Debt Armaggedon / impact on Property

DEBT ARMAGGEDON - the Dangers of Leverage in a post-QE World,

and the impact on Property Values

======================


Here's a Long Article from Lucane1 and I think that it derserves a thread of its own


(ARTICLE):

Intentions and expectations - are we discussing economics and finance or Keynesian hopes and dreams?

Real world economic results have never been based upon intentions but instead on incentives. We need to examine the incentives that a government action creates in order to begin crafting expectations of what the future results will be. Analyzing the stated intentions of government action is wholly irrelevant.


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The Fed is buying more than the entire US deficit and it is doing so because no one else will at yields the US Government can afford. The Fed can only cease this operation if there are new buyers who currently are unwilling to buy the debt but are willing to at X date in the future (at yields the US Government can afford without blowing its budget). But who will this new buyer of 1 trillion of debt be?


Historically when the US began running serial deficits in the 70s people like Buffett screamed that it would lead to massive inflation and serious fiscal trouble. What Buffett could not have predicted was a wave of Japanese investment into the US that financed our deficits for more than a decade. As the Japanese financing began to peter out, other investors such as George Soros took up the same hyperinflation argument again because he correctly anticipated the decrease in Japanese willingness to finance American deficits. What Soros did not see though was the new wave of financing provided by a growing China.


Today we are again at the same tipping point that we've faced twice before - twice we have averted disaster by lucking into a new "rich Uncle" who was willing to finance our spendthrift ways. The question is who today is the new rich Uncle who will finance the USA? Please keep in mind the following:


- the US deficit used to be a much smaller amount both in real terms and relative terms to GDP (ie it took less wealth to finance us).

- it used to only take a country of 100 million Japanese to finance us, but it then took a country of 1 billion to finance us. The next rich Uncle will have to be far more wealthy and productive than the previous two were (due to debt accumulation)


I contest that there is no more rich Uncle out there to save the USA. What we have today is a pseudo rich Uncle in the form of global central banks. The central banks have infinite capacity to print currency and use it to finance American deficits. However there is a critical difference between the banker rich Uncle and the Asian rich Uncle: the Asian rich Uncle actually produced goods that grew the global economy whereas the banker creates nothing. The Asian Uncles made real things, then loaned us money in order to allow us to buy their newly built things. The bankers do nothing of the sort.


The only possible greater rich Uncle is the USA itself if it can manage to grow its GDP at 10%+ per year. I, as an American, contend this possibility to be laughably impossible. The US is so bogged down in smothering regulation and its cultural work ethic so diminished that I ascribe a 0% probability to the "America works its way out of the hole" option. Over half of the population lives on the take and they have little reason to ever voluntarily give it up.


It becomes far too easy for people to become confused by what these debts and numbers mean. Its all so esoteric that it seems as if they are irrelevant and can just be wiped away without any serious harm. But what these debts symbolize are real services that people are depending on to receive and will soon find out that they cannot actually receive. An illustrative example would be a squirrel who has saved nuts & acorns all year long, thinking he has a stash to survive the winter, only to find on December 1st that it was all a dream and he never had a food horde to begin with. The squirrel is the American adult aged 50+ and the nuts and acorns are social security, medicare (which is their entire healthcare system for those who are not American and do not understand medicare), and pensions both public & private.


It is a simple fact that the American economy cannot actually produce the goods and services that have been promised to its seniors. It is not a matter of money, debts, dollars, or deficits - it is the cold hard truth that America cannot provide the basic necessities a vast percentage of its population has depended on it being able to provide. We are the squirrel who is now just waking up from his dream and realizing that he has no ability to survive the winter.


Back in the 70s-00s it was possible for America to serially deficit spend because what its people needed / wanted were importable goods. As such the Asian rich Uncle was fully capable of both producing and financing these goods for us and satiating our demands. But today the requirements have changed - Americans now need locally based services on an immense scale never historically seen before - these demands cannot be met by imports and central bank dollars only provide an illusion of coverage, but not the actual necessary services themselves.


What I am trying to convey is that this time is truly different. America (and Europe) need a new source of imported goods/services and financing (to buy those imported goods) that is even larger than China had been able to provide for the past twenty years. This source does not exist and it cannot be organically sourced because these two economies are over regulated and lacking the culture to accomplish the task. I also believe that no new politician nor law can unregulate the markets - this has been a cultural push towards more centralized control that has gone on since FDR. Other than a very minor decrease in regulation during the Reagan years, every other president + Congress has increased centralized control and regulation. I see no credible sign that this multi-generational 80+ year trend will change anytime soon.


So what we have today are goods & services that must be provided or else there will be a true collapse in quality of living (otherwise known as a depression). The liabilities represent the promises made that people truly are depending on to be fulfilled, the deficit represents our annual inability to provide those services, and the debt + unfunded liability (100 trillion+) is the overall incapacity of America to fulfill the goods it needs.


To put this into perspective, the ~100 trillion of unfunded liabilities is about six years of full GDP. In essence the working population would need to work for six full years and donate 100% of its efforts towards sustaining the elderly population (and since 100% of output goes towards the old, that would mean no food, water, education, electricity, healthcare, housing, shopping, traveling for any working age or young person). The mechanics of how this will play-out are assuredly not as I have described above, the above is only to illustrate the ludicrous level of our situation.


The necessary services can never be met - there must be a devastating decline in the quality of living in the US & Europe. QE is successful only in delaying the realization of the accumulated loss America has made as it creates an illusion of meeting demands on an accounting basis. But economics is not about numbers but instead about real world goods, services, and quality of living - all things that QE cannot create. As such the government can either choose to continue QE indefinitely in order to provide a facade of accounting stability, or it can stop / decrease QE and allow the realization of our accumulated loss. But what it cannot do is prevent the large decline in quality of life in the US.


For those who are thinking that QE might spark some great new economic activity... to think that is to ignore basic economics and monetary systems. QE is inflation, which is to say its the process by which we economically take goods from a person and then ask them to produce something new in order to regain what he previously had. This is not a productive system but rather a reallocative and destructive system - his loss was our gain. If you go further to examine the incentives this system creates you will quickly see why it is an overall net loss to society - eventually, at least on a subconscious level, the worker will realize that he is making zero progress despite the work he conducts. As this understanding sinks in he will instead choose to just produce fewer goods.


Inflation is a bit like stealing a carrot out of a horse's mouth and dangling it in front of him. Yes you can make the horse run for awhile, but eventually he will exhaust himself and collapse. This system can only be a net gain if the rider gains vastly more wealth than the horse lost by collapsing. But in this example the rider is the elderly and the horse is the working population that produces goods and services. I do not see how inflation can spark any sort of net gain to society - at best it can shift assets to the elderly (who produce nothing) from the able bodied workers (who actually produce everything in the entire economy).


Now how does any of this affect our investing / speculation? As long as QE continues asset prices should generally increase. Their real return should be negative but their nominal gain will be positive. If you've levered your portfolio then you will experience a large real return. If you hold currency you will have large negative real returns and if you hold money you should have minor negative real returns. The key to obtaining positive real returns as QE continues is to be levered by borrowing currency.


If QE ends then productive asset prices should plummet resulting in negative real and nominal returns. Glossing over many things, only money / currency should experience real returns if QE ends. If the cessation of QE results in currency being destroyed, leaving only money, then money should experience a truly epic real return (and currency a reciprocally large real loss). If you were levered when QE ends, you risk being bankrupted unless the currency your liability is denominated in is destroyed.


So how does one invest in this scenario? If QE is to continue you must be levered, but if QE ever ends and you are levered then you might lose all of your wealth. To make matters worse, we are in the age of high frequency trading in which hedge funds can electronically parse Fed announcements and execute trades within a millisecond. If QE is ever announced to end, hedge funds would have liquidated their positions literally within a second - we as small investors have zero probability of exiting without realizing untenable losses.


I cannot predict whether QE will continue ad infinitum or end disastrously in the near future (all I know is that the Western economies will be increasingly worse for decades). To invest, perhaps lever yourself with currencies that you expect might not exist in the short-term future and use that leverage to purchase real money. If QE continues your money asset will experience a minor negative real return but your leverage will experience a large real return, for a net positive real return. If QE ends your money might experience a positive real return of epic proportions (if currency disappears) and your return on your leverage will depend on the existence or non existence of the currency your liability is denominated in.


I think someone mentioned Druckenmiller before and I agree with him - its best to stay highly liquid now. Adding to that I would not be overly aggressive with leverage because the line between hyperinflation and deflationary collapse is far too fine. I'd avoid owning assets that are connected to the US, Europe, or Japan.


And since this is the HK property thread, I must make a related comment to it ! If I already owned an owner occupied property here then I would probably do what OTP did. But if I owned a property on Park Island like Remmy does then I would just hold it and be very happy living on beautiful PI.


Sorry to anyone who slogged through my long ramblings. Hopefully it made some sense.

(My Response):


This part, I want to highlight:


"It is a simple fact that the American economy cannot actually produce the goods and services that have been promised to its seniors. It is not a matter of money, debts, dollars, or deficits - it is the cold hard truth that America cannot provide the basic necessities a vast percentage of its population has depended on it being able to provide. We are the squirrel who is now just waking up from his dream and realizing that he has no ability to survive the winter."


You also mention the "cultural" problems in the US. One thing that really bothers me is the sort of Fantasies you read about on the web. Here are a few that I have come across recently:


+ Leo Wanta has trillions stashed in offshore accounts (they never say where) which is enough to pay off the US deficits


+ Nesara is going to put $5 Billion into everyone's bank account, and then no one will have to work


+ You can refuse to pay your mortgage or car loans to a bank, if you just send out a correctly-worded Courtesy Notice, before you stop paying the loan installments


+ A new currency is coming, and when it is put in circulation, all those who have debts will be allowed to keep their homes, and wipe clean their debts.


Well, I don't believe any of these fantasies. And even a tiny amount of investigation will show that they are patently false. But a growing number of people seem to believe them. (Just do a Youtube search on OPPT, and you can find dozens of Videos explaining how this "wonderful new world" will work.)


The fact is that we are probably headed towards a situation where many Debts will have to be written off or forgiven. And the impact of that will be to wipe out the value of many financial assets, and Bonds in particular look as if they are at risk. Those who think they have secure investments and secure pensions, may find they have nothing. Or the spending power of their nest eggs is a few pennies on the dollar. And this big wealth destruction may hit the middle class very hard, because jobs will disappear as the assets get written down and demand collapses. The super wealthy will get hit too, especially those who have kept their wealth in financial assets.


We have seen the Debt write-offs before, after the 1929 collapse in stock prices:


http://astrocycle.net/DebtGDPIntRates.gif


It could be worse this time. And maybe far worse for some. 80-90 years ago, many people had farms to go to, were they could be self-sufficient. Now about half of Americans are dependent on various types of government payments. And that number will rise if jobs are destroyed.


This will mean a painful time, when living standards plummet and many people may go hungry. TPTB seem to be preparing for it, by putting more weapons in the hands of police, thinking that a militarized police force will protect those in power (the 1%) when TSHTF. I wonder. My opinion is that many police and local militia are as likely to turn those weapons on the elites as they are to start shooting the mobs.


I hope I never find out, because this movie plays out in a happier way. But I have a very hard time seeing a positive path through the financial reset that is badly needed.

OTHER VOICES - same Discussion Point

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I wanted to start this thread a day or so ago, but before doing that I wanted to have another voice on the same topic, not just L's and my own.

.

I found a good one!

Jim Kunstler has just done a good podcast with David Collum, a professor Chemistry, who is very informed an Blogs on economic topics.

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David Collom / his blog : http://trailcritter.blogspot.hk/

K-Cast # 229 : Yakking with David Collum

MP3 : http://media.libsyn.com/media/kunstlercast/KunstlerCast_229.mp3

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/source : http://kunstlercast.com/shows/kunstlercast-229-yakking-with-david-collum.html

.

SUMMARY

+ We are in a (brief?) period of temporary equilibrium

+ A worse drop than 2008 may be ahead of us

+ A sign would be when "The Fed loses control of the Bond market"

+ Gold was taken down by concerted action of C-Banks, but it is the safest place to be in the sort of mess we are headed into

+ Is gold a "Geffen Good" where demand rises when the price rises, and falls when prices drop? - If it was, it is not behaving like that now: demand (for physicals) rose while the price fell

Describing gold as a Geffen Good is a bit of a stretch - a Geffen Good is one where demand rises as the price increases because the increase forces them to stop buying something else and spend more resources on the good that has increased in price. The classic example is that if a family lives on a diet of meat and potatoes and has no discretionary income left over then an increase in the price of potatoes may force them to buy less meat and more potatoes because that is the only way to get anough calories to survive.


It's very different from the situation where people become defacto momentum investors by being sucked into buying simply because prices have risen.


I find it very difficult to fit gold into the framework of a Geffen Good, because there is no element of necessity involved in buying gold.


That said, I can't claim any great degree of expertise in the theory of Geffen Goods, so please feel free to correct me.

They spend little time on it - other than saying Gold is not behaving that way - so maybe it was a mistake for me to mention GG in my notes


The Podcast is excellent, and I recommend listening to it


MP3: http://media.libsyn.com/media/kunstlercast/KunstlerCast_229.mp3

Once again, TI is right....

If one agrees with Lucane's article... i.e. that the US will not recover (I would go much further... Japan will not recover... the EU will not recover... China will not recover... massive defaults are coming)...


Then is gold not the only 'investment' that makes sense? i.e. is it not likely to be the last man standing when the proverbialsh*t hits the fan? I am not saying that it is fool proof... but I have looked long and hard for other safe haven options and I see it as the best of many bad choices...


I like to reference the brilliant Michael Burry (featured in The Big Short).... he made billions off of sub-prime and had a stellar track record before that....


60 Minutes interview:

'

You closed your hedge fund after cashing out - what did you do with the money?


I purchased physical gold and productive farmland that has water.

MORE Charts for the Debt Armaggedon


TNX : 10yr.Rates x10:

http://img442.imageshack.us/img442/3915/60255648.gif


TYX : 30yr.Rates x10:

http://img19.imageshack.us/img19/4225/52971891.gif


For update ... ?

Thanks for the link to the Kuntsler program... excellent discussion

It's a mathematical certainty that US is going to implode on it's increasing debt.

Ed,


Things are far too uncertain for gold to be the only place to store your wealth. There are many political reasons for why owning gold can result in large real losses.


The whole world is straddling a fine line between hyperinflation and deflationary collapse. If the world were a free market then we would certainly be undergoing massive deflationary deleveraging right now. But since we live in a highly politicized world in which economic and monetary systems are anything but free, we are instead going through a forced inflation that at any moment could break (break up into hyperinflation or break down into deflationary collapse).


If we go the deflationary route then any asset which is generally levered in the market will fair very poorly in both nominal and real returns. I want to stress that it is not just whether or not you purchased said asset with leverage that matters, but rather whether or not the market as a whole has levered that asset class. Leveraging brings forth years of consumption and spends it all today, thus pushing up prices today to encompass future years' of purchases. The reverse of this, deleveraging, will push prices (and thus purchasing power) back down to where it "would be" without the ability to spend forward years' of income. In general the following assets are levered across the globe: property (high leverage), equities (moderate leverage), and businesses in general (business relies upon credit extensions to make day-to-day cashflow demands).


A business like a grocery store might seem depression-proof since it supplies goods people need no matter how poor the economy is, but you must also consider whether or not the business can actually function if it were to lose all access to capital markets (loans, credit lines, etc). Smooth running operations like Wal-Mart might not be able to operate without daily bank financing.


If things go the hyperinflationary route then many different assets will suffer for varying reasons. Currency is obviously the worst thing to hold in inflationary times, followed by bank deposits and bonds. But those are the obvious losers in inflation. A less obvious loser are equities in general. Even businesses that can maintain sales margins will face massive declines in their return on equity, with increased capex being the primary cause. As the business replenishes depreciated assets its capex will increase at a great rate, pushing the business' equity and asset bases up while maintaining the same sales margin. Hence returns go way, way down. Service industries suffer similar fates because they will find it difficult to maintain any sort of sales margin. Businesses best designed to survive hyperinflationary times are those with a slowly depreciating long-life fixed asset bases - perhaps things like a railroad (no wonder Buffett bought BNSF).


In general property should weather an inflationary storm well as long as it does not involve large maintenance (HK apartment good, large old villa with leaky roof bad).

Danger! Danger!, Will Robinson!


JGB's could be the next Big trouble spot!


http://img713.imageshack.us/img713/2432/53934215.gif


At higher Bond rates, Japan's huge debt obligations become unmanageable, and could trigger a meltdown


RUSH TO GOLD while it is still cheap?

Quite a lot of people did that yesterday.


Did anyone here join me on the NUGT express yesterday ?

OTP,


What, if anything, are you using to short JGBs? I've had my yen short for awhile but that is not a direct speculation on interest rates.

Not doing it, just watching it.


NUGT, and even better Calls on NUGT, seem to be the best way to play a Gold rally:


http://tinyurl.com/GEI-NUGT


Yesterday:

Nugt : $ 9.79 + $1.57 / +19.09%


While:

GLD : 135.12 + $4.05 / + 3.09%

GDX : $28.02 + $1.64 / + 6.22%

Kyle Bass : Japan will be first (to hit the wall)

VIDEO:

http://www.youtube.com/watch?v=ZY6IEpKRA7Y


Japan : "Already in the Zone of Insolvency"

+ 25% of Tax revenues go to pay interest

+ Average rates paid now may be 50 bp, across maturities

+ At 200 bp, all the tax revenues go the debt repayments

+ Bass thinks Japan rates "will go into the teens"

+ Ponzi schemes fail when more people are retiring, than entering the system

+ Japan holds $990 Bn of Treasuries, and may "need the money"

+ Holding Japanese equities : "a pretty scary thing", but could rise another 20-30%

Some's Up in Japan (well, er, Down actually)


NIK: 15,278.64 - 348.62 / -2.23% H: 15,942.60 / off High-of-day: - 4.16%, a big drop !


At 1% rates, Japan's in trouble.

At 2%, they are finished, thinks Kyle Bass,

who thinks rates in Japan will hit the teens.

Abe's plans are (obviously) not the Out-of-Jail-Free card that some thought they were.

I have received quite a number of emails today...


All talking about how "WE MAY BE SEEING A TOP IN STOCKS".


Yesterday's drop, and the Drop in Japan have people spooked

- especially after such a big run-up

A bounce yesterday in Wall Street.

Does this give us a window to "position" for a deeper slide?

STOCK MARKETS are not cheap - and too many people are chasing high yield stocks


That's what a friend of mine who writes a Newsletter says.

EXCERPT

what is being overlooked is the blunt fact that the market is not

cheap; it istrading at 17 times earnings, which is striking especially with zero interest

rates.

However, what I want to see is real fundamentals follow this rally. We still have the

labor participation rate at near 30 year lows. We are struggling with stagnant wages

and huge consumer debt. Nothing has changed, nothing is better. This is a bubble

fuelled on cheap money that isinflating earnings.


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Low yields are causing people to chase yield. Enclosed are charts of

Walmart, Johnson and Johnson and Mcdonalds and Verizon. Note how crazy they

have all gone, straight to the upside. These stocks have yields higher than 10 year

bonds, so investors, in a desperate attempt to make money, are trying to lunge at those

yields. What is interesting is it seems we have a bubble in these sorts of stocks rather

than high growth stocks."


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http://addictedtoprofits.net/