1. Past the Peak of the Credit Cycle
David J Merkel, FSA, CFA
15 October 2007
Investment Section Hot Breakfast
2007 SOA Annual Meeting
Hi, I'm David Merkel, and I'm currently trying to start my own equity investment management firm. I'm looking for my first client.
This talk represents a summary of many of the things that I have been writing about at RealMoney and at my blog for the past four years. (Today is my four year anniversary at RealMoney.)‏
This presentation has been expanded since I originally submitted it, and the full presentation can be found at Alephblog.com on a page titled “Society of Actuaries Presentation.” I presently have a link to it on Alephblog.com's front page.

2. Road Map How did we get to this point in the economic cycle?
Overstimulation of the US economy
Housing finance in the US
The five great distortions of this cycle
Recent changes to the cycle
What next?
Now, I have a lot of ground to cover today, so some of this will go fast. If you have a question that doesn't get answered today, feel free to me, or post at Alephblog.com.
Read slide

3. How Did We Get Here?
Failure of Communism and the “Third Way” led to an expansion of Capitalism globally
Neo-Mercantilists in developing nations dominate their economic policy
Slowing population growth leads to pressure on entitlement systems, and economies generally
The US adopted economic policies designed to avoid all recessions, leading to excessive risk- taking
Read slide

4. Not so much the Success of Capitalism
But the failure of the alternatives...
Collapse of aid from alternatives
Peace Dividend
Tax rates
Regulation
Trade policy progress in the 90s – Uruguay, NAFTA, progress lacking in the 2000s – Doha
Aside from relative nothings like North Korea and Cuba, Communism is banished from all but American Universities...
Remember Sweden and the Third Way? When the bond market balked at buying more of their debt, the magic just left them
More importantly, when the aid and counterexamples dried up, other nations realized they would largely have to do it on their own, which meant some form of Capitalism, even if many are cronyist.
The lack of need to spend on defense was a help, as was improved trade conditions, and declining tax rates

5. OECD Average Tax Rates
As you can see here, tax rates declined across the developed world over the past 20 years. This is true of personal taxes (upper line) and corporate taxes (lower line).
Source: OECD via CIA Factbook

6. New Capitalist Countries
China – 1,320 million people
India – 1,130 million
Russia – 140 million
Brazil – 190 million
3-4x America, Canada, Europe, and Japan
The Capitalist world has grown... it's funny that they get called the BRIC countries, because that's the reverse order of the population size. Perhaps it should be CIRB. Regardless, this has been the biggest factor affecting the global economy over the past 15 years, adding hundreds of millions of workers to the global capitalist labor pool.

7. Major Effects
Capitalist labor force grows drastically, particularly in the lower skilled areas
New technologies like the Internet, bring down the cost of outsourcing, aids distant cooperation
This brings down wages, and raises profit margins, for now
Raw materials are relatively scarce compared to capital, and capital relatively scarce to labor
So, what's in surplus in this new environment? Unskilled labor. That's holding wage rates down to a degree in areas where work can be done non-locally. Even skilled labor is under pressure; a P&C reinsurer that I am invested in, Flagstone, has the grand majority of its catastrophe modelers, mostly Ph.Ds. based in India.
Capital is a little more scarce, which pushes up profit margins.
Energy and raw materials are the most scarce in the short run, and the commodities and equities have outperformed.

8. Energy, Metals, and Commodity Prices
Here you can see Commodities generally (green - 2x), Energy (orange - 4x), Metals (white - 3x), and specifically, Copper (yellow - 5x). What a move since 2001!
Source: Bloomberg

9. Global Equity Returns Stock returns in USD Red line – developed non-US
Green – Canada
White – US
Yellow – emerging markets (4x). What a move since The rewards have gone to developing and flexible markets.
Source: Bloomberg

10. Labor Versus Capital?
Three main points to this graphic, which shows the relative payment to factors of production in the US economy as a fraction of GDP:
Wages receive the lowest share of GDP in 60 years.
Oddly, the share of total compensation to laborers is flat, though. Not as high as the mid-70s, but close to average now. Benefits have grown dramatically as a share of GDP.
The share to profits is not at a 60-year record, but it is at its best level in 40 years.
Source: Commerce Department via The New York Times

11. Neo-Mercantilists Dominate Trade
Producers in developing countries prefer a lower exchange rate than consumers would, and they have more political clout.
Works in the short run because of a surplus of labor
Problematic in the long run, because labor needs goods to survive, not foreign assets
Rising inflation in developing nations could mean the end of the cycle
In the Mercantilist era, countries sought to hoard gold through pushing exports on other countries. In general, the importers won, because hoarding gold doesn't do much for your economy.
Just read the slide, and say: in this era, gold is not what is being hoarded, but USD debt claims in central banks and other foreign institutions around the world.

12. Chinese & Indian Inflation
Now, this could be the end of the party. I'm using China and India as examples here, but inflation is rising across much of the developing world.
The trouble with Neo-mercantilism is that it does not deliver enough goods to the workers, which drives up inflation eventually
Source: Bloomberg

13. Benefits to the United States
Cheap consumer goods restrain inflation
Investment in US securities keeps interest rates low and P/E multiples relatively high, which stimulates the US economy
Neutralizes any restrictive Fed policy
It's like the period near the end of the Bretton Woods treaty, but without the gold.
What could be sweeter for the US for now. Read the slide.
Much of the developing world wants to maintain a low fixed exchange rate to the dollar, so their exporters can sell to the US; unfortunately, they must buy our assets, usually bonds to make the books balance. That forces them to import our monetary policy.

14. 10 Year Swap Rates
These are rates that AA banks lend to each other for 10-years at, over the last 19 years. The top 3 are the US, UK, and Germany, which is a good proxy for developed Europe. The bottom one is Japan.
These long rates have been low and stable for the past ten years, fueling growth in the developed world.
Source: Bloomberg

15. Slowing Global Population Growth
Many nations below replacement rate
Affects savings, consumption, productivity
Forces immigration on slow-growing and shrinking countries that want to keep their economies growing
How much can the working economy be taxed to support the consuming economy?
Global population growth is slowing. Here are some of the issues: read slide

16. Aging Japan
I'm going to slow you some Population Pyramids for five countries - Japan, China, Italy, Canada, and the US. They show the population distributions, with men on the left and women on the right, and older people on top. The dates chosen are upper left 1990, upper right 2010, lower left 2030, and lower right 2050.
Japan is shrinking now.

17. Aging China
China isn't shrinking yet, but maybe in another years. If you look closely at the 2010 chart in the younger cohorts, you can see some evidence for infanticide of female babies.

18. Aging Italy
Italy is a good proxy for the rest of Europe, if a bit severe. Keeping up economic growth will require immigration. Is Europe ready for the hard choices involved? I don't think they are.

19. Aging Canada?
Canada will age as well, but more slowly. Part of that is a more open immigration policy.

20. US: Forever Middle-Aged?
In demographics, America is always the exception. We are not forever young, but maybe forever middle-aged. Such a legacy from the Baby Boomers.
Two factors in play here: America is at the replacement rate in fertility. Second, immigration – the immigrants will find a way to get here. They always have over the past 400 years.
The demographics of the US are the best of the developed nations for dealing with retirement security issues... we intensify the problems in other ways, though.

21. Below Replacement Rate
Vietnam
Iran
Turkey
Thailand
South Korea
China
Almost All of Europe
Brazil
Russia
Japan
Here are the largest countries below the replacement rate on fertility, in rough order of size:

22. Above Replacement Rate
India
Indonesia
Pakistan
Bangladesh
Nigeria
Mexico
Philippines
Egypt
Ethiopia
Congo
And here we are for countries above the replacement rate on fertility. We are above replacement rate at 2.9 now, but my guess is that the World hits replacement rate (2.1), and slips below it 30 years from now.
Global Total Fertility Rate: 2.9 children per woman of childbearing age
Source: CIA Factbook 2007

23. Economic Effects
Middle-aged people tend to be the most productive and the biggest savers (Excluding Baby Boomers in the US)‏
Pension and Social Insurance systems will come under pressure – fewer workers supporting each retiree
Immigration will continue to be a “hot potato”
Prosperity will partially depend on increasing global economic integration, with older nations providing capital, and younger ones, labor
Read the slide

24. Stimulation Everywhere for the US
Monetary Policy
Fiscal Policy
Recycling the current account deficit
Mortgage Refinance
Loose oversight over lending
Since 2001 there has been much economic stimulation for the US from five sources, though some of that is ebbing now: Read slide
Let's take them in order:

25. Monetary Policy - Fed Funds Target
Let's start with Monetary policy – Fed policy was fairly accommodative for the entire Greenspan era, especially
Source: Bloomberg

26. Global Short Rates
But not just the US was accommodative, so was most most of the developed world. Here is three month LIBOR for:
US (white)‏
UK (orange)‏
Germany (proxy for Europe – green)‏
Japan (yellow)‏
Source: Bloomberg

27. Global Short Rates (2)‏ And again: US (white)‏ Canada (orange)‏
India (green) – less accommodative
China (yellow) – very accommodative
Global Monetary policy followed US monetary policy in many ways, partially to keep local currencies weaker vs the US dollar, so they could export to the US
Source: Bloomberg

28. Global Broad Money Same graphs for the broad money supply: EU (white)‏
US (orange)‏
Japan (green)‏
UK (yellow)‏
Those are high rates of growth, excluding Japan. The US rate would be higher, but it's just M2, as the M3 series has been discontinued by the Fed.
Source: Bloomberg

29. Global Broad Money (2)‏ Same graphs for the broad money supply:
US (white)‏
Canada (orange)‏
India (green)‏
China (yellow)‏
Monetary policy has been very accommodative globally, though China and India are extreme examples – look at those 20% growth rates
Source: Bloomberg

30. Fiscal Policy
Deficit is coming down, as officially calculated ($318-->$248B), and on an accrual basis as well ($760-->$450B)‏
Much doesn't make it into the official figure
Debt/GDP ratio is still low – 37% if you don't count what is held by other areas of the government, and 67% if you do
Net liabilities on an accrual basis as a ratio to GDP are quite high – 360% of GDP
Because of our deficit spending, the US economy has been stimulated. The figures I cite here are for fiscal 2005 – Read Slide.

31. The Current Account Deficit is a high percentage of GDP
Stimulus also come from the willingness of foreigners to sell the US goods and services, and take back paper assets in return. As a percentage of GDP, the current account deficit likely bottomed in
Source: Bloomberg

32. Net Foreign Assets / GDP
But if the current account deficit is so bad, how come the total net foreign asset position as a percentage of GDP doesn't get worse? Foreigners predominantly buy US debt, which hasn't appreciated much, and may have depreciated in local currency terms, while the US tends to own equity-like claims abroad, which have appreciated, particularly in dollar terms.
That's a pretty sweet deal. Unfortunate that only the reserve currency nation can get it.
Sources: Commerce Department and FRED

33. Mortgage Refinancing Refinancing was a huge source of stimulus
Mortgage equity withdrawal became a large fraction of GDP
No longer so, because mortgage rates have risen, and terms have stiffened
Read slide

34. Mortgage Equity Withdrawal / GDP
But what a party while it lasted. The effect peaked out at over 6% of GDP in late That said, many who refinanced took back new lending terms that were more onerous than before, so part of the stimulus would be very temporary.
Source: Bloomberg

35. Loose Oversight of Lending
Bank exams became perfunctory
Consumer suitability became “Caveat Emptor,” but with no sign that a change had happened
Banks had earnings targets to hit
Accrual items were given too much credibility
For many banks they would not hold onto the loans long
Read the slide

36. Loose Residential Mortgage Lending 2003-2006
The following four slides are from the Federal Reserve Senior loan officers Survey. From 2003 through 2006, loan officers were loose on Residential mortgage lending
Source: Federal Reserve Senior Loan Officers Survey

37. Loose Consumer Lending 2004-?
Source: Federal Reserve Senior Loan Officers Survey

38. Loose C&I Lending 2003-2006 Commercial and Industrial Lending
Source: Federal Reserve Senior Loan Officers Survey

39. Loose CRE Lending 2004-2006 And commercial real estate lending
Source: Federal Reserve Senior Loan Officers Survey

40. Housing Finance
After the tech bubble burst, the Fed forced short term interest rates low enough to over-stimulate the residential housing market. (The Fed can't stimulate dead industries, only live ones.)‏
In the process, they set off a small mania, as housing prices appreciated dramatically due to the new buying power they temporarily created.
The new mortgage loans were low in quality – less underwriting, less information, higher leverage, payment resets
This created a culture of risk in housing finance

41. A Culture of Risk in Housing Finance
Borrowing more as a percentage of home value
Higher debt service as a percentage of income
Debt-to-income levels were very high
Many residential real estate investors had to have capital gains to stay afloat in hot markets
Financing long term assets with short term debt, and the Federal Reserve encouraged it
Read the slide.
Point 4 is important – anytime many owners of an asset class are relying on capital gains in order to survive, there is usually a bubble present.
As for point 5 – With low short rates from the Fed, people misfinanced housing, borrowing short for a long-dated housing assets, also a bubbly practice.
Here's a quick tour through some of these issues:

42. Equity Low in Residential Housing
So far this figure has topped out at 47% of residential property values financed by debt. My guess is that given the current decline in prices, that level is now 50%.
Source: Paul Kasriel of Northern Trust

43. High Debt Service Ratio
Debt service occupies a greater portion of the budget of American consumers
Source: Paul Kasriel of Northern Trust

44. High Consumer Borrowing Rate
Consumers borrowed more in the 2000s to support their lifestyles than in prior decades.
Source: Paul Kasriel of Northern Trust

45. Comparing the Early 90s to Now
During the last housing soft cycle, residential real estate prices really didn't start to move up in price until residential inventories were worked off to a degree.
At present in this soft cycle, our inventory of housing for sale is still rising.
Source: Jeffrey Saut of Raymond James, via The Big Picture (blog)‏

46. Residential Oversupply (1)‏
At ten months of residential housing supply, we are currently at levels seen in
levels – 11.5 month peak. We will surpass that before the cycle turns.
Source: Bloomberg

47. Residential Oversupply (2)‏
As you look at this graph, sales peaked in September of 2005, and unsold new homes grew dramatically after that.
Homebuilders got the signal late. As an aside, my main article on the housing bubble was written in May of 2005, and I updated readers in October 2005 to tell them the the inflection point had been reached.
Aside: at inflection points, the numbers won't help you see the change. Typically, the qualitative chatter gets loud, and there are many disagreeing signals.
Source:

48. Foreclosures Rise
And of course, given all of this, foreclosures are rising dramatically
Source: RealtyTrac, via The Economist

49. Mortgage Resets
One final complicating factor is the ARM resets will be strong through the next nine months, before hitting a steady state. That will help lead to more foreclosures, excess supply, and declining prices.
My guess is that housing prices will draw down on average 20% from the peak before the upswing in the new residential real estate cycle starts.
Source: Bank of America, via the Orange County Register

50. The Five Great Distortions
Current Account Deficit
US Residential Housing and its financing
Carry Trade
Collateralized Debt Obligations [CDOs]
Private Equity
Read Slide
I've already talked about the first two factors. Let's look at the last three.

51. Carry Trade
Borrow in a low interest currency, invest in a high interest currency
Borrow in Yen or Swiss Francs, and invest in NZ Dollars, Australian Dollars, British Pounds, or US Dollars (Size perhaps: $1-2 Trillion)‏
Mortgages denominated in Swiss Francs in other countries
Japanese housewives investing money in NZ Dollars
Hedge Funds
Read Slide
Mention GS Global Alpha

52. NZD-JPY Cross Rate
This is a graph of how many yen it takes to buy a Kiwi. As this rate rises, the carry trade prospers; vice-versa when it falls. You can see how the carry trade has been more and less popular over the years, blowing out from If you look at the far right, can see some of the recent blowout, but so far, it has tended to bounce back.
For the trade to entirely disappear, we would need to see more economic strength in Japan, higher interest rates there, and higher currency option prices, which would make hedging more expensive. The same arguments apply to Switzerland.
Source: Bloomberg

53. Growth in CDOs
Collateralized Debt Obligations [CDOs] are a way of levering up credit exposure so that risk- loving investors can shoot for equity-like returns.
All sorts of debts can be packed in CDOs – bank loans, corporate bonds, trust preferreds, credit default swaps, CMBS, RMBS, ABS (including subprime mortgages)‏
We don't know in full, yet, who the dumb money was, but some bought off of yield and rating only.
Read slide. It seems that foreign investors took a lot of the mezzanine and subordinated pieces. The investment banks are very good at spotting sophisticated neophytes.

54. Growth of the CDO Market
Here you can see the growth of the CDO market. It's slowing down now, but over the past ten years, it has had an 80% growth rate.
Source: Celent, LLC

55. Single-B Industrial Bond Spreads
Demand from CDOs helped to depress junk spreads. Spreads were quite low
Source: Bloomberg

56. Recent Issues are Low Quality
Over 30% of junk bond issuance over the past four years has been B- or wrose in ratings. Demand for debt to place in CDOs allowed more marginal firms to get financing. This should lead to a rise in junk default rates, starting in 2008.
Source: S&P, via The Economist

57. Private Equity
Private equity firms buy ownership interests in private and public firms of which they want to grow the profitability, before selling them off to a new set of owners.
This usually involves expense cuts and increased debt financing. Deal leverage was quite high in this cycle.
The bonds or loans used to purchase the target company are usually junk grade, so they carry protective covenants... in this cycle, the lenders neglected covenants to get more deals done.
Read slide. At the end of the cycle, covenants had been weakened on about 35-40% of all deals.
Those covenants were typically debt service or leverage tests.
The recent back up in the private equity market partially stemmed from a rebellion on the part of loan buyers over the lack of covenants.

58. High Multiples Paid for Recent Deals
At the end of the cycle, buyers were paying an average of 9x EBITDA. I don't know how they'll make money off of those purchases.

59. Why Yield Seeking?
Pensions – Can't meet actuarial return targets through bonds
Hedge Fund of Funds
Individuals learn that they won't have enough money when they want to retire
Now, I summarized these distortions as a form of yield-seeking. Why yield-seeking?
There is investor demand for returns that are higher yet smooth, having low probability of loss – these strategies are yield-like. The types of investors that go for this are some pension plans, most hedge fund of funds, some hedge funds, and loss averse individuals, like retirees, and near-retirees.
Now, how do they seek yield?

60. How Some Seek Yield
Arbitrage Hedge Fund Strategies – Risk, Convertible, Capital Structure, etc.
Risky loans – e.g., subprime mortgages
High yield
Carry Trade
Internal Leverage
CDOs, CPDOs
ABCP, SIVs
Sell Volatility
Arbitrage
Take Credit Risk
Take Currency Risk
Lever up – hedge funds and HFOFs
Lever up and take credit risk
Write options to garner income.
All off these were/are done in a big way to generate smooth returns, at a cost of higher risk, sometimes, much higher risk.
Note: Constant Proportion Debt Obligations, Structured Investment Vehicles

61. Reflexivity Term coined by Soros
Unlike Neoclassical economics, markets don't always tend toward equilibrium
Cycles can be temporarily self-reinforcing, until something “breaks,” and the next phase of the cycle begins
Read slide.
To give you an example, many people began buying residential real estate simply because it was going up, which forced prices up further. Once prices started falling, people backed away from the market, exacerbating the fall.
Markets tend to be boom-bust.
This is what we are facing now as the credit markets move from the bull phase to the bear phase. So what changed?

62. What Changed?
Investors in subprime mortgages and their derivatives realized that the loss experience would be much worse than anticipated.
Investors in Alt-A mortgage loans realized that it would not be much better for them.
CDO equity buyers got skittish, as did buyers of most tranches of CDOs after that.
Bank loan buyers finally balked at the low spreads and poor covenants for private equity [LBO] deals.
Read slide.
Note: the bank loan issue is relatively small, and will get worked through with few losses to the investment banks. That wasn't obvious when I first wrote this slide.

63. What Changed? (2)‏
Some banks and hedge funds that levered up credit exposure through ABCP and SIV conduits found that they could not easily roll over their short term debts.
Global central banks loosened policy through temporary provision of liquidity, and through “discount window” operations, indicating that overall policy would likely loosen.
Carry trades began to weaken as volatility rose, along with credit spreads.
Again, I wrote that originally six weeks ago. The losses from ABCP and SIVs have now been taken and the market for commercial paper has normalized. Longer assets that were improperly financed with CP, are now financed on a longer-term basis.
Central banks have now shifted their policies largely toward easing, but with the exception of the Fed, it is tenuous.
Even the unwinding of the carry trade is something that will take a while to do... the last unwind took four years.

64. Treasury-Eurodollar Spread
Just to show you that short-term skittishness remains in the bank lending markets,the willingness of global banks to lend to one another on an unsecured basis is relatively poor. The TED spread is relatively high at present, which is a gauge of fear... it seems that the banks don't trust each other.
Source: Bloomberg

65. Commercial Paper Outstanding ($T)‏
On the other hand, after significant stress, the commercial paper market normalized. The ABCP that remains is backed by quality assets. Marginal financial companies have moved to bonds for financing.
Source: Federal Reserve

66. Where Are We Going? A greater unwind of the carry trade Weaker dollar
Higher credit spreads
Lower residential housing prices, more mortgage defaults
More goods price inflation, less asset inflation
Wider yield curve
The developing world grows; the US slows.
What I'm giving you here are predominant tendencies. There are always bull market rallies inside of bear markets, and vice-versa. My forecast horizon here is 2010.
Read Slide.
Credit spreads need to reflect the risks taken on, and then some.
The debt overages of the past ten years need to be worked off, then the US economy will grow on a sounder basis.
Looser Fed policy will eventually ameliorate some of this, and lead to a wider yield curve.

67. Where Are We Going? (2)‏
Raw materials and real assets continue to do well
Private equity and hedge funds slow down to grow in line with the global economy
Re-regulation of lending
Public and private pension systems struggle
Rates of taxation rise in the developed world
We are past high-water mark for US capitalism, but not capitalism globally. The US will play a proportionately smaller role in global business.
Here my forecast horizon is longer than 2010.
I would expect less of a free market approach to most things in the US.
I know what I am saying sounds pretty bearish, but here's what I am not saying: I am not calling for a major catastrophe in the US economy, just a protracted period of working through overborrowing issues. It will remind us less of the Great Depression, and more like the 1970s.
Over the long haul, the US will likely continue to prosper, so long as it allows its currency, goods, labor, and capital markets to remain flexible.

68. Q&A – Thanks for Listening
David J Merkel, FSA, CFA