Transcript US Household Financial Imbalances & the Profit Surge

Financiers Gone Wild:
Entering a Minsky Moment
The Levy Economics Institute
Robert W. Parenteau, CFA
April 19, 2007
Minsky & Lakshman’s Suggestion
“The essence of the financial instability
hypothesis is that financial traumas, even on to
debt-deflation interactions, occur as a normal
functioning in a capitalist economy. This does
not mean that a capitalist system is always
tottering on the brink of disaster.”
H. P. Minsky, “The Financial Instability Hypothesis: A Restatement”
2
Minsky on When to Cry Wolf
“Tranquility and success are not self-sustaining states;
they induce increases in capital asset prices relative to
current output prices and a rise in acceptable debts for
any prospective income flow, investment, and profits.
These concurrent increases lead to a transformation
over time of an initially robust financial structure into
a fragile structure.”
H. P. Minsky, “The Financial Instability Hypothesis: A Restatement”
3
Corollary to Lakshman’s Suggestion:
No More Fairy Tales…
4
…& No More Investment Porn…
• Are You Missing the Real
Estate Boom?: The Boom Will
Not Bust and Why Property
Values Will Continue to Climb
Through the End of the
Decade - And How to Profit
From Them
• Spring, 2005 Hardcover Edition
5
…Unless it is Subject to Quick Revision
• What You Need to Know to
Profit in Real Estate Boomin a Buyer’s and Seller’s
Market
• Forthcoming, Spring, 2008
6
Four Key Macrofinancial Questions
• US Household Deficit Spending: are we on
a sustainable trajectory?
• US Landing Path: soft or hard landing?
• New Financial Architecture: efficient risk
distributor, or efficient incentive distorter?
• Intelligent Responses: coherent or
incomplete macro and policy frameworks?
7
US Household Sector Financial Balance
Household Spending & Income
Over a Decade of Deficit Spending
Share of Nominal GDP
80%
78%
76%
74%
72%
70%
68%
Household Disposable Income (LH Scale)
66%
64%
1950
Household Expenditures (LH Scale)
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
8
US Household Sector Financial Balance
Household Sector Saving - Investment
8%
Share of Nominal GDP
6%
4%
2%
0%
-2%
-4%
-6%
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
9
A Persistent Deficit Spending Sector
Must Either:
• Sell existing asset holdings to another sector
– Run down liquid asset holdings
– Liquidate less liquid asset holdings
• Issue new liabilities to another sector
– Equity
– Debt
– Money
10
Applying the Debt Trap Equation
• Debt trap equation in discrete form:
• D1/Y1 = (1 + i – g) D/Y - PFB/Y
• Future Debt/Income Ratio =
• (1 + interest rate – income growth rate) x
• Current Debt/Income Ratio –
• Primary Financial Balance/Income Ratio
11
Household Debt Trap: 1st Condition
Imputed Average Interest Rate on Outstanding Household Debt (in %)
Disposable Personal Income
5 - ye a r a vg %Cha nge
Bil. $
12
12
10
10
8
8
6
6
4
4
55
60
65
70
75
80
85
90
95
00
05
12
Household Debt Trap: 2nd Condition
Household Financial Balance
billions
Monetary Interest Paid: Households and Nonprofit Institutions
Bil. $
750
750
500
500
250
250
0
0
-250
-250
-500
-500
-750
-750
55
60
65
70
75
80
85
90
95
00
05
13
Household Debt/Income Ratio
US Household Debt Outstanding/Disposable Personal Income
( in %)
140
140
120
120
100
100
80
80
60
60
40
40
20
20
55
60
65
70
75
80
85
90
95
00
05
14
The Loophole in the Debt Trap Equation &
Goodhart’s Provocative Question:
Is the Fed stuck with serial asset bubbles?
“Perhaps a more useful question is how to
respond when such an asset/credit boom does
collapse. The current answer seems to be that,
should one asset market, in this case the stock
market, collapse, then the right response is to
recreate another asset price/credit boom in
another market, in this case the housing
market.”
Charles Goodhart, reply to BIS Working Paper
No. 137 by Barry Eichengreen
15
But this strategy is not easy to
manage on the upside
“I cannot rule out the possibility that destabilizing
imbalances are building…
Households with high debt loads need to take account
of the fact that interest payments on their floating rate
loans will increase…
Households and those that lend to them also cannot
count on large increases in house prices persisting.”
Fed Vice Chairman Donald Kohn, April 1, 2005
16
Soft Landing or Hard Landing?
Examining 6 Stages of Decoupling
• Decoupling of housing construction from home prices
• Of housing market from housing related finance
• Of consumer spending from housing
• Of capital spending from the consumer
• Of corporate profits from expenditure growth
• Of global economy from US economic momentum
17
1st Decoupling Debate: Home price
appreciation and construction
18
1st Decoupling: Building from home
price appreciation
19
1st Decoupling Debate: Building
from home prices
Housing Share of the US Economy:
A completed correction?
Share of Nominal GDP
8%
7%
6%
5%
4%
3%
2%
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
20
2nd Decoupling Debate: Housing
related finance from home building
• Wells Fargo buying more 'sub-prime' mortgages
• By E. Scott Reckard, Times Staff Writer
•
December 5, 2006
At a time of pinched profits in the mortgage industry, Wells
Fargo & Co. is increasing its lending to risky borrowers —
betting that they will sign up for additional services such as checking accounts and
credit cards
• Early last year, Wells Fargo was No. 7 in originating sub-prime
mortgages, according to National Mortgage News. The trade
publication calculated that Wells moved into the No. 1 slot by
tripling its investment in sub-prime mortgages to $43.7 billion during
the first half of this year, mostly by buying loans from other lenders.
21
2nd Decoupling Debate: Housing
related finance from home building
Conventional Subprime ARMs: 90 days Past Due, U. S.
SA, %
Conventional ARMs: 90 days Past Due, United States
SA, %
3. 5
1. 4
3. 0
1. 2
2. 5
1. 0
2. 0
0. 8
1. 5
0. 6
1. 0
0. 4
0. 5
0. 2
93
Sour ce :
94
95
96
97
98
99
00
01
02
03
04
05
06
Mor tga ge Ba nke r s Associa tion /Ha ve r Ana lytics
22
2nd Decoupling Debate: Housing
related finance from home building
Home Equity Extraction, Net
SAAR, Bil. $
Home Equity Extraction, Net
4 - qtr MovingAve r a ge
SAAR, Bil. $
1000
1000
800
800
600
600
400
400
200
200
0
0
96
97
98
99
00
01
02
03
04
05
06
Sour ce : Fe de r a l Re se r ve Boa r d /Ha ve r Ana lytics
23
3rd Decoupling: Consumer spending
from housing activity and finance
Personal Consumption Expenditures
% Cha nge - Ye a r to Ye a r
SAAR, Bil. Chn. 2 0 0 0 $
6
6
4
4
2
2
0
0
-2
-2
90
95
00
Sour ce : Bur e a u of Economic Ana lysis /Ha ve r Ana lytics
05
24
3rd Decoupling: Consumer spending
from housing activity and finance
Retail Sales & Food Services
% Change - Year to Year
SA, Mil. $
12. 5
12. 5
10. 0
10. 0
7. 5
7. 5
5. 0
5. 0
2. 5
2. 5
0. 0
0. 0
- 2. 5
- 2. 5
90
95
Sour ce: Census Bur eau/Haver Analytics
00
05
25
3rd Decoupling: Consumer spending
from housing activity and finance
Retail Sales: Total Excl Motor Vehicle & Parts Dealers
% Cha nge - Ye a r to Ye a r
SA, Mil. $
( I)
16
16
12
12
8
8
4
4
0
0
-4
-4
80
85
90
95
00
05
Sour ce : Ce nsus Bur e a u/Ha ve r Ana lytics
26
3rd Decoupling: Consumer spending
from housing activity and finance
Retail Sales: Building Materials, Garden Equipment & Supply Dealers
% Change - Year to Year
SA, Mil. $
Real Private Residential Investment
% Change - Year to Year
SAAR, Bil. Chn. 2000$
22. 5
22. 5
15. 0
15. 0
7. 5
7. 5
0. 0
0. 0
- 7. 5
- 7. 5
- 15. 0
- 15. 0
93
94
95
96
97
98
99
00
01
02
03
04
05
Sour ces: Census Bur eau, Bur eau of Economic Analysis /Haver Analytics
06
27
3rd Decoupling: Consumer spending
from housing activity and finance
Retail Sales: Furniture & Home Furnishing Stores
% Change - Year to Year
SA, Mil. $
Real Private Residential Investment
% Change - Year to Year
SAAR, Bil. Chn. 2000$
22. 5
22. 5
15. 0
15. 0
7. 5
7. 5
0. 0
0. 0
- 7. 5
- 7. 5
- 15. 0
- 15. 0
93
94
95
96
97
98
99
00
01
02
03
04
05
Sour ces: Census Bur eau, Bur eau of Economic Analysis /Haver Analytics
06
28
3rd Decoupling: Consumer spending
from housing activity and finance
Retail Sales: Electronics & Appliance Stores
% Cha nge - Ye a r to Ye a r
SA, Mil. $
Real Private Residential Investment
% Cha nge - Ye a r to Ye a r
SAAR, Bil. Chn. 2 0 0 0 $
22. 5
22. 5
15. 0
15. 0
7. 5
7. 5
0. 0
0. 0
-7. 5
-7. 5
-15. 0
-15. 0
93
94
95
96
97
98
99
00
01
02
03
04
05
Sour ce s: Ce nsus Bur e a u, Bur e a u of Economic Ana lysis /Ha ve r Ana lytics
06
29
3rd Decoupling: Consumer spending
from housing activity and finance
Retail Sales YoY % Change
21%
18%
15%
12%
9%
6%
3%
0%
1Q98
1Q99
1Q00
Company Aggregate
1Q01
1Q02
1Q03
Commerce Department
1Q04
1Q05
1Q06
Commerce Department ex autos
30
3rd Decoupling: Consumer spending
from housing activity and finance
31
3rd Decoupling: Consumer spending
from housing activity and finance
32
3rd Decoupling: Consumer spending
from housing activity and finance
Retail Sales & Food Services
% Cha nge - Ye a r to Ye a r
SA, Mil. $
Employment: Retail Trade
% Cha nge - Ye a r to Ye a r
SA, Thous
12. 5
8
10. 0
6
7. 5
4
5. 0
2
2. 5
0
0. 0
-2
-2. 5
-4
90
95
00
Sour ce s: Ce nsus Bur e a u/Ha ve r Ana lytics, Bur e a u of La bor Sta tistics
05
33
3rd Decoupling: Consumer spending
from housing activity and finance
Home Equity Extraction, Net
SAAR, Bil. $
US Household Financial Balance
( in billions of $ )
1200
1200
800
800
400
400
0
0
-400
-400
-800
-800
94
95
96
97
98
99
00
01
02
03
04
05
06
34
4th Decoupling: Capital spending
from consumer spending
Private Nonresidential Investment: Equipment & Software
% Cha nge - Ye a r to Ye a r
SAAR, Bil. $
Mfrs' Shipments: Nondefense Capital Goods ex Aircraft
1 2 - month Cha nge - a nn
SA, Mil. $
15. 0
15. 0
7. 5
7. 5
0. 0
0. 0
-7. 5
-7. 5
-15. 0
-15. 0
-22. 5
-22. 5
94
95
Sour ce s:
96
97
98
99
00
01
02
03
04
05
06
Bur e a u of Economic Ana lysis, Ce nsus Bur e a u / Ha ve r Ana lytics
35
4th Decoupling: Capital spending
from consumer spending
36
4th Decoupling: Capital spending
from consumer spending
Nonfinancial Net Equity Issuances as a Share of Market Capitalization
( in %)
2
2
0
0
-2
-2
-4
-4
-6
-6
55
60
65
70
75
80
85
90
95
00
05
37
4th Decoupling: Capital spending
from consumer spending
Retail Sales & Food Services
6 - month %Cha nge - a nn
SA, Mil. $
IP: Manufacturing (SIC)
6 - month %Cha nge - a nn
SA, 2 0 0 2 =1 0 0
15
15
10
10
5
5
0
0
-5
-5
-10
-10
90
95
00
Sour ce s: Ce nsus Bur e a u/Ha ve r Ana lytics, Fe de r a l Re se r ve Boa r d
05
38
4th Decoupling: Capital spending
from consumer spending
Civilian Unemployment Rate: 16 yr +
SA, %
Capacity Utilization: Manufacturing [SIC]
SA, Pe r ce nt of Ca pa city
12
92
88
10
84
8
80
6
76
4
72
2
68
50
55
60
65
Sour ce s: BLS, FRB /Ha ve r
70
75
80
85
90
95
00
05
39
5th Decoupling: Profits from
expenditure growth
Ratio: Corp Dom Profits After Tax w/IVA / Net Value Added of Corp Bus
1 - qtr MovingAve r a ge
SA
Ratio of Implicit Price Deflator to Nonfarm Business Unit Labor Cost
4 - qtr MovingTota l
SA
14
397. 5
12
390. 0
10
382. 5
8
375. 0
6
367. 5
4
360. 0
55
60
65
70
75
80
85
90
95
00
05
Sour ce s: BEA/H, BLS/BEAH /Ha ve r
40
5th Decoupling: Profits from
expenditure growth
41
The Kalecki Macro Profit Relation &
the Profit Share Surge
R + W + T + M= I + C + G + X
R = I + (C-W) + (G-T) + (X-M)
C = Cw + Cr
Sw = W – Cw
FB = T – G
TB = X – M
R = I + Cr – Sw – FB + TB
R/Y = (I + Cr – Sw – FB + TB)/Y
42
Applying the Keynes/Kalecki
Relation to the Recent Expansion
Contributions to the Corporate Profit Share Surge
2001 Q4 - 2006 Q2
7
6
Change in GDP Share
5
4
3
2
1
0
-1
-2
-3
After Tax Quality Adjusted Nonresidential Investment
Corp Profits
& Inventory Change
Fiscal Balance
Trade Balance
Implied HH Deficit
Spending Contribution
43
6th Decoupling: Global growth from
US economic momentum
Imports, Customs Value: Goods
% Cha nge - Ye a r to Ye a r
SA, Mil. $
Retail Sales & Food Services
% Cha nge - Ye a r to Ye a r
SA, Mil. $
30
12. 5
10. 0
20
7. 5
10
5. 0
0
2. 5
-10
0. 0
-20
-2. 5
90
95
00
Sour ce s: Ce nsus Bur e a u, Ce nsus Bur e a u/Ha ve r Ana lytics
05
44
6th Decoupling: Global growth from
US economic momentum
The US Current Account Deficit Primarily Reflects
the US Household Financial Balance
2%
8%
1%
Share of Nominal GDP
4%
-1%
-2%
2%
-3%
0%
-4%
-5%
-2%
-6%
Current Account Balance (LH Scale)
-4%
Household Financial Balance (RH Scale)
-7%
-8%
1973
Share of Nominal GDP
6%
0%
-6%
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
45
Mr. Magoo-onomics, like Fairy Tales,
Investment Porn, and Perpetual
Wolf Crying, must go!
46
New Financial Architecture
• Moving away from a commercial bank centered
•
•
•
•
•
financial system
Toward investment bank and institutional
investor centered financing
Rapid innovation of financial instruments
Aimed at redistributing/reconfiguring risk
Heavy reliance on quantitative techniques
Hy’s portfolio manager capitalism - on steroids
47
New Financial Architecture: Down on
the farm version
• Players:
– Investment banks (Goldman Sachs)
– Pension fund managers (GSAM)
– Hedge funds (GS Global Alpha, Amaranth)
• Games and instruments:
–
–
–
–
Leveraged buyouts/private equity
Derivatives
Interest rate swaps
Credit default swaps
48
Corruption of the Private Credit Allocation
Mechanism?
• 40-50% of all mortgage originations by unregulated
•
•
•
•
brokers who are volume/fee maximizers
Securitization of mortgage loans reduces bank incentives
to execute gatekeeper role in determining
creditworthiness (not on my balance sheet)
Diversified nature of securitized debt packages (MBS,
CDO) reduces incentive of institutional investor to
analyze creditworthiness of any one loan
Proliferation of credit default swaps allows further
distribution of default risk away from credit originators
In such a world, no down payment, “stated” income or
low documentation, option ARMs can proliferate
49
An Example of Banks Acting as Volume
or Fee Income Maximizers
“What the underwriting survey shows this year should
give pause. Loan standards have now eased for three
consecutive years. The reasons most frequently
cited are competition, often from non-bank
investors, and optimistic – perhaps too optimistic
– expectations…With fewer home buyers in the
market, competition among lenders appears to be
intensifying…that competition has extended to
weaker underwriting standards.”
Comptroller of the Currency, John Dugan, October 17th, 2006 speech
to American Bankers Association
50
Financiers Gone Wild: IMF warns on
the quality of credit analysis in the NFA
“Discussions with market participants raised questions as to
whether the increased focus on ‘structuring’ skills, relative
to ‘credit’ analysis, may itself present a concern…
For some mezzanine structured credit products, zero recovery
rates are much more likely than on similarly rated corporate
bonds, yet the resulting default probabilities and expected
losses are mapped into traditional corporate bond rating, which
are based on recovery rates that tend to be in the 40-60%
range.”
April 2006 Global Financial Stability Report, IMF, ch. 2, “The Influence of
Credit Derivatives and Structured Credit Markets on Financial Stability”
51
Financiers Gone Wild: The over
reliance on quantitative methods
“The main problem we have described is that the MBS market
is built upon the statistical predictability of mortgage
performance. The CDO builds upon that foundation to provide
additional liquidity. As the performance of mortgages shifts
due to fundamental changes in origination and servicing
practices, investors may be surprised to find the mortgage
claim they purchased is based on a pool of loans with very
different statistical properties than previously experienced
or expected…Hence the degree of leverage inherent in CDO
funding, along with the potential for high volatility in that
funding, introduces the potential for public policy issues.”
Mason & Rosner
52
Financiers Gone Wild: The over
reliance on quantitative methods
“If firms today are implicitly selling various kinds of default
insurance to goose up returns, what happens if catastrophe
strikes?...It may well be that the managers of these firms have
figured out the correlations between various instruments they
hold and believed they hedged. Yet…the lessons of the
summer of 1998 following the default on Russian government
debt is that correlations that are zero or negative in normal
times can turn overnight to one…A hedged position can
become unhedged at the worst times...”
IMF Director of Research, Raghuram Rajan
53
Financiers Gone Wild: The skewing
of incentives, tail risk, and herding
“To summarize, overall incentives to take risk have
increased. In addition, however, incentives to take tail
risk as well as incentives to herd and move prices
away from fundamentals, have increased…The two
distortions are, however, a volatile combination. If
herd behavior moves asset prices away from
fundamentals, the likelihood of large realignments –
precisely the kind that trigger tail losses – increases.”
IMF Director of Research, Raghuram Rajan
54
Financiers Gone Wild: The skewing
of incentives, tail risk, and herding
55
Financiers Gone Wild: The skewing
of incentives, tail risk, and herding
56
Financiers Gone Wild: The desperate
search for uncorrelated asset classes
“Topless dancers, magicians and transvestites all add
up to one thing for Jean-Phillippe Cartier: a sound
investment… Family controlled cabarets such as the
Lido and Moulin Rouge fell on hard times... Now
private equity investors are snapping up clubs,
smartening up interiors and sending their highkicking , bare breasted dancers overseas as the latest
French export.”
“Paris Dancers Pack G-Strings as Investors Send Cabarets Abroad”,
Bloomberg, April 2, 2007 story by Alan Katz
57
Financiers Gone Wild: An Investment
Banker’s Plea for Help
“The markets are really, really red hot…The things we
are seeing being done, both on the investment grade
side and the non-investment grade side, are I would
say borderline stupid…There is just too much capital
going after too little by way of deals.”
Goldman Sachs Chief Underwriting Officer for Europe and Asia,
Eugene Leouzon, quote in a Reuters Nov. 16, 2006 story
58
Financiers Gone Wild: A Private Equity
Financier’s Plea for Help
“The amount of leverage available is just so
strong, very scary, but very strong. Leverage is
available in record amounts…We’re all going
to struggle for returns.”
Warren Hellman, chairman of private equity firm
Hellman & Friedman, quoted in S.F Business Times,
November 16, 2006
59
Wall Street’s Balance Sheet is Behind the
Liquidity/Leverage Surge, Not the Fed’s
Broker/Dealer Financial Assets Relative to Federal Reserve Assets Held
( in %)
375
375
300
300
225
225
150
150
75
75
0
0
55
60
65
70
75
80
85
90
95
00
05
60
Central Bankers may rely too much on a
moral hazard ridden asset prices
transmission mechanism
“ Some observers worry the recent Federal
Reserve policy, by keeping short term rates at
very low levels for an extended period, has
encouraged investors to ‘reach for yield’ – that
is, to shift their portfolios toward riskier and
longer term…Indeed, behaviors of this sort
transmit accommodative monetary policy
through financial markets to accomplish its
intended effect of stimulating demand.”
Fed Vice Chairman Don Kohn in “Monetary Policy
and Imbalances”, April 1, 2004
61
In Summary: Entering a Minsky Moment
• The housing bust is likely to reverse HH deficit spending
• Profit margins will be squeezed as a result, leading to
•
•
•
•
layoffs and further income growth erosion
Servicing existing private debt loads gets harder
A delayed “creditor revulsion” may induce a credit
crunch episode, further restricting hh deficit spending
Given the housing stock overbuild and low corporate
reinvestment rates, Fed easing may be less effective
should a recession unfold
Rebuilding the public capital stock, encouraging domestic
demand led growth abroad are principal exit strategies,
but not yet on the agenda
62
The Key Risk: a rapid reversion of
the household financial balance
63
Policy Objective: Manage the household
sector financial rebalancing
64
Conclusions & Remaining Questions
• Financial innovation, along with repeated moral
•
•
•
hazard interventions, appears to have corrupted
the private sector credit allocation mechanism
Signs of financial instability are beginning to
ripple out from the subprime mortgage market
and more esoteric mortgage derivative products
– this is unlikely to be contained
After this Minsky moment blooms, can financiers
(and policymakers) construct another asset
bubble to revive economic growth?
Not obvious how to realign incentives in the NFA
65