Pro-Cyclical Saturation

By Jeffrey P. Snider

The central insight into the Minsky moment is really about saturation, as that point represents where any system can no longer sustain growing marginal inefficiency. In fact, it becomes so inefficient that its entire forward dependence is predicated on simply more debt being issued to pay off old debt. In terms of the economy, that means so much of financial resources are being used up just to forestall contraction rather than representing incremental growth. The greater those margins of inefficiency, the more likely it is to hit "stall speed" and begin what is always an epic descent into the misallocation abyss.

That was clear enough in the housing bubble, as at some unknown point in the mid-2000s, the increase in mortgage debt owed nothing to the economy and was instead totally dedicated to keeping the enormous price structure from breaking apart. Almost the entire balance of a new mortgage was "used" up as the Greater Fool, allowing nothing more than the previous real estate "owner" to get out. The fact that so many dwellings were built upon that feverish fury simply speaks to the gross misallocation. It also details the distinct lack of true intermediation in credit, instead repurposed as a monetary "flood" of mindless credit predicated on volume.

But that is, again, somewhat misleading, as the buildup of credit was not contained within just the few years after the dot-com bust. Mortgage credit had been growing at an alarming rate throughout the 1990s, really since the S&L bust was finally "cleaned up" in a fit of quasi-too big to fail. Where S&Ls had previously been the entire basis of mortgage finance, the shadow system took over in the 1990s as GSEs and then private label securitization pushed out all competition. They could do so based solely on their new funding model, wholesale money (especially eurodollars), rather than deposits and traditional banking aggregation.

(click to enlarge)

Looking at the bond market, that is absolutely clear in the compound annual growth rates of the ABS, agency and MBS sectors. The demarcation of the Great Recession is equally clear, as mortgage finance has come unglued in light of that Minsky moment that occurred somewhere around 2006. That might be oversimplifying too much, as there was no one factor involved in turning the bubble to bust, but the fact remains that mortgage finance was utterly decimated and, more importantly here, has remained so.

In the place of mortgages, the US Treasury and corporate bonds have filled, partially, the desire for new issuance. Those are really the only two sectors left with any kind of actual growth, as munis have a positive number but debt there has really been flat these past six years. That has presented all sorts of problems in financial plumbing, since MBS as collateral formed the backbone of the marginal growth in repo - with nothing but UST to take up the slack (complicated by QE and other factors like Dodd-Frank).

To a monetarist, that might go a long way toward explaining the reasons for the lack of real recovery in the economy, especially since debt = activity for them. However, that misses the central premise that is just now being incorporated into the wider range of dissatisfaction. There have been problems in the economy, particularly labor and wages, that go back much further than the Great Recession. In fact, as I noted earlier today, even the current vice chair of the FOMC seems keenly aware of this distinct deficiency in the economic trajectory.

That raises a central issue with this debt appeal going back now past even the turn of the century. As I said above, debt growth had been tremendous throughout the 1990s and into the mid-2000s, yet "somehow" the economy downshifted somewhere in there, despite the monetarist appeal to massive credit.

The answer to the non-monetarist lies in a partial observation of Minsky, namely the growing inefficiency of debt as it produces (likely the wrong word to use here; more like "leaks") economic activity. Instead of viewing the credit history of the past four decades as a series of bubbles, in this framework, we instead see one continuous cycle of growing inefficiency broken only periodically by actual market attempts at self-correction. And each of those attempts, which grow only larger over time (going back past the dot-com bubble to even the smaller junk bond bubble of the 1980s and smaller real estate "anomalies" that took down the S&Ls to begin with), are over-ridden by a policy regime that courts no value in contraction and creative destruction.

The current spike in corporate debt is exactly this kind of behavior, now gone into once again dangerous proportions. Back in May, Bloomberg cataloged what looks like bubble behavior, but what is really just higher proportions of inefficient financial utilization.

Loan agreements have "dramatically weakened" and it's easier than ever for borrowers to boost earnings in more ways than investors may realize, including "extremely speculative" cost savings, said Xtract's Pisano, who is based in Westport, Connecticut. Those that do cap add-backs limit them to about 25 percent of Ebitda, up from 15 percent a year ago, he said. 
About 66 percent of junk-rated bonds sold this year scored by Moody's Investors Service included at least one adjustment to earnings the credit rater considered "aggressive," up from 59 percent in 2013 and just 40 percent in 2011. Moody's didn't track the same historical data for loan issuers, though speculative-grade companies will often have both loans and bonds.

This is an extension of the plague of cov-lite that has hit every form of corporate junk since QE3 started the mania, and is really the combination of everything from pricing problems to loose balance sheets to debt that should have likely remained unissued. And that is the degree of inefficiency that plagues the economy, as companies that should be on their way out are instead given a stay of execution by a bond market desperately searching for forward momentum as a feature of persistent repression. Instead of focusing credit on "worthy" projects with more than financial risk, instead, everything and anything gets funded by looser and looser attention to actual risk.

That is the opposite of intermediation, which is a genuine and vital need in a true capitalist system, and it has spread out in quantities that we never really thought possible.

While overall corporate debt growth has remained largely constant since 1992, that takes no account of the proportion of junk within it. Since 2012 began (through July 2014), $863 billion of junk bonds have been issued (which will likely take it over $1 trillion at current rates of issuance). That compares to only $817 billion issued in all of the eight years between the beginning of 2000 and the end of 2007 (the last "cycle" peak). Talk about inflation.

It is now just routine to see between one-fourth and one-fifth of all corporate debt as a junk obligor (and this does not even account for leveraged loans and other forms of low-grade corporate credit), which is precisely opposite the intent of junk bonds to begin with - this market was supposed to be a last resort, not a mechanism of permanent funding of the woefully inefficient. In economic terms, this has taken subprime corporate lending to the mainstream, something apparently monetarists condone with their willful appeals in this manner time after time. The net effect on the economy over time is a lack of dynamism, as the old businesses are propped up by debt; where failure once amounted to a net gain as new firms were given room to grow and expand, especially the gazelles that almost all labor growth depends upon.

But what is perhaps most unappreciated about all this is the now-pro-cyclicality of it. Instead of a much more modest junk market that sees a steady flow of corporate failures, we now get them bunched together in massive waves, like those of 2008-09 and 2000-02. That has as yet been unaccounted for as it relates to the overall economic problems, especially labor. The artificial grouping of failures and defaults is not the same as a steady flow of creative destruction that opens up space for new avenues of growth. These failure and default waves are purely destructive without much by way of enhancing intermediation.

That offers a more potent explanation as to why the economy has downshifted so far under the regime of debt and central planning, as the smaller firms that once accounted for all advance are cast aside with the rest. "Good" and valuable firms that foster economic efficiency are thrown out in the downturn and then overwhelmed by the flood of inefficiency that follows in the monetarist response of repression. The bond market is, by all appearances, operating in this manner, once more waiting out the exact moment of realization rather than rationalization.

August 12, 2014 7:03 pm

US housing: Battle scars

An improvement in the sector is crucial to the economic recovery but is being jeopardised


The first thing that strikes you in the low-income suburbs of south Sacramento is the number of overgrown front lawns. Then you see the worn paintwork on the houses and the cracked walls before being struck by the number of eviction notices tacked to broken windows.

These areas of California’s capital had some of the highest foreclosure rates in the US after the housing bust that wiped out $7tn of homeowner equity in the wake of the financial crisis. Since then, Sacramento has seen a rebound, at least on paper. But there are clear signs that it – and many other cities – are stuck in a multiyear housing hangover that has serious implications for economic recovery.

California, Nevada, Arizona and Florida were among the hardest-hit states when the housing market crashed. Home values plummeted by as much as 50 per cent. But when prices bottomed out in 2012, investors such as Blackstone Group and Colony Capital and smaller operators scooped up cheap properties to convert into rental property.

The result of this surge in investment in places such as south Sacramento has been dramatic. The median price of a house in the area increased more than a third from its trough two years ago to $251,900, mirroring other hard-hit areas that attracted investors. A house price recovery led by big financial investors was not exactly the outcome sought by US policy makers, who had hoped that a combination of cheap prices and low interest rates would lure first-time buyers into the market. Wider home ownership would then help to trigger a broader recovery in the US economy, it was hoped.

Even as the number of distressed sales to investors has declined from the frenetic levels of two years ago, traditional homebuyers concerned by increasing prices and future interest rate rises – are staying away.

“A lot of people . . . [still] can’t afford to buy a home,” says Arora Wheeler, a stay-at-home mother and south Sacramento resident. “They’d rather rent because of the expenses associated with a house. The economy is no good right now.”

Recent US housing data have shown renewed weakness. Although sales of previously-owned homes across the country have picked up in the second quarter of this year, the improvement follows a slump at the start of 2014. Demand for new homes, which has decreased sharply over the past six months, fell to its lowest level in almost a year in June, data from the commerce department show.

The state of the market is being watched carefully by policy makers as weak wage growth, rising house prices, restrictive lending rules, limited land supply and higher mortgage rates curtail growth. On Monday, Stanley Fischer, vice-chairman of the Federal Reserve, said that a soft US housing recovery was a factor in disappointing global growth and warned that it could be a long-term phenomenon.

The lack of vigour in the new home sector – a key driver of construction spending and jobsthreatens economic growth. Historically, the sector has accounted for 5 per cent of the world’s largest economy, according to the National Association of Home Builders. That figure, however, has dropped closer to 3 per cent in recent years and is a concern for the Federal Reserve.

Industry watchers say the low interest rate environment and the high level of investment activity is masking the fragility of the recovery. Some parts of the US are once again experiencing bubble-like conditions, but other regions are still struggling.

Conditions in Sacramento demonstrate that the national housing market is much more of a patchwork quilt and is largely predicated on the health of the jobs market. Heavily dependent on the state government and construction sector for employment, Sacramentounlike the neighbouring tech hub of San Francisco – was defined during the crisis by job cuts and wage freezes.

“It’s hard to find a job,” says Ms Wheeler. “My daughter is a pharmacist’s technician . . . she just graduated, she can’t find a job. We need to have jobs to be able to buy [houses].”

Elizabeth Weintraub, a Sacramento property agent, says that homebuyers remain “nervous”. 
“They’d been priced out of the market so long, then they finally had an opportunity [when prices fell] and it got quickly taken away [by investors],” she adds.

Low- and middle-income workers suffered a steeper drop in earnings during the crisis than their wealthier counterparts. Now, Ms Weintraub and Ms Wheeler, along with other Americans, are waiting for a stronger jobs market to spur a more robust housing rebound.

The unemployment rate in the Sacramento metropolitan region stands close to 7 per cent. Although significantly lower than the January 2010 peak of 12.9 per cent, it is still above the national average of 6.2 per cent.

Although the national jobs numbers tell an upbeat story, having recovered all of their losses since 2008, wage growth has been weak. Over the past 12 months it has remained level with inflation at 2 per cent, which is not enough for consumer spending – which accounts for two-thirds of the US economy – to move into higher gear.

The Fed has signalled it will bring its bond-buying stimulus programme to an end in October. But industry watchers are concerned that a rise in interest rates – which many expect to begin next year – will only keep buyers away.

Economists say that a national recovery in housing is dependent on an across-the-board improvement in the labour market, which has so far been patchy. Job and income growth within and between regions across the US – has varied significantly, intensifying the divergences across the country’s housing markets.

US Housing 2

PayScale, a wage-tracking company, says income rises have been enjoyed for the most part by workers in a few fast-growing industries such as energy, healthcare and technology.

Katie Bardaro, an economist at PayScale, says: “Metropolitan areas that have a strong prevalence of one or more of these fast-growing industries are the ones that are seeing some of the best-performing housing markets, as they attract talent, particularly people who then want to form households. Wage growth and job growth are region-specific, propelling select housing markets across the US.”

So while homebuyers in Sacramento are waiting on the sidelines, those in Austin, Texas are fuelling demand for property as technology jobs proliferate.

“The fact that the divergence between successful and struggling housing markets is as wide as it is, is significant,” says Louise Keely, chief research officer at The Demand Institute, a think-tank, and co-author of A Tale of 2000 Cities . “We see no reason for these divergences to lessen,” she adds. “If anything, they will persist.”

US Housing 3

The continuation of the uneven recovery, warns Ms Keely, could lock some struggling places into “a self-perpetuating downward spiral”.

Back in Sacramento, Linda Swanson, a property broker, says that although service industry employment has risen in recent months, these jobs are not propelling more buyers into the housing market.

Areas such as Natomas, in north Sacramento, she says, still show signs of damage. These middle-income communities remain half-built and lie largely empty

Places like this will never reach those boom-time prices again,” she says as she looks out on to streets devoid of people or cars. Sacramento is still in a lot of trouble.”

Homebuilders, meanwhile, are holding on to once-prime plots in Natomas in the hope that she is wrong.

Austin: Prices lifted by the tech sector

Cyclists pass beneath the downtown skyline on the hike and bike trail on Lady Bird Lake in Austin, Texas September 18, 2012. The 10.1 mile trail runs along the Colorado river through downtown. In Austin, flip-flop-wearing University of Texas students mingle with coat-tie-and-boot-clad state lawmakers and technology workers in jeans. The Lone Star State capital prides itself on its slacker vibe, but it's also the place where a college student named Michael Dell once started a computer business and where Whole Foods Market started and has its headquarters. Picture taken September 18, 2012. REUTERS/Julia Robinson (UNITED STATES - Tags: CITYSPACE SOCIETY TRAVEL) - RTR38JZI

Julia Kahlig-Garuba moved to Austin from New York to start her own cosmetics line.

“As entrepreneurs we could barely afford our apartment much less an extra storage place,” says the former lawyer. “We reached a point in New York where It didn’t make [financial] sense to live there.” 

Young entrepreneurs keen to keep costs low have been drawn by Austin’s low taxes. Tech companies, from Apple and Google to Dropbox, have been expanding aggressively in the city.

Relative affordability combined with a favourable climate have fuelled demand in Austin’s housing market. The population of the metropolitan area has grown by 20 per cent since 2010 to 1.8m – the urban centre accounts for 851,881 – and is expected to reach 5m by 2050, but residents question whether the growth is sustainable.

Occupancy levels are almost at capacity, creating a crunch for residential properties and pushing prices higher. With as many as 150 people moving to Austin daily some question if the city has the adequate infrastructure to support growth in the coming years.

Austin Texas map

“When visitors shower the city with praise and say they want to move here, I say, ‘Oh really? I hear Denver is nice too’,” quipped one Austin native concerned that affordability was becoming more of a problem.

Home sales jumped almost 20 per cent in 2013 compared with the previous year while average prices increased almost 10 per cent to above $200,000, according to the Austin Board of Realtors. The number of listings dropped 20 per cent over the same period.

“We have to be smart with our growth,” says Bill Evans, president of the board of realtors. Although construction activity has picked up, Austin has tighter building regulations than elsewhere in Texas, which is restricting supply.

“We have to make sure it’s not difficult for developers to put houses on the ground. There has to be more supply and there have to be places for those not making at least $90,000,” says Mr Evans.

Austin: In numbers

851,881 (up 26% since 2000)
Median home price
Median annual income
Employment since 2000
Up 21%
Families below poverty line

Some worry that Austin will tread the same path as New York or San Francisco, where affordable housing is in short supply.

Neighbourhoods that saw houses being sold for $210,000 four years ago are now marking up properties to $700,000,” says Eric Bramlett, a property agent. If they are priced appropriately . . . [they] will generally be sold within a week.”

Some analysts maintain the city will continue on its upward trajectory as long as job growth holds up, but others expect price growth to moderate.

How long can we keep pace with [this price growth]? I fear we will hit a ceiling,” says Uday Tekumalla, who moved to Austin to work for Dell. “A lot of people we see moving here [have come] from more expensive places. If they don’t see the cost benefit . . .  what’s the point?”

Akron: A city where time stood still

C72P3K Road to downtown of Akron , Ohio

When Patty Latham sold her house in Akron, Ohio, she did not think she would buy it back 20 years later in 2012 at a $10,000 discount.

The Midwestern city, known for its rubber and automotive industriesGoodyear and Bridgestone were big local employers reeled when thousands of blue-collar jobs moved offshore in the 1970s and 1980s. No new industries filled the void. The financial crisis dealt another blow, draining city government coffers and depleting the savings of Akron residents.

It’s almost as if the jobs market doesn’t exist here,” says Ms Latham, a nurse. “This is not a big city. When you lose that many middle class jobs over time, it creates a toxic environment.”

Although house prices did not drop as dramatically as they did in boom-and-bust towns such as Sacramento, the number of struggling homeowners swelled, properties fell into foreclosure and hundreds became so dilapidated they had to be torn down by local authorities to prevent blight and slum-like conditions. Vacant plots litter the city.

Akron Ohio

“The downturn vastly made worse the problems we already had,” says Ms Latham.

Today, Akron is among the most affordable places to live in the US, but it is also a symbol of the downside of the country’s hit-and-miss housing recovery. A modest house for a family of four sells for $50,000. But in some rundown areas houses can cost as little as a cheap car at $6,000.

Even so, the lack of jobs and income growth is keeping people away. Unskilled workers and high-school leavers struggle to find basic service jobs, while graduates have left in search of work elsewhere.

Housebuilders are only developing more expensive properties on the outskirts of Akron, targeting professionals earning more than $100,000 a year.

Akron: In numbers

195,275 (a fall of 10% since 2000)
Median house price
Median annual income
Employment since 2000
Down 16%
Families below poverty line

Source: Demand Institute

“You don’t build houses in the city if there aren’t any jobs or if confidence isn’t there. It’s as simple as that,” says Carmine Torio of a regional homebuilders’ association. “The number of young families are not forming like they used to.”

Although the overall housing market is weak, the rental apartment sector has surged as it has in other US cities. The median entry-level rent price shot from $536 in 2013 to $995 in 2014, according to the National Association of Realtors. Partly as a result demand for social housing has also risen.

Market-rate rental apartments have rents that are just too high, but these are driven by the private sector so there is nothing we can do about this,” says Helen Tomic, at the city’s department of planning and urban development.

“We’ve built 20 to 30 houses [since the department began its demolition programme]. We know we need to construct more, affordable houses, but we’re waiting for the housing market to pick up.”

Copyright The Financial Times Limited 2014