No Wrench

Bloomberg is reporting (in a nice weekend leak-out) that the credit-default swaps for major New York investment banks are trading at near junk levels. Now I’m not a financial analyst so all this is slightly over my head. But my read of the situation is this. All these big banks have a fairly large amount of money riding in the secondary market on mortgages and probably a fair amount in the primary market as well. For example, Merrill apparently has had two mortgage lenders go belly up underneath it since 2005 and currently owns a third. Now that the housing market is creaking around the edges, companies are starting to worry that the investment banks might be over-extended.

Credit defaults, briefly, are basically insurance contracts against risky bond investments. The more risky the bond investment, the higher the cost of buying the credit default. Merrill, Lehman, Morgan Stanley, and Bear Stearns have all seen their credit default price more than double, in some cases triple. People think they’re holding a lot of bad debt that might be defaulted on.

So what does this all mean? Well, no one is really sure. The credit default market has only existed for a decade. This same sector has just reported its most profitable year ever. So there is little baseline evidence to judge on and from all external appearances the sector appears healthy. But, the big catch in all of this is the sub-prime market. According to the Bloomberg article, most of these companies have about 10-15 percent of their equity locked up in bonds representing sub-prime mortgages. As I said in my previous post, I don’t see a rebound for the housing market in the near future. No rebound means that a lot more of those sub-prime mortgages are going to foreclose, which means a whole world of hurt for the financial sector.

To get on the soapbox for a second, this is what comes from short-sighted corporate management. Sub-prime mortgages were an irresponsible cash grab by the entire financial sector. They were willing to take on disproportionally high-risk because it greatly increased their short-term cash flow and pushed up the bottom line (and the stock price). Anyone running a responsible company would have realized that the cycle was going to end eventually and that pushing consumers farther and farther into debt was only going to backfire. No one cared because everyone at the top was getting paid (and man did those stock options look nice). But now it is getting closer to being time for accountability. Buffet made the point in his report that bad financial policy comes home to roost in the end. It looks like that might start to happen for Wall Street. Between the mortgage lenders and the credit card lenders they’ve strung out the American public to the point where they cannot afford to pay off their debts. And now they’re going to reap the consequences. It’s just sad that so many people may be financially wreaked by this.

I plowed thought Twilight in the Desert a while ago and it gave me a lot to think about. The book, by Matthew Simmons, talks about the eventual inevitable decline in Saudi Arabian oil and what it is going to do to the world economy. Today, Stuart Staniford over at the Oil Drum has up a post in which he crunches the numbers and comes up with a year on production decline of 8% for Saudi Oil in 2006. 8% is a big number when it comes to oil production, especially in a year where Saudi Arabia talked positively about bringing new wells online and boasted that had a maximum production capability of 10.7 million barrels a day.

As Simmons discusses in his book, Saudi Arabia has been drilling like mad for the last decade attempting to find another massive oil field to prop up their older fields. These older fields were (and still are, at least for right now) the most productive fields in the short history of the fossil fuel industry and Saudi predictions have them running strong for the foreseeable future. The only problem?

There is a small, but growing group of watchers who think the Saudi’s are full of it. Simmons, in his book, lays out very reasonable evidence as to how the Saudis are juggling numbers or just making up numbers to assuage the world’s fears about peak oil. The Saudi claims about mbd or about the total amount of recoverable reserves seem to have no correlation with the actual production levels that the Saudis are operating at or with their announcements of new discoveries. I wish I wasn’t traveling and had my copy of his book on me, because there is a great section where he discusses how those numbers have magically risen at times with no substantive proof.

Why would the Saudi’s lie? Because their sole political power comes from being the spigot for the world’s oil. Do you think that America really cares about Saudi Arabia? When all is said and done, they’re the country that has given the most support and aid to Al Quadi and the country which is probably doing more to aid the Sunni side of the Iraqi civil war than any other. But as long as they have oil, they are an inviolate American ally.

This is a small story right now. It will get bigger. The idea of peak oil has been kicking around for the last thirty years or more, but its starting to look like it might be showing up. Head on over to the Oil Drum. Look at the graphs, read the evidence. It is starting to look pretty convincing to me.

For those people predicting a recovery in the housing market, think about what a shock in oil prices is going to do to the construction industry and the American economy as a whole. It is not a pretty picture.

Warren Buffet exemplifies many of things that I find good and respectable about the American business community. He’s a shining example that you can run companies in a legal, above-board manner and still make ridiculous profits. He’s also dedicated his entire holding in Berkshire Hathaway to charity after his death, which will probably be the largest bequest ever. Considering his unsurpassed success as a business leader, when he speaks about the economy, it is usually a good idea to listen and his annual report to the shareholders of Berkshire is now up on the company’s website. A little more than two-thirds of the way through, Buffet discusses the US trade imbalance:

As our U.S. trade problems worsen, the probability that the dollar will weaken over time continues to be high. I fervently believe in real trade – the more the better for both us and the world. We had about $1.44 trillion of this honest-to-God trade in 2006. But the U.S. also had $.76 trillion of pseudo-trade last year – imports for which we exchanged no goods or services. (Ponder, for a moment, how commentators would describe the situation if our imports were $.76 trillion – a full 6% of GDP – and we had no exports.) Making these purchases that weren’t reciprocated by sales, the U.S. necessarily transferred ownership of its assets or IOUs to the rest of the world. Like a very wealthy but self-indulgent family, we peeled off a bit of what we owned in order to consume more than we produced.

I want to emphasize that even though our course is unwise, Americans will live better ten or twenty years from now than they do today. Per-capita wealth will increase. But our citizens will also be forced every year to ship a significant portion of their current production abroad merely to service the cost of our huge debtor position. It won’t be pleasant to work part of each day to pay for the over-consumption of your ancestors. I believe that at some point in the future U.S. workers and voters will find this annual “tribute” so onerous that there will be a severe political backlash. How that will play out in markets is impossible to predict – but to expect a “soft landing” seems like wishful thinking.

Over the next ten to twenty years, it is pretty likely that per-capita income in the US will increase. However, I would say that it is a fair bet or better that inflation adjusted median income is going to drop. In short, there are going to be more poor people and the rich people will have more money. This is part of the inevitable backlash that Buffet is talking about (or at least it is in my mind).

The interesting dynamic to watch, though, is what starts to happen in America as the dollar declines. The single largest reason for the dearth of American manufacturing jobs is the relative strength of the dollar to the Asian currencies. It costs so much less to manufacture things in China and ship them here that there is little to no financial incentive to actually having manufacturing jobs here. That’s one of the large reason that China is so willing to soak up American debt. In order to grow the Chinese economy they need a market that can afford to pay for their cheaply-produced goods. If the US stops buying Chinese goods, then China’s economy is going to have a hard time growing any more.

Well, the US dollar is currently dropping pretty hard against world currency, in part due to the excessive trade deficit that this country insists in maintaining. (As Buffet points out above, it is 6% of out total GDP a year). If the trend continues and if world financial pressure prevents the Chinese from re-pegging their currency (a favorite trick of theirs to maintain their cost edge), then all of a sudden the US manufacturing industry may be facing a new economic reality, where they can compete on price with the Chinese. It would be interesting to see. It would also be interesting to see how much that would effect the ‘soft landing’ chance that Buffet is talking about.

A strong manufacturing economy is what built the American middle-class in the first place. It would be highly ironic if manufacturing’s re-emergence due to currency fluctuation and the seemingly inevitable decline of the US dollar helped save it as well. Just all idle food for thought.

So the housing market is still heading down, though there are plenty of economists who are happy to talk about how it is going to level off or head back up. Meanwhile, the sub-prime loan market continues to rack up high-levels of defaults and numerous sub-prime lenders have exited stage left, over-burdened with bad debt.

So what I’m wondering is why the housing market is going to be going back up any time soon? Look at it this way. Why is the housing market so high right now? It is so high because people have over-extended themselves to buy houses they couldn’t really afford. That was fine as long as the value of those houses kept going up. They could eventually sell the houses, make a profit, and move on having eliminated their bad debt.

A guy I worked with at an old job had this exact plan. He bought a place last year with a 5-year interest only mortgage. There is probably no way that he could afford the house under normal means, but only having to pay the interest part of the loan was affordable. The plan was to let the house appreciate for 5 years and then sell it off at a profit before he ever had to make any of the larger payments.

Now this plan only works if someone else was willing to assume bad debt on their own to buy the house from him. In a situation where the housing market was going up, lots of people were willing to take on that debt. But the housing market is now no longer going up. In fact, it is going down. Which means there is no good reason for someone to take on bad debt to buy more house than they can really afford.

From my point of view, this can only serve to drive prices down. The people living next door to where I grew up are currently trying to sell their house. It is the sort of place that maybe a year ago, I would have considered a million dollar house. Its in a good town, right on public transportation, in what is considered a good school district and it is a large old Victorian house. Their list price started at 925,000 and its currently down to 899,000 having been on the market for over 2 weeks. I’d be surprised if they got over 800,000 for it.

And that’s my point in a nutshell. When people start selling off their houses at a loss or even at a small gain, they’re not going to have the money to invest in another bigger house. The entire housing market has been like a giant pyramid scam. You sell your house for a profit, which lets you buy a bigger house for a profit, which lets the person you bought from do the same thing. But that only works when the first guy takes on enough bad debt to let you buy that next bigger house.

When that doesn’t happen, the entire bubble stops bubbling. And that’s what I see starting to happen now. There is no incentive to take on bad debt to buy a house if you don’t think that someone else will be willing to take on even more bad debt in five years to take it off your hands. With the American saving rate being negative and credit card debts only going up, I think Americans are starting to get wary of taking off more debt, especially when the housing market is seeming like less than a sure bet. Which means I don’t see the housing market rebounding any time soon.

Of course, I could be completely wrong. But the entire thing is a house of cards and the bottom is looking awfully wobbly right now.

I’ve currently in the middle of Anya Kamenetz’s book Generation Debt, and while I’ll get to a larger discussion of what I think of the book and what it says later, there was something in it that caught my eye and tied into my early post on narcissism. On page 93, Anya is waxing on about the motivational troubles that our generation sometimes seems to have.

We were raised to dream big. When we face real challenges, our chronic dissatisfaction can itself be a stumbling block. We spend too much time and borrow too much money shooting for the stars.

It is a different take on the issue than the authors of the study took and it is one that does hold more concern for worry. Our generation is different in a lot of ways. We are the first generation that has been raised with technology. When I was 6 years old, I started using personal computers at home learning on my dad’s IBM XT. The first five years of my life were the only times when I was not fully enmeshed in a technologically connected world.

One of the largest things that this has done is that it has drastically shrunk the difficulty involved in sending work overseas. Everyone has, most likely, had to deal with an Indian technical support call-center at some point in the last few years. That is just one of the most visible facets of out-sourcing. And the truth about out-sourcing is that it is barely working right now. Cultural differences are too great, language barriers are still fairly high, there are significant obstacles. But that is all going to change. The financial implications are just too great for it to not be successful.

What is being seen right now if the just the tip of the iceberg in terms of the global spread of business and jobs. And that brings me back to the part about my generation here in America. There is no precedent for this. Consider that someone graduating from a four-year college in the early 1980’s was most likely going to walk into a job that would pay them reasonable well, probably had health care and some sort of retirement, and which could potentially last them a life time. Consider that those facts gets more and more true as you travel back through the 60’s and 70’s to when our parents were graduating. The future that we were brought up to live in is not the future that we actually live in.

The paradigms have shifted, now, where the important thing is not necessarily the college degree, but the ability that an individual has to hone their skills and then market them in a rapidly changing environment. Interestingly enough, I think that being narcissistic may help here as well. Anya mentions that we’re spending too much time and money creating churn, and that is probably true right now. Any new situation requires some reorientation. Adapting to the new economic climes is going to be rough, but in the end, a strong sense of self and the belief that you have vital skills is going to be key. If you can’t tell yourself that you’re a special person, then no employer is going to take a chance on you either.

I need a retirement account question answered. I’m a self-employed individual and I want to open up a SEP-IRA. Normally this should be a fairly straight-forward procedure, since I’d had to a nice discount broker like FirstTrade and open an account there. However, considering that I’ve found myself happily entangled with a member of the financial community, my ability to open accounts with discount brokers has vanished (due to SEC regulation issues, companies place strict limitations on places where people involved in the financial industry and their significant others can open accounts to make compliance easier). So I have to pick and choose where I open accounts in order to successfully minimize the account fees and purchase fees I’m paying.

So when I open up my SEP-IRA, I actually want to have it be two or three separate accounts at different brokerages and mutual fund companies. The only problem, is that there does not appear to be any documentation anywhere on the IRS site that explicitly states if you can do this. I’ve read publication 560 and 590 cover-to-cover and also read their FAQ on SEP-IRAs. Nothing doing. They do state that you can have multiple SEP-IRA accounts with different employers, which makes sense since each employer makes separate contributions . But they never state one way or another if an individual can make contributions to multiple SEP-IRA’s in the same year.

So I called them up to see what the deal was. The number for question about employer retirement plans (which this classifies as, even though I’m self-employed) is 877-829-5500. I waited on hold for about fifteen minutes. The first guy I got on the phone said that it was a great question and he had no idea what the answer was. I was then put back on hold for another ten minutes to wait for a specialist. She also had no idea what the question was, but put me on hold to go consult the documentation (publications 560 and 590 I would assume). When she returned she confirmed my inability to find a statement. So she took my name and phone number and the IRS is going to call me back in 3-5 days with an answer.

Am I the only person who has ever tried to do this? I’ve been really surprised at the lack of discussion of this topic online, so if anyone has ever done this, let me know.