Wednesday, August 15, 2007

The Credit Squeeze of 1966: BUY BUY BUY


US Real estate went up and up some more for most of the years after WWII up until 1966. Then, suddenly, the market, in cooperation with central bankers and politicians engineered a credit squeeze. I remember this well because my mother was a real estate agent at the time. The banks and savings and loans had money to lend, they were financially solvent but, due to arcane laws about interest rates (Banks could not legally pay more than 7.5% on a certificate of deposit), it made no sense for them to make mortgage loans. Suddenly, it did not matter how good your credit was, no one could get a home loan. Review the economic history of that year and you can see the chilling effect this development had on the economy. Still, there was no recession, only a mid cycle rotation.

This time around, the credit squeeze will not last as long. It will take time to unwind the carry trades but money will be available at a price. Lenders are still making loans today. Jumbo loans of greater than some $400,000 plus are temporarily hard to find but ask your local credit union and you will find good loans available at good rates. The re-sell market is temporarily dry for the big loans. This time, the bankers could generally could make the loans if they wanted but they are not sure where interest rates will settle once the highly leveraged carry trades are unwound. With a world wide capital spending boom in place, the concern is that business borrowing is going to push rates up. The good news is that inflation rates are low, causing loan rates to stay low.


The Japanese economy has been in a funk since 1989. Interest rates have been so low in Japan that hedge funds have been willing to borrow at low interest rates in Japan and to re-lend in other nations around the globe. The problem is that doing this trade exposes the practitioner to currency risks. If the Yen appreciates in value, the borrower of Yen must payback the appreciated currency value, not the currency that he borrowed. For as long as Japan was "in the funk", the deal paid handsome rewards. Now that the economic mid cycle turn is here, the Yen is "steadily" appreciating, these borrower-lenders must scramble to collect their funds as quickly as possible so they can buy the Yen before it goes even higher. To some extent, this is at least a temporarily self fullfilling action as the demand for Yen puts all the more lenders into a temporary bind. On the other hand, some of the central bankers of the world that were injecting emergency funds just a few days ago are now regularly withdrawing excess liquidity; the big ripples in the pond are getting smaller day by day. Another big stone could ripple the waters again but the worst is over.

It is ironic that Greenspan has been blamed for keeping the fed funds rate too low at 1% for too long. The truth of the matter is that it was Japan that suffered deflation for the past couple of decades and it was Japan that offered the world cheap cheap cheap money. For many years, the central bankers of Japan could hardly lend Yen at zero interest. They said take the money please!, pay us back when you wish and there will be no interest added to the principle. As the currency was declining in value, the deal could only be made when foreign, profitable projects could be funded with this money.


The world economic recovery is real. The world's economy in the past year grew as fast as it ever has in history. Japan, which is still much more dependent on manufacturing than is the USA, was hit harder than others by the competition from China, India, et. al. Now that the mid cycle correction is well under way, Japan will enjoy the late cycle capital goods spending boom that is underway. For example, Japan will build a number of the 40 nuclear power plants planned in China. Much of the the excess currency reserves built up in China over the past 20 years will be spent on items such as 787 DreamLiners and nuclear power plants. In the mean time, there are still a few hundred million Chinese who are willing to work for more than food. The growth in China continues. The speculation in the China market has sucked up money from around the globe. The mid cycle correction will be over by the time there is much of a slow down in China.


While the sub prime mess gets more than its share of the ink, the other news around the world is interesting. (The sub prime story is the news media's way of talking about the unwinding of the carry trade. Saying the world is coming to an end as a result of a "crash" in the residential real estate market demands a bigger audience than saying that speculators can no longer borrow in Japan to lend elsewhere).

One item of note is the move by some airlines to sell or spin off their frequent flyer programs. Canadian Air completed its spin off last year and others are at least taking a look. It has been said that UAUA was offered $7.5 Billion for its program. Flyers on UAUA would still earn frequent flyer miles but they would be managed by an independent company. A major difference in some of these programs is that all flights become available for frequent flyer rewards. The points needed to fly at peak demand time might be higher but, since an average of 17 percent of these points are never redeemed, it makes sense for an independent system. Points can be used for all sorts of purchases, everything from upgrades to consumer goods.


The pressure to make a deal is still on Iran, Iraq and the USA. The time is drawing near for a number of deals to be struck. President Bush is applying new pressure on Iran. The administration is about to declare the Iranian Revolutionary Guard to be an organization that supports terrorist. This is a significant action as the Revolutionary Guard is an industrial-military complex. It is a "machine". It takes in a lot of money from many sources and uses these funds to support terrorist in Lebanon, Afghanistan, "Palestine", Iraq, etc. By proclaiming the status, the USA can disrupt the commercial activities that are used to support this organization.

The Iraqi prime minister is under great pressure and he is pressuring others. Iraq needs to increase oil production as this is the primary source of revenues for the government. Most of the Iraqi interest groups understand that the country needs to settle its differences in regard to the sharing of oil revenues so economic progress can be made. Once it is clear that the central government is a long lasting entity, the rational for cooperating through the government will increase. I still have faith; establishing a free government is no small challenge, one that takes time to build.


The most recent sub prime mess will contribute to slower growth in the US economy. However, with exports growing at 11.2% and with a capital building and spending boom in progress by American businesses and with year over year profits rising at better than 14%!, I see no recession in sight. I say this, knowing that we have had a slightly inverted yield curve for about a year and that growth in the monetary base is at recession levels.

WOW! Car sales down, housing sales down, hedge funds and mortgage brokers going belly up and NO RECESSION! I believe there is about a 20% chance that we will actually see a recession. Who knows how scared the public has gotten as a result of the "bad news". For most US citizens, the Yak, Yak, Yak about sub prime is of little importance. The unemployment rate is near record lows and, while this is an incidental indicator, leading edge numbers still show great strength in the economy.

WOW! If profits are up 14% and with the business spending boom continuing and with competing treasury securities selling for higher and higher prices, STOCKS SURE DO LOOK ATTRACTIVELY PRICED!

Oil futures keep trading up each time a storm is named but the OPEC oil sellers continue to report that selling oil is becoming like pushing on a string. For the past 5 years, anyone who had oil did not need to hang out a sign. Buyers would find the sellers. Now buyers are getting choosy. They are not running their high cost refineries and are buying fuel that is easy to refine. Why "cook" heavy grades of junk at high temperature if the sweet stuff is available. On the other hand, one refinery after another with access to cheap Canadian tar sand oil is expanding or converting production.

Hurricanes usually miss most of the production assets. As each one misses, you can expect the price to retreat. The unwinding of the carry trade will reduce the money available for all sorts of speculations. With Ben and company holding real short rates up, I expect the commodity complex to see some pain in the coming months. Commodities down; technology stocks up!