Empire of Debt, Empire of Lies
August 6, 2008

Correspondent Mike D., who has been working in China for the past five years, recently nailed an issue which is absolutely critical but which strangely receives virtually no attention: the Empire of Debt is entirely dependent on an Empire of Lies.

We all know this. Commentators from Mish to John Williams to Nouriel Roubini to David Rosenberg to Richard Russell and many others have noted (and dissected) the preponderance of outright lies, obfuscatory half-truths and prevarications in virtually every nook and cranny of the U.S. financial system, including:

1. unemployment/birth-death model
2. CPI/consumer and producer price indices
3. assets (and losses) held off balance sheet
4. assets marked to model rather than to market
5. earnings manipulated by accounting legerdemain
6. distressed/defaulted mortgages and loans masked or hidden away
7. so-called "leaders" stating again and again that no capital infusions will be needed, and then raising capital days or weeks later
8. government officials and others understating the losses
9. government officials declaring the "crisis" over even as it picks up momentum
10. government officials bailing out lenders and investors under the guise of "helping homeowners"

I could go on but I would tire of typing even a partial list of all the outright lies which have been foisted on us. It is truly remarkable how the sychophants in the MSM and financial media accept each lie as if there were no history of blatant, achingly obvious lies spewing from the same mouths just weeks ago.

The issues are: when do all the lies erode trust in the vaunted U.S. financial system? And, if this trust hasn't already been utterly destroyed, why not?

For such a supposedly religious nation, the lies have drawn remarkably little moral outrage or even comment in the U.S. Just "business as usual," eh? The reason is also obvious: many are complicit in the hope that the endless repetition of blatant lies will somehow "save" them.
* "Save" the U.S. homeowners and lenders from declining housing values
* "Save" the Asian and EU exporters from an imploding market for their goods
* "Save" the speculators and investors, overseas and U.S. alike, from the stupendous losses which an honest accounting would reveal in all U.S. mortgage, loan and derivative markets
* "Save" U.S. politicos and regulators, keepers of the public trust, from having to accept the blame for aiding and abetting the fraud, lax oversight and phony accounting that have gutted the U.S. financial system and left the taxpayers to clean up the mess

It's not politicially correct to issue any moral judgments on anything or anyone in today's U.S. of A. (you might hurt somebody's feelings, poor things), but again I am stating the obvious that if there was any justice on this planet then the U.S. financial system would be reduced to a smoking ruin, and the foundation of a truly trustworthy, transparent system built on its warm ashes.

Here are Mike's comments:

I'm sure you know about the Merrill Lynch sale of CDO's at 22c/$ which is really a sale at 5.5 cents on the dollar. Nouriel Roubini explains it very succinctly on his website. Charles, I am a Canadian Chartered Accountant, equivalent to a CPA in America. I honestly don't understand America's GAAP (generally accepted accounting principles) anymore. This sale should clearly be valued at 5.5, not at 22. I am also somewhat quizzical of the reported off-balance sheet holdings of derivatives by the big dogs Citibank, Wamu, etc. If these holdings are in any way guaranteed by the parent, they represent a liability of the parent (Accounting 101).

I'd like to share a couple of quotes:

"The smart and very savvy Mohamed El-Erian (co-CEO of Pimco) put it in polite terms when he recently said while commenting on this financial crisis: “What has suffered most is the credibility of the most sophisticated financial systems in the world." Or as Bill King (a senior financial analyst) put it: "Eventually a critical mass of investors and traders will become cognizant of the obvious scheme and distrust of financial firms’ results, guidance and motives will increase substantially. John Thain’s (Chairman and CEO of Merrill) credibility is now an issue. It is both the credibility and viability of the most sophisticated financial system that is at stake now as most of this financial and banking system is on its way to substantial and formal insolvency and bankruptcy."

The reason New York is the center of the financial world is to a large degree a result of the purported "transparency" of the American system. (Emphasis added by CHS) The Asian markets (especially Shanghai) are opaque to a greater or lesser degree. But, with these latest machinations, I am wondering when and if, the investors of the world will get fed up and move New York somewhere else where there is some control and financial data can be trusted.
What effect do you think such a move would have on the US economy if the NYSE and NASDAQ were to become virtual backwaters in the global economic system and do you think this is possible?
I include Roubini's take on the Merrill con below.

Excellent question, Mike. I hope it's possible, but that would require investors who aren't dependent on fraud for their own profits. I am not an accountant, but I have read as widely as possible about Asian banks, especially Japanese and Chinese banks. Unfortunately, it seems that hiding impaired assets is rampant in Asian banks as well. The pan-Asian system seems designed to provide a "face" of compliance and rigor which is basically a facade hiding distressed/non-performing loans which must be masked for political reasons (the borrowers are state-owned, "too big to fail," etc.)

In other words, the same flaws seem to be present in Asian banking as well, though perhaps Singapore, famously rule-of-law, has the systemic courage and rigor to be truly transparent. Sadly, rule-of-law in the U.S. means "with these exceptions:" too big to fail, Fannie Mae gave me thousands on campaign contributions, I need to bail out my banking buddies, etc.
London certainly has taken the mantle of global banking center, but it remains to be seen if U.K. banking is any less impaired, obfuscatory and riddled with phony accounting than the U.S. Are U.K. banks just as insolvent as U.S. banks? As U.K. property values implode, they soon may be insolvent if they are not yet so.

We should also draw a distinction here between merchant banks, mortgage lenders and investment banks. Though everyone is getting into everyone else's business, investment banks and mortgage lenders generated much of the fraud which has now undermined the entire system. Banks which restricted themselves to lending to legitimate businesses (if any such lending institutions still exist) would have little to hide unless they'd foolishly loaded up their own balance sheets with credit swaps, CDOs, etc.

But as a financial entity, clearly the U.S. financial system deserves zero trust from anyone--most especially the dazed taxpayers who have been saddled with the rescue of the speculators and criminals who profited so immensely from the frauds, lies and phony accounting which has become "root" (a nod to Unix fans) to the entire system.

Put directly: could the U.S. financial system survive if strictly honest accounting and transparency were imposed tomorrow? We all know the answer is "no."

Some observers like John Mauldin has suggested that the obfuscations and phony accounting have to be tolerated for a few years so the system can "rebuild" itself.

This is akin to allowing the coach of a drug-riddled, scandal-torn team a free hand to keep hiring more steroid-pumped freaks-of-nature "athletes" while he "rebuilds" the team. So once you're caught lying, cheating, stealing, etc., then we have to allow you to keep lying, cheating and stealing until you've "rebuilt" your corrupt team? Exactly how can corruption and fraudulent accounting be "fixed" by enabling years more of the same chicanery?

Even worse, now that the U.S. financial sector has squandered trillions in outright gambling and fraud, now we the taxpayers are being tapped to bail out the perps and speculators.
What lesson is being taught here? Just this: if the con is monumental enough to threaten the "system", then you will not just go scott-free, you will be rewarded and recapitalized to enable you to go out and gamble another couple trillion for your own private gain--at taxpayer expense. Hey, pretty sweet. Sign me up!

Risk has been shifted to the taxpayers, while the perpetrators of this era of stupendous fraud, accounting legerdemain and betrayal are being rewarded with new capital to play with after the furor dies down.

The only possible brake on this madness is the bond market. But if non-U.S. players continue to buy up any and all U.S. debt to the tune of $60+ billion a month, without any demands for transparency or a rate of return that isn't less than inflation, then they are insuring a cataclysmic collapse when the losses finally outweigh their need to prop up the Empire of Debt and the Empire of Lies it depends on for its very existence.

In summary: an enormous opportunity awaits any nation with sufficient respect for strict accounting and rule-of-law (and some fiber-optics lines) to take away legitimate business from New York, London, Tokyo, Shanghai, et al. The players whose very existence depends on perpetrating lies and fraud will of course remain in New York to serve those with the same agenda, i.e. defrauding people via financial and accounting trickery.

For those who may have missed Roubini's dismantling of Merrill Stench's smelly pile of lies and purposefully misleading accounting, here it is:
Nouriel Roubini, July 29, 2008: Super-Senior Tranches of CDOs are Worth Much Less than 22 Cents on the Dollar: Another Ponzi Scheme of “Selling” Toxic Garbage with More Leverage

Merrill Lynch decision to “sell” a good chunk of its remaining CDOs at 22 cents to the dollar has been widely praised as the firm finally recognizing the full extent of its losses on these toxic instruments. This batch of $30.6 billion of CDOs was already marked down to $11.1 billion. Now with the “sale” of it to Lone Star at a price of 6.7 billion Merrill Lynch is taking another $4.4 billion writedown and “selling” it at 22% of the original face value.

But is this a market-based “sale”? No way as calling this transaction a “sale” is a joke.
Let me explain next why…

First, note that the secondary market for CDOs is now extremely illiquid and Merrill will provide financing for 75% of the purchase price, or a financing of $5.055 billion. That implies that these CDOs are worth much less than 22 cents of the dollar. These type of “sales” transactions – broker dealers “selling” their toxic waste at a discount and providing hedge funds and private equity funds with heavily subsidized financing for it – has going on for a while.

That discounted “sale” price often ends up being much higher than the true value of the assets (and the ensuing writedown of the assets is smaller than the correct one) because of three reasons:

the selling broker dealer is providing most of the financing for the transaction as this market is totally illiquid and no one could dump $11.1 billions of toxic and illiquid CDOs in such a market;
the interest rate at which the financing occurs is often significantly lower than the appropriate rate at which this risk financing will occur. Merrill has not announced what are the terms of its financing of this deal and this leaves the serious suspicion of a heavily subsidized transaction;
the collateral for this risky financing is the same toxic waste that was sold to a fund. In the case of the Merrill transaction if the market value of this $11.1 tranche (now priced at $6.7 billion) falls another 25% the collateral for the 75% financing (that is non-recourse as it is secured only by the collateral) will be worth less than the underlying assets and thus additional losses will be incurred by Merrill.

In other terms, as pointed out by Bloomberg since “the financing is secured only by the assets being sold, meaning Merrill would absorb any losses on the CDOs beyond $1.68 billion”. Thus, in a extreme scenario in which the CDOs actually end up being worth zero Merrill will end up having sold them to Lone Star for 5.5 cents on the dollar rather than 22 cents. I.e. leaving aside the first loss of 25% taken by Lone Star all of the remaining credit loss is borne by Merrill.

So, based on the above consideration, is this toxic junk worth 22 cents on the dollar? No way and one would have to assume that the true market value of this garbage is closer to zero than 22 cents. So the street is now arguing that 22 cents on the dollar sets a market benchmark for writing down CDOs (Citi is still carrying them at a value of 53 cents rather than the 22) and many other firms will now have to use this benchmark; but the reality is that this toxic garbage is worth much less than 22 cents. So the charade of pretending to mark down to market the value of this junk will continue for a few quarters with continued bleeding of earnings.

At this point it would be more honest for the financial firms to write down to zero the value of these assets (with possible positive revaluation if they turn out being worth more than zero) and keep them on balance sheet rather than pretending to “sell” them via greater debt that massively adds to the credit risk that these firms are taking at the time when they should be deleveraging rather than releveraging further.

What is the sense of taking on another $5 billion of risky debt that has toxic garbage as collateral? Is this sound financial balance sheet restructuring or another Ponzi scheme of a house of debt-upon-debt cards? Selling worthless junk and providing financing for it is not a “sale”; it is another accounting scam whose purpose is hiding the full extent of the losses on garbage, not coming clean on them. So beware of the cheerleading chorus of banking “analysts” praising Merrill and this transaction.

The entire episode stinks with the Merrill CEO making a series of misleading statements on Q2 earnings and on no need for further capital and now coming out of the blue with this new surprise and a new large capital injection that will massively dilute current shareholders a few days after the dismal Q2 results were reported. Add to this charade the fact that what will be raised in this new round of recapitalization will be much less than the announced $8.5 billion once Temasek and other shareholders who participated in the previous recap will be compensated for the massive losses they incurred in that round of recapitalization of Merrill. "

Thank you, Karl H. ($15), for your very generous donation to this site. I am greatly honored by your support and readership.

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The U.S. and China: Empire, Expansion and Decline

August 5, 2008

On Saturday I promised a synthesis (of some sort) of two themes: The End of Work by Jeremy Rifkin, and The Evolution of Civilizations by Carroll Quigley.
Quigley posited that all civilizations pass through seven stages. Here is a quick rundown of the stages and their characteristics: The Seven Stages of Civilization (excerpts from Bart Stewart's commentary)

1. Mixture Out of the mixture of cultures has come a new culture, with the opportunity to become a civilization.

2. Gestation The incipient civilization must develop an instrument of expansion. Without such an instrument, a society cannot gain the critical mass required for its members to begin conceiving of themselves as having a unique identity--that is, as a civilization.

3. Expansion Once a civilization has a functioning instrument of expansion, it will begin to grow.

4. Age of Conflict Eventually all instruments become institutions. Once this process has occurred to a substantial degree to a civilization's instrument of expansion, the civilization enters an age of conflict.
This period is marked by four trends:
a decline in the rate of expansion an increase in class conflicts, especially in the core an increase in imperialistic wars an increase in irrationality and general pessimism
As the instrument of expansion becomes an institution in order to preserve the privileges of the elite, the civilization--particularly in the core--becomes more static, bureaucratized and legalistic. This tends to punish innovation instead of rewarding it, and progress in the accumulation of surplus is slowed as a result of the decline in inventiveness.

5. Universal Empire As previously noted, once an instrument of expansion has become an institution, one of three things will happen: it will be reformed back into a functioning instrument; it will be circumvented by the creation of a new instrument (which permits expansion while leaving the trappings of power to those who controlled the previous institution); or those with vested interests in preserving the institution of expansion will prevail, and it will become permanently entrenched.
In the former two cases, in which there is a new instrument of expansion, the civilization returns to Stage 3, the age of Expansion. Otherwise, it proceeds to Stage 5: Universal Empire.

6. Decay Once it becomes clear that the bulk of a civilization's wealth has been used up, the decline is usually mercifully swift. "Mercifully," because this is a period of great distress.
During this time, as recognition of the civilization's poverty spreads, the standard of living falls quickly. Law and order break down. Civil unrest sparks protests, some of which turn violent. Taxes cannot be collected, and other forms of public service such as military service (and military actions themselves) are resisted. Property cannot be protected except (if at all) by force. Personal violence becomes a daily occurrence. Trade fails, as fraud can no longer be punished. Town life fails; basic survival needs force people into the country where they can grow food, and the "middle class" disappears. Religious revivals sweep the land. The medical technology that sustains life becomes difficult or impossible to obtain, resulting in high rates of infant mortality and shortened lifespans.

7. Invasion Whether by military occupation or political annexation, or simply by incorporation through settlement, invasion at some point destroys what was once a civilization. The mixture of old and new cultures may produce a new culture, forming Stage 1 of what will become a new civilization, or it may not. But the old civilization is gone.

As Mr. Stewart notes, this is not a deterministic process but one of choice.

In contrast to Spengler's deterministic view, in which a civilization is doomed from the moment it comes into being, Quigley asserts that any civilization can survive indefinitely, just as long as it keeps reforming or circumventing its institutionalized instruments of expansion.

Members of civilizations, Quigley says, have a choice. If they act in one way, they return to expansion; if they voluntarily choose another way, they step onto the road that leads to empire and extinction. This non-deterministic "if-then-else" structure seems intuitive to, say, a computer programmer, but it is a remarkable insight for a historian, scientist or no, to perceive in a long-duration human organization such as a civilization.

Let's begin by observing that many see the U.S. as unequivocally in the "decay" stage and China as in the "expansion" stage. I am going to challenge those overly broad assumptions.
But first let's stipulate a few points.

A. "The West" is the civilization, the U.S. is simply the current dominant nation within that civilization/worldview/economic-legal system.

B. China did not suffer destruction as a civilization, but many in China view the collapse of the Qin Dynasty in the early 20th century and the rise of Western hegemony in China (Britain annexing Hong Kong, etc.) as a kind of decay-invasion end-point, which then set the stage for the emergence of Communist China as the mixture of Chinese elements and Marxism/Leninism.

C. China's current success is unfolding within the legal, economic and scientific system of Western Civilization, albeit with "Chinese elements" that are different from but analogous to Japan's "unique elements." The Grand Experiments in a "different way" were monumental, catastrophic failures: Marxist/Leninist collectivism and the uniquely Chinese monstrosity of the Cultural Revolution (Maoism run amok).

D. China is also unique in taking the stage as an emerging global power even as 2/3 of its population remain quite poor. For a realistic depiction of China's rural poverty, I recommend The Story of Xiao-Yan (A Unique Schooling is the Hong Kong English title). This film follows a young girl in western China as she tries to raise the few dollars needed to pay for her next year of public school. If she fails to raise the money, her education is over.

This is a beautifully rendered and acted film which garnered six awards, including several Golden Roosters (best new director, etc.)

I was surprised such a searingly honest film was allowed to be made and distributed. That alone documents just how far China has progressed in the past 20 years.

I am positing that the 2008 Olympics are China's high-water mark in the "explosive growth" stage. This is not to say growth has come to an end, only that the initial "instruments of expansion"--industrialization and the influx of foreign capital--have run their fast-growth course and new instruments of expansion must take their place.

If China fails to develop the governmental and economic structures needed to enable new instruments, then it could enter an Age of Conflict before settling back into expansion. Nothing is pre-determined in life or history.

As I have written before, the most dangerous element for both China and the U.S. is the disparity between people's inordinately high expectations for future prosperity and the realities of inequality, Peak Oil, corruption/malfeasance, etc.

In other words: being poor is tolerable until one's expectations are raised. Then what was once acceptable becomes utterly unacceptable. In the U.S., absurdly high expectations and a grandiose sense of entitlement virtually guarantee a vast disappointment/rage when unrealistic expectations for prosperity and ease crash into diminished resources/failing "instruments of expansion."

China too faces a collision between the expectations of 600 million people who want to join the 300 million who have "made it" in the past generation and the limits of financial borrowing/legerdemain, resources and the coming decline of the entire trade/labor arbitrage model which enabled China's rapid growth.

One element of American culture which is largely ignored is our propensity to flay ourselves with near religious zeal for our faults/decay. It's been my observation in both Europe and Asia alike that most people resent criticism of their country and are reluctant to really lay out their nation's faults (at least to visiting Americans).

While many such defensive Americans exist as well, it is nonetheless true that Americans have a unique ability to flagellate ourselves for falling behind. These paroxyms of self-criticism and angst have often led to massive reforms and renewal. I believe this trait can be traced back to at least the early 19th century's Great Awakening religious movements, some of which led to the moral demand to end slavery regardless of its economic impact on the South.

The 1950s were dominated by "The Red Scare" in which Americans trembled and worried over "falling behind" the Soviet Union, which had famously threatened to "bury you." And with the Sputnik launch proving Soviet invincibility, Americans fearfully rushed to "catch up." John Kennedy actually scored points in the 1960 election by claiming a frightening "missile gap" between the U.S. and the U.S.S.R., another sign of "falling behind" our rival. (Yes, a Democrat was actually more hawkish than a Republican.)

In the 1970s, the decline of America was a given, and commentators bemoaned the inevitability of U.S. decline. It's over, folks, the decline is terminal. Watergate, stagflation, Vietnam, the Iranian conflict, oil spikes--all evidence of inevitable decay.

American angst/fear of permanent decline exploded in the 1980s as Japanese domination of consumer electronics proved America was doomed (again). Books declaring inevitable Japanese domination of "the 5th generation" computer technology crammed the shelves, and thrillers were packed with Japanese businessmen buying up America for a pittance.

The wailing and gnashing of teeth over the permanence of our decline was fierce: our education system was terminally horrible, our companies were flat-footed failures, our government a flailing giant incapable of stemming the decline, and so on. We were doomed to all be living in Sony Towers serving drinks to Japanese tourists who owned what was once an independent nation.

The non-American readers among you may reckon I am exaggerating. I am not. Pronouncing the "End of the American Century" is a core cultural trait, one occasionally interrupted by brief periods of triumphalism which set the stage for grand displays of hubris which quickly end in new pronouncements that America is once again (for the 4th or 5th time in 50 years) doomed to decline and decay.

For abundantly sound reasons, the hue and cry of permanent decline is once again pervasive. Yes, our financial system and energy complex are doomed to decline/ failure, along with our suburban model of growth, our waste of topsoil, our sclerotic medical system, our wretched educational system, our crumbling infrastructure, our decrepit failed political system and several dozen other fundamental crises. And all of them are true failings and true sources of decay/decline.

The real enemy of renewal is complacency. As with individuals, the capacity for self-criticism is absolutely essential to growth/renewal/adaptation. Although I cannot offer a rigorous defense of this idea, I suspect that a key factor which deepened and lengthened The Great Depression in the U.S. was denial and complacency that anything structurally was wrong with U.S. institutions and instruments of expansion. All the "make work" programs of the New Deal were essentially that--"make-work" wallpaper glued over a failed, deeply flawed system. Is it any wonder they failed to end the Depression?

Thus I welcome the strident calls for "the end of days" and the "inevitability" of U.S. decline. The harder we whip ourselves, the deeper the angst, the starker the decay, the sooner people will rouse themselves. The more that the Mainstream media and our elected politicos claim that all is well and sound, the longer and more damaging the decline will be.

If we as a people choose "bread and circus" (lapel-pin American flags, mercenary armies, American Idol(try), etc.) then the decay will be terminal.

Correspondent Michael S. took up my challenge to synthesize the topics; here are his cogent comments:

"Can these apparently disparate topics be wound together constructively? Stay tuned."
For the first book, The End of Work, I'd say that the traditional corporate culture is becoming outdated and cannot compete with the worldwide collaboration that happens over the internet since it is: a) diverse; b) priceless; c) talented; d) parallelized; e) motivated; f) etc...
Examples are: "Open Source," Linux, Firefox, "free patents online," etc...

While I haven't read the book, I do believe that the world will ALWAYS need workers but not the traditional office building (as they are now) or the traditional corporate structure. I'm hoping that worldwide medical collaboration, for example, will improve hospital care tremendously.
In general, I like the idea of "affinity groups" (virtual communities, based on meritocracy) that come together to solve a particular problem; from a business standpoint, investors would invest in these "affinity groups" based on preceived return.

The second book "Evolution of Civilizations" seems to rehash "old problems" (based on the description) since "resource fights" have been around since man was around.
Einsten, in particular, said that: "You can't solve a problem with the same mind that created it" and, thus, dominant cultures probably peak and then become weak.

Globalization, I think, is a gutsy gamble at trying to diversify our culture to the point where we're seeing outside of our box again.

My hope is that our communities evolve to the point where people simply settle in where they fit best. And I think that "trickle down economics" will work and, thus, I have faith that the best and brightest will build a world in which I can survive!

Thank you, Michael, for making a number of fascinating points.

Having not yet addressed "the end of work," I hurry to make this distinction: there is always plenty of work. It's simply unpaid work. If you see the film The Story of Xiao Yan mentioned above, you will see people busy all day long. There is plenty to do. It's just that almost no one is receiving a salary or paycheck save the school teacher, and his pay is apparently meager.

Life doesn't end when there's no paid work. People gather crops, raise pigs, tend children, barter/trade for goods, gamble for pennies, and so on. There is a government presence, albeit a small one, but people get along. There isn't streetfighting warfare as per videogames, nor are there warring gangs out to control the goat herd or what have you. There is no need for martial law. People walk a lot to get places, they get married, they flirt, they suffer disappointments and gain small victories, and so on.

So before we proclaim the coming decline in paying jobs necessitates the Apocalypse, maybe we should shed some of the grandiose sense of entitlement which underpins that expectation of Collapse. Maybe instead of Collapse with a Capital C, Americans will make do like the hundreds of millions of Chinese who currently get along without SUVs, McMansions, big salaries, credit cards, and all the other supposedly "essential elements of survival."

Short of a major nuclear exchange or a scourge of deadly Avian flu, life goes on, people adapt and try to better their situation however they can; renewal is possible. Shedding denial and embracing self-criticism is the first step to avoiding collapse, and perhaps we're making some small progress in that regard.

Thank you, Jon T. ($10), for your much-appreciated generous donation to this site. I am greatly honored by your support and readership.

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Should I Buy or Sell? Seven Considerations
August 4, 2008

I have received many emails from readers which pose one of two critical questions: should I sell my house? Should we buy a house now? It can be a difficult decision for any number of reasons, many of them emotional.
To cut through the emotional stakes and reach a sound business decision, here are questions I ask of these readers. (Note: I do not give advice on any investment dilemma, but if you answer the questions fairly and honestly, they might help you reach a well-grounded decision.)

Before I start, I should confess to having made this critical decision earlier in my life on raw emotional attachment. We'd built a house with our own little hands in the early 80s, and when the Japanese Credit Bubble reached the shores of Hawaii in the late 80s, our modest house zoomed in market value from about $85,000 to about $180,000 (about $312K inflation-adjusted to today). Realtors began sending us letters soliciting a listing, and we actually had need of the capital trapped in the low-mortgage property.

But I was emotionally attached to the house we'd built ourselves, and held on too long, selling a few years later after the bubble burst for $45,000 less--a needless 25% haircut which was in fact a staggering amount of money to us and a huge percentage of our net worth.
Lesson: despite the great difficulty, you must separate your emotional attachments and memories from your investment decisions. We all become bound up with our homes in ways we don't with bonds, stocks or gold coins. But nonetheless real estate is for most of us our largest investment and the one we can least afford to screw up.

OK, on to the questions. The answers to these questions will help pare away deeply emotional issues such as "we have another child on the way" and "we really like this house" which play into what is essentially a massive financial decision-- a decision which will likely have an enormous impact on one's future financial health/wealth.

1. What if you can't sell the house later? All real estate is local, until it's global. The cost of money is now set by global markets, so in this sense all real estate is indeed global. While realtors will tell you the value is set by local appraisals and comps (comparable properties which recently sold), in a very real way the value of any property is set by bankers in Beijing, Tokyo and Dubai--if they stop buying U.S. debt in the hundreds of billions of dollars each and every quarter, then interest rates rise and the value of all property declines in see-saw fashion as prices come down to what is affordable to borrowers paying higher rates.

As interest rates begin to rise (and I've explained my reasons for considering this as certain as sunrise) then lenders will begin hesitating to write long-term 30-year mortgages. Why write a mortgage at 8% when you fear rates will be 10% in a few years? That's simply too big a risk to take.

In the analogous period in the 1980s, 30-year mortgages from FHA carried outrageous "points" (origination fees) on the order of 7, 8 or even 9 points. That is a cash closing-cost expense of $18,000 on a $200,000 mortgage.

Needless to say, few buyers stepped up for such costly mortgages, and so the market for cash-out home purchases essentially froze up.

In most cases, sellers had to carry the mortgage themselves, so-called "agreements of sale." In other words, no cash-out: the buyer paid the seller monthly instead of paying a lender. Obviously those needing their entire capital from the sale of the home were out of luck.
In an era of rising interest rates, real estate becomes a capital trap. If you might need the capital for other purposes, consider the risks of rising rates and capital traps.

2. How close is the house to public transit, walkable shopping areas, good public schools and other community resources like parks, libraries, etc.? I have already posited that there will be two sets of housing: those homes far from these community assets and job centers will sink toward zero while those nearby these assets will decline much less.

If the primary facility in the area is a shopping mall, think about what will happen to values when that mall closes/becomes a ghost mall/skateboard "park".

3. How recession-proof is the local economy? All real estate values are essentially based on income--if there are no jobs, then the value of property sinks to near-zero. Who wants to live there/can afford to live far from their job? Do not assume this recession will be short and mild--assume it will be long (at least four years), deep and global.

If you work for a government agency, ask yourself: is my agency dependent on property taxes or sales tax revenues? As those decline, what will happen to the agency? How will payroll be trimmed as revenues fall? Does the agency face skyrocketing pension and retiree healthcare costs? How will those extra expenses be paid as tax revenues decline?

Being honest about the prospects of being laid off is not easy. Again, assume a four-year decline in everything related to sales, income, tax revenue, etc. and a 20-year cycle of rising interest rates. If the area around your house is heavily dependent on bubble-era businesses like retail, construction, finance, etc., then you have to ask: who can buy my house later if few have jobs?
Recession-proof (meaning they will survive in some fashion) industries include energy, farming, education (colleges), alternative energy, submarine and aircraft carrier shipworks and hospitals. Unfortunately, all government agencies, including Medicare and Defense, will get haircuts as the costs of paying interest on our stupendous deficits and meeting unfunded public pension obligations eat away at all current spending.

Tourism is based on cheap credit and oil, surplus income/savings and the euphoria of good times. It will decline sharply as every one of those preconditions goes away on a global scale.
4. Can you afford the mortgage on one income? Again, be realistic about the odds that one of a working couple might get laid off for a time, or have reduced hours or salary. As painful as it is, be hardnosed about the odds of an entire company/ division/industry just drying up and going away. "Creative destruction" is the academic term for how capitalism cuts away the dead wood, but it's not academic when it takes away your livelihood.

Again, consider the nature of housing as a capital trap in a potentially illiquid market. If someone can't afford the mortgage, and they also can't sell/cash out, then they will lose the home and their equity. Renters have the option of moving somewhere cheaper and conserving their capital/deploying it for other uses.

5. How great is the differential between renting and owning? If it costs twice as much to own as to rent, you then should ask: what are the odds of rent doubling in a recession? What are the odds of housing continuing to decline? If housing declines further, then why pay twice as much every month for the privilege of trapping your capital in a depreciating asset?
If the cost of owning is comparable, and you don't need the capital for other purposes (medical care, caring for elderly parents, college for your kids, etc.) then buying makes sense in this way: your housing costs are fixed (along with your capital) so you won't get rent increases. In fact, if housing keeps declining, then your property taxes will also decline (if you pursue a valuation/tax reappraisal).

6. Can some part of the house be rented to boarders/tenants? If the home is near jobs, a walkable downtown/shopping area, parks, schools, libraries, etc. then it will probably be desirable to tenants/renters. If your income falls in half due to recessionary loss of a job, then renting out part of your house/building is one survival technique many are already pursuing.
6. How much of your thinking is emotion-based and how much is cold, calculating financial investment analysis? If you love a house, but fear buying it could destroy you financially, then consider the house purely as an investment: how much will it cost--really, not some minimal number. Dwellings need maintenance. What is the opportunity cost, i.e. what else could you do with the money that might have a better rate of return? Can you afford to trap your capital in an asset which might decline for years to come? Could anything happen which could disrupt your plan "to live here for the rest of our lives"?

Yes, a house is a deeply emotional investment--but it remains an investment. The guiding light in a recession is "preservation of capital." Can you preserve capital by owning real estate? That is an iffy bet if interest rates are set to rise and the global economy is entering a long, deep recession.

In sum: what's your Plan B if the recession drags on until 2012, your income falls in half, housing continues to slide, etc.? What are the odds that real estate will suddenly double next year, and you'll regret not buying "at the bottom"? What if the folks "buying the bottom" now are, in correspondent Azvitt's apt analogy, like those who rushed out to gather up the flopping fish on the beach, just before the tsunami roars in, wiping out all in its path?

No one can tell us what to do, or what's right for us and our family, but answering these questions analytically, based on the best available evidence and data, will help ground the decision-making process.

Correspondent Unix Ronin notes that there is one other reason to own property, and it's an important one:

You state "there are only two valid reasons for buying a dwelling, [...] It's cheaper to buy than rent, or you can make money on Day One by buying the dwelling and renting it out."

There's a third, but it goes beyond the pure dismal economics of the transaction. Ownership of housing, or more particularly, the land it sits on and is surrounded by, has historically conferred a measure of power to the owner. The more land you own, the more power you have. (Although, in absence of a functioning government, you only own what you can control.) Even if that power basis is only reflected in being able to make certain decisions without anyone else's approval, such as: "I would like to knock this wall down to build a library," or, "I want several dogs in my home."

The ability to make these decisions is worth a premium over Maslow's needs, for those who can afford it, and is typically unavailable to the serfs that rent their dwelling. I don't see this factor disappearing. I find it likely that a sizable number of people will choose to live in Thoreauian shacks than rent, wherever possible. Perhaps I over-estimate the power of the "American Dream" that got us here in the first place.

I also expect "Squatter's Rights" to make a comeback in those 15 million unsellable, unused homes; or rather, that no one's going to care if someone wants to live in the hovel that is left behind when the pipes and wires have been ripped out of them. No one's going to waste the dynamite, though. Those 15 million homes are scrap material. Excellent points; thank you, Unix Ronin. I would add this single caveat: owning land does confer benefits--but only as long as the owner of the land can pay the ownership costs.

Four New stimulating Readers Journal Essays:

Plus two new readers' poems

The Self-Selected Remnant (Chris Sullins, August 4, 2008) One of the very few simple Arabic phrases I bothered to learn in Iraq was "I am a doctor." If I was captured despite my best efforts to die in a blaze of glory, I thought the phrase might buy me some time. Although it was not quite an accurate description of my actual military occupational specialty it sounded better and a lot shorter than "I am a licensed master of force multiplication and controlling angry combat."
The Carp Culture (Rene Andre, August 4, 2008) I am just an average joe schmoe who is trying to suck up an existance from the detritus and flotsam cast off by the Cream of Society. I know it, and so do you, that Americans are a wasteful bunch, who'd rather buy new than repair. They're trendy and competitive as well, so they have to have the newest latest gadget or toy so that they can continue to put on airs as the creme de la creme of society. Enter the bottom feeders. I am not ashamed to claim that moniker. I have always been a scrounger and a trash can entrepreneur.
Energy and the Balance of Power (Mark A. Ancona, August 4, 2008) The United States is losing global hegemony. This is an uncomfortable, yet immutable truth, now repeated by an increasing number of powerful industry leaders and government officials. Having bankrupted our Nation with an un-winnable war, public bail-out of private investment bankers and Alan Greenspan’s nuclear housing bubble, we can no longer afford to engage in the frivolous waste of oil and natural resources. Many countries are coming of age with the re-discovery of their valuable natural resources. Previously third world nations are building first world infrastructures and economies with their new-found bounty.
Astounding Facts of Hidden History (R. Christoffersen, August 4, 2008) Things They Didn’t Tell You in History Class
Readers Journal essays express the views of the essays' writers and do not necessarily reflect the views of CHS. I post essays with a variety of views in order to stimulate our collective critical thinking. I have long posted essays which run counter to my own views because I could be wrong--and often have been.

Thank you, Dennis G. ($55.62), for your outrageously generous donation and kind words regarding this site. I am greatly honored by your support and readership.

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Saturday Quiz: What Is The Fourth Turning?

Q: What is The Fourth Turning?
A: A term denoting long-wave generational cycles: The Fourth Turning by William Strauss and Neil Howe (recommended to me by correspondent Matt S.).

Matt also recently recommended The End of Work by Jeremy Rifkin.

In this challenging report, social activist Rifkin (Biosphere Politics) contends that worldwide unemployment will increase as new computer-based and communications technologies eliminate tens of millions of jobs in the manufacturing, agricultural and service sectors. He traces the devastating impact of automation on blue-collar, retail and wholesale employees, with a chapter devoted to African Americans. While a small elite of corporate managers and knowledge workers reap the benefits of the high-tech global economy, the middle class continues to shrink and the workplace becomes ever more stressful, according to Rifkin.

Other readers have recommended The Evolution of Civilizations by Carroll Quigley.
An excerpt of an amazon.com reader review:

This is a striking book. When one is past the formative years, it rarely happens that a single book can substantially change one's view of the world. For me the "Evolution of Civilizations" influenced my understanding of history more than anything I've read in many years.

The most important author's contribution to historical analysis is identification of the growth mechanism - "instrument of expansion", which can be quite different in different civilizations. It must include two necessary conditions - generation of surplus output, and its investment in productive economic activities. Later, this "instrument of expansion" becomes institutionalized, when surplus is spent on maintenance of status quo of ruling elites and various vested interests, and a society enters "Age of Conflict".

Can these apparently disparate topics be wound together constructively? Stay tuned.

Thank you, readers, for your many emails--I will be answering each one as I catch up with my large backlog/volume of correspondence. Each one is important to me and I very much appreciate your patience.

Excellent New Readers Journal Essay:

Read all five of this month's superb essays if you missed them

Why the Trend in Oil Is Up (José de Freitas, July 30, 2008)
Although I'd be lying if I said I am certain of which direction the oil price is going, my gut feeling is telling me that it's going up as a general trend, despite brief respites. A few points have not been sufficiently made, and I think Rainer H.'s piece exhibits some of the problems those points would address.

Thank you, Kevin L. ($15), for your much-appreciated donation and encouragement to this site. I am greatly honored by your support and readership.

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Long Cycles: Cheaper Goods, Costlier Capital, Income Disparity Increases

Welcome new readers. It seems a few thousand new-to-OTM inquisitive souls happened upon the site in the past few days--I hope the content and reader essays keep you coming back. Here is our RSS feed; archives are in the right column, other goodies are in the menu at the top of the page. I received many emails--thank you--and it will take me a few days to catch up. I appreciate your patience.

Truly great books provide a treasure trove of insights. One such analysis is The Great Wave: Price Revolutions and the Rhythm of History by David Hackett Fischer (sent to me by longtime correspondent Cheryl A.)

I have visually displayed Fischer's Price Wave along with three other long-term cycles: oil depletion (Peak Oil), generational (4th Turning) and Kondratieff (credit expansion and renunciation/contraction).

What else can we mine from Fischer's deep-history analysis? If history echoes, which it tends to do because human nature remains firmly stuck in Version 1.0 of Homo sapiens sapiens, then we can expect these long-wave trends to continue through at least 2021 (the expected full-blown epochal crisis/opportunity point), if not longer:

1. Manufactured goods stay cheap in terms of purchasing power. As far back as the 14th and 16th centuries, during long-term economic declines the cost of manufactured goods like nails stayed flat or decreased while the cost of food and capital steadily rose for decades.

Could this pattern repeat in the decades ahead? I would say yes for one reason alone: overcapacity. Those of you who follow consumer prices of manufactured goods (and who doesn't?) know there are two competing forces at work in manufacturing costs: the rising input costs of commodities and oil/energy, and the intense global overcapacity and price competition.
It comes down to this: everybody is getting into everybody else's business. What was once the reserve of high-tech manufacturing bases like Japan (think flat-screen monitors and TVs) is now made in Korea, China and elsewhere. As a result, the market is quickly glutted with oversupply and prices plummet to to the point where profits are negligible or negative.

Karl Marx explained this mechanism well in the 19th century. He was wrong about a lot of things, but Marx captured the dynamic of capitalist manufacturing rather well: any profitable venture attracts competitors, production skyrockets to meet demand, then exceeds demand. Prices drop, manufacturers exit or close, and "monopoly capital" takes over the remaining production, forming either a monopoly or a oligopoly which enables profits by constraining supply and/or fixing prices.

This was the case with The Big Three automakers before the coming of Japanese competition. In terms of pure monopoly, look no further than your cable TV/Internet provider, as in most areas there is only one choice. This goes a long way toward explaining why internet and cable prices in the U.S. are so much higher than in Japan and the EU. (Yes, here in the home of "free market capitalism" we pay about double what other developed country citizens pay for these services.)
As profits plummet, major companies exit or take over marginal competitors and then try to muscle into whatever profitable business remain. You get what we have now: Everybody everywhere is pursuing the same goal: creating another Silicon Valley of innovation and wealth generation.

So everybody everywhere is building business parks and examining their education programs, lining up tax breaks for biotech, nano-engineering, software, etc.-- the "clean" wealth-producing industries of the future. Hmm, do you foresee future overcapacity in the making? How many "miracle drugs" will produce billion-dollar profits when dozens or hundreds of research centers start producing competing medications? Now that Intel, Appied Materials, et al. and their Japanese, Chinese, European and Korean silicon-etching rivals are all jumping into silicon-based solar panels, how can anyone corner billion-dollar profits? The productive capacity of the major economies is so vast they can quickly outstrip even robust demand.

Flat-screen TVs were supposed to be the profit-center for consumer electronics giants, but that hope has fizzled as everybody and their brother jumped in and built factories with stupendous capacity. Ditto for steel, autos, you name it: China's capacity to produce steel and autos has already grown far beyond potential demand, and the shakeout is already visible.

Whatever profit centers remain are either protected by enormous entry costs (commercial aircraft, silicon wafers, etc.) or by ephemeral marketing legerdemain and temporary technological advantages (iPod, iPhone, Blackberry, etc.)

Even as the forces of competition and overcapacity relentlessly squeeze profit margins, the costs of raw materials and energy are rising. While it's comforting to hope prices for materials will plummet in a global recession--and no doubt they will temporarily--The Great Price Wave is fundamentally based on demographics.

As populations surged and wealth increased in the 13th and 16th centuries, demand eventually outstripped supply. Now that a billion additional people have gained some access to developed-nation type consumer lifestyles, even global recession will be unable to repeal long-cycle rises in commodity and energy prices.

You cannot double the number of global consumers and have no effect on price.

Two other factors feed overcapacity: an oversupply of labor in developing countries and robotics in developed economies. As competition and rising input costs squeeze profits, manufacturers turn to automated production or cheaper labor markets. Even now some manufacturers are fleeing "rising labor cost" coastal China for lower-labor cost climes in the interior, or elsewhere in Asia. Frquent contributor Albert T. just sent in this link: China Manufacturing Shrinks for First Time on Record.

Some auto plants in Japan are so automated that the entire plant only requires about 125 workers. That's how you get global overcapacity in virtually every manufactured good.

2. As manufactured goods remain low in price, the cost of capital rises. The seeds of such a rise in the cost of capital are already clear: with credit contracting and stupendous capital impairment/losses being taken, there will be much less capital and borrowing power sloshing around the global economy. As a result, those who want access to capital (borrowing actual cash saved by someone somewhere) will be bidding against others for that dwindling capital.
Yes, the sovereign wealth funds of oil-exporters are currently groaning under the weight of oil profits, but three long-term trends will eat away at the surplus capital available to oil-consuming nations like the U.S.:

A. oil-exporters' skyrocketing populations
B. oil-exporters' skyrocketing consumption of their own oil
C. the eventual demand of oil-exporters' populace for greater domestic investment

3. Income disparity increases as owners of capital reap increasing gains. Fischer showed that even as purchasing power of most citizens declined, the cost of rents/food/energy rose. Strangely enough--or perhaps not so strangely-- we see just these trends developing in the present. Demographics--that additional billion consumers--is driving up the cost of food and energy, and the decline in purchasing power is motivating people to move from marginal exurbs and suburbs to cities with nearby FEW resources (food, energy, water), enabling landlords in desirable areas to raise rents.

Perniciously, the rising cost/dearth of capital makes it harder for wage-earners to join the rentier class, i.e. buy buildings and dwellings in these desirable areas.

We cannot know precisely how these long-term cycles will interact and play out, but we can know this: those who understand them will have a much higher probability of weathering the future/prospering than those who have no idea of the forces at work beneath the surface of everyday life.

(I discuss the impact of these trends in my soon-to-be-published book, Weblogs & New Media: Crisis in Marketing.)

Excellent New Readers Journal Essay:
Read all five of this month's superb essays if you missed them

Why the Trend in Oil Is Up (José de Freitas, July 30, 2008)
Although I'd be lying if I said I am certain of which direction the oil price is going, my gut feeling is telling me that it's going up as a general trend, despite brief respites. A few points have not been sufficiently made, and I think Rainer H.'s piece exhibits some of the problems those points would address.

Thank you, Ben G. ($50), for your second wonderfully generous donation this year and for your ongoing contributions of ideas and encouragement to this site. (Les Pauls rock!) I am greatly honored by your support and readership.

Read more...