You do the Math

It all started with a stapler. My first week in the training program at DLJ in New York, I requested a stapler from our Goldman Sachs-trained drill sergeant. Little did I know the can of worms I’d opened. Requests for office supplies, I was told, were reserved for individuals who merited oxygen. We trainees, on the other hand, ranked just below bottom feeders on the ocean floor. The name “Stapler Danielle” stuck for years to come.

How a propros. As a young child, I played office rather than dolls. I set up a desk and files and occasionally even scored real office supplies from an indulgent parent. Staplers, though, came at a premium. Hence the dismay that I would have to wait as an adult as well. One has to wonder what will elude the current generation of young workers. Is it something as trivial as an implement with which to maintain paperly order on a pathway to a vibrant career? Or is it something more profound?

Unlike many other countries ravaged by the financial crisis, youth unemployment in this country has come tumbling down since peaking at 19.5 percent in April 2010; it is flirting with a 12-percent floor and below its 12.3-percent average dating back to 1955. Likewise, at 5.3 percent, the overall unemployment rate is promising to break the five percent rate; it is below its 5.8-percent average dating back to 1948 and also a pittance of its October 2009 peak of 10.2 percent.

Is it time to pack away the worries and call it a day? That’s impossible to say because no one truly comprehends the contextual relevance of the above comparisons. There are simply too many variables absent from the above figures, many, but not all, of which relate to the shrinkage of the size of the workforce since the onset of the great recession.

The old adage about the decline in the labor force participation rate to 62.6 percent, the lowest level since 1977, when I was running my first “business,” is as tired as the recovery and equally as uninspiring. It’s been boiled down to two words which most economists can repeat in their sleep — demographics and discouragement.

Now Baby Boomers retiring have been joined by those who have found it impossible to replicate their earnings from before the crisis and have simply thrown in the towel to the detriment of our economy. And several QE campaigns ago, Fed policy entered into the fray to address the discouraged faction. Leave interest rates low enough for long enough and businesses will eventually acquiesce and follow the central bank’s script. Borrow cheap funds. Spend to grow the business. The need to hire new workers necessarily follows.

Only history can decide whether policymakers were innocent bystanders to the countervailing forces thwarting their determined money-printing efforts. Some studies, which have ignited political debate, have concluded that many sidelined workers are economically encouraged to remain out of work. Sad to say, they are making sound financial decisions: The more benign of these papers conclude that many workers’ incomes would have to double to entice them back into the workforce.

Add those on disability to the 93 million underemployed and one can roughly deduce that the current flat wage environment has much to do with the bifurcation in the labor market. There are the worker haves and have nots. There are those capable of working who have the power to command higher wages and job security, and those who don’t. My whiz bang partners in economics sleuthing, Philippa Dunne and Doug Henwood of The Liscio Report, found evidence of a continuation in this trend in the latest July data release.

Those who had jobs in June and lost them in July fell to 1.1 percent, one of the lowest readings since the onset of the recovery; those who had jobs leaving the labor force were also down. The flip side: the share of those unemployed in June who found work in July also fell and hard, from 24.1 to 22.3 percent. Meanwhile, those who were jobless in June and left the labor force also rose, from 24.8 to 25.7 percent. Their conclusion: “Less job loss, but also less job finding.”

Were it not for one more trend, the story would end in this bifurcated manner. But a recent chat with Vadim Zlotnikov, the chief market strategist at Alliance Bernstein, left me unsettled. He contended that the labor market was not bifurcated, but rather trifurcated. Yes there were those who were discouraged and disengaged. Yes, there were those who were all-powerful and completely engaged, particularly those in such industries as biotechnology whose higher wages could be passed along to end users. But there was a critical cohort being left out of the calculus – the part-timers.

To take the latest month’s data and extrapolate seems a bit ridiculous. While 6.5 million or so part-timers who would prefer to be working full-time were notable, their numbers have contracted meaningfully over the past few years. In fact, part-time employment is down smartly, by 3.3 percent over 2014 while full-time is up 2.7 percent. But that wasn’t where Vadim was headed with his observation.

Since 1955, those working part-time for noneconomic reasons have been rising steadily – they number about 20 million today. There is no huge news flash in revealing that this movement hugged the en-masse entry of females into the workforce, which meshes with the Bureau of Labor Statistics’ definition of “noneconomic.” This includes medical limitations, childcare and family obligations, and retirement or Social Security limitations on earnings among others. But something disruptive has taken place between moms and their choosing to work part-time since the onset of the Great Recession.

Beginning in 2010, the labor force participation rate for women has declined while that of part-time for noneconomic reasons has risen steadily. After suffering a temporary blow, the number of non-economic part-timers has rebounded and is approaching its all-time high. This, Vadim suggests, backs the Uber economic evolution. Think about it. A typical Uber driver sets his or her own hours and personifies the move towards flexibility being in high demand as one service industry after another is disrupted and reinvented. The clincher is that “flexibility” usually equates to part-time.

The catch is that detached workers and part-timers alike – regardless of whether they’re freely making a choice that suits their lifestyle or forced into part-time employment but would prefer a full-time job – have little in the way of wage pricing power. The theory, at least among Wall Street economists who insist wage inflation is right around the corner, is that those full-timers who are closely tethered to the workforce have enough in the way of pull to lift earnings in the aggregate. Wage pressures have never been ignored by the Fed and will in turn force a rate hike. And yet wage growth remains elusive at best – earnings are up 2.1 percent over the last year. They’ve been growing at this anemic pace for several years now.

My greatest fears for the long-term health of the job market were aired in a Wall Street Journal story that recapped the July jobs report. The president of an industrial manufacturer lamented, as many have in recent years, the skill disconnect between those seeking employment and the job requirements needed. In the wake of the housing crisis that left many a construction worker in this lurch, it wasn’t too surprising to hear this age-old refrain. But it wasn’t as simple as that. One of his laments was that he couldn’t find workers, “because people can’t handle eighth-grade math.” That one stopped me cold. We’re not talking about a construction worker who can’t work a shale site but rather a grown child with an inadequate education.

In the spirit of JFK, one suggestion for the next great debate, the outcome of which could determine who will fill an upcoming job vacancy in DC: Ask not about how to get this great nation back to work, but rather ask how to set all of our children on pathways to productive careers.


You’re Gonna Need a Bigger Boat

Size matters. Just ask Roy Scheider. As incredulous as it may seem, I only recently sat myself down to watch that American scare-you-out-of-the-water staple Jaws for the first time. As a baby born in 1970, the movie at its debut in 1975 was hugely inappropriate for my always precocious, but nevertheless only five-year old self. And by the time this Texas girl and those Yankee cousins of mine were pondering breaking the movie rules during those long-ago summers in Madison, Connecticut, it was not Jaws but rather Brat Pack movies that tempted us. We started down our road of movie rebellion with St. Elmo’s Fire, then caught up with a poor Molly Ringwald in Pretty in Pink and then really stretched our boundaries with Less than Zero – you get the picture.

And so finally during this long, hot summer of 2015, a seemingly appropriate time with our country gripped from coast to coast with real-life shark hysteria, I watched Jaws for the first time and heard Roy Scheider as Chief Martin Brody utter those words, “You’re gonna need a bigger boat.”

Prophetically, the reality might just be that the collective “we,” and quite possibly sooner than we think, really will need a bigger boat. That is, as it pertains to the global debt markets, which have swollen past the $200 trillion mark this year rendering the great white featured in Jaws, which can be equated with past debt markets, as defenseless and small as a teensy, striped Nemo by comparison.

The question for the ages will be whether size really does matter when it comes to the debt markets. It’s been more than three years since Bridgewater Associates’ Ray Dalio excited the investing world with the notion that the levered excesses that culminated in the financial crisis could be unwound in a “beautiful” way. A finely balanced combination of austerity, debt restructuring and money printing could provide the pathway to a gentle outcome to an egregious era. In Mr. Dalio’s words, “When done in the right mix, it isn’t dramatic. It doesn’t produce too much deflation or too much depression. There is slow growth, but it is positive slow growth. At the same time, ration of debt-to-income go down. That’s a beautiful deleveraging.”

I’ll give him the slow growth part. Since exiting recession in the summer of 2009, the economy has expanded at a 2.1-percent rate. I know beauty is in the eye of the beholder but the wimpiest expansion in 70 years is something only a mother could feign admiration for. That not-so-pretty baby still requires the wearing of deeply tinted rose-colored glasses to maintain the allusion.

As for the money printing, $11 trillion worldwide and counting certainly checks off another of Dalio’s boxes. But refer to said growth extracted and consider the price tag and one does begin to wonder. As for debt restructuring, it’s questionable how much has been accomplished. There’s no doubt that some creditors, somewhere on the planet, have been left holding the proverbial bag — think Cypriot depositors and (yet-to-be-determined) Energy Future Holdings’ creditors. Still, the Fed’s extraordinary measures in the wake of Lehman’s collapse largely stunted the culmination of what was to be the great default cycle. Had that cycle been allowed to proceed unhampered, there would be much less in the way of overcapacity across a wide swath of industries.

Instead, as a recent McKinsey report pointed out, and to the astonishment of those lulled into falsely believing that deleveraging is in the background quietly working 24/7 to right debt’s ship, re-leveraging has emerged as the defeatist word of the day. Apparently, the only way to supply the seemingly endless need for more noxious cargo to fill the world’s rotting debt hulk is by astoundingly creating more toxic debt. Since 2007, global debt has risen by $57 trillion, pushing the global debt-to-GDP ratio to 286 percent from its starting point of 269 percent.

Of course, the Fed is not alone in its very liberal inking and priming of the presses. Central banks across the globe have been engaged in an increasingly high stakes race to descend into what is fast becoming a bottomless abyss in the hopes of spurring the lending they pray will jump start their respective economies. Perhaps it’s time to consider the possibility that low interest rates are not the solution.

Debt is a fickle witch. When left to its own devices, which it has been for nearly seven years with interest rates at the zero bound, it tends to get into trouble. Unchecked credit initially seeps, and eventually finds itself fracked, into the dark, dank nooks and crannies of the fixed income markets whose infrastructures and borrowers are ill-suited to handle the capacity. Consider the two flashiest badges of wealth in America – cars and homes. These two big-line items sales’ trends used to move in lockstep — that is until the powers that be at the FOMC opted to leave interest rates too low for too long. In Part I, aka the housing bubble, home sales outpaced car sales as credit forced its way onto the household balance sheets of those who could no more afford to buy a house than they could drive a Ferrari. True deleveraging of mortgage debt has indeed taken place since that bubble burst, mainly through the mechanism of some 10 million homes going into foreclosure. It’s no secret that credit has resultantly struggled mightily to return to the mortgage space since.

Today though, Part II of this saga features an opposite imbalance that’s taken hold. Car sales have come unhinged from that of homes and are roaring ahead at full speed, up 76 percent since the recession ended six years ago, more than three times the pace of home sales over the same period. It’s difficult to fathom how car sales are so strong. Disposable income, adjusted for inflation, is up a barely discernible 1.5 percent in the three years through 2014. Add the loosest car lending standards on record to the equation and you quickly square the circle. Little wonder that the issuance of securities backed by car loans is racing ahead of last year’s pace. If sustained, this year will take out the 2006 record. At what cost? Maybe the record 16 percent of used car buyers taking out 73-84 month loans should answer that question.

To be sure, car loans are but a drop in the $57 trillion debt bucket. The true overachievers, at the opposite end of the issuance spectrum, have been governments. The growth rate of government debt since 2007 has been 9.3 percent, a figure that explains the fact that global government debt is nearing $60 trillion, nearly double that of 2007. The plausibility of the summit to the peak of this mountain of debt is sound enough considering the task central bankers faced as the global financial system threatened to implode (thanks to their prior actions, mind you). In theory, government securities are as money good as you can get. Practice has yet to be attempted.

The challenge when pondering $200 trillion of debt is that it’s virtually impossible to pinpoint the next stressor. Those who follow the fixed income markets closely have their sights on the black box called Chinese local currency debt. A few basics on China and its anything-but-beautiful leverage. Since 2007 China’s debt has quadrupled to $28 trillion, a journey that leaves its debt-to-GDP ratio at 282 percent, roughly double its 2007 starting point of 158 percent. For comparison purposes, that of Argentina is 33 percent (hard to borrow with no access to debt markets); the US is 233 percent while Japan’s is 400 percent. If Chinese debt growth continues at its pace, it will rocket past the debt sound barrier (Japan) by 2018. As big as it is, China’s debt markets have yet to withstand a rate-hiking cycle, hence investors’ angst.

My fear is of that always menacing great white swimming in ever smaller circles closer and closer to our shores. I worry about sanguine labels attached to untested markets. US high-grade bonds come to mind in that respect even as investors calmly but determinately exit junk bonds. Over the course of the past decade, the US corporate bond market has doubled to an $8.2 trillion market. A good portion of that growth has come from high yield bonds. But the magnificence has emanated from pristine issuers who have had unfettered access to the capital markets as starved-for-yield investors clamor to debt they deem to have a credit ratings close to that of Uncle Sam’s. Again, labels are troublesome devils. Remember subprime AAA-rated mortgage-backed securities?

We’ve grown desensitized to multi-billion issues from high grade companies. Most investors sleep peacefully with the knowledge that their portfolios are indemnified thanks to a credit rating agency’s stamp of approval. Mom and pop investors in particular are vulnerable to a jolt: the portion of the bond market they own through perceived-to-be-safe mutual funds and ETFs has doubled over the past decade. Retail investors probably have little understanding of the required, intricate behind-the-scenes hopscotching being played out by huge mutual fund companies. This allows high yield redemptions to present a smooth, tranquil surface with little in the way of annoying ripples. That might have something to do with liquidity being portable between junk and high grade funds – moves made under the working assumption that the Fed will step in and assure markets that more cowbell will always be forthcoming rather than risk the slightest of dramas unfolding. Once the reassurance is acknowledged by the market, all can be righted in the ledgers. It’s worked so far. But investors have yet to even consider selling their high grade holdings. It’s unthinkable.     It’s hard to fathom that back in 1975 when I was a kindergartener, security markets’ share of U.S. GDP was negligible. Forty years later, liquidity is everywhere and always a monetary phenomenon. That is, until it’s not.

Nary are any of us far removed from a poor stricken soul who has suffered a fall from grace. In the debt markets, a “fallen angel” is a term assigned to a high grade issuer that descends to a junk-rated state. It could just as easily refer to any credit in the $200 trillion universe investors perceive as being risk-free. Should the need arise, will there be enough room on policymakers’ boats to provide seating for every fallen angel? That is certainly the hope. But what if the real bubble IS the sheer size of the collective balance sheet? If that’s the case, we really are gonna need a bigger boat.


Ladies Don’t Dance on Graves

I am often asked why I would leave the freedom of being a columnist to subject myself to the confines of the Fed, a bureaucratic institution frozen in a mindset that was diametrically opposite my own. I had already escaped compliance once when I left New York after selling my book of business to Credit Suisse and signing a non-compete (something about “equities in Dallas.”) “Retiring” to write a column about the financial markets was truly a dream come true and proved to be deeply gratifying work. Thou shalt never besmirch The Fourth Estate. It should be the 11th Commandment.

Don’t get me wrong. Calling Greenspan to task as the subprime crisis hurtled at warp speed towards the world economy was not exactly well received by the public, or my publisher for that matter. But that was in 2004 and 2005 when home prices looked as if they would continue on their skyward trajectory indefinitely. At some point, though, my “crazed” predictions came to pass and hate mail writers began to pen apologies as they were, after all, losing their homes to foreclosure. That, I can assure you, was not what I had signed up for.

The dark humorists always claimed that the Fed had hired me for one sole purpose – to shut me up. My stock answer, aside from the honor of being called to serve my country, has always been that ladies don’t dance on graves. There was no satisfaction in being right. Better to try to do something about it by changing the minds of policymakers from the inside. Let’s just say I had no idea what I was getting myself into.

The day was September 29, 2006. To put into five words my state of mind: My hair was on fire. The housing crisis was coming and the only question was one of how to contain the damages that would ensue. My anti-schadenfreude and personal history of living through the S&L crisis in hand, I marched myself into the Fed to meet the oncoming crisis head on. Straight into a brick wall, that is.

The housing crisis was nowhere to be found in most economists’ play books – unless (inconveniently) the Great Depression was included in the time frame examined. The go-to stress test for Fannie and Freddie to gauge how bad things could possibly get was the S&L crisis in Texas. Suffice it to say, that benchmark was wiped off the planet as a point of reference within a matter of months as the housing market crashed, dragging the interconnected global financial system down with it.

I am sad to report that what was readily apparent to me was oblivious to the ingrained myopia that infected most Fed economists. Market historians will recall that on March 28, 2007, the following words were publically stated by one Ben S. Bernanke: 

“At this juncture, however, the impact on the broad economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency.”

To think that this statement was made nearly two months after HSBC, at the time the world’s third-largest bank, announced that its bad debt charges would be 20 percent higher than forecast due to the deteriorating state of subprime mortgages it held. Foreclosures were up 35 percent over 2006 and for a fifth straight month, more than 100,000 properties entered foreclosure because the owners couldn’t cover their payments. This situation was “contained”?

As incredulous as this rookie was at the depth of the pervasive blindness, what was to come would prove more unsettling yet and lay the groundwork for a housing market “recovery” that eludes to this day.

Over seven years ago, the housing bubble peaked and rolled over. Normalcy has yet to return. The latest case in point occurred in June when existing home sales hit an 8 ∏-year high. The news was widely lauded by the economist community and in the media. But the composition of today’s buyers is no cause for celebration. Some 30 percent of homebuyers in June were first-timers. Moreover, the May to June increase in existing home sales was the weakest in seven years despite aging millennials who should be seguing from rentership to homeownership.

Think about that for a moment. June sales reflect contracts signed in April and May as many young families are contemplating such things as school districts and perhaps moving into their first home. First-timers should theoretically represent a disproportionate share of buyers as the school year is coming to an end. And yet they remain stubbornly conspicuous in their relative absence.

How things have changed in the short space of a few years. At the peak of the housing bubble, first-timers were over half of the buyer market, which was equally out of whack with a normal state in which 40 percent of buyers are first-timers. Back then, mortgage standards were ridiculously lax, which of course, led to the subprime fiasco and in turn snowballed into the financial crisis.

It was in the cleaning up the aftermath of the crisis that things went very wrong. No doubt, ripping the bandage off by standing back and allowing the market to clear would have led to a deeper recession, which is saying something. But maybe today housing would be a realistic option for more young Americans if more homes would have been sold at fire sale prices. That is not to even begin to suggest that foreclosure is a kind event in a homeowner’s life. But consider the fact that enough time has passed that many who lost their overvalued homes to foreclosure early on are once again now eligible to take out a mortgage.

Instead of market clearing, policymakers and politicians went out of their way to cushion the fall. Such was the height of this tall order that it took years to play out. Amid all manner of fanfare, one modification program after another was unveiled to “help” homeowners remain in homes they can still not afford. Even today, after all this time, one-quarter of bottom-tier homes are underwater; their mortgages still exceed the home’s value thus trapping the occupants.

As for the banks, they’ve been regulated and fined to kingdom come, which makes for great soundbites but does nothing for mortgage applicants. Lending standards are just now beginning to ease. The public might have been better served had they had the satisfaction of seeing even one perp walk on the evening news. Widespread mortgage fraud should have been convictable on some level. But that has yet to happen.

In the meantime, low interest rates invited a new breed of homebuyer to muscle its way into the market. Deep-pocketed private equity investors, armed with their price-ambivalent purchasing power, have been an immense driver of home price appreciation in recent years. In all, investors have amassed a stable of 2.6 million rental homes, which may not seem like much given the fact that there are 133.6 million homes out there. But ask any realtor and they will tell you that investors have had a tremendous effect on comparables. You don’t need too many homes sold above their true market price to affect the rest of the neighborhood.

And so it followed that home prices never did fall as much as history would have predicted. The white knight investors with their saddlebags filled with someone else’s gold rode in to save the day. Or at least that’s how the happy-ending version of the story is told. Try telling that to buyers who have been priced right out of the market. The median price of a home sold in June rose to $236,400, the highest on record.

If the stated goal of the Fed was to put a floor under home prices, I suppose policymakers can take a bow. But I doubt they applaud the effect of high prices and tight mortgage standards shutting out many first-time homebuyers. Instead of taking advantage of the cut-rate prices a market clearing would have produced, many millennials have instead made a prolonged stopover in the apartment rental market. Since homeownership peaked in late 2004, some 8.7 million renters have been created while the ranks of homeowners have contracted by 1.2 million.

With rent inflation running at the fastest pace in a decade and home prices at a record high, it’s safe to say we’ve returned to the heyday of the housing bubble, but not in a good way. Well-intended but predictably ill-conceived Fed policy has now managed to put housing out of reach for not one, but two, generations of Americans.

The parade of casualties does not end there though. The significance of a lost generation of first-time homeowners for the Baby Boomer generation and the economy’s prospects are undeniable. A 2012 study concluded that by 2030, some 26 million Baby Boomers would endeavor to sell their homes and retire. Success, however, hinges on move-up buyers in significant numbers lining up to buy Boomer’s high-end homes. The odds of a sufficient number of move-up buyers being created are slim to none given the absence of first-timers ready to trade up. Policymakers may lament the fact that so many millennials are living in their parent’s basements today. Just imagine how they’ll take the news that increasing numbers of Baby Boomers have simply switched places with their offspring.


The Seven Dollar Cantaloupe

Existential crises are rarely brought on by produce. Consider me the exception. It was December 1996. One week after completing Donaldson, Lufkin & Jenrette’s MBA training program in New York, I found myself booted out of the posh accommodations that had been provided and holed up in a sunlight-starved apartment in midtown. A bit of budgetary math had revealed that my take home pay would just cover my rent, student loan, and almost nothing more. Hence my public meltdown at a corner deli upon discovering the same cantaloupe that sold for next to nothing from the backs of pick-up trucks on numerous street corners back home in Texas were commanding a princely seven dollars.

What to do on such a stretched budget? There were always the free lunches at roadshows for one internet startup after another that paraded their profitless wares on the IPO expressway that ran straight through our midtown office. Parental support would also prove critical those first few months, but what mom could spare tended to get my dry cleaning out of hock and little more. To say the incentive to overachieve was acute is an understatement. True grit and a healthy fear of delis and other purveyors of edibles pushed me to my limits. Within a year, my student debt had been paid in full and produce as luxury goods was no more, at least for me.

To take nothing away from the hard work required of me, nearly two decades later, I recognize that timing and luck also played a role in my success. But there was also the invisible hand of the Fed at the helm of Wall Street’s fleet of ships, and I, like many, was pulled along in its wake. Unbridled greed ruled the day. The movie “Wall Street” was required viewing on day one of the training program. As for macroprudential policies, they were nowhere to be found even as margin debt data screamed red alert and fruit stand operators day-traded stocks (was that how produce prices went parabolic?)

How the story ends is no surprise. In Greenspan’s mind, no actions could be undertaken to rein in the bubbly excesses; only the aftermath could be addressed by the tools available to central bankers. In the case of the Nasdaq crash, the policy solution was another period of exceptionally low interest rates that in turn inflated the next bubble – housing. No surprise, the unchecked speculation invited by ultra-loose monetary policy resulted in another crash, that of house prices. Did similarly disastrous outcomes prompt a shift in thinking among policymakers?

I’m distressed to report, but this flawed approach continues to drive Fed decision-making-by-model to this day. The consequence: cantaloupes, or whatever millennials hold sacred as the little extra in their lives, have never been so out of reach for new entrants to the workforce as skyrocketing rents have sentenced millions to their parent’s basements.

Harvard’s Joint Center for Housing Studies recently released its 2015 State of the Nation’s Housing report. In the decade to 2014, an average of 770,000 renter households have formed, the fastest pace since the late 1980s when Baby Boomer’s nests were emptying. This would not necessarily be bad news if it was purely a case of millennials moving out of their parent’s homes and into apartments as Generation X’ers moved up into their first home. But that is decidedly not the case for the 42.3 million Americans who rent today, many of whom would rather own their own slice of the supposed American Dream but remain trapped in rentership.

Why is that? In 1980, only 22.9 percent of the population ages 18 to 34 lived with their parents. Today, 30.3 percent of millennials, those born 1985-2004, find themselves in that same unmoored boat. The most obvious reason behind this troubling trend is the increase is student debt. The share of renters carrying student debt increased from 30 percent in 2004 to 41 percent in 2013, the latest year for which data are available. The kicker: the average amount of debt has risen nearly 50 percent to $30,700.

One of the most damaging legacies of the housing bubble is the wreckage that remains due to the lax lending standards which allowed parents to tap their swollen home equity to finance their children’s college costs. It’s plain that monetary policy has been impotent in staunching the continued rise in higher education inflation. Ergo, accruing student debt has been the only way for many millennials to stay the course. Their pricey educations are clearly not a gift that keeps on giving considering where so many are forced to call home.

One could argue that Fed policy has only had an inadvertent effect on the stratosphere-reaching cost of higher education. The ease with which student loans can be accessed and a cultural stubbornness that insists that every child should attend college, regardless of its value in the after-degree world, have both played their part in this debt-ridden tragedy.

What is undeniable is the direct effect Fed policy has had on runaway rental inflation. Eras of low interest rates never fail to attract investment dollars to anything with a discernible yield. Unlike less attractive commercial real estate sectors such as retail and industrial, in the years following the housing bust, multifamily developers enjoyed unencumbered access to cheap financing. This sector is “awash in capital” according to a recent report, which has catapulted multifamily to the top-performing commercial real estate sector: Multifamily property prices are 25 percent above their 2007 peak compared with an aggregate that captures all sectors which is up by 10 percent.

In keeping with Wall Street’s Michael Douglas’ character’s mantra that “Greed is Good,” a recent study found that 82 percent of the apartments that came to market from 2012 to 2014 have been high end properties that command lofty rents. Why should investors settle for less when they can chase major-market multifamily properties whose prices are up 47 percent, nearly double that of multifamily as a whole? It’s no wonder rents are out of control.  But don’t worry, the Fed tells us inflation is too low.

If optics are the objective, the Fed can claim to be “concerned” about low inflation to justify its extremely easy monetary policy stance. The fact is, policymakers can flatter their case by using an inflation metric that minimizes the influence of many of life’s necessities, especially rent, which is by far the biggest line item in a household budget. Other inflation gauges are less kind. The widely recognized consumer price index revealed that rents rose 0.4 percent in June. That works out to 3.5 percent over the last year and the fastest pace in a decade.

Axiometrics, a data provider that zeroes in specifically on apartments, has been tracking rent inflation since April 2009 (they exclude single-family rentals, which now account for a near-record 37 percent of the rental market). In June, they reported that rent growth had risen to a 5.1-percent annual rate, a four-year high. The quick pace extends 2015’s five-month streak of 5.0-plus growth to the longest in at least six years. Axiometrics had already crowned 2014 as “The Year of the Apartment” given its strength. It may be tough to come up with a better title for this year, all things considered

Economists continue to hope that the abundance of apartments coming online will cool rent inflation. They’ve got good reasons to be optimistic – there are more units under construction than at any time since 1974. That said, multifamily starts continue to surprise to the upside. The 29-percent spike in June starts put the ratio of single-family- to-multifamily starts at 1.4-to-1; that’s a far cry from the historic ratio of four-to-one. As for the economics of the distorted ratio, each multifamily unit started creates about two jobs, less than half the four to five created by a single-family housing start. Moreover, as a recent Bloomberg story rightly pointed out, homebuyers buy more stuff.

The Harvard study provides stark evidence of how monetary policy with a stated goal of making housing more affordable has perversely made renting more expensive than ever. Demographers break up millennials into two cohorts – 18-to-24 years old and those ages 25 to 34. Renters in the older group, traditional first-time homebuyers, have literally been hammered by decisions undertaken by the same central bankers mandated with curbing inflation: Over the past 10 years, the share who spend more than 30 percent of their income on rent has increased to 46 percent from 40 percent. Meanwhile, the share with “severe” burdens – they expend more than 50 percent of their income to rent the roof over their heads – has risen to 23 percent from 19 percent.

It’s hard to imagine these folks splurging on a cantaloupe, much less saving up for a down payment on their first home (or on that $7 cantaloupe). But the fact is, if these traditional homebuyers remain renters for too long, the middle tier move-up market will be the next victim to suffer at the omnipresent hand of ill-conceived Fed policy. And if a sufficient number of seasoned first-time homebuyers are absent when the time comes for move-up buyers to stake a For Sale sign in their front yard, it’s the McMansion-saddled Baby Boomers who will be the next casualty. They’re the ones banking on move-up buyers allowing them to sell their homes and retire in peace.


What if Charlie Munger is Right?

“In your lifetime, the idea of the efficient frontier will go the way of the dodo bird.”

So said Charlie Munger, Warren Buffett’s lifelong right-hand man. This prediction was made in a private conversation nearly a decade ago. The notion that the efficient frontier, the accepted framework for creating diversified investment portfolios, is headed for extinction may be blasphemous. It could just be Munger has a way with words; after all he’s best known for being quotable. But what if he’s right? What if the efficient frontier is not destined to survive?

There’s a good chance Munger wasn’t banking on the Fed accelerating the demise of one of finance’s pillar theories. But then who could have foreseen interest rates being pinned to the mat for so long? One of the gravest consequences of prolonged periods of Fed-enforced low interest rates is the damage wrought on presumably well-constructed portfolios. When markets eventually wrest control from the clutches of central bankers, correlations between historically diverse asset classes will align too quickly for investors to take cover. Now consider the fact that the markets have never experienced a period of ultra-loose monetary policy as protracted as the current era. The implications for investors of all stripes are dire. It is the risk to the weakest links in the U.S. public pension system, however, that is mortal; some municipal bonds would unquestionably be imperiled given the weight of pensions bearing down on the fiscal health of issuers.

To be sure, it’s critical to disclaim that most municipal bonds are money good. For starters, a fresh report by Standard & Poor’s finds that in 2013, the latest for which data are available, 26 states either maintained or increased their pensions’ funded ratio. That’s over double the number of states that reported the same in 2012. As an added bonus, the market disruptions sure to prompt future negative headlines will present buying opportunities for the overwhelming majority of solid credits. When asked where to invest in today’s minefield of financial markets, a safe answer is always a good, seasoned municipal bond manager

But hear me well. The fact is good municipal credits may be one of the only places for investors to hide during the next market upheaval. If that smacks as alarmist, consider the 24 states whose funding levels declined in 2013 despite the magnificent rally across the full spectrum of asset classes, commodities notwithstanding. The deterioration in funding status across weak state pensions was significant enough to outweigh the 26 states whose funds saw improvement. Or, taking a longer view, last year, only 41 percent of state and local pensions received their full contributions, down from 65 percent in 2008.

So what’s an underfunded pension to do? Apparently, swing for the fences.

A bit of pension accounting before continuing: Pensions operate under assumptions about future returns. The median assumed rate of return these days is 7.75 percent. Without getting too deep in the weeds, if a pension fails to hit this target – year in and year out — they’ve got to make up for the shortfall some way, somehow.

Suffice it to say, with a yield of about 1.5-percent, parking the bulk of pension assets in Treasury bonds won’t do the trick. Nodding to this reality, pensions have been reducing their holdings of these so-called risk-free assets. At about three percent, corporate bonds offer a bit more in the way of return, but not much.

The gulf between the return on safe investments and the rate of return assumed presents the industry that advises pensions with an ethical dilemma. These well-heeled consultants could acknowledge the elephant in the room — the fact that prudent investing on behalf of current and future pensioners will never result in a 7.75-percent return over the long haul. They’ve read the reports. They know that a recent survey of fund and asset managers projected the average return over the next 10 years on a portfolio of 70 percent stocks and 30 percent bonds to be 5.9 percent.

Rather than own up to the odds against their ability to deliver, in which case they’d be out of a job, advisors pull out their efficient frontier software. Into it they pour rosy assumptions about the diversification capabilities of this and that alternative asset class. And voila! Out springs a portfolio that hugs the efficient frontier, a suite of asset classes that, when combined, perfectly satisfy the accountants, the actuaries and most importantly, the politicians.

Detect anything wrong with this happy ending? Surely all is well when the advice costs as much as it does?

Brian Reynolds of New Albion Partners has been tracking pension allocations for several years. The headlines he shares in his missives would be pure entertainment if they weren’t so disturbing. Here’s a small sample, all from the end of June:

The Pennsylvania public school pension allocated $300 million to an opportunistic levered loan fund and $250 million to an opportunistic credit fund that targets distressed debt and direct lending.

The South Carolina pension is putting $125 million into a debt fund specializing in problematic companies.

The Alaska pension is allocating $200 million into high-yield commercial real estate mortgages.

You just can’t make those headlines up. And according to Reynold’s latest tally, there are 650 other similarly cautionary headlines that he’s archived since embarking on this revelatory journey 34 months ago. Over that span, a distinct trend has emerged. What started out as generic allocations to private equity funds has turned into a stampede into private equity real estate funds.

Could it be that private equity commercial real estate has been crowned the new ‘it’ girl asset class? This new darling of pension advisors was the fastest growth area in private equity funds raised last year, up 16 percent over 2013, a good clip faster than buyout funds’ 11-percent rate. By the end of June 2015, global funds earmarked for private equity real estate had surged ahead of December’s levels by 37 percent to a record $254 billion. As if on cue, 79 percent of recently surveyed active investors plan to increase their allocations to private equity real estate funds in 2015. This will “attract the largest capital inflows this year of all alternative asset classes.”

And state pension fund managers are true believers. The wise souls shepherding Illinois’s state pensions are abiding by their ever efficient frontier’s directives. In their well-compensated wisdom, they’ve just allocated $30 million to a private equity fund and another $30 million to a private equity real estate fund. Rest easy. Their models tell you you’re in good hands.

The inevitable downfall in asset allocators’ well laid plans is that crowding-in and diversifying tend to move in opposite directions. The more an asset class is chased to hedge a portfolio’s risky holdings, the less potent its power to diversify.

As for pensions’ prospects, the insult to injury is borne of the illiquid nature of private equity investments. As damaging as fire sales can be in times of market meltdowns, the inability to sell at all promises to prove more painful still. The unsettling fact is many pensions have ventured too far out on both the risk and liquidity spectrums. But please don’t share this disconcerting news with Grandma. She might not sleep well tonight.

Pension holdings demand deep exploration. A recent relaxation of Japanese pension law allows up to 50 percent to be allocated into stocks with the balance held in bonds. Meanwhile, British law caps the assumed rate of return at 3.5 percent. And yet, the average U.S. public pension allocates 72 percent to risky assets, including stocks and alternative investments, and assumes a rate of return more than double that permitted in the U.K. Reforms aimed at making pensions less dependent on unrealistic assumptions would be an obvious first step on lawmakers’ parts, one that would begin to safeguard the nation’s 19.5 million current and future beneficiaries’ retirement assets.

In a recent study, the 50 states were ranked according to their fiscal health. Illinois came in last in no small part due to its deeply underfunded pensions. Illinois based Allstate has been validating the findings of the 50-state study by divesting itself of its home state’s municipal bonds. When prompted for an explanation, the insurer’s CEO answered by asking the following: “If you don’t like the income statement, the balance sheet or the governance, why would you loan them money just because they never defaulted before?”

Illinois may be the extreme example. Be that as it may, reforms of the magnitude we should be contemplating, coupled with realistic accounting, would give a whole new meaning to “underfunded.” It’s best we find out now.


The Smell of Dry Powder in the Morning

William Blake, the English poet once wrote, “In seed time learn, in harvest teach, in winter enjoy.” By Blake’s rule, fresh data suggest that the winter has set in with subzero temps and that there’s much to enjoy as private equity emerges from a record $73 billion in first-half buyout sales. In seed time they learned well one of the oldest lessons on the Street: Buy low, Sell high. It’s always wonderful when it works. The real question is what the kings of Wall Street have learned as they prepare to plant the next season’s crop? Will restraint rule the day? Or will the siren call of untapped fees be too much to resist, prices be damned?

News that private equity is cashing out is unabashedly good for investors. Limited partners, as private equity investors are known, agree to lock up their money for the better part of a decade in funds run by general partners. In exchange, limited partners rely on the promise of outsized returns when the companies that have been taken private are harvested via an initial public offering or a sale to another entity. Distributions, the crop harvested, is cash plus profits — and critically, net of generous fees.

According to a recent Triago report, fund managers distributed a record high $477 billion to their investors last year. That’s up 39 percent over 2013 and a shocking 215 percent above the six-year average.

This year’s distributions, an estimated $503 billion, are on track to surpass that of 2014. One trillion dollars over two years matters given the asset class totals $4 trillion in equity investments and commitments.

Did limited partners stuff their distributions under the mattress? Not hardly. In 2014, reinvestments and fresh commitments pushed annual funds raised to a post-crisis high of $438 billion. Not to be outdone, 2015 is shaping up to take out last year’s high with fundraising up 11.4 percent.

Traditional funds raised, when a limited partner commits to invest in a fund structure, tell only part of the story. Some $113 billion in new “shadow capital” commitments were also made last year through structures other than funds, such as co-investments, separate accounts and direct investments. Once again, 2015 is poised to unseat the record high for shadow capital commitments. Forget the post-crisis years which began in 2009. If the record paces hold for reinvestments, fresh funds and shadow capital commitments, 2015 could mark a historic high for new commitments to private equity.

The risk: there’s not a healthy enough fear of commitment moving forward. Despite record distributions, private equity is sitting atop a record heap of $1.2 trillion in dry powder, an industry term that captures committed capital that has yet to be deployed. It’s easy enough to comprehend why private equity is selling high. It’s much more difficult to explain how managers approach today’s investing landscape with the stated goal of buying low.

Judging by last year, the challenge is growing. In this year’s first quarter, the money called by fund managers to make new investments declined to the slowest annualized pace since 2009. The contrast between then and now is striking. In 2009, there was blood in the streets. The stock market was trading at its cheapest valuations since the early 1980s as the financial crisis raged on, taking down 200 victims that year alone among companies defaulting on their publicly-traded bonds. Today stocks are trading at over twice the valuation levels as 2009 thanks in part to the wide-open debt markets that have helped finance record share buybacks. As for defaults, though companies do fail to make due on their obligations from time to time, the quenchless thirst for yield largely prevents most companies from resorting to default. Such is the appetite for new issues of debt with any kind of a coupon.

The Federal Reserve’s zero-interest rate policy has done much more than facilitate record bond sales and share buybacks. Record low borrowing costs have also helped private equity cash out: bond sales for the express purpose of paying the company a one-time dividend were all the rage until last year when issuance fell off. That’s a good thing as piling debt onto an over-indebted company’s balance sheet tends to end badly for bondholders. On a more subtle level, the implicit floor under the stock market has allowed buyout firms to place 97 stock offerings in the three months to June, yet another record pace.

And yet, leveraged buyout volumes have fallen by 47 percent to $28.9 billion versus $54.1 billion a year ago. This suggests private equity firms recognize their weak position competing against merger-famished companies that are even more desperate to off-load some of their huge cash positions. The latest estimates places the global corporate cash cache at $4.2 trillion. If only easy money could get out of the way and in doing so lay the groundwork for investing this cash in organic growth and job creation rather than Monkeying With Your Balance Sheet 101!.

It stands to reason that leveraged loan volumes have fallen by 43 percent over the same time as the need to finance risky deals has cooled. Alongside the decline is a similar falloff in “covenant-lite” bond issues, in which bondholders are denied standard protections they’re given in a less frenzied issuance environment. Finally, bond sales by the weakest-credit issuers have fallen to half of last summer’s crazed pace. The reckless late-stage credit cycle behavior would appear to be ebbing.

It would be great news if this story ended there, on a prudent note. But the fact is, dry powder earmarked for buyouts is $450 billion. Meanwhile, debt issued to fund mergers and acquisitions is on the rise and approaching 2007’s peak levels. At some point, private equity may succumb to the gravitational pull of the credit cycle that has plenty of room left to run in no small part becausethe buyout kings have yet to unleash their purchasing power. The alternative would be returning committed capital to investors and foregoing the rich fees attached to it. The denial of the earth being round would soon follow.

All sarcasm aside, there’s never been evidence of humility in the DNA makeup of the self-proclaimed smartest guys in the room (the heads of private equity firms are the current titleholders – net worth is the yardstick that determines the reigning champions). Returning dry powder to limited partners would thus go against the very nature of the gentlemen who run what just 23 years ago was a cottage industry with $50 billion under management.

The alternative: spend the money, come what may in the pricing arena. After all, distributions enrich the general partners to a greater degree than their fee-laden limited partners. In other words, the kingpins of Wall Street have made so much money (the highest paid individual pocketed nearly $700 million last year alone) that they can afford to be price agnostic because they’re playing with someone else’s money.

Of course the Fed could step in and attempt to pull away the punch bowl. But that would too be out of character. The current generation of central bankers insists that their role is akin to that of a clean-up crew called in after the police have already been called by the neighbors.

It’s difficult to envision what the next harvest will yield. If the power of buyout capital is unleashed, knowing full well that private equity always juices their deal structures with leverage, then the current credit cycle has room left to run, and then some. As for the debt market’s cousin, the equity market, math dictates that the reduction in aggregate share count produced via buyouts will necessarily boost stock prices. Hence, despite lofty valuations, between corporations and private equity firms flush with cash, there may be more than enough buying power in the kitty to inflate both the bond and stock markets to untenable levels. The smell of dry powder in the morning may simply be too much to resist.


Rational Exuberance?

“The mob will now and then see things in a right light” — Horace

If one dares make mention of overvaluation in the U.S. equity market, the derision incited takes one back in time to angry Roman mobs. Is it not plain, the masses shriek, based on a traditional price-to-earnings (P/E) ratio, that stocks are valued just a hair above their long-term average? Indeed, if you look back over the last 12 months of reported earnings, the current P/E of 20 is not alarmingly above its long-term average of 15. And that’s that.

But is that, that simple? At nearly 76 months, the current rally in stocks is surpassed in length by only two other stretches since 1932 – the 86-month run that ended in 1956 and the extraordinary 113-month era that culminated with the bursting of the Nasdaq bubble. Shouldn’t the current stock market rally prompt a rational investor to at least ask what underlying factors are driving the persistent trend? There’s no post-war economic surge that promises to produce the next Baby Boomer generation. Nor has a technology emerged that begins to compete with the advent of the world wide web? The shale revolution aside, the current rally has not been catalyzed by anything that appears set to alter the course of history.

Of course, stocks could have been so undervalued in March 2009 that they were simply poised to rise after a brutal and prolonged slump. The problem with this line of thinking is that history suggests otherwise. Stan Nabi, now the Chief Strategist “Emeritus” at Silvercrest once told a group of wet-behind-the-ears MBAs in training that there was one rule that never failed to deliver when it came to valuing stocks. Way back in 1996, when Greenspan was angsting about “irrational exuberance” and Nabi was still at Donaldson, Lufkin & Jenrette, Nabi said, “Stocks never emerge from a bear market until the Standard & Poor’s 500 is trading at a single-digit P/E multiple.”

There was little doubt in our minds as to Nabi’s credentials. He’d had the good fortune to study at Columbia University under the tutelage of Benjamin Graham, the father of value investing. It didn’t hurt that he’d attended Graham’s class with a young student named Warren Buffet. Suffice it to say, a long vigil began that day for one very impressionable market watcher for whom the wait has yet to end. The closest the market got to a single-digit P/E breach occurred in March 2009 when the S&P 500 troughed at the ominous level of 666, taking the P/E down to its most recent low of 13.3.

As for the true secular bottoms, ones that laid the groundwork for secular bull markets? The years 1921, 1931, 1942 and 1982 featured bear market troughs, when the P/E ratio did skid to a single digit. In some of these cases, P/E’s languished below 10 for prolonged periods prompting investors to cry “Uncle!” and abandon the despised asset class once and for all.

While there’s no doubt stocks had put deep fears into investors’ hearts by early 2009, they were nevertheless not the screaming bargain history suggested they could be. Maybe it was good enough that there was a gaping distance between 13.3 and 1929’s 32.6 to say nothing of December’s record high of 44. Maybe, but that reasoning just didn’t sit right with this market historian, especially from my perch within the halls of the Federal Reserve.

It’s undisputed that the financial crisis sparked by the subprime mortgage conflagration was the worst since the Great Depression. Why then, did stocks not react in kind, bleeding out until they too were trading at a single-digit P/E as they were in 1931? Could it be that interest rates, which had been slammed down to the zero bound three months prior, had a hand in halting history in its steps?

Few Fed insiders would deny that extraordinary measures undertaken in the heat of the financial crisis put a floor under asset prices of all kinds, including stocks, though such aims could never be uttered publicly by policymakers. Except for the fact that they were, on October 20, 1987 in a statement released by Alan Greenspan’s tightly-run Fed: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”

The Fed intervened in the markets that very day bringing the fed funds rate down by a half-percentage point to just under seven percent. The stock market responded in kind, rallying as if on cue. Throughout the course of the next few months, The Fed repeatedly took overnight interest rates lower. Sometimes, as an added bonus the central bank would go so far as to give trading desks advance notice. How awesome was that, traders must have thought, the ability to position to profit before the fact.

Nobel Prize winner Robert Shiller has devised a twist of sorts on the traditional P/E ratio by comparing stock prices to the average inflation-adjusted earnings from the previous 10 years. The thinking behind this construct is corporate earnings can be affected by the bumps in the business cycle, which can render the traditional P/E ratio highly volatile. Smoothing out volatility to make any indicator less noisy and therefore more efficacious is intuitive enough. And yet, the Shiller ratio has become a target of stock market cheerleaders, many of whom have made a professional sport out of debunking his methodology. (Shiller’s measure suggests a higher current level of overvaluation than the more malleable, shorter-term P/E does, so what’s to like?)

To his credit, legendary investor Jeremy Grantham has not succumbed to attacking Shiller. Rather, he recently made an elegant observation with regard to the good professor’s full historic data set: The Shiller P/E averaged 14.0 times earnings from 1900 to July 1987; in the period that’s followed Greenspan’s taking the helm to present day, the Shiller P/E has averaged 24.4.

In other words, some element appears to have entered investors’ calculus that justifies paying prices that are markedly higher than they were before Black Monday, before Greenspan committed to provide liquidity to support the financial system. Years ago, investors even came up with a nickname to describe the effective floor placed under all risky asset prices since the Fed began making policy with an aim to mitigate losses: the “Greenspan Put.”

A put is a contract that allows the owner to profit if the price of an underlying security declines. If you own a put contract on the broad stock market, you make money as the stock market declines. To be sure, investors have changed with the times when it comes to the identity of the put’s benefactor. The current put is ever so originally called the “Yellen Put,” which replaced, of course, the “Bernanke Put.”

So which history should investors reference to judge the current value of the stock market — the pre-Greenspan era or that which followed? The former casts the current Shiller P/E of 27 as frothy, if not rich; the latter suggests investors are perfectly rational in their exuberance. After all, stocks are not nearly as overvalued today as they were in 1999. And more to the point, policymakers remain loathe to end an era, regardless of the damage it has wrought on the notion of price discovery.

The catch is that a put, as is the case with any contract, is not designed to be in effect in perpetuity. Then the question becomes, what happens if history eventually catches up with stocks, ultimately pushing valuations into single-digit P/E territory?  In that event, investors would rightly conclude that interventionist policymaking, while well-intentioned in name, was nevertheless destructive in the end.


The Sin of Commission

To omit is to care-less. To commit is to care not. From the perspective of the populace and the financial markets, the question is whether the Federal Reserve has committed a sin of omission or commission when it comes to the thorny issue of inflation.

The subject of inflation has never been as complex as it is today. No doubt, an oversupply in countless industries, many of which would be more competitive if not for the ease with which inefficient operators can stay in business, pulls down traditional price gauges. This dynamic underlies the case for pronouncements that prices across the full spectrum are rising in benign fashion according to the metrics employed by those charged with safeguarding the dollar’s buying power. Economists deploy the term “hedonics” to shush-shush the whiners, ensuring the masses that their dollar buys so much more today than it did in prior times. The problem with this is the masses don’t necessarily need another cheap television, especially one that’s bound to break down. Last we checked, two of their most important needs– affordable education and health care–are not available at Walmart.

The (not) funny thing about inflation is that is doesn’t exist unless it pertains to something you need to buy, in which case inflation is a very real phenomenon, at least if you populate what is nostalgically known as the American middle class. Listen to any retiree and they will regale you with exact data points on the price of a pound of ground beef, their statin prescription, or a gallon of gasoline. Step down the demographic ladder to would-be empty nesters and they will tell you the pain in their budgets emanates from helping their children pay their rent, the cost to maintain their own home, and the fact that dining out, flying away or sleeping over at a hotel makes travel a thing of luxury, and therefore for many, also a thing of the past. Slide down one more rung on the age ladder and you arrive at the truly hard pressed — families whose high-schoolers live and die for an iAnything, or worse, those with offspring entering college. These folks are faced with some of the most difficult financial decisions of their lifetimes. Such is the reality of out-of-control higher education inflation, spurred on by the fact that student debt has become a profit center.

There is a distinct irony to easy monetary policy helping fuel the skyrocketing cost of a college education. Data on mortgage equity withdrawal (MEW) do not detail where the money goes, but the nearby graph suggests that during the housing boom, home equity withdrawal provided a potent support for tuition increases. Many of those bills are just now coming due as home equity lines of credit (HELOC) that were originated in the mid-2000s are nearing the end of the ten-year period over which only interest payments are made. (Never mind that Reatytrac recently reported that 56% of the 3.3 million open HELOCs in that $158 billion pipeline are “seriously underwater.”) After the bubble burst, the crash in house prices that began in 2006 put mortgage equity withdrawal into hibernation. Did that arrest the rise in tuition costs? Not hardly. Student debt added fuel to that fire.

Mortgage Equity Withdrawal

While there is no suggesting that student debt is a nouveau form of household debt, the fact that its growth took off in earnest in 2006 is anything but coincidental. Wage growth stagnating at the same time did nothing but exacerbate the budgetary dilemma of families. Something had to give and in the end the new source for the lack of wherewithal to fund higher education became student debt. The overall figures are widely reported but nevertheless breathtaking. There is even a student debt clock that has been designed by an educational website for MarketWatch which is modeled after the infamous National Debt Clock. Though it’s hard to fathom, student debt increases by $3,055 every second based on the growth rate in the nine years through 2015’s first quarter. The latest data point from the New York Fed placed total student debt at $1.2 trillion, a figure that has doubled since 2007 and surpasses both auto and credit card debt. Without doubt, cuts in public spending on higher education have not helped matters. The less the public can contribute, the more families have to.

Of course, there is a class of Americans who roundly applaud the Fed’s advancing an exclusionary definition of that scourge inflation and what it allows – the investors. Asset price inflation, whether speaking of stocks, bonds, commercial real estate and by extension, high-end residential real estate has been magnificent. The good news for the tony invitees to the rally’s party is asset price inflation is anything but benign and wholeheartedly welcome. The better news is measured inflation gives the Fed license to never remove the proverbial punch bowl. The catch is when the bubbles inflating all of these asset classes burst, the exit will not be wide enough to allow each and every investor who has been enriched since 2009 safe passage from paper to realized wealth. Perhaps then, the other kind of inflation, the one that is poorly measured but oh so critical, will make a difference, even to investors.

In the end, when the results of the grand experiment in easy monetary policy are in hand, history’s judges may determine that a more honest approach to measuring inflation was needed all along. If that is the case, the Fed’s sin will not be one of omission but rather that of commission.



The Great Abdication

The business cycle is dead! Long live the business cycle!

Not too long ago, in a land not so far away, the business cycle was declared to be defeated. Policymakers at the Federal Reserve were credited with slaying the pesky beast that featured recessions as part of its nature. Such was the faith in the permanence of the business cycle’s demise that the era was given its own label, The Great Moderation, a perfect world in which inflation ran not too hot or too cold and profit growth was accepted as the steady state.

As is so often the case, reality rudely disturbed nirvana’s prospects. The Great Moderation devolved into the Great Recession precipitated by one of the most devastating financial crises in U.S. history. The veneer of calm advertised over the prior years was stripped away. In its stead, economists had to concede that an era of benign monetary policy had encouraged malinvestment, the scourge that Austrian Ludwig von Mises warned of in the early 20th century. An overabundance of debt, if left unchecked, inevitably leads to the misallocation of resources. In the case of the first years of the 2000s, the target was, of course, the housing market.

The hope today is that the current era of easy monetary policy will have no deep economic ramifications. Such thinking, though, may prove to be naive. It goes without saying that the heat of the financial crisis merited a monumental response on policymakers’ part. That said, the most glaring outgrowth has been politicians’ exploiting low interest rates to their benefit. While it’s conceivable that well-intentioned central bankers want no part in encouraging Congressional malfeasance, the fact remains that the lack of action on politicians’ part would not have been possible absent the Fed’s allowing Congress to abdicate its responsibilities to the manna of easy money.

Of course, we all appear to have been spoiled over the last 25 years. A funny thing happened when the Fed placed a floor under stock prices with assurances that investors’ pain and suffering would be mitigated – recessions faded from the norm. Over the past 25 years, the economy has contracted one-fourth as often as it did in the 25 years that preceded this benign era. Hence the illusion of prosperity, one that has rendered investors complacent to the point of being comatose. That’s what happens when entire industries are able to run with more capacity than demand validates simply because the credit to remain in operation is there for the taking. To take but one example, capacity utilization is at 78.1 percent, shy of the 30-year average of 79.6 percent some six years into the current recovery. The downside is that the cathartic cleansing that takes place when recession is allowed to play out all the way to the bitter end of a bankruptcy cycle never occurs – winners and losers alike stay in business.

The savvy fellows in the C-suites are not blind to reduced competitiveness. As such they are remiss to expand their core businesses too much, that is, until the time they can truly assess the operating environment in a post-easy money world. The tricky part is that the credit is still there for the taking. What’s to be done? In the words of one of the wisest owls on Wall Street, UBS’s Art Cashin, such environments raise the not-so-fine art of financial engineering to a “botox state”. It’s no secret that companies have been gorging themselves on share buybacks and mergers and acquisitions, non-productive but highly lucrative endeavors. When combined the results are magnificent – costs are cut, profits juiced and bonus season becomes the most wonderful time of the year.

The insult added to the economic injury is the players who are compelled to underwrite the not-so-virtuous cycle. Broken pension accounting and incentives continue to force the hands of the individuals tasked with allocating the portfolios underlying the nation’s $18 trillion in public pension obligations. One of the least discussed consequences of easy monetary policy is the damage wrought on the nation’s pension system. Not only have low interest rates compounded underfunded statuses, they have driven pension assets into riskier and less liquid investments than anything prudence would dictate. The catalyst is the perverse rate of return assumptions that are wholly disconnected from reality. Averaging 7.75 percent, these bogeys have forced allocations into credit plays, many of which are caged in the least liquid corners of the debt markets. The irony is that many pensions have sought to diversify away from their bloated equity holdings by seeking out what they perceive to be the traditional safe harbor of fixed income investments, much of which flows straight back into the stock market via debt-financed share buybacks and M&A.

All retirees’ security is thus at risk when the massive overvaluation in fixed income and equity markets eventually rights itself. Pension math, however, will forestall the day of reckoning in the financial markets given the demographic surge in retiring beneficiaries that require states and municipalities to top off pensions’ coffers. Pensions will thus dig themselves into a deeper grave than they would otherwise by buying the credit craze more time.

Meanwhile, would-be retirees who don’t have the safety of promised pensions continue to be punished by low interest rates. The past seven years have criminalized conservative cash savings. The Swiss Re report quantified what U.S. savers have lost in interest income at $470 billion, while debtors had an easier time. It’s no coincidence that the average 401k balance for a household nearing retirement will only cover two years based on the nation’s median income. Nor is it any wonder that the labor force participation rate for those aged 55 and older has increased by three percentage points over the past decade. If only they were all earning what they did in their prime years.

And the lesson to be learned when making ends meet is simply not feasible? That would be the tried and true economic offset, the magic behind the miracle of our consuming nation, which for too long now has been debt that pulls forward the demand that should have to wait. Despite the collapse in mortgages, overall household debt remains elevated; it isn’t that far below its pre-recession level, and households are now splurging on cars as lending standards have caved. Even credit card borrowing is making a comeback – the average household’s credit card balance of $7,177 is the highest in six years. Meanwhile, student debt is scaling record heights as families struggle to keep pace with the most egregious inflation plaguing household budgets, that of higher education.

As for the gravest sin of the QE era, in the fiscal year 2015, the U.S. government paid 1.8 percent on public debt. One would be hard pressed to identify any other debtor whose borrowing costs decrease despite its trebling in debt outstanding. Actually, that’s a privilege we need to protect. As for indemnifying the nation’s balance sheet, that opportunity has been squandered by spineless politicians who would rather maintain the veneer of scant deficits rather than extend the maturity of the nation’s debts. Our wise neighbors to the south recently issued a 100-year bond. Where, one must ask, is our leaders’ wisdom when we need it most?

Could it be that hiding behind the Fed’s largesse is the path of least resistance? It would certainly appear to be the case. All the while, the excesses in the financial markets continue to build unchecked. The time has long come and gone to abandon the model-driven decision framework that pushes the Fed into an ever-shrinking corner. It is high time central bankers acknowledge their complicity in enabling Congress to fiddle while the country burns. As was the case with the revelation that the Great Moderation was but a myth, it is crucial that our leaders retake the country’s reins thus also bringing to an end the deeply damaging era of The Great Abdication.

Up next:  Some ideas on next steps for the country.