Earlier this month, Mary Kay and I joined some of her family members down in Sanibel Island, Florida.  I hadn’t been to Sanibel since my senior year of college.   On the night before spring break, some friends and I were gathered at a local establishment for an evening of very clearheaded thinking.   We decided that none of us wanted to spend our last spring break in Minnesota.

The next morning, we piled into my buddy’s parents’ Ford County Squire station wagon and pointed it in the direction of Florida.  Someone had a connection to a condo on Sanibel and we had a car with faux wood side panels.   What could possibly go wrong?

None of us knew anything about Sanibel, but it was in Florida and Florida was the College Spring Break Capital of the Universe!!! Visions of beer and wet T-shirt contests danced through our hormonally charged heads.

Nothing was going to stop us and nothing did…for the first 12 miles.   We had taken off in a blizzard, certain that the weather would improve as we headed south.  It didn’t improve fast enough.  Forward motion proved challenging.   Glimpses of the road upon which we were trying to drive became increasingly infrequent.  It turned out that the road wasn’t close enough to the Country Squire.   We were surprised to learn that once the snow got deep enough to cover its fake wood side panels, the Country Squire wanted to retire to his manor house…or whatever house in front of which it happened to be stuck.

The farmer, whose yard we had been trying to drive across, graciously invited us into his home. We wound up staying overnight on the floor with a bunch of other knuckleheads who also thought the weather would improve as they headed south.   At some point the next day, with the help of his tractor, we had succeeded in getting all of our cars out of his yard and we were off.

Our next surprise was Sanibel itself.   The previous spring break, ten of us had rented a Winnebago and driven cross-country to a Girls’ Fashion Design School in Long Beach, CA (but, that, as they say, is an introductory anecdote for another editorial).

Spring Break-wise, Sanibel was not like Long Beach.

It turned out that not all of Florida was the College Spring Break Capital of the Universe!!! Sanibel was a mild-mannered enclave where retirees got up early to comb the beach for seashells, and then pretty much called it a day.   The only wet T-shirts we saw were drying on clotheslines.   On the bright side, the Country Squire blended in perfectly.

Now, three decades later, Sanibel attracts a much younger crowd…closer to my age.   More importantly, it proved to be an ideal place for us to get away from our long, cold Chicago winter, which had already dragged on for the better part of a week.   Bicycling, sea kayaking, airboat rides and hiking kept us active while excellent food kept us sated.

I’m still itching the memories of our trip.  They have invisible insects down there called No-See-Ums (Invisibilae Vampirus).  They found me faster than a legislator can find a reason to raise the debt ceiling.   As a result, even after a week back home, blind people can still use their fingers to read the skin on my arms.   My legs remind me of this topographical relief globe we had in elementary school where you could run your fingers across the protruding mountains.

While we couldn’t see the No-See-Ums (maybe that’s where the name comes from), we did see a lot of other wildlife.   One of my favorite memories from the trip was hiking through Ding Darling National Wildlife Refuge.   I kept think of poor Ding always being hounded by his wife:

Ding, Darling, would you be a doll and build me a National Wildlife Refuge, pretty please?   Mr. Everglade built one for his wife.

Yes, dear.

We were about 80% of the way through our hike when we turned a corner to meet this mother of two lounging on our path:

We were nonplussed.  We became even less plussed once we saw one of her babies scurry to hide behind her.  After several moments, even though it meant walking all the way back the path we had just hiked, we realized that…

THIS CHANGED EVERYTHING, PART TWO
A PLUMB PERSPECTIVE EDITORIAL

Last month, in Part One of this editorial, I described how the Boskin Commission’s change of the CPI calculation methodology instantly reduced reported consumer price inflation. Furthermore, this change infiltrated all sorts of other U.S. economic reporting, creating such illusions as the Great Moderation, Jobless Recoveries and the Productivity Miracle.   This month, we’re going to discuss how this new methodology laid the foundation for our current (and next) global financial crisis.

The Fed has a legislated dual mandate to pursue price stability and maximum employment. Prior to the mid-1990s, there was a natural tension between these two goals.   Tight monetary policy was beneficial to price stability, but it restricted the financing necessary for businesses to expand and hire more people.   Conversely, loose monetary policy encouraged businesses to expand, but threatened price stability.   This changed with the Boskin Commission.   After the CPI calculation methodology was altered, the Fed was freed to pursue a much more expansionary monetary policy without fear of having it show up in a rising CPI.

This shift is very evident in the data. From 1959 through 1996, the broad M3 money supply rose 7.8% per year and the CPI rose 4.6% per year.   Since 1996, the M3 broad money supply growth rate has increased to 8.7% per year, but the CPI growth rate has fallen to 2.4% per year.

Greenspansionary Monetary Policy

Last month, I facetiously intimated that Greenspan might not have read the 1996 Boskin report because he was busy polishing up his market rattling irrational exuberance speech.  After 1996, Greenspan never uttered the phrase “irrational exuberance” again.   Perhaps this is because, given the Fed’s free reign to open the loose money spigot, “exuberance” was no longer irrational.  Greenspan didn’t just fail to take the punch bowl away; he spiked it!  I’m in the small minority that’s NOT exuberant about this.

At the end of 1996, the U.S. stock market was trading at extremely high valuation levels.  In fact, based on the valuation measure used by Dr. Robert Shiller in his book Irrational Exuberance, the only time it had ever traded higher was during the last five months before the 1929 stock market crash.

From this nosebleed valuation level, it’s not surprising that many value investors were baffled by what happened next.   In 1997, the S&P 500 gained 33.4%.   It gained 28.6% in 1998 and it added another 21.0% in 1999.   By the time the stock market party ended in 2000, the valuation chart looked like this:

How Did This Happen?

The Fed, under the chairmanship of Alan Greenspan, was critical in making this possible.   Unshackled from the fear of increasing the CPI, the Fed was free to grow the money supply at a much more rapid rate.  Crucially important was something that came to be known as the “Greenspan Put.”   When the stock market crashed in 1987, Greenspan was brand new on the beat.  His statement of reassurance to the market, affirming the Fed’s “readiness to serve as a source of liquidity to support the economic and financial system,” became a defining hallmark of his chairmanship.  It seemed to work.  The market quickly regained its footing.

Henceforth, whenever the downside of excessive risk-taking raised its ugly head in the financial markets, Greenspan opened the liquidity spigot.   It provided fast, temporary relief in 1987, so this was the playbook to which Greenspan referred again at the start of the first Gulf war in 1990, the Mexican peso crisis in 1994, the Asian Contagion in 1997, the meltdown of Long-Term Capital Management in 1998, Y2K in 1999, and the burst of the dot-com bubble in 2000.  Each crisis was met with more Fed liquidity.  The Greenspan Put meant that he had investors’ backs and they could take more risk.

Absent the need to worry about its price stability mandate, the Fed invented a new mandate that amounted to protecting investors from the consequences of their own reckless behavior.  The problem with the Greenspan Put was that it not only created the moral hazard of privatizing profits and democratizing losses, but it also pushed the problems out into the future, making them that much bigger.

When the dot-com bubble burst, Greenspan took the Fed funds rate from 6.5% in 2000 down to 1% by 2003, and he kept it there for a full year.   The result was that, despite the huge drop that had taken place in the U.S. stock market from 2000 – 2003, the excesses of the dot-com bubble were never fully purged.   When the S&P 500 bottomed in early 2003, Shiller’s P/E10 had only dropped to 21.3.   This was closer to previous market bubble peaks than it was to the pre-1996 valuation average of 15, let alone any kind of valuation bottom.

As shown above, after previous bubbles, the P/E10 had always dropped into single digits before starting a new bull market–but not this time.   Greenspan had once again protected investors from fully suffering the consequences of their own folly.

This had required an unprecedented flood of liquidity.   The graph below shows both the Fed Funds rate and the year-over-year percentage change in the CPI during Greenspan’s tenure as Fed chairman:

The evolution of the Greenspan Put is evident when we look a graph that shows the Fed Funds Rate minus the year-over-year percentage change in the CPI:

The trend was clearly down.   Despite the fact that the CPI was very low after the 1996 change in the CPI calculation methodology, the Greenspan Fed brought the Fed Funds closer and closer to the CPI, even taking it below the CPI for three full years beginning in mid-2002. During this period, we weren’t in recession.  The GDP growth rate was rising and averaged a healthy 3.0% per year.  Unemployment was declining from 6% to 5%.   The CPI was also rising from mid 1% to mid 4%.  With the economy growing well, unemployment low and declining, and the CPI rising, we have to ask the question…

Why Was Greenspan Keeping Rates So Low?

The only answer I can come up with is that he wanted to cushion the decline in the stock market.   After the bursting of the dot.com bubble, the S&P 500 declined -9% in 2000; it was down -12% in 2001; and it dropped another –22% in 2002.   In response, Greenspan flooded the market with liquidity and, once again, prevented investors who took too much risk from fully suffering the consequences of their imprudence.  Unfortunately, this massive moral hazard malfeasance only laid the foundation for an even bigger bust.

Greenspan’s Fed kept interest rates way too low for way too long.   This extraordinarily loose monetary policy was in no way justified by the fundamentals, but he could get away with it because it didn’t cause a dramatic rise in the CPI.  And, the reason it didn’t cause a dramatic rise in the CPI is because of the 1996 change in the calculation methodology.

Once interest rates were set too low, all the players you’ve heard blamed for our current financial crisis simply did what was in their rational self-interest.  Without ultra-low interest rates, none of this would have happened.

What’s A Fixed Income Investor To Do?

Artificially low interest rates might have been a boon for borrowers and speculators, but they put fixed income investors in a real bind.   You see, there are huge fixed income investors who rely on a reasonable interest rate for their portfolios.   Insurance companies, endowments, state and local governments, pension funds and many more are required to invest the majority of their portfolios in ultra-safe fixed income securities.   By artificially keeping interest rates below even the CPI growth rate, Greenspan forced these investors to look for ways to boost their yields in order to meet their obligations.  This created an enormous artificial demand for safe fixed income securities with higher yields.

Wall St,, seeing this huge demand, figured out a way to supply it; they created collateralized mortgage obligations.  The basic idea was that an individual mortgage was too risky for these fixed income investors to buy.   Instead, Wall St. bundled a bunch of mortgages together and then sliced them back up again (into pieces called tranches).  By slicing up these pooled mortgages (“securitization”), Wall St. created lower tranches that were very risky (and would only get paid off after all the other tranches got paid).  But, it also created higher tranches that were supposedly very safe.

These safe tranches were just what the fixed income investors needed.   They offered a higher interest rate than the artificially low interest rates of Treasuries, but they were supposedly almost as safe.  In fact, the highest tranches were given the highest possible credit rating by Standard & Poors and Moody’s.

So Maybe We Can Blame The Credit Rating Agencies

We can try, but I think it’s pretty naïve to assume they would have done anything other than act in their rational self-interest.   First, they were being paid for their services by the investment banks that were doing the securitization.   Second, for the credit rating agencies to assume that the highest tranches would default required the agencies to speculate that we were going to experience a housing crash that was unprecedented.   You can say they should have seen this coming, but expecting them to turn away business based on a speculation that was in no way supported by anything in history is simply wishful thinking.

More importantly, if the Fed hadn’t put fixed income investors in such a bind, Wall St. wouldn’t have created all these dodgy mortgage-backed securities for the credit rating agencies to mis-rate.

Can’t Get Enough Of ‘Em

The fixed income investors loved these AAA-rated tranches.  From Iceland to India, they devoured them as fast as Wall St. could package them together and slice them up.   It was like me with French Silk pie. The problem was that they needed more.  Not enough mortgages were being generated for Wall St. to securitize.   It seems that there were only so many people with good credit who could put 20% down to buy a house.  These “strict” lending standards were the reason the home ownership rate in the U.S. had been stable at 64% for years.

It’s not that the other 36% of people didn’t want the American Dream of Home Ownership; many of them simply couldn’t qualify for mortgages.

This all started changing in the mid-90s (why does that timeframe sound familiar?).   If not enough people could qualify for loans, the obvious solution was to lower the bar.  Traditional mortgage requirements became so-o-o last generation.  These stodgy standards were as passé as setting aside money for retirement.

We entered the era of alt-A loans, subprime loans and option ARMs.  No down payment?  No problem!  Take out a home equity loan to finance the down payment!  It became common to say that the only requirement for getting a mortgage was the ability to fog a mirror.   Mortgage brokers called these NINJA (No Income, No Job or Assets) loans.  Liar-loans, where the borrower didn’t provide any documentation to support his creditworthiness, became popular.

This created a whole new pool of people who were now able (at least temporarily) to “buy” a house.   Naturally demand soared and soaring demand caused prices to shoot up.  Then, we were off to the races.

As prices soared and lending standards dropped, more people entered the market.  It wasn’t just first-time buyers.   Now people wanted 2, 3, 10 homes.  Speculators poured into the market. Homebuilders saw their margins skyrocket and they couldn’t build houses fast enough.   Here’s what happened to the historically stable home-value-to-income ratio:

Compared to the housing bubble, the dot-com bubble was barely worthy of Clearasil®.

When a bubble this big bursts, there is shrapnel flying everywhere.  In this case, it set off the biggest financial crisis since the Great Depression.   And, the first thing everyone wanted to know was…

Who Can We Blame?

• Mortgage Brokers? They just did what they were paid to do.  They didn’t need to worry about whether the loan got repaid.   They were just going to sell it to Wall St., anyway.  They got paid to generate as many loans as they could.  They weren’t paid based on how well those loans performed.   As such, they had every incentive to qualify any borrower with a pulse.  If they didn’t, the lender down the street would.   Anyone who expected any different, didn’t pay enough attention to the ads with which we were constantly being bombarded.
• Appraisers? They had to say that the houses were worth these ridiculous prices or the deal would fall apart.  What would happen then?   Well, the lenders would just find another more cooperative appraiser and the uncooperative appraiser could find another line of work. Besides, if three other houses on the block just sold for a ridiculous price, what basis did the appraiser have to argue against it?
• Unqualified Borrowers? Many point fingers at people who bought houses they couldn’t afford.   While I’m not a big fan of these people being bailed out, I do think the borrowers generally acted in their own rational self-interest.  They took a gamble and it paid off big for many before the bubble burst.   They could buy a nice house for no money down and a temporarily low monthly payment.  If the house value went up, they got to keep the profit.   If the house went down, they had to go back to renting after living in a nice house for a while.  Maybe they got to live there for a while longer making no payments.   And, maybe they got to live there even longer if the government came to their rescue.  There really wasn’t much incentive for them not to reach for the American Dream.
• Speculators? The same was true for speculators.  The U.S. housing market became a one-way bet for speculators.   Without the requirement of a substantial down payment, they were able to borrow at teaser adjustable rates, wait for the property to appreciate and flip it. When the music finally did stop, they simply had to stop making payments on the houses and return the keys back to the lenders.   The lenders couldn’t go after the profits they made on the houses they had already flipped.
• Real Estate Professionals? They earned their living by selling houses.   It was not in their interest to tell buyers they were overpaying or getting in over their heads.  In fact, it was just the opposite.   At the very peak of the housing bubble, this blockbuster hit bookstore shelves: Why the Real Estate Boom Will Not Bust – And How You Can Profit from It: How to Build Wealth in Today’s Expanding Real Estate Market.   It was written by David Lereah, Chief Economist for the National Association of Realtors.  This book received numerous 5-star customer reviews on Amazon…from other real estate professionals.  I was not as enthused (see, for example, Bubble, Bubble–Is My House In Trouble from March 2005).

Once the Fed artificially reduced interest rates to levels below anything resembling fair market value, the die was cast.   All the above-mentioned players did exactly what they had an incentive to do.  They all acted in their rational self-interest.  More importantly…

No One Was There To Stop Them

Outside of the U.S., France is the only real estate market with which I have much familiarity. France has not experienced nearly the decline in residential real estate prices that we’ve witnessed in the U.S.  So far, the decline in France has been about -10%, while U.S. residential real estate has declined -32%.  Even this relatively modest French decline does not seem to be so much a result of the bursting of their own real estate bubble as it is a secondary impact caused by the bursting of real estate bubbles outside of France.   French prices did not even start declining until more than two years after the real estate bubble began bursting in the U.S. Yet, like in the U.S., they have shown a blip up in the last 3-6 months.

I believe this difference stems in large part from a difference in lending standards.  In France, by law, lending standards are much stricter.   Buyers are required to make substantial down payments and their mortgage payments can’t be more than a third of their income.   If these standards sound familiar, it’s because this is the way mortgage lending used to work in the U.S. back when lenders kept the loans they made.   They had to be strict because they were worried about getting repaid.  Unfortunately, worrying about whether a borrower would be able to repay his mortgage became downright un-American during the housing bubble.   As a result, while the U.S. homeownership rate soared from 64% to 69% during the bubble, the French homeownership rate stayed virtually constant at about 55%.   Apparently, the French motto of “Liberté, égalité, fraternité” didn’t include the right to buy a home you couldn’t afford.

In contrast, in the U.S., we created a landscape littered with empty slogans from disasters like:

• Fannie Mae

Our Business is the American Dream

• Freddie Mac

We Make Home Possible

• Countrywide Financial

Easy, Really

• Ameriquest

Proud Sponsor of the American Dream

• Washington Mutual Home Loans

The Power of Yes

This WaMu commercial was a sign of the times.

Obviously, lawmakers could have reigned in the riskiest lending practices.  Instead, they were cheerleaders.  Homeownership ranked right up there with apple pie and motherhood.  Instead of outlawing these practices, they were out lauding them.   Even with the ultra-low Fed interest rates, we could have been spared much of this financial crisis if, like France, the U.S. had required some reasonable mortgage lending standards.

Uh-Oh, Domino

So there you have it—the domino chain that led us to where we are today:

• The Boskin Commission lowered the CPI.
• With a lower CPI, the Fed was able to reduce interest rates way below fair market value.
• Artificially low interest rates created a huge demand from fixed income investors for higher-yielding, “safe” investments.
• Investment bankers worked with credit rating agencies to meet this demand by securitizing mortgages and turning them into AAA-rated investment products.
• To meet the overwhelming demand for these products, lenders lowered their standards.
• Lower standards meant more people could qualify for a mortgage.
• This drove up demand for houses causing prices to soar way above fair market value.
• Rising prices and easy credit created even more demand from speculators and people who wanted second homes.

And, politicians cheered all this on, because home ownership was at the core of the American Dream.

Liquidity Under The Bridge?

Is this all just so much liquidity under the bridge?  Is it all old news?  Unfortunately, it’s not.   It seems that our leaders are doing everything they can to cushion the impact of the current crisis by aggressively doing more of the same things that caused it.  I agree with Jim Rogers, who told Maria Bartiromo in this CNBC interview:

That’s like saying to Tiger Woods, “you get another girlfriend and it will solve your problems.”

A fast as the dominoes have been falling, Ben Benanke’s Fed, Congress and the White House have been lining them up again.   Next month, we’ll look at this line of dominoes, what could cause them to start tumbling again and how we can prepare ourselves.

But, right now I better stop writing.   Just today:

• TIME magazine named Ben Bernanke its Person of the Year.
• The Federal Reserve reiterated its commitment to keep interest rates “exceptionally low” for an “extended period.”
• And, the House of Representatives voted to raise the National Debt Ceiling to $12,394,000,000,000.

After a day like today, words are starting to fail me.