Friday, July 31, 2009

More on the "Impossible" Healthcare Solution

Readers checked in with diverse responses to this week's entry on The "Impossible" Healthcare Solution: Go Back to Cash

Readers added excellent commentaries to The "Impossible" Healthcare Solution: Go Back to Cash. Ideas covered below include catastrophic insurance and an insightful comparison to auto insurance.

Frequent contributor Michael Goodfellow provides an excellent summary of Obama's healthcare "reform" (read, "more of the same only with more transactional churn, more bureaucracy, more penalties and more waste"), and columnist Walt Cook's column concludes today's entry.

This is a huge topic, so please read each commentary. I responded to Mark A.'s insightful critique, otherwise I stay in the peanut gallery today.

Steve R.

I just had a similar conversation with my Aunt (sharp and spry at 86) who sees modern insurance/healthcare for the scam it is. Before it became "the healthcare industry" doctors and clinics/hospitals were paid directly in cash by most patients. There was considerable discussion among her friends in town about what their doctor charged vs the service/outcome provided. No publication just word of mouth grapevine - people were pretty well informed too.

Yes people once actively shopped for medical care based upon price and perceived level of service. Imagine that! Now it is all but impossible to do so. A token co-pay is all most are really aware of. The argument that everyone should receive the best possible healthcare regardless of ability to pay is utopian nonsense.

Actual healthcare is quite valuable but the actual costs are hidden from the end user to support a bureaucratic "industry." Having the government pay for it (by taxing the rich?) appeals to basic human nature but largely defies logic.

Our whole society seems to have these flawed incentives and entitlement attitudes. Maybe we ARE all collectively deranged. "We have Paleolithic emotions, medieval institutions, and godlike technology - a dangerous combination."

Certainly our institutions can change and adapt but they tend to exploit the individual's irrationality of emotions through confusion/ obsfucation and fine print.

Human emotion we view as a relatively fixed concept - the primal "old brain" portion of animal instincts. But can this evolve over time and the experience of generations? I'm not sure but I hope so. I think it may require a huge societal change in attitude.

Kevin M.

I'm so glad you wrote this! I actually said this very thing to a group of ten men on Saturday--that insurance IS the problem because it enables everyone to insist on the best healthcare but no one wants to pay for it--and there was dead silence, as though what I'd said was either brutally honest or a blatant heresy. Then the subject changed.

Also, I agree completely that the system will collapse and not as far into the future as most of us like to think. The system is crashing now and there's no public or political will or concensus to bring about true reform, so we have to assume that what we'll get is an unmanaged collapse, better known as a crash. The health insurance companies may be the next bubble to burst.

Cory A.

I have wealthy friends in Boca Raton, FL that are already paying a yearly 'retainer' for health care from specific physicians. They have to be invited in by the doctor by referral and have to sign a malpractice waiver. This is a direct response to our present and broken system.

There is another example I like to use which contrasts the stupidity of our present government/insurance system (I say government because the HMO rules came into being by an act of Congress in the 1970s) and that is that we buy home and auto insurance for catastrophic and non-routine circumstances yet we do not do this for health care. It would be akin to having insurance for minor things such as a pump failure on an AC unit or the replacement of a part of a toilet.

If we carried catastrophic coverage and paid cash for everything else, costs would come down for the reasons you stated.

Your article is even more noteworthy because I realize that you also have an affinity for socialism under certain circumstances.

Congressmen Ron Paul was delivering babies in TX as an MD prior to the 1970s health care changes and stated that nobody was ever turned away from their hospital and nobody went to the emergency room for routine visits as happens today.

"Ishabaka" M.D.

That was an interesting article about cash only medical care. It's something I've wondered about for a long time, swinging from one side to the other. The "conservative" AMA types (I have never belonged) are generally pro-cash for care.

One huge advantage would be that it would eliminate all the hands dipping into the health care pot which contribute nothing to health care - medical billing companies, health insurance companies, and government workers running Medicare and Medicaid.

The next is, the idea of actually being paid when you provide a service is attractive. To give you an example of the runaround us docs get - I started a new part-time job in a clinic last October. I have a Medicare "provider number". That number is "assigned" to wherever I work so they can collect Medicare payments under their name (the clinic pays me a fair rate per hour). Well, the clinic's billing person applied to have my Medicare number assigned to them - and it hasn't happened YET. That means that they have to withhold billing, and don't get paid for all the Medicare patient's I've seen until someone in government gets off their duff and makes this change - which I'm sure takes all of five minutes.

Third, I have always been frosted when relatively poor people bring their baby, or mom in for care, pay nothing, and nobody can collect anything from them because they "have no money". You are right, they all have cell phones. Here, I would gladly take payment in kind, and I know just what I want! Someone to mow my yard (it is a miserable job in the Florida heat and humidity now), and wash and wax my car. There seems to always be one healthy young male in the entourage that comes in with such patients, I'll let you decide how many lawn mowings or car washings would be fair per whatever I do!

There really are people who have no money and nobody to pay/work off their bill. In the E.R., I've probably treated enough homeless people to overflow our local NFL stadium. We have to treat these folks if we want to consider ourselves a humane society, and that means increasing the bills of those who can pay a little.

Finally, there are patients who, even under your rates, would bankrupt their family. I remember a little girl I treated when I was in training who had climbed up on the stove to get something and her nightgown had caught on fire, causing severe widespread burns. She had been in the hospital a month when I came on the burn service, and was still in the hospital and far from being healed when I left the burn service at the end of the month.

Premature babies also require huge amounts of resources - they really need them to live and not wind up brain damaged (one of the reasons our infant mortality rate is high is because we try to keep these children alive, other, less advanced countries simply let them die at birth). You need around the clock nursing - one nurse per two babies, and those nurses WORK, you need a doctor in the neonatal care unit almost 24 hours a day, the babies need blood tests often several times a day (tests they really need, not to pad anyone's pockets).

It's a nightmare - the only thing in medicine I really couldn't handle - all those tiny babies being constantly tortured (so I felt) with needles and tubes - but a surprisingly high percent grow up healthy in body and mind.

One idea would be if medical expenses exceed a certain amount of family yearly income, we might have a government program to assist.

My last point, is that fee schedules for doctors, clinics, and hospitals would have to be made public. Last year, at age 53, I decided I really should have a colonoscopy. I went through the yellow pages, and to the websites of the doctors I knew were good - absolutely no information about fees whatsoever. I was very lucky that a friend of mine - an excellent gastroenterologist - offered to do the procedure for me at no charge.

Richard K.

Kudos on your "Cash for Healthcare" blog.

I have been a vocal (to my friends) evangelist against the great evil health insurance industry. I agree that if we had to pay for medical care ourselves, it would have to be cheaper.

Take two research-intensive industries: consumer electronics and pharmaceuticals. Although both invest in lots of research and have relatively inexpensive costs of manufacturing, electronics keep getting cheaper and drugs keep getting more expensive. Why? Because the users of electronics have to pay for the products themselves.

Now the evil of insurance is spreading to veterinary medicine. Both veterinarians and insurance companies are pushing the idea. A pet owner might balk at paying $700 for a pet's operation, but they will willingly pay $30/month. Now pet healthcare costs can increase because the owners of healthy pets will pay the bills for the owners of sick pets, just as in human healthcare.

Veterinarians will charge more and make more. Insurance companies will make profits, and pet owners will get the infrequent expensive operation paid for by insurance. What a deal! Just wait fifteen years.

Morris P.

Your topic today hit the nail right on the head. How would people survive today on a "cash only" basis? When I went to cash only about 15 years ago my lifestyle (I'm a widower) changed quite a lot but I can't begin to describe to you the peace of mind gained from not having a house payment or car payment. It feels as though the weight of the world is lifted from your shoulders. Yes, I now live in a 35 year old mobile home and drive a 1991 Toyota but they are both in great condition because I take care of them. I live very comfortably with window AC units and space heaters. I actually am able to save a few dollars each month.

Our Walmarts now have walk-in clinics with the price for medical services listed on a "menu" behind the receptionist. The clinics are staffed by Nurse Practitioners whom I consider to be just as capable as any doctor. Although for an emergency you would still need to visit the ER at the hospital, these clinics can take care of a lot of things that many people now visit the ER to have treated. Of course they ask for cash but the prices appear reasonable to me. I haven't had the need to visit one but they seem to be busy most of the time. Maybe this is the beginning of what you what getting at in your column today.

Mark A.

As always, I'm a fan of your blog, and I've been reading it long enough that I reckon I know the boundries of your worldview(s) by now. In re: the heathcare issue, then, I'm compelled to comment, 'cause while you admit at the start that your proposal is "impossible", and so disclaims a certain amount of seriousness, the proposal also seriously oversimplifies the issue to a degree not typical of your other thinking.

Start with the rhetorical question, "is medical care 40 times better than it was in 1952?" You say it isn't; that the marginal benefit hasn't justifiied the expense. To a large degree I agree with you - costs have certainly been inflated by the prevasiveness of insurance money and the decoupling of the payer from the vendor. But - keeping in mind that this reaction is visceral and not statistical - it's probably at least 10 times better, and it's exceedingly facile to ignore the truly fantastic advances in medicine that have been made over the past 50 years.

I'm not sure how one proves that through gross statistics, but I think using those statistics grossly understates the value of medical advancements. (It strikes me that in the aggregate we may have "consumed" much of the health product (think heart-bypass surgery) through lifestyle offsets (think crappy diets) or environmental contributions (e.g., pollution), but who knows...)

Think only of the interventions that are now possible in the case of premature infants, heart disease, trauma (car accidents, battlefield medicine), cancer, schizophrenia, etc., and I hope you admit that you'd rather have the benefit of the medicine of today rather than that of 1952.

That all of this costs too damn much is not in dispute. Certainly many costs have been embedded into the system by the presence of too much free money. But I suspect at some point one has to differentiate between, say, the costs of routine health maintenance (that anyone should be willing and able to pay for) and the costs of acute interventions that no one could ever afford without insurance. A routine physical with lab work shouldn't cost me $500, but it does, and it's a good candidate for a cash transaction. But if a car accident puts me into the emergency room because some dork was texting his wife, I don't see how it can cost me any less than $25,000, or how society would not expect to create insurance to cover such events. Old-age maintenance is arguably another category of expense that needs to be rethought, but it is hard to see how it could ultimately fit into a cash-only scheme either.

I suppose my point is that part of the surplus of our years of economic supremacy has been invested in capital and systems that it would be foolish to ignore or surrender. These systems manifest as embedded costs, and those costs are now becoming excessive relative to our product, but they are not superfluous. Environmental knowledge begets environmental laws begets onerous regulation, but the knowledge remains a necessary asset. At the point where you start to suggest that nothing that has happened in medicine since 1952 has been worth the added cost, you start to sound irrelevant, like some cranky granddad no young person wants to listen to, and I'm sure this is not who you are or want to be.

Thank you for the thoughtful critique, Mark. You picked up that this is one of my entries designed to stake out a radical solution which everyone considers "impossible" as a starting place for discussion.

I think there are two points we need to discuss further. One is your presumption that an auto accident would still cost $25K of care. Let me ask you this--what do you think it would cost in China or Thailand, where people go for heart surgery etc. because it's affordable? The MRI machines are exactly the same as the ones here. I don't know the actual number but it isn't $25K. The cost structure here is bloated in so many ways and it all stems from there being no "market" at all. Please read the other comments today for other examples.

The other searingly difficult issue is whether we as a society have the money to pay for preemies, etc. which cost hundreds of thousands of dollars each--part of the advances you describe that are actually extremely marginal--meaning a relative handful of citizens absorb an outsized proportion of total medical expenses.

Regardless of the ethics, I know the US government will become insolvent soon and be unable to pay its bonds, much less healthcare or global empire. We as a nation have fooled ourselves with trillions of borrowed money that we still have a "surplus"--we haven't had a surplus in decades and I don't mean a Federal surplus, I mean an economy-wide surplus. We've lived off financial bubbles and that is about to end ingloriously within the next 5 years.

I suspect high-end healthcare will very quickly be off-shored because we as a nation can no longer afford it being done here. You can already get high-end procedures in India and Thailand for 20% the cost here, with equivalent (or better) care. That is the future if the system remains as it is. The dental clinics across the border in Mexico which are designed for cash-paying gringos will be joined by clinics for preemies, heart surgery, etc.

Walt Cook

I just read your column on the benefits of paying for medical treatment with cash. Good stuff. Anyway, I'm a columnist for a Wyoming newspaper and wrote something a couple weeks ago that was very similar (we agree on the problem, though my proposed solution is different). I thought you might want to take a look at it. I compare health insurance to car insurance. There are references in the column to a society of hypochrondriacs, and abusers of health insurance being akin to someone who would buy neon undercarriage lights with car insurance if they could.

(Walt's column is reprinted by permission below.)


You are exactly right; and I own a medical equipment company. The whole business is built on selling equipment that will get Medicare reimbursements but docs have been forced into Mother Gov of course.

Check this out: one area of healthcare has actually been going down in price (not a lower rate of increase, but prices going down.) That would be cosmetic surgery. Insurance doesn't cover it so a free market has developed that drives efficiency and customer satisfaction. Impossible? Nope.


So, a little while ago I went to see my regular doctor. Very nice guy. About 2 years ago I asked him if he was ready for what was coming. He said what and I said an extreme recession or a depression. He asked me what that meant and how to prepare so we talked about it a little.

Anyway, this time we talked a little more and I said well at least you will have work. The bad news is you will get paid with chickens.

He had done some work in a third world country and told me "Well that has happened before."

I always remember the scene of "To Kill a Mockingbird" where the lawyer is paid by barter.

Michael Goodfellow

I want to ask one of these guys who benefits from Obamacare? As I read it:

- If you are on plan Medicare like seniors or disabled, you hope for no change. Some mythical cost control.

- If you have Medigap insurance, I'm not sure what happens to it. It won't get cheaper, and might get more expensive due to mandated minimum coverage limits on all insurance. Or it might go away somehow, since I think they want maximum deductibles and minimum percentage payouts. On the other hand, AARP would really lay into Congress if they messed with this, so I doubt they cut coverage. If they increased the things it has to cover (like adding mental health coverage) it would get more expensive.

- If you are employed with insurance, you (or your employer) might also see increased costs due to mandated coverage and reduced deductibles.

- I'm not sure what happens if you are employed with insurance and lose your job. Is there still COBRA so you can pay your existing plan? Or are you immediately fined for not having insurance, just when you become unemployed? Or are you expected to get subsidized insurance then drop it again when you get a new job?

- If you are employed without insurance, there's an 8% penalty on the employer for not insuring you, and a 2.5% penalty on you for not having insurance. The problem is if you make $20K a year, that's a $1600 payment for the employer, which is cheaper than individual insurance (and a lot cheaper than family insurance), and a $500 penalty on you, which again, won't pay for insurance. So you might lose $2100 from your salary (employer share has to come from somewhere) and still not have insurance. You get some kind of subsidy, but it would have to be a lot to put a years health insurance under $500, especially for a family.

- If you are self-employed and have a Health Savings Account with high-deductible policy, it sounds like that goes away. The mandates for insurance make those policies impossible to write. Not sure if they eliminated the HSA program or not, but without the insurance policy behind it, it's kind of pointless. You pay more for more insurance.

- If you are unemployed and uninsured, you get a subsidized policy, but you of course have no money. I think you pay a penalty, but perhaps not if those are a percentage of income.

- If you are homeless or just the type that goes to the emergency room for everything and doesn't pay, then you probably continue to do this. They still aren't going to turn you away, and still won't be able to bill you. The only change is that costs which used to be padded onto the bills of the insured might now be coming from the Feds.

- Illegals still don't get insurance, and they are 8-10 million of the famous 45 million uninsured. Another big chunk are the unemployed, and as I said, I'm not sure what happens to them. A lot of the poor still can't afford insurance (esp. mandated gold-plated insurance) and so aren't covered. That's what happened under the Mass. plan.

So I can't see who benefits. The cost controls are an illusion at this point, and the Feds run another 15% of the economy. Sounds like a losing proposition all around to me. When push comes to shove and they run out of money, they will ration, the way Britain is doing now. Except I don't think Americans will take it as well. The NHS was government run from the start. Our system will still have lots of people who remember "the good old days" of private care.

Car insurance vs. health insurance What if one were more like the other?

By Walter Cook reprinted with his permission

Imagine if car insurance wasn't just for emergencies.

Say you could use it to pay for things like oil changes, window tinting, spark plugs, neon undercarriage lights, new tires and hydraulic lift kits.

What would happen? To start with, many people wouldn't be able to afford car insurance, as the insurance companies would be paying out so many frivilous claims that they'd have to raise their premiums in order to make their desired level of profit.

Basically, the guys abusing the system to tint their windows and install lift kits would be screwing over the people who just needed insurance in case they crashed. Abuser or not, everybody would pay the price.

Luckily, the world of auto insurance doesn't work like this. But, sadly, this is how the world of medical insurance runs. Because of this, health insurance is a lot more expensive than it needs to be.

Health insurance in America is seen as something you're going to use, not as something to have around just in case. But that's not really insurance in a traditional sense. That's an entitlement.

When it comes to auto or home insurance policies, nobody -- unless they're fraudsters -- actually wants to use them. Who wants to get into a car crash or have their home burn down, after all? But if people could buy a new car stereo or a new washer-and-dryer set with their policies, things might be different.

If they could buy such things, car and home insurance wouldn't just be extremely expensive; such abuse of the system would also spur an artificial demand for all kinds of trinkets and furnishings -- thus creating a price bubble.

Before you knew it, car stereos would cost $4,000 each, and washers and dryers would go for about $20,000 apiece. Such inflation seems to have already happened in the medical field.

The entitlement aspect of health insurance has both driven up premiums and spurred demand for medical services -- thus driving prices up.

Supply and demand in medicine isn't a bad thing per se. It's only bad when hypochondriac types get involved and abuse the system.

Unfortunately, there seems to be a lot of such people in the United States. Just look at the late-night boner-pill and antidepressant commercials for proof. And don't forget the perfectly healthy people who get full-body CAT scans just for the peace of mind. Do you think they paid for such an expensive procedure with their own cash? I doubt it.

Deep down, many American consumers of medial services are no different from the guy who would purchase neon undercarriage lights if his car insurance allowed it.

But such abuse of the system doesn't mean health insurance isn't needed. After all, every day, people shatter their femurs in skiing accidents, they contract deadly communicable diseases, tumors grow in their brains, they are attacked by vicious dogs, they are shot, they get old and frail, etc.

Such people need help, no doubt about it. They need insurance. The best way to ensure they continue to get the help they need, is to put a pin to the medical services bubble inflated by hypochrondriacs and the marketers who peddle paranoia. Socialized medicine (with an expensive private option for those who can afford it) is the best way to pop that bubble.

Because our government is broke, a taxpayer-funded insurance system would weed out the abusers. The cash-strapped government (I don't care what President Obama says) would flat-out refuse services to those who didn't need them, marking the end of the days of $90 bottles of hospital aspirin.

I can see it now: old ladies won't be refused funding for a pre-existing condition, people won't be bankrupted by insane medical costs -- and the fit 20-year-old on his parents' insurance with a cold won't be handed bottles of tetyracycline, Prozac and codeine and sent on his way. In fact, he probably won't even get in the door.

Thank you, readers, for your valuable input on this important topic.

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Thursday, July 30, 2009

More on Capital Traps, Buying, Holding and Selling Housing

Readers checked in with diverse responses to this week's entry on houses as capital traps.

Readers found a number of holes in Housing Recovery: Sell Now Or Your Capital Will Be Trapped (July 27, 2009). To wit: if you can buy a house with a 3.5% down payment FHA loan, that modest amount is in effect an "option" that the fixed-rate mortgage will continue to cost less than rent.

Matthew C.

I have read your blog often over the last couple years and I am always impressed by your sharp analysis, not to mention that your charts and graphs are excellent, which back up your analysis.

However, upon reading your recent article, I think you are missing a very important piece of the puzzle. People buying a home today will NOT be trapped. In fact, now is a great time to buy because of the possibility of rising rates.


I live in San Diego County and bought my first house in 2002 for $220,000. After becoming convinced that we were in a speculative bubble, I sold this house in the summer of 2005 for $385,000. I rented for 3 years and just bought my second house this April for $450,000 (would have been $700K+ at the peak).

Here is the scenario:

3.5% down = $15,750 minus $8,000 Obama tax credit = $7,750 down.

Seller paid all closing costs per contract.

FHA loan at 4.75%, 30 year fixed. Payment with taxes, insurance and MIP = $3,047.66.

Now here are my options under your scenario:

Rates go way up (in your example 4.5% to 9%). Now I can sell my house with my ASSUMABLE FHA MORTGAGE at 4.75% for more than market value and use the money to buy a new house at true market value while keeping my payments the same and getting a much bigger tax deduction due to my higher interest rate on the new home. Furthermore, FHA purchase loans are non-recourse, so I could walk away anytime if I ever owed more than the home was worth. By the way, if anyone says that is wrong, I say BS, because I am paying mortgage insurance (MIP) for that very reason.

Not to mention, I am paying $3,000 a month for a house that would rent for the very same amount and I am getting a huge tax deduction in the process. I also locked my payment at $3,000 a month for 30 years versus rents that will go up with the coming inflation you describe.

Not to mention, my $7,750 is a pretty cheap “option” on my home considering that if the price does increase (due to inflation), my return on investment could be huge. A $77,500 increase in value would be a 1,000% return on my money. Of course I am not counting monthly payments; but why should I when the rent would be the same as my payment and I have to live somewhere anyway. Not to mention I am actually getting by cheaper per month because of the tax deduction.

I agree that I would have been a fool for buying in 2005 when I actually sold my first home.

But on the same token, I would be a fool for renting right now when I can buy a house for the same as renting and give myself a non-recourse loan and a massive tax deduction. Furthermore, because the loan is assumable, I won’t be trapped. In fact, I will be delighted to sell my home for more than market value, only to purchase another bigger and better home with the proceeds. And if the sales price is less than I paid (because of rising interest rates), EVEN BETTER, because now I will have a capital loss to offset future capital gains, all the while buying another bigger better house with a lower property tax base and an even bigger mortgage deduction due to the higher future interest rates.

Do you see anything wrong with my analysis?

I forgot to mention how the “assumable” works with FHA loans.

The new buyer just has to qualify based on income. They DO NOT have to pay the MIP which you already paid and NO new appraisal is required.

They just take over the loan and you walk. The other terms are per contract and can be whatever the buyer and seller agree to. It is super easy and clean.

So the bottom line is: Minimum down payment FHA loan is the way to go in today’s market. Here is a Q and A on FHA loans (I just typed in “FHA loans are assumable” on Google and clicked the first link.)

Excellent points, Matthew, and my only comment is that I should have specified I was addressing people who had large equity positions in their home--potentially trapped capital--and even more specifically, a large percentage of their net worth tied up in their house. In other words, those for whom a drop in house value would be catastrophic to their overall net worth.

Buying a house with 3.5% down is certainly a sound strategy if the overall monthly cost of ownership is relatively fixed and on par with local rents. But there's no capital to be trapped in that scenario, only the modest "option."

The assumable FHA loan could well be a major advantage; if the loan is fixed at say 5% and interest rates rise to 9%, then selling a house with the 5% mortgage (assuming the buyer qualifies for FHA financing) would be far easier than selling the house to a buyer who must finance the purchase at 9% with a conventional 20% down payment.

And all this assumes the Federal government will continue to have the means to subsidize the housing market with unlimited FHA loans.

Richard H.M.

Housing Recovery: Sell Now Or Your Capital Will Be Trapped is 100% correct and right-on. I came of age after the collapse in the 70's and saw the same thing from a different point of view: House prices HAVE TO be low when interest rates are INSANE!

You did a bang up job of explaining of how we get there from here, back to those low prices with insane interest rates.

I'm a financial guy, so easy to read your article.

To explain it to Joe Six Pack: When your ARM explodes, no one else will want your house, either.

To explain it to Goldbugs: Avg home has historically sold for 100 oz. of the yellow stuff. So houses are still way overpriced today, by about 2 to 1.

I grew up with Depression era Dad who taught me to pay cash for everything. By the time I started owning houses (never a mortgage), I looked at homes as "stuff you own" like your pots & pans and collection of old Beatles albums.

Actually, it's worse than that, more like a car... there are endless taxes, fees and maintenance costs, and as the deferred maintenance accumulates, you are likely to have a lower residual value, like a used car.

The only houses that seem to really appreciate are in high end neighborhoods where the owners constantly renovate. When you subtract all the costs of keeping your home in perfect condition and constantly remodeled and "updated"... still, not much of an investment.

The real catch-22 is that in boom times, there is nothing for rent in the exclusive neighborhood, and in hard times, when there are rentals available, then the neighborhood doesn't seem so exclusive anymore.

We have a block called "foreclosure gulch" right in the middle of Reno's most exclusive established gated community. Was fine until the real estate market peaked, then it quickly became a block full of bank REO's, short sales, and half finished remodels abandoned by spec. builders and left with a pile of liens and loans that no one will touch. And that's Reno's BEST neighborhood.

Bill C.

I am with you on just about every point except one. If inflation kicks in won’t that lift the stock market rather than have it fall? Coincidentally, won’t cash be devalued as inflation rises, like Zimbabwe?

Excellent point, Bill. What gets confusing is whether we actually get inflation or not, or if we get modest inflation but much higher interest rates. The worst case is also possible-- prices deflate AND interest rates rise because there's so little cash in the world (surplus capital) and too much demand (govts, business and people wanting to borrow). I guess we'll just have to to wait and see which we get. If we get high inflation, then you're absolutely right, cash will lose value (purchasing power) unless interest rates rise faster than inflation--which is also possible.

Greg R.

RE: Home Equity being trapped.

At one point you suggest, selling your home and putting the equity into a savings account in a rising inflationary economy, so the equity is not trapped.

Is that really a good thing to do?

If I did that, I would no longer have a home and have to rent. Monthly Rents in my area exceed the monthly mortgage cost for the same home. With a fixed mortgage I have limited my monthly housing costs, something I cannot do with renting in an inflationary period. I lose the ability to deduct the interest portion of my loan, but then that is mostly offset by having to pay property taxes. My money is in a savings account with fixed interest, in an environment with rising inflation.

In rising inflation investment returns rarely meet or exceed inflation itself, which means I'm now losing money on that former equity.

You haven't convinced me that selling my home and removing the equity is a sound decision.

If I had investment property, I might consider what you've suggested, as it would allow liquid funds to be quickly placed into gold until inflation blows over.

I bought my home in 1983 for $98,500 with 25% down and a mortgage of 13.25% (remember prime interest rates were 9%+) My mortgage payment in 1983 was was about $920/month; I refi'd three times since then. I'm now in the last few years of a 15yr loan at 5.25% with a monthly payment of $484/month My home's value peaked in 2006 at $640,000, It's now going for $440,000.

Like I said If I had investment property I might be inclined to bail, well actually I would have in 2006-7 as I've felt for 5-6 years that this economy was unsustainable and heading for a fall.

My property taxes are limited under Calif prop 13 to 1.5% annual increases.

I guess one issue here is comparable rents; if the costs of owning are fixed and lower than rents, then that is a major positive as inflation could drive rents higher. On the other hand, if vacancies rise due to foreclosures, poor economy, etc., then rents could fall even in an era of modest inflation.

As noted above, there is no reason why interest rates could not double even as the economy remains in a deflationary period.

I should have stressed in the "capital trap" entry that a key issue is how much of one's total net worth is in a single property. If essentially all of one's capital is in a house, then the eventual value of that house dictates the value of one's entire worth. That is a big gamble in a global economy which is falling apart at the seams.

Deon N.

Nice piece on the "Housing Recovery". I enjoy your perspective, insight and original thinking.

On a related note with regards to rising interest rates and lower home prices, one very little discussed topic is what I call "impact of capital".

In other words, in a higher interest rate environment capital (cash) has a higher impact on principal sums. Quite simply using your "Interest Rate See-Saw" example, let's suppose a buyer gives a $125K down payment on the the $500K purchase price. This $125K represents 25% of the total amount. In a high interest rate environment, citing your $250K purchase price, the same $125K down payment would represent a whopping 50% of the total amount. But that's not it, the real impact of capital is that every extra dollar put in towards the balance of principal($125K balance) represents over 100% more "impact of capital" than in the current low interest rate environment (original $500K purchase price). This is because every dollar represents a higher percentage towards the lower principal amount, (purchase price of $250k vs $500K). Although obvious, nobody really brings this fact up in the mainstream media.

The ramifications of this "impact of capital" are huge and becomes even more significant over the long term as the principal is reduced.

Thank you, readers, for your valuable input on this big topic.

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Wednesday, July 29, 2009

The "Impossible" Healthcare Solution: Go Back to Cash

The expansion of health insurance and government entitlements created "free money" and thus the explosion of healthcare costs. The solution is simple and "impossible": we all pay cash.

Here's why healthcare (a.k.a. sick-care) costs cannot be reduced; the entire system is based on vast pools of "free money." The corporate-America or union/government employee who goes to the doctor pays a few dollars for a visit and drugs; the "real cost" is of no concern. Ditto the "real costs" charged to Medicare and Medicaid.

The link between the "consumer" of healthcare and the provider has been broken for decades. There is no "free market" in healthcare--there isn't any market at all. We live in a Kafka-esque nightmare system in which "some are more equal than others" and hundreds of thousands of dollars are lavished on worthless tests, procedures and medications for two reasons:

1. because there's "free money" to pay the bills

2. so-called "defensive medicine" in which worthless tests are administered to stave off random (sometimes valid, sometimes nuisance) malpractice lawsuits.

There is a solution so simple and so radical that it is "impossible" (and of course you're reading it here): shut down insurance and all government entitlements, and return to the "golden era" of the 1950s when everyone paid cash for healthcare.

Here are the costs of childbirth as of 1952 at one of the finest hospitals on the West Coast, The Santa Monica Hospital:

And here are the obstetrical rates:

Having a baby cost $30, which is today's dollars is $244. A private deluxe room cost $23 or $187 in today's dollars. According to the Bureau of Labor Statistic's inflation calculator, $1 in 1952 is $8.14 in 2009 dollars.

What does it cost to have a baby now? $10,000? Or is it $25,000? Who even knows?

I know all the reasons why "costs had to skyrocket": we're getting so much better care now, right? Actually, as measured by death rates and any other metric you want to select, there is simply no way to justify a 40-fold increase (or is it 100-fold?) in medical care costs. The returns on all the "miracles of modern medicine" are in fact exceedingly marginal-- but nobody wants to talk about that.

In 1952, if something awful happened and a patient died, here was the response: "We're very sorry." Families weren't outraged; they expected people to die and interventions were not expected to be miraculous every single time. Doctor Kildaire and all his imitators on TV had not brainwashed the public into reckoning that if someone died, a mistake had been made. They also hadn't been brainwashed by the mental disorder known as "the American Legal System" into thinking that in every possible circumstance in life, there is liability, and the only question is where to pin it for the big bucks jackpot.

Stories about people suing doctors and hospitals for 5 times the value of a house ($1 million in today's money would have been $120,000 in 1952, when you could buy a nice house for $20,000) simply did not exist in the 1950s. The cultural mindset that someone somewhere must be at fault and it's a "right" to go after them did not exist. Since insurance was limited, there was no "free money jackpot" to go after, either.

I know you're probably outraged at the suggestion that "modern safety nets" of insurance and entitlements are the cause of our ills, but follow this idea through:

With no insurance or government program to bill vast sums, then every clinic, doctor and hospital in the U.S. would instantly go broke. Someone would pick up the pieces for $1 or whatever the auction price happened to be and start charging people $50 for a visit to the doctor--not a "co-pay" which was accompanied by a bill for $500 or $1,500 or $15,000 to an insurance company or the government, but $50 cash--that would be the total cost. People might decide they did not need to see the doctor every time they got the sniffles. They might ask the doctor if an MRI was really going to help diagnose their problem or if it was gilding the lily.

As for malpractice, maybe the clinics/hospitals would be non-profits. Go ahead and sue the bejabbers out of them--they have no insurance and no cash. Go ahead and win a huge settlement: you'll never collect because there's simply no money. The non-profit folds and another one buys the clinic for $1. With no giant pot of "free money" to pillage, the pillaging goes away. Hospitals which sought stupendous profits would presumably charge more, and hence would have fewer customers. It would be up to the consumer.

The solution to malpractice is information, not lawsuits. Based on my conversations with the M.D.'s who frequent this site, here are some simple policy/regulatory steps which would have very low end costs:

1. License all M.D.'s nationally so they don't need to go through the absurd waste of time and money being licensed in multiple states.

2. Make all information on clinics, hositals, surgeries, etc. public on the Web. Those doctors willing to take on the very ill will have more patients die than those who avoid the risky cases; it will be up to consumers to sort out the track record of the people who they choose to hire to attend to their health.

Something magical would happen to prices: they would drop to what people could afford to pay cash. Yes, those wonderful folks in the pharmaceutical industry could list their drugs for $10,000 a dose, but few would be buyers. Just as in other countries with no "free money" to tap, the price of that drug would quickly drop to $50. That, or the pharmaceutical companies can go bankrupt and let others fill the vaccum.

What would happen is simple: marginal care would vanish because few would be willing to pay for it. The cost of an MRI in China is a tiny percentage of the cost of an MRI in the U.S., and the machine and training of the technicians is the same; so why does it cost 25 times more for an MRI here? Because there's a pot of "free money" available to tap.

If the entire system collapsed and everyone paid cash, the cost of an MRI would be $100 or so, regardless of any other conditions. Or, the owners of the MRI machines could declare bankruptcy, sell the machines and auction and let someone else provide the service to those who decided it was worth the expense.

But what about the "poor people" who can't afford medical care now? Well right now they have to stand in line at emergency rooms--the most wasteful, inefficient system possible. Even "poor people" can afford a few dollars--there's endless excuses provided yet how many "poor people" have cell phones, eat costly fast-food, do costly illegal drugs, etc. etc. Everybody has choices; we're not all deranged, and for those who are deranged, then clearly the government will have a role in their care when it exceeds the capacity of their family or if they have no family.

Everybody's got an excuse in our current system, and perhaps that's why it is morally and financially bankrupt. The U.S. (and certainly not Santa Monica) was not a Third World nation in 1952; people did not feel their healthcare was deficient or poor. There was simply no money to pursue marginal returns except perhaps for a few millionaires seeking exotic treatments. Fine, it's their money; most died right along with the rest of us and at about the same lifespan.

As for "overall health" of the populace: what with the "diabesity" epidemic out of control due entirely to lifestyle changes, it's hard to say we've gotten 50 times healthier as a result of our healthcare costs rising 50-fold.

When it comes right down to it, the current system is based on this premise: the average American is too dumb to figure out healthcare for themselves and so we need a gigantic structure of "experts" to figure out what should be done and what it should cost. It's not even really "insurance" because everyone gets old, ill and then dies.

This has resulted in the most brutally inefficient and even cruel system possible, one in which the very elderly are milked for hundreds of thousands of dollars of "healthcare" in the last days or weeks of their lives while tens of millions get no care at all except at the emergency room. Since no one takes responsibility for their own health or healthcare costs, then people take poor care of themselves and thus many of our ills are self-inflicted. People save little to nothing for emergencies because they've learned to expect someone, somewhere, to pay for their healthcare. (It's a "right." Really? At whose expense? The Chinese who buy our debt?)

I know, I know--going to a market/cash system is "impossible." But the irony is that's where we'll be in a few years, regardless of what anyone thinks or wants: "healthcare" in its present incarnation will bankrupt the nation just as surely as the sun rises.

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Tuesday, July 28, 2009

"Recession's Over, Recovery Underway": What's Missing in Action

The mainstream media is gleefully hyping "the recession is over, the recovery is underway." Nice, except for everything that's missing in action.

"The recession is over, the recovery is underway." Exactly what will be driving this fabulous "recovery"? Let's check in on the usual forces which have powered previous recoveries:

1. Autos/vehicles: missing in action (MIA). Annual sales have plummeted from 17 million vehicles a year to about 9 million a year, and the U.S. probably contains about 30 million surplus/lightly used vehicles ( a number snagged from economist David Rosenberg's latest report). Modern vehicles can easily last 15-20 year, so the "need" to replace vehicles is rather low. Actual "necessary" replacement might require as few as 5 million vehicles a year.

With unemployment at 16%, assets down by $10 trillion and the FIRE economy (finance, real estate and insurance) in disarray, where does anyone think the consumer borrowing firepower will come from to finance an extra 8 million vehicles a year?

2. Housing/real estate: missing in action (MIA). Let's see: new home sales down from 1.4 million a year to 350,000 a year and the headlines are screaming "recovery in housing" even as house prices are down 50% from the bubble peak and still declining. The Case-Shiller index just came in at a year-over-year decline of 17% and the market is cheering because it's a few tenths of a percent "better than expected."

The U.S. has 18.7 million vacant homes and even if you bulldoze a couple million in shrinking rust-belt cities we still have 16.7 million vacant dwellings, plus thousands more foolishly being constructed every year.

Furniture sales and auctions of old furniture are in the ditch; ditto draperies, carpeting, hardwood flooring, etc. etc., much of which is still manufactured in the U.S. No wonder the manufacturing sector is still contracting as well.

The bubble in commercial real estate has yet to pop but the needle is currently being inserted into the balloon. Too many malls, too many strip malls, too many office towers, too many CRE buildings everywhere.

3. FIRE economy: missing in action (MIA). Finance, real estate and insurance were the boomtown industries in the housing bubble. They're diminished and will never come back; the consumer must save now to avoid a retirement in a cardboard box, flipping houses for profits is history and people are paying off debt, not churning new loans.

4. Healthcare: missing in action (MIA). Everybody and their brother has been touting healthcare as the "growth industry" but since it already consumes 17% of the entire U.S. GDP, there's very little oxygen left. The ever-expanding entitlements of Medicare and Medicaid are actually being trimmed, and those 15 million people who have lost their jobs and/or benefits can't go to the doctor and have their insurance carrier billed $10,000 any more. Healthcare has peaked and a growing share of the government's revenues will be going to pay interest on the ballooning national debt, not expanding healthcare. Any other view is fantasy; the interest on the debt is already $400 billion a year and interest rates haven't even started rising.

5. Education: missing in action (MIA). This is the other highly touted "always expanding" jobs factory. Tell that to the thousands of teachers, janitors, and administrators being laid off as local government tax revenues crater. And people are finally waking up to the unfortunate fact that private diploma mills are not actually offering much of an edge in the real world; in fact, neither are pricey private universities.

When it comes time to create your own job, nobody cares about your diploma--they only want value and results. The current crop of graduates may be in some sort of elevated state of denial--i.e. believing the job drought will end next year--but the old ploy of going back to graduate school to wait out the recession may not work unless you're getting a graduate degree in stem cell research or network security. In any event, education is no longer the "guaranteed job factory" because funding for all local government functions is being slashed.

6. Local government: missing in action (MIA). The same can be said for government itself, which continued to add tens of thousands of jobs even as the recession began slashing and burning the private sector economy. The reductions in local government headcount have yet to really kick in, as Federal stimulus funding is staving off cuts that would have resulted from plummeting tax revenues. All the stimulus has done is push the job cuts in state, county and city governments forward into 2010.

All three of these sectors--government, education and healthcare--expanded dramatically because tax revenues skyrocketed as a result of the bubble. For example, look at this chart of the total assessed value of Florida real estate 1990 to 2005: it tripled. Now think of all those luscious property taxes which gushed into local government coffers:

All those expecting unlimited growth in government, education and healthcare seem to forget that all these expanded as a result of the bubble in tax revenues derived from the bubble in credit, stock and bond markets and real estate.

7. Small business: missing in action (MIA). Small businesses are the real job engine of the economy, but unfortunately very few small businesses are expanding and anxious to hire more employees. The vast majority are still trying to stave off insolvency and are looking to cut more hours and staff positions. There simply is no alternative as the State (all levels of government) increases the tax load on small business even as they claim to "care about small business." True, in one way: they care the way parasites care about not killing the host outright but merely bleeding it to the point of near-death.

Unfortunately, the parasites misjudged and their host is expiring.

8. Domestic manufacturing: missing in action (MIA). While the manufacturing sector is still formidable in many areas, as we all know much has been shipped overseas for the basic, classic capitalist reason that the move increased profits stupendously. Now, however, a "recovery" or "export boom" in manufacturing cannot pull the entire economy any longer because the manufacturing sector has shrunk to such a small percentage of the overall economy.

9. Structural reform: missing in action (MIA). Instead of cleaning out the embezzlement, fraud, gaming, leverage, exploitation, obfuscation, etc. at the heart of the U.S. financial sector, the guilty have been rewarded with gargantuan bailouts and the innocent (taxpayers) punished. The public pension systems which boosted retirement benefits in the bubble years are heading for insolvency but rather than reform them the unions and political lackeys are shoving this reality under the rug lest various interest groups get angered.

Healthcare, a.k.a. sick-care, is in desperate need of deep structural reform but instead we are treated to a Kafka-esque nightmare charade in which another trillion dollars will be squandered "to save money later." The special interests have this "industry" in a chokehold and will only release their grip when the poor old system expires, as it most certainly will, and soon.

10. Strong dollar: missing in action (MIA). If the dollar loses half its current exchange value (as measured by the DXY Dollar Index) as many expect then the cost of all imports such as oil magically double. Thus we could see $130/barrel oil even as the price in gold or other currencies didn't move at all or actually became cheaper.

11. Collateral/borrowing power: missing in action (MIA). You've probably seen this chart or one like it recently:

With $10 trillion of assets down the drain and the entire economy maxed out on credit, where do economists expect new credit growth to come from? Martians with good credit landing and hurrying into Bank of America for loans?

12. Leadership: missing in action (MIA). We have few leaders in any sector, public or private; we have panderers to various special interests and voting blocs, similar to any run-of-the-mill Third World kleptocracy. To my knowledge only Ron Paul speaks to fundamental issues such as getting rid of the Federal Reserve and the failure of the entire Keynsian "intervention/manipulation of free markets to save them" project. Few speak to the end-state of all government dependent on credit bubbles for its growth and policy: insolvency.

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Monday, July 27, 2009

Housing Recovery: Sell Now Or Your Capital Will Be Trapped

As news reports of housing's "recovery" fill the mainstream media, the devastating effects of rising interest rates are never mentioned: every house with equity becomes a capital trap.

Here's the "housing is recovering" story graphically depicted:

Anecdotally, breathless stories of the return of multiple bids are filtering into a Mainstream Media anxious to report "proof" of a "recovery in housing."

Just for context, let's take a quick look at the Case-Shiller Index:

This translates into a 50% decline in bubblicious areas of the nation: Dr. Housing Bubble: Calif. Housing drops 50% from peak.

As noted in the above article, fully 58% of all California home sales are foreclosure resales. In other words, "the bottom is in, now is the time to snap up bargains."

Not so fast. Let's focus on the key feature of buying a house as opposed to, say, a TV: very, very few people buy a house with cash. The vast majority of real estate purchases are financed with mortgages--debt.

And credit is lent at a rate of interest. As a result, the relationship between interest rates and the value of real estate is a see-saw. Buyers can only afford X per month in mortgage payments. If interest rates double, they can only afford to buy a house at a much lower valuation. Here are graphic depictions of the relationship:

In other words, when interest rates double, house prices will drop in half, regardless of any other conditions. The newly risk-averse lenders will only originate mortgages which amount to roughly a third of the borrower/buyer's monthly income, and so this is the metric which controls the price of housing.

The price can be set to whatever level the seller desires, but it will eventually settle to the price the buyers can actually afford.

So why am I suggesting interest rates could double from 4.5% to 9% in the near future? Please consider this chart of total U.S. debt, 1929-2008:

The above debt expansion might remind you of the curveset to the right: exponential (and thus unsustainable).

We've all read about the $2 trillion Federal deficit for this fiscal year; but let's not forget that corporations, local governments and agencies and real estate buyers also want to borrow money.Bottom line: the demand for surplus capital far exceeds the supply of surplus capital globally.

Every other government on the planet (yes, even the Chinese government) is also anxious to borrow huge sums of money from someone to fund their exploding deficit spending. Courtesy of frequent contributor U. Doran, here is a report from Sprott Asset Management on how dependent the U.S. is on non-U.S. capital: The Solution...Is the Problem.

The excellent John Mauldin recently issued a report on how governments want to borrow $5 trillion but there is no more than $3 trillion available to borrow: Buddy, Can You Spare $5 Trillion?

This is the classic "unstoppable force hitting the immovable object"--oh, but wait: interest rates are set by the market and are thus quite movable.Consider this chart of the 10-year U.S. Treasury bill yield:

Note that the rise from 2003 lows was aborted by a global "flight to safety" and a massive intervention in the capital markets by the Federal Reserve and U.S. Treasury which caused interest rates to plummet to unprecedented lows.

But longer term, this cycle of declining interest rates is already extremely long in tooth at 28 years and counting. the average interest rates cycle has historically measured about 20 years in length, suggesting this cycle is due for a turn and the start of a 20+-year cycle of rising interest rates:

But wait: it gets worse. Surplus money looking for a home is drying up even as the demand for surplus capital skyrockets. This vicious circle can be displayed thusly:

The net result is interest rates will have to rise--and soon. While it is impossible to predict exact dates, simple laws of supply and demand dictate that rates will soon rise and will rise steeply as the shortfall between what governments want to borrow and what's available to borrow becomes visible (not to mention private demand for capital).

As interest rates rise, then the Capital Trap shuts on all equity locked in real estate. I covered this subject last year: The Housing Capital Trap Snaps Shut (May 28, 2008)

The mechanism can best be illustrated with an example. Let's say a homeowner who bought long ago has a $100,000 mortgage on a home which was once worth $450,00 at the bubble peak. Now the property has sunk to a value of $250,000. The owner still has $150,000 in equity: quite a substantial sum.

But if interest rates double, then the house would have to fall roughly in half to be affordable to buyers. Equity would shrink to a mere $25,000. Or alternatively, if the owner insisted the "true value" was still $250,000 based on other metrics, then the capital is trapped as the house cannot be sold in the marketplace.

Thus it can be argued that to the degree a house is an investment and the basis of household wealth, the owner would be wise to sell the house now in this brief "housing recovery" while rates are still low, pocket the $150,000 equity (For simplicity's sake, I leave out commissions, property taxes, etc.) and rent an equivalent home.

As interest rates rise, that equity will begin earning a decent return in a simple savings account.

I know this concept--that savings will accrue more wealth than equity in a house--is so alien as to be absurd. We have been conditioned by the past three decades of explosive rises in real estate valuations and declining interest rates to believe "real estate always rises" and cash is essentially trash. But the 28-year long orgy of ever-lower rates is ending, and may end abruptly, and soon, as the U.S. Treasury seeks not just to borrow trillions more but also roll over expiring bonds.

The key concept here is that a house is only worth what someone can afford to pay for it. Thus we must be wary of divining "the bottom" based on metrics which don't take rising interest rates into account.

Why can't the Fed just print the $2 trillion the government wants to borrow? Wouldn't that solve the problem? In theory, perhaps, but in practice, when the Fed did exactly that, announcing it was printing $300 billion to buy Treasuries, the bond market reacted violently by pushing rates up dramatically.

Printing trillons of dollars is seen as inflationary by the bond market, and if inflation is being ramped up to 4%, why buy a bond that pays 2%? To keep buying bonds which are guaranteed to lose money is simply unwise. The net result is the Fed cannot just print $3 trillion (don't forget all the bonds which have to be rolled over) and buy Treasuries--the bond market would instantly demand much higher rates to compensate for the additional risks of inflation.

Real estate industry cheerleaders counter by saying housing "always rises in inflationary eras." By that they refer to the 70s, when real estate shot up alongside rising inflation. But what they forget is that housing was rising from extreme levels of affordability, and that the Baby Boom was entering its prime homebuying decade in the 70s.

Now we have 18.7 million vacant homes, a high level of unaffordability and rising interest rates.

There are many psychological reasons to own property: the sense of security, that you can do what you want with the home and yard, and so on. These are very real and valuable. But as an investment, rising interest rates will trap whatever capital is sunk in the house. To the degree a house is not just shelter and psychological security but an investment, that matters.

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Sunday, July 26, 2009

A Wild Speculation: the Stock Market and the Economy

Here's a wild speculation on the stock market and the real economy: the Powers That Be have engaged in a covert but easily visible wild speculation.

Bear with me while I speculate wildly about an unprecendented campaign of wild speculation by The Powers That Be.

The U.S. economy is at a cross-roads. Either it is exiting the recession and about to resume its glorious path of "growth" or it is teetering on the abyss.

If you were the Powers That Be--those holding the reins of political power and those making hundreds of millions in Wall Street bonuses--which alternative would you prefer? Which one would you throw your weight behind?

Duh--you'd be working every covert and PR lever possible, and inventing many new ones, to push the idea that the recession is over so spend, spend, spend.

Now here's the first thing we have to understand: borrowing $200 billion at zero-interest and dumping it into the $12 trillion U.S. economy is akin to spitting in the wind. The Bush-era "stimulus" of around that size just vanished sight unseen, barely registering in the economy at all.

But $200 billion dumped into stock market futures and churned in program trading and high-frequency trading has enormous leverage. While the total value of the U.S. stock market is in the $10 trillion range (down from $15 trillion at its 2007 height), only a few percent of the total outstanding shares trade hands each day.

But by buying futures contracts and churning via program and high-frequency trading--essentially buying from oneself or others in your manipulation game until other traders join in the bogus rally--the leverage is greatly increased. Thus a mere $10 billion thrown in relentless buying of futures contracts can spark a huge rally.

Before the Internet era, technical analysis was a black art of charting done by hand. Now every punter and middle-class owner of a 401K or IRA has access to thousands of charts displaying dozens of indicators and models. Everyone has access to data which was once limited to the exchanges and large brokerage houses.

Now that everyone see the same indicators and data, guess what becomes much easier: manipulating the market. Just two weeks ago, the mainstream financial media was filled with stories about the supposedly ominous "head and shoulders" chart pattern. In the past, H&S patterns were never mentioned in the MSM except in commentaries by market technicians. For Technical Analysis to have spread to the headlines is noteworthy.

Why? If you set out to manipulate the market higher, this makes your job much easier. Now that everyone "knows what to look for," then all you have to do is engineer a rise to certain levels which triggers "buy signals" that will be screamed and trumpeted in one media venue after another.

Want to engineer a rally behind the scenes? It's easy:

1. Kick-start a rally with massive buying at the open of the market day. Counter every bout of selling with massive buying of futures, and then "paint the tape" with more buying in the last 15 minutes. Then buy thousands of futures contracts at higher bids in the after market to set expectations that the rally will continue the following day.

2. As everyone who holds bets that the market would decline (shorts) has to buy back the stock they shorted, then this adds buyers (albeit reluctant ones) which further boosts the "Bull rally."

3. Do this for 10 days in a row, so the MSM can make fawning comparisons to previous "bull runs" in previous "Bull markets."

4. Identify key "technical signals" and then trigger them so the MSM can pump up this "proof that the Bear is dead and the recession is over." Recently, there was a frenzy of MSM coverage of the "bullish cross" in which (on at least some charts) the moving averages crossed in a "we're going higher" signal.

Other "buy" signals which have recently been triggered include "a new yearly high" for all the indices and a "Dow Theory Buy" as the Dow Transports and the Dow Industrials both logged new annual highs.

Seen in this light, sparking a Bullish frenzy is like taking candy from a baby.And most amazingly, it doesn't take much money to do so because the leverage offered by futures contracts and high-frequency trading is so extreme.

Take a look at this chart of the DJIA. Note that every indicator is bullish except for one: volume.

To market insiders this fly in the Bull-market ointment is critical, because "volume is the weapon of the Bull." If there's declining volume, that is extremely suspicious because volume is the one metric insiders can only pump so high on their own.

If you follow the market, you've seen the charts which depict that over half the trading done every day is program ("black box," "algorithmic," "computer," "quant," etc.) trading by Goldman Sach and other large broker-dealers, large hedge funds and other insiders. Trading by so-called "retail" investors (like me and you) and other investors below the level of top-tenth of one-percent make up only 17% of the trading. The other 83% is all in the hands of the 1/10th of 1%.

Despite their tremendous leverage, the insiders (and the Fed and Treasury, which announced last year that they would do anything to goose the markets higher, including buying equities and Treasuries, an unprecedented confession of open market manipulation by the Federal government) cannot force others to participate in the rally.

All they can do is drive the markets so relentlessly that anyone who wants to make money has to buy into the rally. And that includes, well, just about everyone.

As I've indicated on the chart above, there are basically three scenarios in play at this critical juncture:

1. The "melt-up" continues as the MSM announces (endlessly) that "the recession is over." In this scenario, the stock market continues its relentless ascent as everything gets better and better. The ultimate "top" has been touted as 15,000 on the Dow: a level which would top the 2007 high of 14,000+ by a wide margin. Go team, rah, rah, rah!

2. A school of technical analysis known as Elliott Wave Theory (EW or EWT to those in the know) forecasts a slightly less positive future: a brief dip in the coming days which will be followed by one last rise--and then a sharp drop to previous lows or even new lows.

3. Then there's the scenario which virtually no one even states, much less touts as plausible: the rally collapses right here, starting next week. Nobody is dumb enough, naive enough, foolish enough or uninformed enough to even timidly suggest that the open manipulation of the Powers That Be could actually fail because it's obviously so well funded, planned and executed that it can't possibly fail.

Well, there is one person foolish enough to voice it, I guess: me. This entire 10-day "rally" (or call it 12 days if you look only at the Nasdaq) simply doesn't pass the "sniff test." Technical analysts avoid confusing the charts with fundamental data like auto sales, unemployment, etc.--they look only at "the tape" (prices) and various indicators.

Techical analysis (TA) thus does not attempt to explain trends, it only seeks to identify and follow them. Thus a manipulated rally is just like an organic or "real" rally (that is, one driven by actual profitability, low price-earnings ratios, robust economic growth as measured by metrics which haven't been manipulated, etc.)

Nonetheless, TA practitioners should be wary that volume is declining during this "rally." Despite all the trickery, manipulation, tape-painting, propaganda and false "buy" signals, the market is showing very little participation as measured by volume.

This suggests to me a market in which every participant is anxiously eyeing the exit doors. That is, everyone is waiting to see how much higher their profits will rise before they exit (sell). The problem with this "wait to get the last dime" strategy is that when the selling begins, those exit doors will turn out to be awfully narrow and few will get their sells through before the declines turn into a waterfall.

Ironically, this "don't sell because the market's going higher" strategy is based on an implicit faith in the Powers That Be: this rally can't fail, Goldman Sachs is behind it!

In a manipulated rally, the market falls once the spigot of insider buying is turned off. And when everyone has been holding on to the last moment to see just how high this puppy can run, then everyone will try to sell not on the way up but on the way down. That's how a low-volume rally turns into a rout.

Why would the Powers That Be gamble so heavily on creating a bogus rally here? Because it's the cheapest way to convince the American middle-class that "everything's fixed and the recession is over." It's also the easiest way to generate billions in trading profits which can distributed to the 1/10th of 1% playing the manipulation game.

(If you don't believe in manipulation, please start reading Zero Hedge.)

Anecdotally, I see evidence that this ploy--"proving" the "recession is over" by goosing the stock market to "new highs for the year"--is working. A friend of mine who rents vacation rental cabins in Virginia told me his phone started ringing two weeks ago (when the rally started) and he booked over $10,000 of business in the past two weeks--and this is after a very slow start to the summer season.

Granted, this flurry of summer-fun could have many causal factors, but it would be rather obtuse not to notice the alignment with the "recession is over" stock market rally.

It's really quite brilliant. Dump a few trillion dollars into "saving" the investment banking sector from any hardship (like well-deserved bankruptcy), spread another $787 billion around as mulch in the real economy ("stimulus") and then "buy" a blazing-hot stock market rally for a relatively paltry sum which forces every mutual fund and hedge fund manager to jump on board lest they "underperform" and consequently find themselves unemployed.

It's like paying people to stand in line at a new restuarant opening; passersby will assume the food is outstanding and join the line. It's only when the meal is served do they realize they've been conned.

But funny things can happen on the way to an economic "recovery" triggered by blatant, orchestrated stock market manipulation: reality can still stick its nose under the tent flap. While I cannot predict what sort of reality could penetrate the wall of manipulation which has bulldozed all doubts and all selling, I do see the declining volume as the Achilles' Heel of this manipulated rally. Once the players and punters and managers seeking alpha (outperformance) realize the game is over, the selling could overwhelm the dealers' card tricks.

Right now that seems impossible, but the very fact that literally no one anticipates that as even a remote possibility ironically makes it much more likely. When the consensus of Bulls and Bears alike is that we will get a brief, shallow "correction" which will inevitably be followed by another massive leg up, I start wondering if the market--as manipulated as it is--will do what 90% of the punters expect.

I hear the spirit of legendary trader Jess Livermore whspering in my ear that the market will take along the fewest possible participants. For more on Jesse, please read Reminiscences of a Stock Operator

Lastly, let's look at this long-term chart again. If the wheels of the "real" U.S. economy, the one dependent on exponential growth of credit/debt to survive, much less "grow," have indeed fallen off, then just how low do you reckon this market could fall?

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Friday, July 24, 2009

Oil for Food, Food for Oil

Oil and agriculture have a peculiar correlation: all large-scale agriculture is dependent on oil even as the oil exporters depend on oil revenues to feed their populations.

Longtime correspondent Albert T. has often drawn my attention to the grain markets; he recently connected the drop in revenues of oil exporters to their growing demand for grain:

Yemen calls for aid to fend off famine:

"Oil revenue, which accounts for 90 per cent of export income, sank 75 per cent in the first three months to $365 million (Dh1.34 billion) from $1.46 billion in the same 2008 quarter, the central bank said."

Take $365 million, now take their food imports below at 2.5 million times, lets say $266 a ton taken from the FAO link, will equal $665 million. The increased oil consumption by the gulf states and their own populations goes out the window since now they have to sell every drop of oil at any price to feed themselves... Even if the price for wheat is significantly less, ergo grain from Ukraine or Russia which is generally a little cheaper than U.S., it does not fix their problem.

International wheat prices have increased sharply in recent weeks (FAO website)

"Abdul Hamid Al Soofi, assistant general manager of the state Yemen Economic Corporation, last month predicted the wheat crop would rise to 900,000 tonnes this year from 600,000 in 2008 and wheat imports would hold steady at 2.5 million tonnes in 2009."

"Of course we are buying wheat on the open market, but with the oil price dropping, the question at the end of the year is how much foreign exchange Yemen will have," Al Iryani said.

This article shows an example of what I think will happen globally in a year or two: oil prices collapse to very low levels while food goes higher. (emphasis added, CHS) Replicate the above process with countries from Iran to Nigeria to Saudi Arabia etc.

If grain goes to $400 or $500 a ton even large oil producers like the Saudis or Iran will have a very very painful reality. Basically I assume two things:

one, if someone buys wheat for $400 a ton and then turns it into flour they have to charge $800 to be viable furthermore after that once the baker gets it and makes bread or some other thing they have to charge $1600 for that end product. Ergo a quintupling effect through the supply chain.

The second assumption is that once large imports of grain occur due to supply/demand impacts they continue for a while. A drought does not end in one season and soil does not recover instantly once it does end.

Now take for example Iran which imported about 6 million tons of wheat in 2008 due to drought. Imagine the price going from $1.2 ($200 a ton) billion for wheat and $4.8 billion paid by the end user to $2.4 ($400 a ton) billion and $9.6 billion paid by the end user.

Now lets for the sake of argument assume Iran makes $10 billion in profit off of its oil. It would need to provide end users with $9.6 billion in subsidy so that they wouldn't be "unhappy". Keeping people fed would take priority over subsidizing gasoline usage and other wonderful things like the nuclear weapons program, etc. If people are upset this much by an election over which figurehead leads them into the future, who knows, maybe they will be more angry over not having bread.

Another absolute idiocy I see is the focus on prices by nonprofits so that they could give grain for free to the poor nations. During good times it created a dis-incentive for farmers globally to plant grain because non-subsidized prices were low. So volumes kept falling and acreage went to other crops; if prices are successfully suppressed, volumes will continue to decline. This focus on the symptom, ergo prices (due to shortages and not disease) is astounding.

Thank you, Albert, for a fascinating look at food and oil. If grain was not affected by anything but the price of oil, than as oil dropped in price then eventually so too would the price of grain, and the oil exporters would be able to buy grain for lower prices even as their oil revenues dropped.

But a funny thing happened on the way to lower oil prices leading to lower grain prices: drought and other supply forces. Food production is dependent not just on oil but on water, and as correspondent Bart D. reports, Australia's farmers and grain production is suffering from a historic drought of epic proportions. That matters globally because Australia is a karge grain exporter.

Mortgagee sales depress rural property values.

On top of everything else we have our historic drought. This river system, which is rapidly closing down, is the principle water source for about 1 million people in the State of South Australia. I live 700km away from it and even we use its water. Our own ground water supply is critically depleted across the region and water restrictions have just been intensified. There is talk of blocking all new development in our region until water security is achieved.

Reality (here in australia at least) says thing are getting tight and there won't be much cheap surplus grain to be had for third world famine relief. I feel that the price signal the market is now giving out could be dangerously wrong. Not unlike the price signal for oil/gas.

Starvation because of cheap grain would be ironic.

If I was a farmer here, I'd avoid selling forward and wait for the price to rise later in the year or early next year. Trouble is the banks are demanding forward contracts as part of financing arrangements for putting in this years crops.

Our government here in Australia is making some solid efforts at helping farmers find the best ways of moving forward through change and uncertainty - both climatic and economic.

My primary concern is that the capital that farmers have left to deploy into 'change' is rapidly dwindling. Particularly in areas hardest hit by our current drought cycle.

Thank you, Bart, for this troubling report. We should also note that the demographic trends in most oil exporting nations are dramatic: their populations are exploding as birth rates are high and healthcare improves.

A year ago when oil was nearing $150 a barrel, the idea that the cost of feeding their populaces could exceed their oil revenues was unthinkable. But if one of the few major grain exporting regions (Ukraine, Canada, France, Argentina and the U.S.) suffered a decline in production due to drought, severe weather or rampant disease, then grain could easily double in price even as oil revenues fell in half due to the global depression lowering demand. (This is the "oil head-fake" I predicted quite some time ago: Oil: One Last Head-Fake? (May 9, 2008)

As Albert noted, such an imbalance would force many oil exporting nations to make exceedingly unpopular /difficult choices; as the Bob Marley song had it, "A hungry mob is an angry mob," and the glory of owning nuclear weapons might pale when one's children are hungry and the government till and granaries are empty.

As this somewhat dated chart reveals, it's not just oil-exporting nations who are importing huge quantities of grain to feed their rising populations and/or rising demand for meat raised on imported grains.

Maybe grain will be the "new oil"--you need it, we have it, now ask us want we want for it. How about some nice cheap oil, or "cooperation" in things which matter to us?

I've explored this idea in the past: Is There an Organization of Grain-Exporting Countries (OGEC) in Our Future? (May 26, 2008)

Lagniappe chart: Since we discussed the Dow Jones Industrial Average yesterday, here is a chart from 2007 at the market peak which displays key fibonacci projections. Interestingly, key levels around 8,800 and 7,200 have been key points of resistance and support on the way down to the bottom in March 2009 and the move up since then.

According to the MSM, we are on a runaway train to 10,900, on the way to 15,000 and up; but I wonder if the train won't make a stop at 5,500 first.

If you want more troubling/revolutionary/annoying analysis, please read Free eBook now available: HTML version: Survival+: Structuring Prosperity for Yourself and the Nation (PDF version (111 pages): Survival+)

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Of Two Minds is now available via Kindle: Of Two Minds blog-Kindle

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