Wrap Me in a TARP, and Bury Me Shallow (January 2009)

This lengthy rant’s a response to a friend’s question about a coming economic depression and references the following site and article:

www.contrahour.com/contrahour/2009/01/martin-armstrong-the-coming-great-depression.html

via email:  January 2009

K -
 
I agree with what Armstrong asserts; his points seem valid though I've no means to check on historical perspectives he cites.
 
DEBT
 
Debt is indeed the key.  I've thought for a long time that spreads between consumer interest rates (especially credit cards) and LIBOR/Fed Funds rates were ridiculous and usurious.  The banks developed models to perpetuate consumer debt in order to provide an eternal pool of accounts receivables they could use as collateral.  This model worked so well, they decided to extend the model to the mortgage market using negative amortizations, low teaser rates, high-cap ARMs, prepayment penalties, and poorly collateralized home equity loans to tie consumers to their banks permanently.
 
Once this enhanced model was ingrained, banks could engage in riskier speculations in junk bond/stock markets and in investment banking activities.  After all, everyone wanted to be an investment banker despite the fact that it is a highly skilled and uniquely focused business.  Citi wanted to be Goldman Sachs and be able to offer its officers Goldman partnership-like bonuses.  They forgot they were bankers, not investors, and that they had no corporate aptitude for I-banking.  They could bring in a few (very expensive) rainmakers but it would have taken a decade to develop and nurture this business within a large money center bank.
 
Then insurance companies (notably AIG) who know even less than bankers about I-banking, thought they'd join the parade by making their own investments with no due diligence and by formulating and growing credit swap instruments.  The insurance companies figured that bankers must know what they were doing so why shouldn't they carve off a piece of the action.
 
So to abstract Armstrong, moving money and selling leverage became a major element of our new "service economy," a term that's scared me since I first heard it 25 years ago.  By their very nature, service businesses are people-intensive both in terms of assets and customers.  When times get bad, first customers evaporate, then employees disappear since they represent a service company's largest cost.  Unemployment will rise quickly since these companies aren't inhibited by plant closing notification laws or labor agreements.  Note also how service companies generally lack accurate productivity metrics, so they have no way to know when their businesses are in trouble or when they're out of trouble.
 
Any downturn in the economy accompanied by a jump in unemployment does what?  It fucks up the banks' collateral models.  Think about it:  a bank with $500 billion in annual turnover goes from 30 days for receivables to 35 days.  That's $7 freakin' billion dollars gone missing.  And the banks' response?  Increase credit cards' interest rates and add huge (percentage-wise) penalties to mortgage payments.  But guess what, a collateral pool that is 35 days old instead of 30 won't achieve the same bond rating and won't net the bank as much leverage.  It's a classic circle jerk.  Defaults commence at both ends of the food chain:  consumers can't pay and the banks can't pay.
 
It lets me understand why banks accepted TARP funds but are not lending them out.  Banks need to hold TARP cash as reserves, their collateral, since mortgages and receivables are in the toilet and nobody trusts their valuations.
  
In the olden days we used simple measurements when investing, like debt to equity ratio.  In that world these numbers were accessible.  Now who can tell?  But in the simplest sense, the country's debt to equity ratio has skyrocketed.  We have no factories, refineries, or oil reserves, and what we have is old, depleted or depreciated.  Our companies have built their new facilities abroad or simply contract manufacture in China.  Our only equity is paper and people, both difficult to value.  America’s become like a shady company that carries inordinate and inexplicable  ‘Good Will’ on their balance sheet.

Armstrong points out how consumer debt as a % of GDP is higher than ever.  This is only going to get worse...much worse.  And of course, this is reflected in the level of National Debt, a number no one comprehends or really seems to worry about except in philosophical terms.
 
I think with Armstrong:  the stock market is a lagging indicator because true speculation is only a small part of the market.  Most consumer and institutional investors are conservative.  They buy and hold; that's true for most mutual funds.  They simply won't free up capital or new monies to reinvigorate markets, especially since a few big investors (Buffet) and Uncle Sugar have made huge deals giving them preferred stakeholder status. In a year there’ll be no dividends designated for common stock holders.
 
Things’ll get worse: I think we're looking at a market down for upwards of 5 years and recovering slowly.  Remember the math:  if a stock drops 50% from $100 to $50, it needs to go up 100% to recover original value.  At 15% of gain each year, it takes 4 years and 10 months to double back.  And how long is this going to take if preferred holders suck out all the dividends?
 
STRATIGERDY (my last Bushism)
 
It's hard to imagine trying to move the economy back away from the service model toward a manufacturing and natural resource base.  Especially when no one has any money to buy anything.  In 1939, the country was lucky enough to have Hitler get all antsy.  We rebuilt our economy with military construction, first impoverishing the Brits, then spending our own wealth.  But it paid off by employing nearly everybody, much more effectively than the WPA, as Armstrong notes.  11 million men in the service; millions more in defense jobs; and massive and realistic efforts towards sustainability.
 
This is what needs to be done now.  In the absence of a major war, we need to address infrastructure and sustainability.  Obama's plan includes both elements and they will help some, though as Armstrong implies, too few people will be employed in these projects initially.  These jobs are all skilled:  we just don't need 2 million, $20/hour flagmen out there working on their suntans.
 
Less skill and more bodies are needed in home construction, but we're not going to see much of that over the next ten years.
 
Solar cell and wind turbine manufacture is highly specialized and automated.  The problem with US automakers is that they have old-fashion assembly plants the need too many expensive workers.  Their brand new plants (smaller vehicles, electric cars and hybrids, batteries, new CVTs, etc) will all need fewer, not more workers.
 
Down in Charleston, I went to a series of workshops on health care reform and modernization and I liked what I heard, but these new efficient models don't require as many people to run them on down the line.
 
We can double the number of teachers in our schools, but we'll still fall short employment-wise and in terms of personal income.
 
Energy independence is crucial and I still favor natural gas and biodiesel.  This is no time to cut or delay development efforts.
 
One proposal I'd like to make is for a national NFP credit union.  Such an institution would represent a return to traditional banking and would engender a high level of confidence and security for people whose banking needs don't go far beyond checking, debit cards, savings, car loans, and student loans.  Big money center banks don't give a shit about these customers.
 
PERSONALLY
 
First off, I stopped spending...not on products but services.  I don't eat out and shop almost exclusively over the Internet.  I've cut back on travel.  We’ve friends in the restaurant and resort businesses and this hurts them but we have to stop the bleeding.
 
I've been buying fine art, books, antiques, and durables, even looking at a new car.  The deals are great.  I pay cash for everything and paid off all my mortgages.
 
A portion of my investments are in private equity (GSO&G and Manzanita Pharmaceuticals) and more in royalty trusts (oil, gas, and timber) that don't provide for preferred holders.  I stick with trusts that have simple business models and whose assets comprise mineral reserves and land.  And I still believe oil will be one of the first commodities to rise, with prices above $80 by spring 2010.
 
I'm back writing, trying to figure out how to make a few bucks that way.
 
This year I plan to raise a few cattle on the farm, plant corn to help feed them, and start some grapevines.  We've stocked our freezers with home-grown vegetables, post-holiday frozen turkeys, and venison.  These businesses might be marginal, but they represent my effort to breakeven for now.  Sustainability is the goal.  On a larger scale, our village is considering options for a substantial community garden:  Welcome, comrades, to the new reality!
 
So if/when the new depression arrives, sustainability is more important than anything else.  Worst case, the only assets to hold are tangible ones:  a home, productive land, durables, and things you enjoy and with which you find comfort.
 
Now I hope this all makes you feel better.  As I offered in the opening paragraph of my lecture last March on Oil, War and Sex, I included 'Sex' in the title because we're all fucked!  Talk to you soon.
 
Tom