“IT IS FRAUD to accept what you cannot repay,” said Publilius Syrus way back in the first century BC.

But Syrus was merely a Roman hack…and a freed slave to boot. So what would he know about collateralized loan obligations? No more or less than today’s Bank of England, perhaps.

“British venture capital heavyweight John Moulton told a reporter,” says Sean Corrigan of Diapason CM, “that at a recent breakfast meeting with Bank of England officials, none of them knew what a ‘CLO’ actually was…”

Full disclosure: I wouldn’t know a collateralized debt obligation if it kissed me and took me out to dinner. Nor does The Economist magazine, judging by its latest stab at explaining haute finance to its readers. The Financial Times has been lost on all things “collateralized” since it first tried to cover the CDO market in January 2005.

But unlike the policy wonks on Threadneedle Street, the journalists on Southwark Bridge aren’t paid to jet out to Jackson Hole, Wyo., while defending financial stability back in Britain. Nor is it their job to underwrite those lenders who’ve conspired in the Great Credit Fraud of 2002-2007…issuing loans to debtors with no serious hope of repayment.

“It is too soon…to quantify the impact on the economy as a whole,” said Mervyn King, governor of the Bank of England, in an open letter sent to the British Parliament on Wednesday morning. “In the short term, some corporate loan rates will rise with interbank rates. Banks that are unable to sell pools of loans that they had securitized, or who need to support off-balance sheet vehicles, may cut back on new lending.”

What’s a central banker to do? “The provision of liquidity support [by the BoE] undermines the efficient pricing of risk by providing ex-post insurance for risky behavior,” says King, entirely guiltless in getting us all here in the first place.

“That encourages excessive risk-taking and sows the seeds of a future financial crisis.”

No fooling!

Thus, the trimmer’s choice today: Make free with financial support for the country’s biggest banks…or let the market “reprice” their risk-taking and take a gamble on the nation’s financial stability instead?

Put another way — and expressed so succinctly by the anonymous Mayfair hedge fund manager at FiNTAG.com — King’s choice is the same as Ben Bernanke’s:

“Put rates up and win a Nobel Prize in Economics. Put them down and get a lucrative job at Lehman. Leave them as they are and look pathetically weak.”

In which case, a pathetic back-office job at Lehman Bros. looks the most likely reward…

“Mass delusions are not rare,” wrote Garet Garrett, nearly 2,000 years after Publilius Syrus scratched out his maxims in Latin. In Garrett’s 1932 tome, A Bubble That Broke the World, the editor of the New York Tribune noted how mass delusions “salt the human story.

“[But] a delusion affecting the mentality of the entire world at one time was hitherto unknown. All our experience with it is original.”

Garrett was speaking of the late ’20s bubble on Wall Street, but his words do more than just echo today. “This is a delusion about credit,” he went on. “And whereas from the nature of credit it is to be expected that a certain line will divide the view between creditor and debtor, the irrational fact in this case is that for more than 10 years, debtors and creditors together have pursued the same deceptions.

“In many ways, as will appear, the folly of the lender has exceeded the extravagance of the borrower.”

Fast-forward to September 2007 and has the folly of lenders exceeded the extravagance of borrowers once again? In June, some 30% of first-time homebuyers in Britain resorted to an “interest-only” mortgage, just so they could make the monthly payments and grab the keys to the door. That might sound like extravagance.

But fewer than one in three of them presented an investment plan to their lender with a view to ever repaying the principal…leaving one in five of ALL first-time buyers paying the interest alone, with nothing set up to cover the base debt itself.

On the part of the lenders, that sounds like folly. Five years ago, just one in 20 of Britain’s first-time homebuyers opted for interest-only home loans with no plan for repayment.

“The market has it wrong in that it calls this the subprime crisis,” says Barry Wilby, former manager at Oppenheimer Funds, the $250 billion asset management firm. “I think it’s really a crisis in the underwriting and packaging of debt. That means it has implications for the extension of credit, because of the trust that people will have in institutions.

“It’s a big psychological problem for capital markets,” Wilby warns, thinking no doubt of the spike in interbank lending interest rates — now at fresh two-decade highs just shy of 7% here in London, “which will result in a slowdown in credit extension, which I think will result in the slowing down of the global economy.”

Credit extension in the U.K. looks set to slow — fast! The Bank of England might not know a collateralized loan obligation when it sees one. But it said Tuesday that the average variable rate mortgage issued in August rose by 0.25%, to a nine-year high of 7.69%. “Fears of Retail Bloodbath as Interest Rates Hit Home,” screams The Times in response. JJB Sports, a major High Street retailer, has cut its full-year forecast by one quarter. The CEO of Next, a leading U.K. clothes store, warns the real crunch could hit just as Christmas arrives.

Borrowing what you cannot repay is indeed fraud, but the great fraud of limitless consumer spending now looks utterly spent. Lending what you cannot hope to get back, on the other hand, is pure folly.

And now that game is up too; you might want to check just who owes what to whom in your stock market portfolio.

Regards,
Adrian Ash

September 18, 2007

Fraud, Folly, and Central Banking was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“Business outlays for new equipment and facilities have slowed sharply over the past year. That’s important because when businesses expand their operations they also add to their payrolls. Job growth over the past couple of years has been the primary support under consumer spending, so any sharp slowdown in capital spending would most likely have an even broader impact on consumers than the weakness in housing…

“The odd feature of this weaker spending pattern is that it has occurred during a period when the fundamental drivers of business investment have been generally strong. Based on robust earnings and record profit margins, the prospective returns on new plants and equipment have been high, even as investment costs have been low. The cost of borrowing in the credit markets remains relatively cheap, and banks, on balance, have not tightened their lending standards for their corporate customers. Companies also sport exceptionally high levels of corporate cash and solid balance sheets.

“This disconnect between the ability and desire of companies to spend appears to reflect a sharp turn toward caution in the boardroom. Companies have been rocked by one uncertainty after another since 2000, including recession, corporate scandals, terrorist attacks, war, and a tripling of oil prices…

“As for corporate confidence, one of the best indicators is businesses’ willingness to plunk down money for new equipment, a trend that has gone south in recent months. Orders for capital goods, such as machinery and high-tech hardware (outside of defense items and commercial aircraft), fell 1.2% in February, the fourth decline in the past five months. The three-month moving average of orders, which gives a good reading of the trend, has dropped sharply after heading almost straight up for about two years. The longer companies keep their capital-spending plans on hold, the more vulnerable the economy will be to other downdrafts, such as any new surprises from the housing market.

“The current slowdown in capital spending is actually part of a longer-term hesitancy on the part of businesses to expand their plants and equipment. Throughout this five-year expansion, the growth in outlays has failed to match the pace of the 1990s expansion, even prior to the boom late in the decade.

“For the past four years, the real, or inflation-adjusted, stock of equipment and software in place at nonfinancial corporations has generally not grown any faster than that sector’s real gross domestic product, based on Federal Reserve data. That suggests the 4.4% growth rate in equipment outlays in 2006, the slowest in three years, has been insufficient to keep up with the rate at which old computers and machines are wearing out.

“Companies aren’t wary only about spending. They also seem unwilling to borrow for anything other than financing stock buybacks and taking their businesses private. Recent Fed data show that nonfinancial corporations last year, on net, retired a record $602.1 billion in equity. In the fourth quarter alone, they set aside $701.2 billion, measured at an annual rate, far more than the additional $604.6 billion they borrowed in the credit markets. Companies seem interested in cutting their overall cost of capital, but they don’t seem very hot on taking advantage of cheaper capital to invest in expanding their operations.

“The answer to this paradox goes back to corporate prudence, and the heavy demands investors have placed on companies to perform. Capital spending decisions depend most crucially on prospects for demand, which has slowed in recent quarters, with little to suggest a pickup. Recent news that sales of new single-family homes plunged to the lowest level in more than six years, along with new evidence of falling house prices, only reinforces the perception that demand is softening.”

There is no paradox about falling capital spending, nor is there a disconnect, except in the minds of proponents of the Goldilocks theory. It remains complete silliness to expect businesses to expand in the face of rising defaults, rising bankruptcies, and decreased needs for all kinds of durable goods associated with home purchases. Nonetheless, that is what nearly everyone seemed to believe.

Lower Earnings, Less Capital Spending, Less Hiring

MarketWatch is reporting, “Lower earnings could cut into capital spending, hiring”:

“U.S. corporate profits fell in the fourth quarter of 2006, signaling the end of one of the greatest profit cycles in the postwar era, economists say.

“Economic growth is slowing, hurting corporations’ top line. Meanwhile, costs are rising, squeezing profit margins.

“‘Profits growth has turned decisively down, and the end is not yet in sight,’ wrote Gabriel Stein, an economist for Lombard Street Research.

“‘As the expansion matures and unit labor costs rise, profit margins will be under pressure,’ said Stephen Stanley, chief economist for RBS Greenwich Capital…

“‘The deceleration of profits may be dramatic,’ wrote Mickey Levy, chief economist for Bank of America, in a research note. ‘If so, weaker profit growth may affect business hiring and capital spending decisions, and will likely influence financial markets.’

“‘Weaker profits may undercut any rebound in capital spending,’ Levy said.

“Although corporations are sitting on a mountain of undistributed profits, their spending plans are based on future returns compared with the cost of capital. Money doesn’t burn a hole in a chief financial officer’s pocket as it can with a consumer. Corporations have been returning much of their profits to shareholders through dividends and share buybacks, rather than investing in expanding production.”

Awful Data

The grim reality is that, excluding transportation, durable goods orders fell 0.1% in February:

“‘Awful data,’ concluded Ian Shepherdson, chief U.S. economist for High Frequency Economics, in an e-mail.

“The outlook for capital spending and economic growth…’is at risk,’ wrote Drew Matus, an economist for Lehman Bros.

“The figures ‘inflicted a sharp blow’ on the outlook for U.S. gross domestic product growth, wrote Mike Englund, chief economist for Action Economics, in an e-mail. He now expects growth of 1.6% in the first quarter and 2.8% in the second quarter.

“The rise in orders for durable goods was mostly powered by an 88.4% increase in orders for nondefense aircraft, eclipsing a big drop of 60.4% in January…

“Economists surveyed by MarketWatch had been expecting durable goods orders to rise by 3.8% in February, after falling by a revised 9.3% in January…

“Shipments of durable goods overall fell by 0.8% in February.

“Inventories rose 0.2% in February. The inventory-to-shipments ratio rose to 1.44, the highest since August 2003.

“While not addressing February’s report specifically, Federal Reserve Chairman Ben Bernanke noted a greater softening in the demand for capital goods than would be expected at this stage of the business cycle.

“In testimony on Capitol Hill, he expressed optimism that business investment would ‘grow at a moderate pace this year.’”

Bernanke’s Testimony

Picking up on the Capitol Hill testimony theme, let’s tune into highlights from Bernanke’s economic outlook before the U.S. Congress Joint Economic Committee on March 28, 2007:

• Economic growth in the United States has slowed in recent quarters
• The inventory of unsold homes has risen to levels well above recent historical norms
• Weakness in residential construction is likely to remain a drag on economic growth for a time as homebuilders try to reduce their inventories of unsold homes to more normal levels
• Business spending has also slowed recently. Expenditures on capital equipment declined in the fourth quarter of 2006 and early this year
• The magnitude of the slowdown has been somewhat greater than would be expected given the normal
• Despite the recent weak readings, we expect business investment in equipment and software to grow at a moderate pace this year, supported by high rates of profitability, strong business balance sheets, relatively low interest rates and credit spreads, and continued expansion of output and sales
• Investment in nonresidential structures (such as office buildings, factories, and retail space) should also continue to expand, although not at the unusually rapid pace of 2006
• Thus far, the weakness in housing and in some parts of manufacturing does not appear to have spilled over to any significant extent to other sectors of the economy
• The continuing increases in employment, together with some pickup in real wages, have helped sustain consumer spending, which increased at a brisk pace during the second half of last year and has continued to be well maintained so far this year. Growth in consumer spending should continue to support the economic expansion in coming quarters
• Overall, the economy appears likely to continue to expand at a moderate pace over coming quarters. As the inventory of unsold new homes is worked off, the drag from residential investment should wane. Consumer spending appears solid, and business investment seems likely to post moderate gains
• Core inflation, which is a better measure of the underlying inflation trend than overall inflation, seems likely to moderate gradually over time
• Although core inflation seems likely to moderate gradually over time, the risks to this forecast are to the upside
• The rate of resource utilization is high, as can be seen most clearly in the tightness of the labor market
• Anecdotal reports suggest that businesses are having difficulty recruiting well-qualified workers in a range of occupations.

Those interested can click here for a video of Bernanke’s testimony.

If inflation risks are to the upside, then why did he remove the statement about additional firming being required from the latest FOMC statement? Answer: He is spooked more than he is letting on about the risks of a continued housing implosion.

When it comes to jobs, are we now down to “anecdotal reports…that businesses are having difficulty recruiting well-qualified workers in a range of occupations”? What about anecdotal reports about “The Disposable Workforce”? That last jobs report was anemic, with fewer than 100,000 jobs created, and 39% of those were government jobs.

With so many homeowners missing payments, exactly why should “growth in consumer spending…continue to support the economic expansion in coming quarters”? What about “Hot Lines for Hard Times” and 2.1 million homeowners who are struggling so much that they missed a home payment in the fourth quarter?

It is pretty tough to swallow the idea of strong consumer spending in the face of 2.1 million homeowner delinquencies. And what about those rising inventories in both housing and durable goods? What about the effect of interest rate resets, the bulk of which have not yet hit?

If someone is looking for a major disconnect, here it is: Bernanke is expecting growth in consumer spending in the face of a housing bust, a slowdown in capital spending, rising defaults, and massive interest rate resets that will culminate later this year.

Unlike Greenspan’s typical congressional testimony, one can actually understand every single word Bernanke said. Unfortunately, we have traded Greenspan’s incomprehensible gibberish for Bernanke’s comprehensible doublespeak. That doublespeak allows Bernanke to sit in his ever-tightening box pretending that these economic problems will go away, there will not be a housing spillover, capital spending will rise, and consumers will not throw in the towel. He is wrong on all counts.

Regards,
Mike Shedlock ~ “Mish”

April 3, 2007

Capital Spending: Myth and Reality was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.