Macro Tsimmis

intelligently hedged investment

Oscillating Skid—Why We are Likely to Crash

Posted by intelledgement on Sat, 22 Sep 07

Sunday, 19 December 1965: scariest day of my life, so far.

I was 12 years old. My sister, Jill (10), and I had been allowed to skip a few days of school so we could start the winter break early that year, and with my parents, we flew from New York to Washington to visit my mother’s Bell clan family and—of course—go skiing. (My father, Lee, was—still is—a zealously religious skier, so any vacation that included him pretty much had to occur in a mountainous region during winter.) After a couple of obligatory days at my uncle’s Tacoma home—where it never snows—we were headed up to Packwood in the mountains, where he had a cabin near some first-rate ski areas. We took two of the Bell kids in our rented Dodge Dart, while my mother’s brother and his wife and daughter Eadie Kaye (she was my favorite both because she had the same name as my mother and we shared the same birthday—21 March—although she was two years older than I) traveled in their station wagon.

Lee was a skilled and aggressive driver, but he was more than usually anxious to make time that night, partly for the usual reason (the sooner we got there and to bed, the less trouble he would have getting us going bright and early on Monday morning so as not to lose any valuable skiing time) and partly because a significant snowstorm was brewing that night. Lee had been unable to obtain a rental car with snow tires at the SEA-TAC airport—it never snows in Seattle, either—and he wanted to get to Packwood before any significant snowfall degraded driving conditions; he figured he could rent chains once in mountain country and we’d be good to go for the rest of the week.

The Dart never made it to Packwood.

We were not familiar with black ice. It is not all that common a phenomenon in the Northeast. That night, we received a very quick education.

The Dart was doing about 85 MPH as we crested a rise on a two-lane blacktop highway about 90 minutes into our trip. Ahead of us was a downhill straightaway stretching out beyond the reach of our headlights; no traffic in sight ahead or behind us. Suddenly—all six of us could feel it—it was as if the car had become unhinged from the highway. We were still headed downhill, but the car was no longer pointed straight ahead…the rear end was fishtailing to the right, and the front end was drifting across the double yellow line into the oncoming traffic lane! Lee let up on the accelerator and turned the wheel to the right, into the skid. The turning maneuver straightened the car momentarily…and then the rear came around to the left, and we were now pointed off the road on our side…we were in a dreaded oscillating skid! The road was in a gully, and a few feet off each edge rose twelve-feet high embankments…the good news is there were no serious trees in play. Lee turned into the left skid and again our lurch towards the edge of the road—and the embankment beyond it—reversed…into another right skid. There was no question of braking, but some speed was bleeding off; we were now moving slower than 80 MPH…left, right, left, right, down to below 60 MPH…THUMP! The car had sailed off the road and the left front corner caught the embankment, we tumbled for a second or so, and…BOOM! We stopped.

The car had flipped completely over and we had landed, right side up, off the left side of the road facing back in the direction we’d come.

Have I mentioned that none of us had seat belts on? Miraculously, among the six of us we suffered only one broken collar bone (my cousin Ricky who had been in the death seat), one minor concussion (Jill, in the back seat left window) and a few days of sore ribs and minor internal bleeding for Lee (whose impact with the steering wheel had been hard enough to warp it). Possibly even more amazing, all six of our pairs of skis, stowed on a roof rack which had been torn loose when the car flipped, were virtually undamaged, save for some cosmetic scratches on the top of one of Lee’s.

The Dart, however, was totaled, with the radiator driven into the engine block.“So,” you may be wondering, “what does this have to do with investing? I already know not to buy Chrysler stock even if the Germans hadn’t taken it private.”

LOL right, well we probably wouldn’t be recommending Chrysler here—not that the accident was in any way the fault of the Dart—but that is not the takeaway. The point of the story is that the proper way to fight a skid is to turn into it, not against it.

For nearly 80 years now, the U. S. government has generally responded to economic downturns by loosening credit and spending more money, and to inflation by tightening credit and spending relatively less money…and generally speaking, the results have been pretty positive. For some months, now—as evidence of the collapse of our real estate bubble has mounted—some economists and most of the financial community have been militating in favor of a Fed rate cut, with the calls getting ever more strident and hysterical. That some big name financial institutions are seriously at risk there can be no doubt of. And on Tuesday, the Board of Governors of the Federal Reserve came through with a 50 basis point cut from 5.25% to 4.75%—the first cut in the federal funds and discount rates since June 2003, when it was lowered to 1%. Starting a year later, we had had 17 consecutive rate hikes, which streak was broken Tuesday.

Unfortunately, the tried and true response to an economic downturn here is the wrong response. We are not just dodging a pothole here. We are in a skid, and if we don’t correct it, it will take us off the road.

In a nutshell, Jim Cramer is right about the problem, but wrong about the solution. (If you didn’t listen to his famous “Ben Bernanke has no idea” rant the first time we linked to it above, please do so now.)

The problem is that there are a lot of financial institutions with bad paper out there who could be insolvent. No one knows for sure, because it is unclear how many “broken” mortgages there are (where the putative owner of the property owes more debt than the property is worth). And even if you did know that, the wizards who sliced up the mortgage obligation cattle and repackaged bit and pieces of them into new debt hamburger-style instruments have done such an arcane job that it is hard to sort out the true value of each individual security. For example, your interest payments—or just the first, say, five years of them—on your mortgage might have been repackaged into one mortgage-backed security currently owned by Lehman Brothers while the principal payments—or maybe just your payments from the 23rd to the 30th years of your mortgage—may be in another mortgage-backed security being held now by Wachovia. And your end-of-your mortgage payments may be mixed with other end-of-mortgage payments—which would be relatively easier to value—or with some other early-year payments or some interest-only payments on high interest loans, or whatever—which are harder to value. About the only things we know about many of these securities is that [a] the lapdog credit agencies rubber-stamped them all AAA and [b] the utility of those ratings is about the only thing we can confidently price: zero.

So, if you run a financial institution, and another financial institution you suspect may be insolvent asks to borrow money from you—as all these companies routinely do every day in order to conduct business—is it prudent for you to say “yes”? Obviously not…and that’s the problem. Cramer is right: some of these guys stand to go out of business if things continue on this path.

Which brings us to Cramer’s proposed solution: loosen credit by lowering the fed funds rate. The prime rate will come down, the mortgage rate will come down, fewer homeowners will be rate-adjusted out of their properties, the value of the mortgage-backed securities will be saved from extinction, no financial institutions will face insolvency and bankruptcy, and everybody can go back to buying the latest cool cell phone.

We see only two problems with this solution: [a] it won’t work and [b] it will make matters worse.

Lowering interest rates won’t help homeowners with balloon mortgages here because the problem is they bought their properties at sky-high prices in a bubble market on spec with the intention of flipping the property at a profit before their higher mortgage payments kicked in. That bubble no longer exists and they can’t flip the property to a greater fool at a higher price, irrespective of the mortgage rate. And, irrespective of the mortgage rate, they owe more on the house than it is worth and once they face that reality, the rational move is to default on the mortgage…which obviously is bad for whatever mortgage-backed securities include a portion of that mortgage.

Lowering interest rates will have an effect, but unfortunately it is not a good one, in our view: it will accelerate the decline in value of the dollar.

Everyone knows that the dollar has been declining more or less steadily since the end of the Second World War, but most of that decline has been in opposition to inflation. When inflation was high, the dollar has been relatively weaker, and when inflation is low, the dollar has been relatively strong. But even with inflation still relatively tame here, the dollar as seen a marked decline of late. Check out this chart, which shows the performance of several dollar-denominated currency-based ETFs over the last 15 months. Despite low inflation and interest rates that—until this week—were steady and relatively high, in dollar terms, every currency has appreciated in value. Even the loonie, which was losing ground to the dollar for much of that time, is now +10%. (Note the momentary spike in the value of the dollar when the Fed surprized folks—and sent Cramer over the edge—by not lowering rates in August.)

So if the dollar was uncharacteristically weak even while the fed discount rate was steady at a relatively high level, what happens now that rates are headed down and a flood of new dollars are being created both electronically and on paper?

What will happen is that the banks who facilitated bad behavior on the part of the mortgage and home sellers and buyers will get a lease on life that they don’t deserve, and the cost of that lifeline will be borne by dollar holders, domestic and foreign both, because their wealth is being devalued.

We are hooked on easy credit and we were responsible, we would employ some tough self-love to get ourselves detoxed, cold turkey. We would feel like dying for a spell, but in relatively short order we would bounce off our collective sickbed healthier and wiser…and a lot wealthier than we are going to end up the way things are going. Which is, we are not feeling great so they are force feeding us more credit! This makes about as much sense as treating an alcoholic by increasing his bar tab limit—and will have consequences just about as devastating.

Under normal conditions, it makes sense for the Fed—when they see an economic downturn pothole ahead—to steer the economic car away towards easier credit…and when they see an inflation obstacle in the road, to steer back towards tighter credit. But these are not normal driving conditions. In effect, we are in an oscillating skid, an a huge patch of economic black ice, zooming ever closer to either edge of the road with every swerve…and our driver, instead of turning into the skid, is fighting it every inch of the way…and instead of slowing down, is speeding up.

These violent maneuvers may postpone the inevitable for a spell, but with every wrench of the steering wheel, our control is less effective and with every boost in speed, the damage we will likely incur when the crash eventually comes, as it must, increases.

Hope you’re smarter than we were in Washington so many years ago: hope you have your seat belt securely fastened.


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