Moneyization Part Twenty-two
Moneyization: The global financial phenomenon of individuals and businesses moving their funds to monies in which they have the highest confidence, or money in which they have a higher store of faith.
Or, Money Illusions
Money serves many roles in our lives. One of those roles is to subjugate us to the control of the government which issues the money. We are bound to our national money in many ways by our government. First, it extracts taxes in the form of the national money. Governments rarely will accept poultry in payment of taxes. Second, the government pays the vast army of bureaucrats working for it with the national money. Should we desire to do commerce with these citizens, it must be done in the national money. The government pays pensions, health benefits, and seizes our land and property, all with the national money. We are forced to accept it in the initial transactions.
From that initial transaction on, citizens have choices as to which national money they denominate their wealth. Latin Americans have traditionally sought monetary haven in U.S. dollars, due to proximity. Russians moved to the U.S. dollar after the rouble crisis. Canadians have been hauling wealth out of the country for decades, so much so that one would think it was a national hobby. Swiss banks at times have been paid by depositors to take money, negative interest rates. Individuals having learned not to trust the value of all national monies, moved their wealth to monies in which they have a higher faith.
Maintaining and enhancing the purchasing power of your wealth requires understanding the money illusion. Money illusion is when the amount of money one has rises, but the real value of that money is declining. The value of money is not the accounting concept of how many dollars, pesos, or roubles one possesses. The value of money is an economic concept, or what that pile of money will buy.
Governments are the masters of money illusion. Ever since sovereigns substituted base metals for precious metals in coins, they have been trying to fool the people about the value of money. The calculations on consumer prices in many countries, especially the U.S., are statistical manure. Why? So the citizens will not understand the true destruction of money wealth. Governments prefer to steal by stealth rather than overtly.
Some of the recent monetary illusions have included that the U.S. dollar went up 2005, and that the Canadian dollar has been stronger that the other dollar. The first misconception comes from the attention given to the dollar index, which is arbitrarily weighted toward the money of some countries. It is not the value of the dollar, just another arbitrary index such as the CPI. The misconception on the Canadian dollar is typical of the conclusion reached when the value of a national money is not viewed in a global context. Gold is the global money. In the first chart the Gold price of both dollars is plotted, or how much of an ounce of Gold is needed to buy each dollar. Clearly, the value of both national monies has declined. Finding a national money that has indeed appreciated is difficult. Dollar investors, Canadians in particular, should not allow money illusion and misleading indices to misguide them.
Perhaps one of the greatest monetary illusions of all times is in the recent era. That being that the value of housing, particularly in the U.S., has risen. In simplest terms, the monetary value of one house will buy just one house. Relative regional prices aside, the inflated price of a house today in Anytown will do nothing more that buy a similar house in that location. The purchasing power of those dollars is simple one house. The victims of this illusion will include those making loans based the illusionary price. Another group that will lose is the borrowers that will be held liable for the illusion created debt.
For some time, as shown in the second chart, the Gold price of a house has been declining. The increase in nominal dollar value is an illusion. In that second chart is also plotted the median price, in nominal dollars, of homes that traded during the month. That series is plotted wit h a line of triangles, and uses the right axis. The bars in that chart are the Gold price, in ounces, of the median priced single family home in the U.S. that traded in the marketplace. Left axis is used for the bars. A year ago, about 440 ounces of Gold bought the typical house that traded. In the latest month, only about 380 ounces of Gold were required. Since July, the Gold price of a single family U.S. home has collapsed by about 25%!
The following table is part of an effort to fight News Illusion. Last week when the February data was released on existing home sales, the popular media and Street analysts tried to put a positive spin on the data. Taking it as just another data point leads to the information in the following table, which is aptly named. What is unfortunate is that investors have to go to sites that specialize in real money, Gold, to get such information.
|U.S. HOUSING BUBBLE BURST TRACKER
in Nominal U.S. dollars.
|Peak Price||Aug 2005||Oct 2005|
|Price Decline - Annualized||-10%||-19%|
|Data: Median Prices from NAR|
That table suggests the danger in the "Can't lose money in real estate" Illusion. Some of you are certainly thinking about a condominium for retirement. The third chart portrays recent data on the U.S. condominium market, in nominal or current dollars. As is readily apparent, the rate of change in prices, plotted using triangles and right axis, has a fairly ugly trend. The other line is the inventory to sales ratio. That overhang of listed properties is going to be "overhead supply" for a long time. According to Paul Owers, writing in the Sun-Sentinel on 24 March, for example, condo sales in Naples, Florida were down 50% from a year ago. Single family home sales did much better, down only 47%. At current prices, about 390 ounces of Gold will buy the median priced condominium. How much Gold should one put away for that retirement life condo? About 100 ounces ought to do.
For speculators, the unrealized losses are compounding. Suppose a speculator bought the median priced condominium in February of last year and sold last month. This speculator put down 5%, borrowing the rest. For a year the speculator has been making loan, association, utility, property tax, and insurance payments. Rent for the period was zero, as qualified renters have been rare. The seller pays a standard agent fee on the sale. The cash return, before any and all tax ramifications, on the cash investment is approximately NEGATIVE 200%. Now, that is a great investment. This "never can lose money" investment would have lost $2 for every $1 invested in the past year. And, the downhill slide is just beginning! No, of course they don't have to sell. The speculator can just let the losses compound, like 1999 buyers of the NASDAQ.
Lastly for this effort, is the Financial Stability Illusion. Much talk is thrown about on how the banking and financial system are so sound at the present. Such is as it should appear at a secular economic peak. Minsky tried, mainly in vain, to get us to understand that during a boom financial fragility builds up in the financial system. Financial institutions have gorged themselves on mortgage and real estate loans and investments. Despite what many say, someone somewhere owns all the mortgages that have been made.
Financial fragility is the vulnerability of financial institutions to a change in the economic status quo. Financial institutions are today at the "maximum" exposure to the risks of the Mortgage Bubble bursting. Yes, they look nice and stable. Yet their financial fragility, or risk of loss, due to the mortgage bubble is at the highest. They have been maximizing their exposure to the most profitable investments and loans of the past decade mortgages and real estate related. Kind of the reverse of "its looks the darkest before the dawn."
The graphs so far discussed make evident that the foundation of the Mortgage/Housing Bubble is starting to crack. Investors need to understand how this unwinding will play out. That unwinding has three phases. At the end of this natural and often repeated progression, housing prices in the U.S. will be 50-75% below current levels, or the government will own the housing stock. That loss in value will be split between those that own the loans and those that borrowed the money.
The economy will be in shambles at the end. Loans for any purpose will be near impossibly to obtain. Dollar denominated investments will have been ravaged. Foreign investors will be attempting to flee them. Financial asset prices will be dramatically lower. Interest rates in the U.S. will be rising dramatically. When bonds are sold the dollar value or price declines, which causes the interest rate, yield-to-maturity, on the bonds to go up. The dollar, both of them, will plunge in value on foreign exchange markets. $Gold will be appreciating daily. Let us consider the various phases so all will understand the coming chain of events.
First is the Humpty Dumpty Phase. If you have ever read this book you likely saw a picture of Humpty sitting on a wall. The wall is not very tall, and Humpty did not take a really big fall. His landing was the problem. In the early phase of the housing crumble, the falls are not really that big. But eggs are broken, and eggs cannot be put back together again. Individuals and businesses are financial damaged. Financial contagion develops as one person's financial problems become someone else's when the bills cannot be paid. We are in the Humpty Dumpty phase at the present. Little falls are being taken and small eggs are being broken. In Florida, the manifestation of this phase is evident in builders walking away from contracts they cannot afford to do and buyers walking away from contracts that now look like losers.
The Loan Loss Phase comes second. In this phase the banks come to realize that no matter how many phone calls they make or how many letters they write, the borrower does not have the money to pay the loan. The banks take the houses and businesses. A modest amount of that is in process at the present. At first the banks take the property, hoping for a full recovery of the loan's value. Initially the bank tries to avoid selling at a loss. But if they lent money to the speculator in the example above, they are going to lose money. Slowly the banks realize that the loan value and the market value of the house are far apart. The banks start to write down the value of the loan, a loan loss. That hurts, in ways we talk about later.
Finally, the Auditors' Mentality Phase develops. In short, this phase is an attitudinal one. The lenders freeze up. They are afraid to approve loans. The "auditor" mentality takes over on loan applications. Reasons to reject are found rather than reasons to accept. Imagine being a loan officer that just got beat up by a superior for some previously made loans gone sour. How would that loan officer react to the next loan applicant? Round file! The volume of loans to purchas e hous ing becomes non existent. Now remember the answer to this question. Where would house prices be if all buyers had to pay with 100% cash, or even 50% cash?
Understanding how the financial system works is important to comprehending the consequences of the current situation. In this example, MegaMortgageFinancial is our hypothetical f inancial institution. As shown in the table, it has a billion dollars in equity and ten billion in housing loans outstanding. The ratio of equity to loans, shown in the bottom line, is 10%. Regulators are quite pleased with this performance. That ratio is well above the required, or desired, ratio of, say for example only, 8%.
|At the top
|Equity to loan ratio = 10%|
With the slide in housing, our financial institution takes a hit on some loans. Not a lot, just 5% of their loan portfolio goes sour. They write off five hundred million dollars of loans against their equity, as shown in the next table. Yes, the accounting is simplified. Loan loss reserve is just equity made to look like a contra asset account. The loan account and equity are each reduced by five hundred million due to the losses. The equity to loan ratio is now 5.3%. Since that ratio is below the required or desired level, MegaMortgageFinancial can make no more home loans, or loans of any kind. The only way left to buy a house is with cash. What do prices do in that situation?
|After the slide
|Equity to loan ratio = 5.3%|
The coming economic slide in the U.S. will be based on the forced liquidation of debt. Housing debt will be extinguished by the pencils of accountants. Financial values that might have existed will no longer exist. Financial institutions, those now owning the mortgages, will be hemorrhaging red ink. The equity that many consumers thought existed will have disappeared as do all mirages. Consumer spending will collapse as consumers will be unable to buy on debt. Cash will be the only way of making purchases.
Many, however, believe that the Federal Reserve will lower interest rates and all will be restored. But remember the poem, all the King's men could not put Humpty back together again. Low interest rates did not return the NASDAQ to over 5,000. Additionally, such a rosy scenario ignores the ramifications of foreign investors. It considers the U.S. in financial isolation, which is a false view of the world.
Gold will be the money to which investors migrate. Canadian $Gold, last chart, rising to a new cyclical high is probably an indication of the market's recognition of these problems. Opportunities for dollar-based investors, both of them, to buy Gold regularly appear, as shown in the graphs below. Do not miss these future opportunities to participate in Gold rising to US$1,300+. Chart also available in Euros.