steady the target for the Fed Funds Rate.

Right now, everyone is very focused on the Fed due to the condition of the credit market. Many believe that to keep the economy righted the Fed should cut rates at its September meeting. This would supposedly shore up liquidity in the credit markets and generally ease fear, two things that could work together to put a hurting on the economy.

The problem today was that reading the minutes painted the picture of a Fed that was fairly comfortable with the state of the economy -- despite knowing the risks it was facing -- and still had its eyes fixed on inflation. Upon reading this everyone immediately started worrying that this meant that the possibility of a rate cut in September was out the window.

Now I'm not going to get into a discussion here about whether a rate cut in September is an absolute necessity, but the key to point out is that the Fed meeting, and therefore the minutes, was on August 7th. On August 17th, the Fed found that conditions had deteriorated to the point that the Fed decided to cut the discount rate (the rate that the Fed charges the banks that it lends to). They also released the following statement:

"Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets."

Draw your own conclusions, but I would be more apt to go with the Fed's statement from August 17th than to read a lot of meaning into what it had to say ten days earlier.

-AvgJoe

Housing Market: So Who's to Blame?

When something goes wrong, it seems to be human nature to look for the culprit. Then, once we figure out whose fault it is, we can then take a big, deep breath and move on with our lives. Right?

Unfortunately (as most of us know at least intellectually), many (most?) problems in life are simply too complex to be able to point at one person or group and say, "It's his/her/their fault!" I'd argue that this is the case when it comes to the current housing market problems that have ballooned out and had serious effects on the credit and equity markets. That said, let's take a quick look at the suspects involved.

The Federal Reserve - Many are laying blame squarely on the shoulders of the Fed because of the ultra-low interest rate environment that the Fed -- then led by Alan Greenspan -- created after the Internet bubble burst. These rates both gave the spark and the squadoosh to the real estate craze by allowing super-low intro rates and then steadily raising those rates.

Lenders / Mortgage Brokers - Blame has been put in the court of the lenders and mortgage brokers who pushed exotic loan products on buyers that couldn't afford what they were buying and allowed too much flexibility as far as loan documentation. Many homebuilders like KB Home (NYSE: KBH) and Lennar (NYSE: LEN) have their own lenders or originate the loans for the homes they sell. Even more spectacular was the rise and fall of some of the subprime and Alt-A lenders like Accredited Home (Nasdaq: LEND) and Impac Mortgage (NYSE: IMH). And we wouldn't want to overlook the behemoth Countrywide (NYSE: CFC) here either.

Real Estate Agents - The blame being heaped on RE agents is similar to that of the mortgage brokers, ie pushing buyers toward homes that they really couldn't afford, encouraging crazy loans, etc. They were also able to help propel the real estate mania by advising clients that they market would continue to perform well above historical norms.

Banks / Investment Banks - This was the group securitizing and selling many of the loans during the RE mania. The complaint here is that these guys were creating the myth that as long as the risk was spread there was no risk at all. Critics see this group as finding creative ways to sell junk as something other than junk. Goldman Sachs (NYSE: GS), Lehman Brothers (NYSE: LEH), and Bear Stearns (NYSE: BSC) are a few of the bigger names that could be cited here.

Buyers - We don't want to leave out the buyers here. I can buy the argument that the buyer was duped by predatory lender / RE agent / seller in a few cases, but these are the vast, vast minority of cases during a time when real estate was running absolutely gangbusters. Though many buyers may not have fully understood the loan they were using to get their new home, what most of them certainly should have been able to understand is that they were buying a more expensive home than they should have been able to and were not having to put any money toward that house up front. You know what they say about a deal that sounds too good to be true...

Bond Rating Agencies - Rating agencies like Moody's (NYSE: MCO) were responsible for slapping ratings on the securities that were being produced from all the securitizations. There are many that feel these guys were simply asleep at the wheel, and some that think they were too interested in collecting fees and not interested enough in really exploring how gross some of the loans out there were.

Fixed Income Investors - Somebody was buying the product churned out by the securitizations after all. Were they really doing adequate diligence or were they being lazy and just relying on the rating agencies? Had they turned off the cash spigot sooner it would've been much tougher for problems to accelerate.

Hedge Funds - This is a more recent player, but still significant. This group, which includes the hedge fund subsidiaries of i-banks like Goldman and Bear as well as private hedge funds, used huge amounts of leverage and mixed it with some hubris, aggressive investing, and good ol' fashioned chutzpah to make big bets on the direction of the housing/lending/real estate markets. The ones that were wrong, well, let's just say they caused some problems.

[n.b. I'm not saying the above criticisms are necessarily fair/correct, I'm just reviewing the criticisms]

You may have figured out where I'm going with this already, but the bottom line is that the situation we're in right now is not one that could have easily been created by the actions of any one of the groups above. Instead, it was all of the above working together to bring us to where we are today. Which brings me to my final culprit:

Greed - If you feel it absolutely necessary to blame this all on one, single entity, let me suggest greed. If it makes it easier, you can even picture it as a little goblin running around messing with peoples' heads and putting bananas in cars' tailpipes (oh yeah, he's that nasty!). When money is involved it's tough to find anyone that doesn't have a little of the greed monster inside. Generally speaking, though, the markets pit many opposing forces against each other so that the greed of one group typically keeps the greed of another group in check, or at least in balance. Sometimes, this doesn't work so well and you have many groups working in what could almost be called collaboration towards their greedy little ends. These unusual situations don't last forever (cough, cough, Internet bubble) and the result is that participants eventually come to their senses and everyone scrambles to get themselves on good footing. Enter market correction.

In the end, I'm sure we'll continue to see the vilification of one group or another -- we may even end up with some government intervention to those ends -- but to do so is really to overlook the bigger picture.

-AvgJoe