The Great Debate

Another dip in U.S. housing looks likely, bringing with it difficulties for banks and for their government guarantors.

What is perhaps worse: having chucked money at supporting asset markets in order to support banks the past two years, the policy options for handling another housing downturn and banking crisis would be greatly circumscribed.

If you think the debate about more fiscal stimulus is heated, wait until you see the venom which the prospect of another housing and banking bailout brings.

Despite absolutely massive official support, via the FHA, Fannie Mae, Freddie Mac, a now expired housing credit and other initiatives, air now appears to be leaking out of the housing market faster than it is being pumped in.

The recent run of data in the aftermath of the expiration of the housing credit has been terrible. Existing home sales fell 27 percent in July to an annual rate of 3.83 million, the lowest figure in the 11-year history of the data, leaving inventories above a year’s worth of sales even before you account for the shadow inventory of foreclosures and would-be short sales. Nearly 15 percent of all loans are past-due or in foreclosure and 23 percent of properties encumbered by a loan are in negative equity, meaning they have very good reason to default if they haven’t already. Another 5 percent of mortgaged homes have 5 percent equity or less.

Remember when business and economic leaders droned on about “100-year storms,” 2008′s get-out-of-jail free card for people who missed the housing bubble?

This was the whole idea that there was no way that people could be held accountable for the crisis because the notion of there being a problem with continual double-digit house price growth and sky-high leverage was just so darned unlikely.

Well, it looks like we have the 2010 version of how the dog ate their homework again and this time it is called “Knightian uncertainty.”

It may seem like a  world turned upside down: stocks are desired for their dividends and bonds are all about capital appreciation, or at least preservation.

It was all so different over much of the past 20 years, when despite steady falls in inflation and rising prices for bonds, the real money was perceived to be in equity price gains.

Dividends were for widows and orphans; those without the knowledge or guts to take the big risks and make the momentum plays.

-Laurence Copeland is professor of finance at Cardiff University Business School. The opinions expressed are his own and do not constitute investment advice. -

The unemployed and the terminal insomniacs who have nothing better to do than read my blogs will know that I have long been gloomy about most of the Western economies. How can you fail to be pessimistic when the world economy is still dominated by the U.S. - a basket case, becoming weaker every day, with a political class too blind or too scared to admit in public the obvious fact that the country cannot carry on living beyond its means?

Now house prices are plunging again and, with the dollar still strong, the prospects for an export-led recovery look bleak. In fact, a return to recession is far more likely, and the markets are starting to show signs of that sickening here-we-go-again feeling.

Europe’s long summer holiday still has a week to run but this year’s reentry will bring with it evidence that very little progress has been made on the issues that threaten to rend the currency union and upend the global economy.

Despite waving the stress-test magic wand over its banks in late July the same problems continue to grow unchecked: a euro zone periphery that can’t compete, may not be able to pay its debts and so may bring down with them the very banks that have been pronounced healthy.

While the German economy is growing at a rate not seen since the Berlin Wall came down, things are a good bit worse in Ireland, Portugal, Spain, Italy and especially Greece, all of which face some combination of an austerity-induced recession and debts public and private which which threaten their banking systems, local governments and Treasuries.

Forget about politics, the biggest divide in the U.S. is between stock and bond investors, who aren’t so much arguing as speaking entirely different languages.

Stocks, while about flat for the year, are priced moderately cheaply by historical standards, implying that investors think they have a reasonable, if not spectacular, outlook for the next couple of years.

Earnings are strong, and forward looking estimates of earnings, while coming somewhat off the boil, are still rosy and cash balances are high.

Fear of deflation haunts investors and stalks the halls of the Federal Reserve in Washington.

But how bad are declining prices, and why have they become a problem? Should investors and the Fed stop worrying and learn to love deflation, at least at moderate levels?

For 70 years, deflation was a distant threat as policymakers and economists wrestled with the problem of taming high and persistent inflation rates instead. It started to become an issue in the 1990s when inflation dipped below 3 percent for the first time in three decades, sparking a debate about “optimal inflation rates” and how the Fed should define its price stability mandate.

The Federal Reserve’s decision to move to a kind of quantitative neutrality is a tacit admission that it, or rather that the United States, is in a political bind that makes a bold response to a deteriorating economy difficult.

Despite reams of evidence that conditions are worsening — much of it cited in the statement the Fed made as it left rates on hold — the U.S. central bank made only a token gesture; announcing that as mortgage-related debt it holds on its balance sheet comes to term and is repaid it will replace it  with new, mostly long-term, Treasuries.

That keeps its quantitative easing policy essentially static, a strategy dubbed “quantitative neutrality” by Northern Trust economist Asha Bangalore.

A look at company earnings implies it is a great time to be a corporation in America, but for investors a rising savings rate and the threat of deflation mean that, ugly and risky as they are, government bonds looks good in comparison to stocks.

So far it has been a pretty remarkable earning season in the U.S. Almost 80 percent of companies reporting have beaten analysts’ estimates and profits among the largest companies are up more than 40 percent on the same period last year.
Perhaps even more remarkably, companies are managing to trouser a record 10.2 cents in every dollar of revenue after operating costs, according to Standard & Poor’s.

That’s the rub – profitability growth is outpacing revenue growth, which has been 9.0 percent, implying that the gangbusters pace of profits is more due to cost cutting and efficiencies than a sustainable expansion in anyone’s business model.

Apparently, the U.S. economy is being held back by massive uncertainty over new regulation, future taxation and the deficit and how it will be handled, a state so frightening and confusing that investors won’t invest, businesses won’t hire and nervous consumers have taken to their beds.

That, at least, is the account of Dallas Federal Reserve President Richard Fisher, who, in a speech last week, blamed fear of the arbitrary exercise of power by those in government for slowing the economy and putting those who make, employ and spend in a “defensive crouch.”

“For some time now in internal discussions with my colleagues at the Fed, I have ascribed the economy’s slow growth pathology to what I call ‘random refereeing’ — the current predilection of government to rewrite the rules in the middle of the game of recovery,” Fisher told business leaders in San Antonio.