Newsletter - May 11, 2007

[FRED]

Dear iTulip.com Newsletter Subscriber,

"Are they seething with righteous anger with pitch forks and torches in hand? Are they ready to storm the bastions of so-called housing boosters like the closing scene in some modern day Frankenstein movie? Or does the 'I' in iTulip actually stand for idiot?"

- Carl Steidtmann, chief economist and director, Consumer Business - Deloitte Research

Everyone's heard of the wildly successful For Dummies book franchise published by Wiley & Sons, also publisher of "America's Bubble Economy," to which yours truly contributed. The "Making and Managing Money" series of For Dummies includes gems like "Hedge Funds For Dummies." We haven't read it, but assume it's about how to choose a hedge fund to invest in, not how to start and run one, although in the current environment that might sell well, too.

A big idea for a For Dummies type series presented itself after a reader alerted us to a report recently issued by Deloitte Research. Its author is chief economist and director, Consumer Business at Deloitte Research, Carl Steidtmann, quoted above. He derides our insistence on the existence of a housing bubble, and our warning that some who encouraged unnecessary risk taking by home "investors" while it was in full swing can expect to take some heat as the housing market declines. In his opinion, this is evidence that we are "idiots."

In Are We Idiots? we gave it the usual iTulip treatment, noting that we identified the housing bubble in August 2002 and that our description of the process of its demise from January 2005 continues to track. Recently, nearly five years after our initial warning, publications from the New York Times to the Wall Street Journal simply refer the housing bubble as a fact after the fact.

What bright idea for a For Dummies type series did the Deloitte report inspire? An entirely new book franchise for the Deloitte economics research team: forget Economics For Dummies. How about Economics By Dummies? It's going to be huge! Take it away, boys. No charge.

Upside Down to Right Side Up
Banking for Dummies
Today, opportunities to extend the For Dummies series are legion. James Scurlock, creator of the movie and author of the book "Maxed Out," told us in an interview that the FDIC recently issued guidance to banks stating that when loaning money a bank should 1) verify a customer's income and 2) evaluate a customer's ability to repay. Presents a clear opportunity for Wiley to extend their "Professional" For Dummies series.
If you haven't heard of Scurlock, he is the Wharton Business School grad who set out to look into the "victims" of so-called predatory lending reported on in the press. He expected to find dummies with bad judgment who got what they deserved. After six months of interviewing borrowers, lenders, bill collectors, government policy makers, lobbyists-the whole personal credit bubble crew-he came away with the story of an out-of-control consumer credit system, driven by the rational behavior of economic actors: lenders in desperate competition with each other for loans (assets to them, debts to you and I), customers, and profits to maintain share prices and keep up with the demand from investors for mortgage-backed securities; consumers grabbing as much cash as they are allowed to borrow to maintain living standards as inflation in everything from food to gasoline to medical insurance eats up their pay checks; lobbyists who pushed bankruptcy "reform" through Congress just in time to catch the wave of over-indebted consumers-a creation of the lending industry that pays the lobbyists-who will try to escape the system in the next recession, and regulators asleep at the switch. Our piece Upside Down to Right Side Up explains where we think the lending system is going.

Upside Down to Right Side Up

A School of Bankers
Does Salmon Smell Stronger than Fear?
iTulip member Christoph von Gamm, based in Germany, was yesterday rubbing elbows with a school of bankers-"school" as in moving together like fish in the ocean-in Zürich when he came across Kenneth Lewis, CEO of Bank of America. Christoph asked him, "Are we in a Credit Bubble?" He reportedly replied that we're close to a bubble, that any deals BoA turns down for reasons of bad risk are quickly written by another bank, that there are too many immature players in the market, that every banker believes that by the magic of securitization a benign "this time is different" outcome for credit excesses is assured, but that we will all soon be lamenting a past era of silly lending behavior. Christoph concludes his report cheerfully, "Just before the salmon lunch arrived, I could smell of fear of 100 bankers."

Much is said about the madness of crowds, less about the collective neurotic behavior of bankers during credit booms and busts. Christoph's report, taken together with my recent experience talking to bankers, reminds me of my days in venture capital during and after the technology stock bubble. (Venture Capital is banking, too, although VCs don't like to hear that. It occupies the high risk, high return, low liquidity end of the banking system, buying equity versus selling debt.)

What I experienced was a group of intelligent, hard working, thoughtful men and women saying and doing the most ridiculous things, which in the repeating became self-fulfilling accepted wisdom and fact. "Public venture capital," was one happily accepted fiction, as if retail stock investors have access to the kind of information as VCs to judge the merits of an early stage business and industry; even with their own access and methods VCs get it wrong nine times out of ten. Billions were invested in companies with no technology, intellectual property, or barriers to entry by competitors. The bet was that the markets would continue to provide enough liquidity to allow anything, no matter how silly, to exit at a profit. They did for a while.

What incited this aberrant behavior among wizened banking professionals? A torrent of cheap money created by a positive money creation feedback loop: investors' money went into VC funds, start-ups got funded, start-ups went public, generated average 60% returns in 1999 which went back to investors who re-invested it into VC funds, and so on until, eventually, prices reached absurd extremes and an event (mass selling of stocks by investors in April 2000 to raise cash to pay taxes) triggered a collapse. Similar money generating feedback loops have existed for the past few years in everything from hedge funds to private equity to mortgage lending. Under the influence of a torrent of money, a new group of bankers were infected by delusions.

Nothing is so likely to produce delusions of grandeur, invincibility, super-intelligence, and other forms of magical thinking than billions in nearly free money raining onto bankers and their investors during a liquidity bubble. Take the liquidity away, and the delusions go with it.
Starting with the US sub-prime market and the bankers in Zürich, the inexorable process of decline and epiphany is underway again. Those of you among our readers who were in the VC business as the technology bubble started to collapse, note the familiarity of the language used by Lewis, especially assertions that the cause of the bubble was the gamblers who entered the market late to fund low quality deals and drive up prices, forcing bankers to fight each other for over-priced and risky deals or take the heat from their investors for not going after the bubbling market and its extraordinary returns.

Competition among banks, whether VCs funding start-ups or mortgage lenders financing Florida home flippers, is, ultimately, the major driving force behind rising asset bubbles. Sub-prime loans may be the mortgage bubble equivalent of a dot com. For those who expect the mortgage bubble collapse to start and end with sub-prime loans, recall that the collapse of the technology stock bubble didn't end by wiping out only lame consumer web sites. Thousands of viable technology companies went out of business for lack of VC funding in the downdraft that followed the collapse of the NASDAQ bubble. If history is any guide, good credit risks will be washed out with the bad as the mortgage bubble collapses and loss fears waft through the banking industry like the smell of salmon at a banker's conference.

Martin Mayer, Banking Expert
iTulip Select Interview
It is tempting to lay all the blame on the bankers, but too easy. They're mostly doing their job, to go after earnings and take care of shareholders. I blame the central banks for lacking the will to do their job, to figure out how to effectively regulate a modern credit system which relies heavily on derivatives to manage risk. Since the 1980s, global central banks have dismantled the governor that used to limit the global credit machine, and now rely on modern theories of risk management to do the job, even though risk management remains more ideology than science. Central bank management of the global credit system consists of throwing public funds into the banking system when the money creation feedback loops eventually cause the credit machine to run out of control and blow itself up. In one of these boom-bust credit cycles, this approach isn't going to work; the Fed and other central banks will find that they didn't really understand how the machine actually works, and may find it irreparable. It would not be the first time.

"It is of the utmost importance to realize this: given the actual facts which it was then possible for either businessman or economists to observe, those diagnoses-or even the prognosis that, with the existing structure of debt, those facts plus a drastic fall in price level would cause major trouble but that nothing else would-were not simply wrong. What nobody saw, though some people may have felt it, was that those fundamental data from which diagnoses and prognoses were made, were themselves in a state of flux and that they would be swamped by the torrents of a process of readjustment corresponding in magnitude to the extent of the industrial revolution of the preceding 30 years. People, for the most part, stood their ground firmly. But that ground itself was about to give way." - Joseph A. Schumpeter, Business Cycles, 1939

Substitute "information revolution" for "industrial revolution." Note high personal debt levels, low household savings, and extreme wealth inequality not seen since the 1920s. Consider Jeremy Grantham's stunning observation in his April letter to investors (see our interpretation Sell Everything), the first ever inverted return to risk curve in history. Put it in the context of Schumpeter's analysis of what went wrong with global credit machine version 1.0 in the 1930s and you have a prescription for an unpleasant one-off outcome of a potential breakdown of version 2.0, the latest instantiation of the machine, at some point in the future.

Martin Mayer is an expert in banking, investments, markets and money, and author of over a dozen books, including "The Fed and the Markets" (Free Press, 2001), "The Bankers: The Next Generation" (Dutton, 1997), "The Greatest-Ever Bank Robbery: The Collapse of the Savings and Loan Industry" (C. Scribner's Sons, 1990), "Markets: Who Plays, Who Risks, Who Gains, Who Loses" (Norton, 1988), "The Money Bazaars: Understanding the Banking Revolution Around Us" (Dutton, 1984), "The Fate of the Dollar" (Times Books, 1980), and "The Bankers" (Ballantine Books, 1975). Mr. Mayer graduated from Harvard University in 1947, consulted to the American Council of Learned Societies (1962-1964); Twentieth Century Fund and Carnegie, Ford, Kettering, and Sloan Foundations (1962-1966); Member, President's Commission on Housing (1981-82); Member, President's Panel on Educational Research and Development (Kennedy and Johnson administrations); and Columnist, American Banker.

Speaking as an expert on the unregulated over-the-counter derivatives market, Mayer concludes:

"Derivatives markets guarantee a winner for every loser, but they will over time concentrate the losses in vulnerable sectors. Nature obeys Mayer's Third Law, which holds that risk-shifting instruments will tend to shift risks onto those less able to bear them, because them as got want to keep and hedge while them as ain't got want to get and speculate. The logic behind margin requirements in stock markets and capital requirements in banking also holds in the derivatives markets. Permitting highly leveraged institutions to hold private parties behind closed doors is the political version of selling volatility: the predictable likely gains will one day be overwhelmed by an equally predictable disastrous loss."

In our iTulip Select interview, Martin explains where the risks are today and what is most likely to occur.

Martin Mayer, Banking Expert ($ subscription)

America's Bubble Economy
Profit When it Pops
The hardcover book "America's Bubble Economy," published by John Wiley & Sons, is best summed up by reviewer Ken Kurson, financial writer for Esquire and Money Magazine: "More roadmap than crystal ball, this book doesn't simply advise a reader what's coming; it tells a reader exactly how to plan and respond. That it manages to predict an awfully troubling near future while still managing to be readable and even funny in spots is no mean feat."

Go to Amazon.com...

All information provided "as is" for informational purposes only, not intended for trading purposes or advice. Nothing appearing in this free newsletter should be considered a recommendation to buy or to sell any security or related financial instrument. iTulip, Inc. is not liable for any informational errors, incompleteness, or delays, or for any actions taken in reliance on information contained herein. Full Disclaimer here.
__________________________________________

Sorry to end on such a aphotic note, but over the last year we've talked to dozens of experts around the world, ranging from economists, to commodities gurus, to experts in CDOs and mortgage backed securities, to venture capitalists, to private equity fund managers, to hedge fund managers, to CEOs of public companies (who, incidentally, do not get quoted for obvious reasons). Behind the headlines of new DOW records, a disturbingly familiar picture dominated by wishful thinking and more than a hint of arrogance emerges.

The optimist in us can see how we muddle through next crisis. The pessimist, the one that did not foresee the pace and scale of the recovery of South Korea from its 1998 economic disaster, likely underestimates the ability of the US and world economy to bounce back. The realist knows that the most likely outcome is usually somewhere in between.
Sincerely,



Eric Janszen, Founder & President iTulip.com
Email: updates@itulip.com
Phone: 781-402-1790
Web: http://www.itulip.com