Contemporary Finance's Defect

Doug Nolan


October 3 - CNBC (Jeff Cox): "Federal Reserve Chairman Jerome Powell said the central bank has a ways to go yet before it gets interest rates to where they are neither restrictive nor accommodative. In a question and answer session Wednesday with Judy Woodruff of PBS, Powell said the Fed no longer needs the policies that were in place that pulled the economy out of the financial crisis malaise. 'The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don't need those anymore. They're not appropriate anymore… Interest rates are still accommodative, but we're gradually moving to a place where they will be neutral… 'We may go past neutral, but we're a long way from neutral at this point, probably.'"

Market bulls grimaced. Powell: "We may go past neutral, but we're a long way from neutral at this point…" CNBC's Jim Cramer called it "amateurish." Chairman Powell was certainly candid, something shockingly unusual for a Fed chair. So atypical was his candor, the Chairman was misconstrued as a novice unschooled in the art of modern central banking.

The bottom line is the Fed waited much too long to begin normalizing monetary policy. Moreover, they pre-committed to an extremely gradual path of rates increases. This policy approach essentially ensured that so-called "tightening" measures would fail to tighten financial conditions. Over-liquefied and speculative markets were content to look right through them, confident that cheap liquidity and easy Credit conditions would run unabated. Clearly, stock gains in the multiple thousands of basis points easily counteracted a couple hundred basis point increase in short-term borrowing costs.

I'll add that this issue of a so-called "neutral" rate only confused the issue. What Fed funds target rate would be just right, neither stimulating nor restricting? Well, in this age of market-based finance, market dynamics have a profound effect on economic performance. "Risk on" in the marketplace ensures strong wealth effects, readily available cheap finance for spending and investment, and easy Credit Availability (throughout the economy) more generally. On the other hand, "Risk Off" would see a tightening of financial conditions, tighter Credit, diminished perceived wealth and more restrictive spending and investing.

Perhaps there's a view that a "neutral" policy would be a target rate that balances "Risk on" and "Risk Off." In a policy paper perhaps, but that's not the way markets function in the real world. In reality, if financial conditions remain too loose for too long, powerful Speculative Dynamics take hold. And once inflation psychology takes deep root in the asset markets, the commanding spell will be broken only from the shock of much tighter financial conditions and painful losses. "Housing prices only go up." "Buy and Hold. Stocks for the long-term."

There's further pertinent monetary policy analysis. Back in 2013, chairman Bernanke resorted to "the Fed will push back against a tightening of financial conditions." It received little attention at the time, but it was a fateful declaration. The backdrop was one where the Fed had employed extraordinary policy measures, inflating securities markets as its primary post-crisis stimulus mechanism. It was Bernanke paddling ever deeper into uncharted waters, explicitly signaling to the markets that the Federal Reserve was ready to respond to an equities market pullback with additional monetary stimulus. This was a game changer for market perceptions and played a major role in exacerbating Bubble Dynamics.

For years now, markets have been operating under the presumption that the Fed would immediately pull back from "normalization" in the event of fledgling risk aversion and/or stock market weakness. Chairman Powell on Wednesday afternoon threw the proverbial monkey wrench into this central market perception.

September's 3.7% Unemployment Rate was the lowest since December 1969. Year-over-year Average Hourly Earnings came in at 2.8% and are poised to soon surpass 3% for the first time since April 2009. The ISM Non-Manufacturing Index jumped three points to the strongest reading since August 1997. The ISM Employment component surged almost six points to 62.4, the highest level in data going back to 1997.

Federal Reserve Bank of Chicago president Charles Evans (on Bloomberg TV): "I think that my own take on a neutral longer run funds rate is 2.75%. So, I think getting policy up to us slightly restrictive setting, 3%, 3.25% would be consistent with the strong economy and good inflation that we're looking at."

When even the most perennially dovish Federal Reserve president uses the word "restrictive" and discusses taking the Fed funds up another 100 bps, one has to take notice.

It took a while, but central bankers have become less complacent with respect to inflation risks. For too long they have been fixated on deflation, in spite of the greatest securities and asset market inflation the world has ever experienced. Clearly, the Fed didn't see a 3.7% unemployment rate coming. More importantly, they never anticipated massive late-cycle fiscal stimulus. A booming economy and Trillion dollar deficits? No way. Way.

They were blindsided by the rise of tariffs and protectionism. To be sure, the Fed today has no way to gauge the economic and inflationary consequences associated with a prolonged trade war with China. Rather suddenly, there's a murky future out there that has Fed officials fretting inflation making a dazzling revival on their watch.

All of a sudden, 2% short rates seem incongruous with a booming economy, rising price pressures and the risk of a trade-related inflationary shock. And if central bankers are now on edge, markets better be on edge. This is new and awkward. But what about faltering EM and slowing global growth? All the overcapacity in China and globally?

Well, there is now a not unlikely scenario of faltering markets concurrent with some stubborn inflationary pressures. The GSCI commodities Index was up another 1.7% this week, with WTI jumping past $74. Confidence that any tightening of financial conditions (i.e. weak equities) would be met with resolute measures from the Fed (and global central banks) is increasingly dubious. Ten-year Treasury yields jumped this week to highs since 2011.

I continue to think back to the nineties. And to know where I'm coming from, I was convinced that finance had fundamentally changed in the nineties. No one, it seemed, was paying any attention. I would share my analysis with market professionals, academics, journalists and even Federal Reserve officials and the response was some variation of "Doug, you don't understand." After all these years, this most critical of issues remains unsolved.

I began posting the CBB analysis back in 1999, on a weekly basis attempting to explain what had changed; what was still changing; and what might be some of the momentous ramifications associated with the combination of unfettered "Wall Street finance" and "activist" central bank monetary management.

It was not until 2007, when Pimco's Paul McCulley coined the term "shadow banking," that some began to take some notice. But with the following year's "greatest financial crisis since the Great Depression," desperation saw the focus shift to extreme monetary stimulus and basically using any means possible to reflate the securities markets and Credit more generally. It was not only that concerns for the inherent instability of contemporary market-based finance were pushed to the side. This high-powered finance machine was the centerpiece of central bank reflationary policymaking - around the world.

In an early CBB, I resorted to my CPA training and went through (in painful detail) a series of debit and Credit journal entries to demonstrate how the GSEs would borrow in the money markets to purchase MBS in the marketplace, and how this "liquidity" could be "recycled" back through the money markets and borrowed again and again. In short, the GSEs would issue new short-term liabilities (IOUs) in exchange for "immediately available funds" (IAF). The IAF provided the purchasing power for MBS, with the GSE's transferring these funds to the MBS seller. The seller would then deposit these IAF right back into the money market, where the GSE's (or others) could borrow them repeatedly (exchanging additional short-term IOUs for IAF).

This was akin to the old bank deposit multiplier (fractional reserve banking) but with zero reserve requirements. Traditionally, a bank might lend 80% of a new $100 deposit (20% reserve requirement), with this loan creating $80 of new funds that would be deposited at other institutions (where the next bank could lend 80% of the $80 deposit, then the next 80% of $64 and so on).

I argued that contemporary non-bank market-based finance, operating outside of bank reserve requirements, created an "infinite multiplier effect." And I posited that "unfettered finance" essentially changed everything (market dynamics, policy, saving & investment, economic structure, etc.) In particular, "money" would circulate freely throughout the securities markets, inflating asset prices and incentivizing speculation. In particular, there was essentially unlimited cheap finance available for securities speculation, ensuring price Bubbles inflated by self-reinforcing speculative leverage. "Money" could be borrowed in, for example, the "repo" market to purchase securities, where the proceeds from the sale would be recycled right back into the money markets where it would be available to borrow again and again without limit.

It amounted to the greatest transformation in financial and market structure in history, all backstopped by the "activist" Federal Reserve and global central bankers. It was a New Era - a New Paradigm - that worked miraculously until its 2008 malfunction risked bringing down the global financial system. Most importantly, this incredible system of ever-expanding speculative leverage, seemingly endless liquidity and powerful asset Bubbles has a fundamental Defect: it doesn't function in reverse (with deleveraging). Yet rather than addressing what went so terribly wrong in 2008, global central banks resuscitated and then bolstered this deviant financial apparatus, sending it on its merry way to reflate global markets and economies.

The past decade has seen similar dynamics to the mortgage finance Bubble period: expanding leverage and liquidity spinning around the system, promoting self-reinforcing securities and asset inflation. The big difference during this cycle has been its unprecedented global scale. Central bankers and market bulls are fond of asserting that leverage is not an issue these days. Yet the most egregious leverage throughout this cycle has been in central bank and sovereign balance sheets. Liquidity created in the expansion of central bank balance sheets, in particular, circulated through the securities and funding markets where it has been "recycled" again and again…

A few examples: A hedge fund borrows at zero in Japan to lever in a higher-yielding dollar denominated EM debt "carry trade." This new liquidity flows into an EM banking system, where it is exchanged for local currency by the domestic central bank. The EM central bank then exchanges these dollar balances for U.S. Treasury bonds in the marketplace. The seller of Treasuries, say a hedge fund, then uses the proceeds from this short sale to leverage U.S. corporate debt. The corporate treasurer then uses the proceeds from the debt issue to repurchase equity shares, creating liquidity in the marketplace for the purchase of U.S. equities or even international shares - where it can begin the cycle anew.

Example 2: The ECB, expanding its liabilities, creates "money" to purchase Italian bonds in the marketplace. The seller transfers the sales proceeds to one of the large German banks where it is held on deposit. The German bank then uses this liquidity to purchase U.S. agency securities from a U.S. broker/dealer that had previously acquired these GSE-issued securities with short-term money market "repo" financing. This "repo" loan is repaid, creating money market liquidity to finance other securities speculations. Or instead, the German bank (rather than holding deposits) buys short-term German debt from a hedge fund happy to short these securities at negative yields (borrow at negative interest-rates) to finance holdings of higher-yielding instruments in the U.S.

Example 3: An Asian hedge fund shorts (sells) one-year Singapore sovereign debt at 1.88% and uses the proceeds to purchase Chinese corporate debt yielding 10%. A Chinese bank swaps the Singapore dollars into U.S. dollars, and then deposits these funds with the People's Bank of China (PBOC). The PBOC then exchanges these U.S. dollar balances for purchasing Treasuries. The U.S. Treasury then uses this "money" to service its debts, liquidity that will then be available to purchase additional securities in the marketplace (or, perhaps, "money" to spend on imported Chinese goods, where the dollars make their way to the PBOC and then back into the Treasury market).

Example 4: A U.S. pension fund shorts (sells) Treasuries to finance higher-yielding dollar-denominated EM debt. The pension fund buys bonds directly from a EM government, with the EM central bank exchanging local currency for dollar balances. The EM central bank then uses these dollars to purchase Treasuries, recycling liquidity right back to U.S. securities markets. The seller of Treasuries, a hedge fund operating an "all weather" strategy, uses the proceeds from shorting Treasuries to finance a leveraged portfolio of stocks, fixed-income, EM securities and commodities - "recycling" this liquidity right back into U.S. and global financial markets.

Just a few basic examples of how various leveraged strategies fuel abundant liquidity flows around the globe. I suspect some of the greatest leverage is associated with sophisticated derivatives strategies - cross currency "swaps," myriad bond "carry trades," the proliferation of equities option strategies and ETF arbitrage, to name but a few. And as market prices rise and leverage increases, self-reinforcing liquidity abundance feeds the perception that the party can last indefinitely.

The amount of global speculative leverage that has accumulated over the past (almost) decade is impossible to know. There is no transparency. Most assume it's not an issue. We'll know more over the coming months, but there is ample support for the view of unprecedented global speculative excess - across regions, countries and asset classes. I have posited that the global Bubble has been pierced at the "Periphery," and that contagion effects have begun gravitating to the "Core." This week offered additional confirmation of this thesis.

Let's begin at the "Periphery." A period of relative EM instability came to an end. The South African rand sank 4.3% this week, with the Chilean peso down 3.0% and the Colombian peso falling 2.0%. Asian currencies were under notable pressure, with the South Korean won down 1.9%, the Indonesian rupiah 1.8%, the Indian rupee 1.7%, and the Thai baht 1.6%. The Russian ruble declined 1.6%, the Polish zloty 1.3% and the Turkish lira 1.3%. As for major equities indices, stocks in both Turkey and India sank 5.1%. Equities fell 4.4% in Taiwan and 3.7% in South Korea. Argentine stocks sank 9.8%, with Mexico down 2.9%.

As much as currencies and stocks were under pressure, the more ominous EM moves were in bond markets. Ten-year (local) sovereign yields surged 33 bps in Indonesia, 26 bps in Russia, 21 bps in South Africa, and 14 bps in Hungary. Dollar-denominated EM debt provided no safe haven. Venezuela's 10-year dollar yields surged 70 bps to 38.55%; Argentina's 64 bps to 9.90%; and Turkey's 52 bps to 7.86%. Ten-year dollar yields jumped 19 bps in Indonesia, 19 bps in Chile, 18 bps in Russia, 17 bps in Mexico and 14 bps in Colombia.

How were markets faring at the "Periphery of the Core"? Italian 10-year yields surged another 28 bps to 3.42%, the high going back to March 2014. Italian bank stocks were hit another 4.7%, bringing 2018 losses to 19.2%. Contagion saw Greek yields jump 33 bps to 4.45%, with Greece's major equities indices down 5.0%. European bank stocks fell another 1.9% this week. Equities indices were down 2.4% in France and 2.6% in the UK. UK yields jumped 15 bps to the high since January 2016.

It was as if the dam finally broke. Ten-year Treasury yields jumped 17 bps this week to 3.23% (high since May 2011). Interestingly, long-bond yields were under even more pressure, as yields rose 20 bps to 3.41% (high since July '14). Mortgage securities fell under intense pressure, with benchmark MBS yields jumping 20 bps - surpassing 4.00% for the first time since July 2011. The old mortgage duration problem: When rates jump, borrowers are less likely to refinance their mortgages or upgrade to new homes. Investment-grade corporate debt was under pressure as well, with the LQD ETF declining 1.7% to a multi-year low.

The DJIA traded to a record high Wednesday before reality began to set in. The S&P500 also reached all-time highs in Wednesday trading before selling took over. The broader market was under heavy selling pressure.

It certainly had the appearance of incipient fear of tightening financial conditions - contagion having made important headway from the "Periphery" to the "Core." If, as it appears, global "Risk Off" is attaining some momentum, my thoughts return to Contemporary Finance's Defect: it doesn't function in reverse.

Notice How Quickly Market Psychology Changed?


“How did you go bankrupt?”
“Two ways. Gradually, then suddenly.”


― Ernest Hemingway, The Sun Also Rises


On the surface, nothing much changed last week. The Fed, as expected, raised short-term interest rates very modestly, the US, Canada and Mexico cut a new NAFTA deal (kind of a pleasant surprise), unemployment fell again, Trump continued to tweet while Democrats and Republicans continued to express their mutual disdain via dirty tricks and contrived insults. Business as usual, in other words, in our dysfunctional new normal.

Yet for some reason financial market psychology suddenly shifted from euphoria to terror.

Long-term interest rates spiked…


10-year Treasury yield market psychology


…the dollar rose…


source: tradingeconomics.com


… and stocks tanked. The NASDAQ especially was slammed by the sudden reversal of its previously-bulletproof FAANGs:

NASDAQ market psychology


What happened? Apparently the weight of accumulating problems finally became too great to ignore. Interest rates had been rising for a while as inflation bumped up against Fed targets, but traders only noticed when the 10-year Treasury yield pierced 3%. This cycle’s housing boom had been moderating since June, but lately the bottom seems to have dropped out, generating headlines like this:

Manhattan home sales tumble in market clogged with listings

Vancouver home sales mark steady decline

For Sale home supply surges in hot West Coast markets

Bond-market bloodbath likely to hit mortgage rates soon


And the emerging market crisis – easily managed if the dollar just went back down – suddenly feels permanent as rising interest rates pull the dollar along for the ride. Here’s a recap of last week’s EM action, courtesy of Doug Noland’s Credit Bubble Bulletin:
The South African rand sank 4.3% this week, with the Chilean peso down 3.0% and the Colombian peso falling 2.0%. Asian currencies were under notable pressure, with the South Korean won down 1.9%, the Indonesian rupiah 1.8%, the Indian rupee 1.7%, and the Thai baht 1.6%. The Russian ruble declined 1.6%, the Polish zloty 1.3% and the Turkish lira 1.3%. As for major equities indices, stocks in both Turkey and India sank 5.1%. Equities fell 4.4% in Taiwan and 3.7% in South Korea. Argentine stocks sank 9.8%, with Mexico down 2.9%. 
As much as currencies and stocks were under pressure, the more ominous EM moves were in bond markets. Ten-year (local) sovereign yields surged 33 bps in Indonesia, 26 bps in Russia, 21 bps in South Africa, and 14 bps in Hungary. And dollar-denominated EM debt provided no safe haven. Venezuela’s 10-year dollar yields surged 70 bps to 38.55%; Argentina’s 64 bps to 9.90%; and Turkey’s 52 bps to 7.86%. Ten-year dollar yields jumped 19 bps in Indonesia, 19 bps in Chile, 18 bps in Russia, 17 bps in Mexico and 14 bps in Colombia.

The lesson? When market psychology changes it frequently does so overnight from the point of view of people who weren’t paying attention. But for those who were watching things deteriorate under the surface, the change is actually long overdue.

So the real question isn’t “why is everything changing?”, but “why did it take so long?”

And of course: “If this is the start of another 2008-style Great Unraveling, how can we profit from it?”

Right now the obvious answer is to short everything in sight, joining the long-suffering short sellers who on Thursday and Friday made back a small bit of their past few years’ losses. Here, for instance, is last week’s action in the most shorted of all stocks, Tesla (full disclosure — DollarCollapse staff are happily short this one):

Tesla market psychology


And last but definitely not least: “How far out of control will central banks allow the leveraged speculating community to spin before they reverse course and start cutting interest rates and ramping up next-gen QE programs — and how deeply negative will interest rates have to go to stop the bleeding?

If this sounds like paradise for precious metals, that’s because it is – in theory. Negative interest rates offset the carrying costs of gold and silver stored in vaults, making bullion obviously superior to dollars/euros/yen stored in bank accounts. An added attraction is the new generation of gold-backed debit cards and cryptocurrencies that add portability to these ancient forms of money.

History doesn’t repeat perfectly of course, but this set-up is close enough.


The Real Causes — and Casualties — of the Housing Crisis

mortgage housing crisis bubble

The U.S. is not about to see a rerun of the housing bubble that formed in 2006 and 2007, precipitating the Great Recession that followed, according to experts at Wharton. More prudent lending norms, rising interest rates and high house prices have kept demand in check.

However, some misperceptions about the key drivers and impacts of the housing crisis persist – and clarifying those will ensure that policy makers and industry players do not repeat the same mistakes, according to Wharton real estate professors Susan Wachter and Benjamin Keys, who recently took a look back at the crisis, and how it has influenced the current market, on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)

According to Wachter, a primary mistake that fueled the bubble was the rush to lend money to homebuyers without regard for their ability to repay. As the mortgage finance market expanded, it attracted droves of new players with money to lend. “We had a trillion dollars more coming into the mortgage market in 2004, 2005 and 2006,” Wachter said. “That’s $3 trillion dollars going into mortgages that did not exist before — non-traditional mortgages, so-called NINJA mortgages (no income, no job, no assets). These were [offered] by new players, and they were funded by private-label mortgage-backed securities — a very small, niche part of the market that expanded to more than 50% of the market at the peak in 2006.”

Keys noted that these new players brought in money from sources that traditionally did not go towards mortgages, which drove down borrowing costs. They also increased access to credit, both for those with low credit scores and middle-class homeowners who wanted to take out a second lien on their home or a home equity line of credit. “In doing so, they created a lot of leverage in the system and introduced a lot more risk.”

Credit expanded in all directions in the build-up to the last crisis – “any direction where there was appetite for anyone to borrow,” Keys said. “An important lesson from the crisis is that just because someone is willing to make you a loan, it doesn’t mean that you should accept it.”

Lessons from those experiences are relevant to current market conditions, Keys said. “We need to keep a close eye right now on this tradeoff between access and risk,” he said, referring to lending standards in particular. He noted that a “huge explosion of lending” occurred between late 2003 and 2006, driven by low interest rates. As interest rates began climbing after that, expectations were for the refinancing boom to end. A similar situation is playing out now in a rising interest rate environment. In such conditions, expectations are for home prices to moderate, since credit will not be available as generously as earlier, and “people are going to not be able to afford quite as much house, given higher interest rates.”

Wachter has written about that refinance boom with Adam Levitin, a professor at Georgetown University Law Center, in a paper that explains how the housing bubble occurred. She recalled that after 2000, there was a huge expansion in the money supply, and interest rates fell dramatically, “causing a [refinance] boom the likes of which we hadn’t seen before.” That phase continued beyond 2003 because “many players on Wall Street were sitting there with nothing to do.” They spotted “a new kind of mortgage-backed security – not one related to refinance, but one related to expanding the mortgage lending box.” They also found their next market: Borrowers who were not adequately qualified in terms of income levels and down payments on the homes they bought — as well as investors who were eager to buy.

According to Wachter, a key misperception about the housing crisis is that subprime borrowers were responsible for causing it. Instead, investors who took advantage of low mortgage finance rates played a big role in fueling the bubble, she pointed out. “There’s a false narrative here, which is that most of these loans went to lower-income folks. That’s not true. The investor part of the story is underemphasized, but it’s real.”
 
The evidence shows that it would be incorrect to describe the last crisis as a “low- and moderate-income event,” said Wachter. “This was an event for risk-takers across the board.
Those who could and wanted to cash out later on – in 2006 and 2007 — [participated in it].”
Those market conditions also attracted borrowers who got loans for their second and third homes. “These were not home-owners. These were investors.”

Wachter said “some fraud” was also involved in those settings, especially when people listed themselves as “owner/occupant” for the homes they financed, and not as investors. They took advantage of “underpriced credit,” which she and her co-author Andrey Pavlov detail in a research paper titled “Subprime Lending and Real Estate Prices.” Those borrowers had “put” options and “non-recourse” loans, which meant they could therefore “walk away from [their] mortgage [obligations],” she said. “If you’re an investor walking away, you have nothing at risk.”

Who bore the cost of that back then? “If rates are going down – which they were, effectively – and if down payment is nearing zero, as an investor, you’re making the money on the upside, and the downside is not yours. It’s the bank’s [downside],” Wachter said. There are other undesirable effects of such access to inexpensive money, as she and Pavlov noted in their paper: “Asset prices increase because some borrowers see their borrowing constraint relaxed. If loans are underpriced, this effect is magnified, because then even previously unconstrained borrowers optimally choose to buy rather than rent.”

After the housing bubble burst in 2008, the number of foreclosed homes available for investors surged. That actually helped homeowners who held properties that lost value, especially those that were underwater. “Without that Wall Street step-up to buy foreclosed properties and turn them from home ownership to renter-ship, we would have had a lot more downward pressure on prices, a lot of more empty homes out there, selling for lower and lower prices, leading to a spiral-down — which occurred in 2009 — with no end in sight,” said Wachter. “Unfortunately, [those] people who were foreclosed upon and couldn’t own had to rent. But in some ways it was important, because it did put a floor under a spiral that was happening.”

The Hit to Minorities

Another commonly held perception is that minority and low-income households bore the brunt of the fallout of the subprime lending crisis. “The problem is that the most vulnerable households to recession are minority and low-income households,” Wachter said. “The fact that after the [Great] Recession these were the households that were most hit is not evidence that these were the households that were most lent to, proportionally.” A paper she wrote with coauthors Arthur Acolin, Xudong An and Raphael Bostic looked at the increase in home ownership during the years 2003 to 2007 by minorities. “The increase was higher in the majority area than the minority area,” she said. “So the trope that this was [caused by] lending to minority, low-income households is just not in the data.”

Wachter also set the record straight on another aspect of the market — that millennials prefer to rent rather than to own their homes. Surveys have shown that millennials aspire to be homeowners. The problem is that they find it harder to secure housing loans as lenders have tightened their requirements after the defaults that occurred in the last crisis. “One of the major outcomes – and understandably so – of the Great Recession is that credit scores required for a mortgage have increased by about 100 points,” Wachter noted. “So if you’re subprime today, you’re not going to be able to get a mortgage. And many, many millennials unfortunately are, in part because they may have taken on student debt. So it’s just much more difficult to become a homeowner.”

Keys noted that many borrowers, especially first-time borrowers, use FHA (Federal Housing Administration) programs, where they make 3% down payments, or programs for veterans where in many cases the down payment could be zero. “So while down payments don’t have to be large, there are really tight barriers to access and credit, in terms of credit scores and having a consistent, documentable income.” In terms of credit access and risk, since the last crisis, “the pendulum has swung towards a very tight credit market.”

Signs of the Wounded

Chastened perhaps by the last crisis, more and more people today prefer to rent rather than own their home. “The rate of growth in the transforming of the home-ownership stock to the renters stock has slowed considerably,” said Wachter. Homeownership rates are not as buoyant as they were between 2011 and 2014, and notwithstanding a slight uptick recently, “we’re still missing about 3 million homeowners who are renters.” Those three million missing homeowners are people who do not qualify for a mortgage and have become renters, and consequently are pushing up rents to unaffordable levels, Keys noted.

Rising housing prices no doubt exacerbate the overall inequality in wealth and income, according to Wachter. Prices are already high in growth cities like New York, Washington and San Francisco, “where there is an inequality to begin with of a hollowed-out middle class, [and between] low-income and high-income renters.” Residents of those cities face not just higher housing prices but also higher rents, which makes it harder for them to save and eventually buy their own house, she added.

Although housing prices have rebounded overall, even adjusted for inflation, they are not doing so in the markets where homes shed the most value in the last crisis. “The comeback is not where the crisis was concentrated,” Wachter said, such as in “far-out suburbs like Riverside in California.” Instead, the demand — and higher prices – are “concentrated in cities where the jobs are.”

Even a decade after the crisis, the housing markets in pockets of cities like Las Vegas, Fort Myers, Fla., and Modesto, Calif., “are still suffering,” said Keys. “In some of these housing markets, there are people who are still under water on their mortgage, and [they] continue to pay.” He noted that markets that have seen the biggest shifts – “the Phoenixes and the Las Vegases” — are experiencing a relatively depressed housing market overall; it may be a matter of time before they recover along with the rest of the economy.

Clearly, home prices would ease up if supply increased. “Home builders are being squeezed on two sides,” Wachter said, referring to rising costs of land and construction, and lower demand as those factors push up prices. As it happens, most new construction is of high-end homes, “and understandably so, because it’s costly to build.”

What could help break the trend of rising housing prices? “Unfortunately, [it would take] a recession or a rise in interest rates that perhaps leads to a recession, along with other factors,” said Wachter. She noted that some analysts speculate that another recession could take place by 2020.

Regulatory oversight on lending practices is strong, and the non-traditional lenders that were active in the last boom are missing, but much depends on the future of regulation, according to Wachter. She specifically referred to pending reforms of the government-sponsored enterprises – Fannie Mae and Freddie Mac – which guarantee mortgage-backed securities, or packages of housing loans. “They’ve been due to be reformed for 10 years now.” Although the two organizations “are part of a stable lending pattern right now, the taxpayer is a 100% at risk” if they were to face a crisis.


U.S. Stocks Are Still Leading the World. Here’s Their Secret

U.S. Stocks Are Still Leading the World. Here’s Their Secret
Photo: Brianna Santellan



No man is an island, John Donne wrote, but the U.S. stock market’s performance is increasingly separated from the rest of the world. That divergence has widened in recent months, coincident with the escalation of tariffs and trade tiffs between America and its trading partners, notably China. But Wall Street’s outperformance stretches back far further, almost to the beginning of the bull market.

The important questions for investors are: What has accounted for U.S. stocks’ stellar showing and, more important, will it continue?

The divergence has been especially acute recently. In the 12 months through last Tuesday, the S&P 500 was up 15.68%, while the MSCI Asia Pacific index was down 2.41%. Until early June, the two had been roughly in sync, according to a chart distributed by Peter Boockvar, chief strategist for Bleakley Advisory Group, to his firm’s clients. “This is not a sustainable trend, and something has to give in one direction or another as the Asian region is one-third of global [gross domestic product], greater than North America and Europe,” he comments. Specifically, Japan has the biggest weighting in the MSCI Asia Pacific index, some 38%, followed by China with 18%, Australia, 11%, South Korea, 8%, and Taiwan, 7%, with others accounting for the rest. 
Looking back to the end of 2010, Bespoke Investment Group finds that the relatively more robust performance of the MSCI U.S. index versus the MSCI World ex-U.S. index has been driven “consistently by stronger earnings,” although higher valuations also played a part.

BCA Research reaches the same conclusion, although it notes that profits in Japan have kept pace with those in the U.S. in recent years, but only after a long stretch of weak growth. BCA also sees investors responding to better American profits by awarding higher price/earnings multiples to U.S. shares.


The stronger earnings growth and higher valuations attest to the strength of the U.S. economy, which recovered much sooner and more strongly than those elsewhere, owing to Washington’s relatively rapid policy response. Fiscal stimulus was provided in the wake of the financial crisis; the government further helped by putting capital into the banks (which was repaid to the taxpayers at a profit). Most particularly, the Federal Reserve quintupled the size of its balance sheet from its precrisis level. In contrast, the European Central Bank actually raised interest rates in 2011 to fight phantom inflation, while forcing fiscal austerity in the euro zone, especially in Greece.

But the U.S. market’s outperformance also is tilted by technical factors. Notably, its indexes are more heavily weighted toward sectors with faster profit growth. For instance, 12-month forward earnings in the technology sector have jumped by almost 160% globally since 2010, while those for materials companies have increased by just 25%, according to BCA. But the dominance of Big Tech in the American economy means that the sector’s weighting is 15 percentage points higher in the U.S. index than in the global one. Conversely, the U.S. weighting in weak materials stocks is five percentage points below that in the global average.

Bespoke Investment Group concludes that, if the weights were equal in both indexes, the performance of the non-U.S. index would more than double.

But profits still are the main factor. The bad news is that BCA sees corporate profit growth slowing in 2019. Earnings per share also are likely to get less of boost from stock repurchases, in light of high valuations and rising interest rates.

Profit margins are apt to be squeezed by increased wage growth brought about by the tight labor market, a welcome change on Main Street, if not Wall Street. BCA also looks for a stronger dollar to eat into earnings. The firm estimates that a 5% appreciation in the trade-weighted greenback reduces S&P 500 earnings by 1% over the subsequent 12-18 months. This year, the buck has risen by 6.2%, on a trade-weighted basis, and BCA expects further increases.

Global growth is likely to weaken, in part because the U.S. is running out of excess capacity. Emerging markets, meanwhile, are struggling. BCA also thinks “the policy environment will become more challenging.” The EU is limiting internet companies’ ability to collect personal data, while the Trump administration is targeting social-media companies for allegedly curtailing conservative viewpoints, it notes. Then there are the U.S.-China trade tensions.

BCA thus sees potential for disappointment in investors’ “wildly optimistic” earnings expectations. The average S&P 500 company is forecast to increase earnings at an annual rate of 16.5% over the next three to five years, according to the forecasting firm. That’s six percentage points higher than estimates just three years ago, and only exceeded by the “euphoric projection” of 18.7% earnings gains in the giddy dot-com days of 2000.

Strong earnings have fueled U.S. stocks’ outperformance throughout this bull market. That fuel might start running low next year.


The Siren Song of Left-Wing Populism

Cristóbal Rovira Kaltwasser  

Nicholas Maduro Evo Morales

SANTIAGO – Social democratic parties around the world are struggling. In France’s 2017 presidential election, the candidate for the Socialists – once the mainstream party of the French left – received a mere 6% of the vote, and the party has since been forced to sell its headquarters on the chic Rue de Solférino in Paris.

Likewise, Germany’s Social Democratic Party (SPD) gained just 20% of the vote in that country’s federal election last fall – the party’s worst showing in the postwar period. And the Spanish Socialist Workers’ Party (PSOE) secured just over 20% of the vote in the 2015 and 2016 general elections, which is half the share it received a decade ago.

Meanwhile, in each of these countries, left-wing populist parties have been capturing a significant share of the vote. Twenty percent of French voters cast ballots for Jean-Luc Mélenchon’s La France Insoumise (France Unbowed) in 2017; 9% of Germans voted for Die Linke (The Left); and 21% of Spaniards backed Podemos.

A growing number of pundits and academics now believe that left-wing populism is the best strategy for returning the left to power and implementing policies to help the so-called “losers” of neoliberal globalization. In her new book For a Left Populism, Chantal Mouffe of the University of Westminster argues that “left populism, understood as a discursive strategy of construction of the political frontier between ‘the people’ and ‘the oligarchy,’ constitutes, in the present conjuncture, the type of politics needed to recover and deepen democracy.”

Curiously, Mouffe spends an entire chapter drawing lessons from Thatcherism, but then overlooks many real-world examples of left-wing populist governments in recent years. These include, most notably, Rafael Correa’s 2007-2017 presidency in Ecuador; the increasingly brutal regime of Hugo Chávez and his successor, Nicolás Maduro, in Venezuela; and the administration of President Evo Morales in Bolivia.

Mouffe thus confines her analysis to Western Europe. Despite some resemblances, she believes that the different varieties of left-wing populism around the world “need to be apprehended according to their various contexts.” But while it is true that the Latin American and Western European strains of left-wing populism are not identical, nor can they be delinked. After all, Western Europe’s left-wing populists have often drawn inspiration from their Latin American counterparts.

For example, Íñigo Errejón, the architect of Podemos’s original electoral strategy, wrote his doctoral thesis on the rise of Morales, whom he openly admires. Similarly, Mélenchon has repeatedly defended Chavism and the Maduro regime. And in his 2017 electoral manifesto, he proposed that France join the Bolivarian Alliance for the Peoples of our America, an intergovernmental institution created by the late Cuban dictator Fidel Castro and Chávez in 2004.

In 2016, Mouffe and Errejón co-authored a book in which they discuss Bolivia’s experience under Morales. And in her new book, she lists Mélenchon in the acknowledgements, even as she omits the Latin American roots of left-wing populism in Western Europe.

But to examine the track record of radical left-wing populism in contemporary Latin America is to find a devastating picture. A cursory review of the scholarly literature shows that such forces have laid waste to their countries’ democracies since the turn of the century.

When Correa, Chávez, and Morales came to power, they immediately implemented major constitutional reforms through referenda. In each country, the new constitutions not only diminished the power of the old elites, but also severely constrained opposition parties’ ability to compete on a level playing field. The executive director of Human Rights Watch’s Americas Division has raised several warnings over the past decade about the deterioration of the rule of law under Correa, Chávez/Maduro, and Morales.

Venezuela stands out in this regard. The judiciary has lost its independence, corruption is rampant, and inflation is out of control. And, as Amnesty International’s Americas director recently reported, “People in Venezuela are fleeing an agonizing situation that has transformed treatable health conditions into matters of life and death.” Under Maduro, “Basic health services have collapsed and finding essential medicine is a constant struggle, leaving thousands with no choice but to seek health care abroad.”

Clearly, Latin America’s recent experience with left-wing populism has been nothing short of disastrous. Those who advocate it as a way “to recover and deepen democracy” would do well to acknowledge this reality. In my own research, I have always stressed the importance of examining the relationship between populism and democracy empirically. The reason is simple: Though populism can bolster democracy, it can also pose a serious threat to it.

An objective, empirical examination of the experience of Bolivia, Ecuador, and Venezuela demonstrates that nominally inclusive populist policies have come at far too high a cost. Morales, Correa, and Maduro have done lasting damage to their countries’ democratic norms and institutions. And Maduro, in particular, has shown that the price for supposedly helping the “losers” can be the creation of an even greater number of them.


Cristóbal Rovira Kaltwasser is Professor of Political Science at Universidad Diego Portales in Santiago, Chile. He is the co-author, with Cas Mudde, of Populism: A Very Short Introduction, and one of the editors of The Oxford Handbook of Populism.


The Billion-Dollar Mystery Man and the Wildest Party Vegas Ever Saw

Armed with a seemingly bottomless supply of cash, an unassuming Malaysian named Jho Low staged the ultimate extravaganza

By Tom Wright and Bradley Hope
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Leonardo DiCaprio, Pharrell Williams, Swizz Beatz, Jho Low, Paris Hilton, Kim Kardashian and Kanye West all attended the Vegas party. Michael Gillette


Around 6 p.m. on a warm, cloudless November night, Pras Michél, a former member of the ‘90s hip-hop trio the Fugees, approached one of the Chairman Suites on the fifth floor of the Palazzo hotel. He knocked and the door opened, revealing a rotund man, dressed in a black tuxedo, who flashed a warm smile. The man, glowing slightly with perspiration, was known to his friends as Jho Low, and he spoke in the soft-voiced lilt common to Malaysians. “Here’s my boy,” Mr. Low said, embracing the rapper. 
The Chairman Suites, at $25,000 per night, were the most opulent the Palazzo had to offer, with a pool terrace overlooking the Strip. But the host didn’t plan to spend much time in the room that night; Mr. Low had a much grander celebration in store for his 31st birthday. This was just the preparty for his inner circle, who had jetted in from across the globe. Guzzling champagne, the guests, an eclectic mix of celebrities and hangers-on, buzzed around Mr. Low as more people arrived. Swizz Beatz, the hip-hop producer and husband of Alicia Keys, conversed animatedly with Mr. Low. At one point, Leonardo DiCaprio arrived alongside Benicio Del Toro to talk to Mr. Low about some film ideas.
What did the guests make of their host? To many at the gathering, Mr. Low cut a mysterious figure. Hailing from Malaysia, a small Southeast Asian country, Mr. Low had a round face that was still boyish, with glasses, red cheeks, and barely a hint of facial hair. His unremarkable appearance was matched by an awkwardness and lack of ease in conversation, which the beautiful women around Mr. Low took to be shyness. Polite and courteous, he never seemed fully in the moment, often cutting short a conversation to take a call on one of his half a dozen cellphones.



But despite Mr. Low’s unassuming appearance, word was that he was loaded—maybe a billionaire. Guests murmured to each other that he was the money behind Mr. DiCaprio’s latest movie, “The Wolf of Wall Street,” which was still filming. Mr. Low’s bashful manners belied a hard core of ambition the like of which the world rarely sees. Look more closely, and Mr. Low wasn’t so much timid as quietly calculating, as if computing every human interaction, sizing up what he could provide for someone and what they, in turn, could do for him. Despite his age, Mr. Low had a weird gravitas, allowing him to hold his own in a room of grizzled Wall Street bankers or pampered Hollywood types. For years, he had methodically cultivated the wealthiest and most powerful people on the planet. The bold strategy had placed him in their orbit and landed him a seat here in the Palazzo. Now, he was the one doling out favors.

The night at the Palazzo marked the apex of Mr. Low’s ascendancy. The guest list for his birthday included Hollywood stars, top bankers from Goldman Sachs ,and powerful figures from the Middle East. In the aftermath of the U.S. financial crisis, they all wanted a piece of Mr. Low. Pras Michél had lost his place in the limelight since the Fugees disbanded, but was hoping to reinvent himself as a private-equity investor, and Mr. Low held out the promise of funding. Some celebrities had received hundreds of thousands of dollars in appearance fees from Mr. Low just to turn up at his events, and they were keen to keep him happy.

But even those stars couldn’t really claim to know Mr. Low’s story. If you entered “Jho Low” into Google, very little came up. Some people said he was an Asian arms dealer. Others claimed he was close to the prime minister of Malaysia. Or maybe he inherited billions from his Chinese grandfather. Casino operators and nightclubs refer to their highest rollers as “whales,” and one thing was certain about Mr. Low: He was the most extravagant whale that Vegas, New York, and St. Tropez had seen in a long time—maybe ever. 
A few hours later, just after 9 p.m., Mr. Low’s guests began the journey to the evening’s main event. As the limousines drove up the Strip, it was clear they weren’t heading to the desert, as some guests thought, instead pulling up at what looked like a giant aircraft hangar, specially constructed on a vacant parcel of land. Among those present was Robin Leach, who for decades, as host of the TV show “Lifestyles of the Rich and Famous,” had chronicled the spending of rappers, Hollywood stars, and old-money dynasties. But that was the 1980s and 1990s, and nothing had prepared him for the intemperance of the night. A gossip columnist for the Las Vegas Sun, Mr. Leach was among the few guests who had gleaned some details of what was coming. “Wicked whispers EXCLUSIVE: Britney Spears flying into Vegas tomorrow for secret concert, biggest big bucks private party ever thrown,” he tweeted.





Britney Spears burst out of a cake to sing ‘Happy Birthday’ to Jho Low at the 2012 Las Vegas party. Illustration: Michael Gillette 


One puzzling requirement of Mr. Leach’s invitation was that he could write about the party, but not name the host. He had made his career from the desire of rich people to brag about their affluence; what made this guy want to spend so much cash in secret? he wondered. A nightlife veteran, Mr. Leach was stunned by the audacity of the construction on the site. As he surveyed the arch of the party venue, which was ample enough to house a Ferris wheel, carousel, circus trampoline, cigar lounge, and plush white couches scattered throughout, he did some calculations. One side was circus themed, with the other half transformed into an ultrachic nightclub.

It must have cost millions, Mr. Leach estimated. Here were new lovers Kanye West and Kim Kardashian canoodling under a canopy; Paris Hilton and heartthrob River Viiperi whispering by a bar; actors Bradley Cooper and Zach Galifianakis, on a break from filming “The Hangover Part III,” laughed as they took in the scene. “We’re used to extravagant parties in Las Vegas, but this was the ultimate party,” Mr. Leach said. “I’ve never been to one like it.”

Mr. Low was careful not to overlook his less well-known friends and key business contacts. Among the guests were Tim Leissner, a German-born banker who was a star deal maker for Goldman Sachs in Asia. There were whispers among Wall Street bankers about the huge profits Goldman had been making in Malaysia, hundreds of millions of dollars arranging bonds for a state investment fund, but they hadn’t reached insular Hollywood.

The crowd was already lively when Jamie Foxx started off the show with a video projected on huge screens. It featured friends of Mr. Low from around the world, each dancing a bit of the hit song “Gangnam Style.” As the video ended, Psy, the South Korean singer who had shot to stardom that year for “Gangnam Style,” played the song live as the crowd erupted. Over the following hour and a half, there were performances from Redfoo and the Party Rock Crew, Busta Rhymes, Q-Tip, Pharrell, and Swizz Beatz, with Ludacris and Chris Brown, who debuted the song “Everyday Birthday.” During Q-Tip’s session, a drunk Mr. DiCaprio got on stage and rapped alongside him. Then, a giant faux wedding cake was wheeled on stage. After a few moments, Britney Spears, wearing a skimpy, gold-colored outfit, burst out and, joined by dancers, serenaded Mr. Low with “Happy Birthday.” Each of the performers earned a fat check, with Ms. Spears reportedly taking a six-figure sum for her brief cameo.

Then the gifts. The nightlife impresarios who helped set up the party, Noah Tepperberg and Jason Strauss, stopped the music and took a microphone. Mr. Low had spent tens of millions of dollars in their clubs Marquee, TAO, and LAVO over the past few years, just as the financial crisis hit and Wall Street high rollers were feeling the pinch. He was their No. 1 client, and they did everything to ensure other nightclub owners didn’t steal him away. As Messrs. Tepperberg and Strauss motioned to staff, a bright red Lamborghini was driven out into the middle of the marquee. Someone gave not one but three high-end Ducati motorcycles. Finally, a ribbon-wrapped $2.5 million Bugatti Veyron was presented by Szen Low to his brother.

Gigi Hadid and Mr. Jho Low at Angel Ball 2014 in New York in 2014. Photo: Dimitrios Kambouris/Getty Images 



Just after 12:20 a.m., the sky lit up with fireworks. Partying went into the early hours, with performances by Usher, DJ Chuckie, and Kanye West. Surrounded by celebrities and friends, Mr. Low piled into a limousine and brought the party back to the Palazzo, where he gambled well into the bright light of Sunday afternoon.

This was the world built by Jho Low.

“While you were sleeping, one Chinese billionaire was having the party of the year,” began an article on the website of local radio station KROQ two days later, mistaking Mr. Low’s nationality. It referred to him as “Jay Low.” It wasn’t the first time Mr. Low’s name seeped into the tabloids or was associated with extravagance—and it wasn’t the last—but the Vegas birthday party was a peak moment in his strange and eventful life. 





Supermodel Miranda Kerr, seen in New York in 2014, dated Jho Low for a time. Photo: Alo Ceballos/Getty Images 



Many of those who came across Mr. Low wrote him off as a big-talking scion of a rich Asian family. Few people asked questions about him, and those who bothered to do so discovered only fragments of the real person. But Mr. Low wasn’t the child of wealth, at least not the kind that would finance a celebrity-studded party. His money came from a series of events that are so unlikely, they appear made up. Even today, the scale of what he achieved—the global heists he is suspected of having pulled off, allowing him to pay for that night’s party and much, much more—is hard to fathom.

Mr. Low might have hailed from Malaysia, but his was a 21st-century global scheme. His alleged co-conspirators came from the world’s wealthiest 0.1%, the richest of the rich, or people who aspired to enter its ranks: young Americans, Europeans and Asians who studied for M.B.A.s together, took jobs in finance, and partied in New York, Las Vegas, London, Cannes and Hong Kong. The backdrop was the global financial crisis, which had sent the U.S. economy plummeting into recession, adding to the allure of a spendthrift Asian billionaire like Mr. Low.

Armed with more liquid cash than possibly any individual in history, Mr. Low infiltrated the very heart of U.S. power. He was enabled by his obscure origins and the fact that people had only a vague notion of Malaysia. If he claimed to be a Malaysian prince, then it was true. The heir to a billion-dollar fortune? Sure, it might be right, but nobody seemed to care. Not Leonardo DiCaprio and Martin Scorsese, who were promised tens of millions of dollars to make films. Not Paris Hilton, Jamie Foxx and other stars who were paid handsomely to appear at events. Not Jason Strauss and Noah Tepperberg, whose nightclub empire was thriving. Not the supermodels on whom Mr. Low lavished multimillion-dollar jewelry. Not the Wall Street bankers who made tens of millions of dollars in bonuses. And certainly not Mr. Low’s protector, Malaysian Prime Minister Najib Razak.

Mr. Low’s purported scheme involved the purchase of storied companies, friendships with the world’s most celebrated people, trysts with extraordinarily beautiful women, and even a visit to the White House—most of all, it involved an extraordinary and complex manipulation of global finance. The FBI is still attempting to unravel exactly what occurred. Billions of dollars in Malaysian government money, raised with the help of Goldman Sachs, is believed to have disappeared into a Byzantine labyrinth of bank accounts, offshore companies, and other complex financial structures. Tim Leissner, who left Goldman in 2016, is now in plea-deal talks with U.S. authorities. Goldman has said it had no way of knowing there might be fraud surrounding the Malaysian government funds.

As the scheme began to crash down around them, Malaysia’s prime minister turned his back on democracy in a failed attempt to cling to power. After a stunning election loss in May, he is now under arrest and facing charges including money laundering. He has denied wrongdoing.

Wanted for questioning by the FBI, Mr. Low is a fugitive moving between Hong Kong, Macau and mainland China as Malaysia seeks his arrest. Through a spokesman, he maintains his innocence.



“Billion Dollar Whale: The Man Who Fooled Wall Street, Hollywood and the World” is the result of three years of research, drawing on interviews with more than 100 people in more than a dozen countries. Every anecdote is based on the recollections of multiple sources and in some cases backed up by photographs, videos and other documentation. The authors reviewed tens of thousands of documents, including public court records and confidential investigative and financial records, as well as hundreds of thousands of emails provided to authorities during the course of probing the case. They also relied on official allegations contained in the U.S. Justice Department’s civil asset-forfeiture cases, as well as court proceedings in Singapore and official reports by Swiss authorities.

Protesters hold images of Jho Low depicted as a pirate in Kuala Lumpur in July.