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    Default Personal Savings Rate Drops to Worst Level Since Great Depression

    Personal Savings Rate Drops to Worst Level Since Great Depression
    February 01, 2007 (AP)

    People once again spent everything they made and then some last year, pushing the personal savings rate to the lowest level since the Great Depression more than seven decades ago.

    The Commerce Department reported Thursday that the savings rate for all of 2006 was a negative 1 percent, meaning that not only did people spend all the money they earned but they also dipped into savings or increased borrowing to finance purchases. The 2006 figure was lower than a negative 0.4 percent in 2005 and was the poorest showing since a negative 1.5 percent savings rate in 1933 during the Great Depression.

    AntiSpin: Recent comments of mine here about feel-good stories sent several of you to the keyboard to express alarm at the possibility that iTulip is about to get all smarmy on you. iTulip reader Noam Krantz sent us the following note today:
    I've read some of your articles lately where Eric Janszen has pointed to more positive stories so that iTulip doesn't seem so gloom and doom oriented. I hope he's being sarcastic because I find the downside analysis to be quite helpful in terms of helping me to hedge against downside risk for personal investment and also for my work. I have an MBA from Columbia and served a few years in banking before coming to work in house on M&A assignments and strategy for a company that is the largest in its industry. I find iTulip useful for getting a good feel on the macroeconmic issues facing the US today. So I say: keep on top of the downside because it is something that nobody else covers the way you do. I also have the same beliefs on housing and have developed some interesting models that show upside and downside returns that I wouldn't mind sharing with your readers if you want. Very useful in helping to determine how ridiculous housing prices are in your area or with a specific house.

    Thanks.

    Noam A. Krantz
    Director, Corporate Development
    (Company name withheld at writer's request)
    Not to worry, Noam. We've covered declining U.S. household savings and rising debt since the early 2000s, for example, but we're not going to drop the topic because it's not happy-happy, joy-joy. Sure, maybe, after eight years, we're getting tired to talking about it. But, as I said yesterday, rather than re-hashing what we already know–that all this careless taking on of household, corporate and public debt is going to end in inflationary policies that bail out debtors (aka Ka-Poom Theory)–we're going continue to refine our understand of how aspects of the Frankenstein Economy, like a negative rate of saving, are likely to turn out for the USA. We're reviewing "Macroeconomic Policy Demystifying Monetary and Fiscal Policy" By Farrokh K. Langdana, who explains in the chapter Long Term Interest Rates, the Yield Curve, and Hyperinflation how interest rates and the yield curve behave during a major inflation, and–perhaps more importantly–how they behave before a major recession with inflation. (Hint: inverted yield curve, as in yield curve October 1978 to October 1981.) And we'll take you up on your offer to share your home price models–thanks!

    These days, when you hear an investment banker use a word that sounds like "brick" he or she means B.R.I.C., the acronym for the emerging economies of Brazil, Russia, India and China. It's a joke on Wall Street that at any one time there are only three ideas on the Street, but no one knows where they came from. The investment idea of B.R.I.C., however, is attributed to a Goldman Sachs white paper written back in 2003.

    What does B.R.I.C. have to do with our savings-less U.S. household? Let's look at what makes B.R.I.C. tick. Raghuram G. Rajan, Economic Counselor and Director of Research, IMF, in "Investment Restraint, The Liquidity Glut, and Global Imbalances" explains:
    The Global Liquidity Glut

    Debt securities typically need to be backed by hard assets that can be repossessed in case of default. So regardless of why the flow of hard new assets is low, the amount of debt that can be issued by corporations is likely to be constrained when investment is low.

    The mismatch between unabated global desired savings and lower realized investment, between the amounts available for finance and the flow of hard assets to absorb it, has led to a liquidity glut which has pushed long term real interest rates the world over lower. This has spilt over into markets for existing real and financial assets — real estate, high-risk credit, private equity, art, commodities, etc — pushing prices higher. Indeed, casual empiricism suggests that the most illiquid markets, where typically there are few transactions, and small infusions of liquidity can have substantial effect, have been pushed the highest.

    The attention a market gets can be flattering. A number of commentators have noted that emerging market debt has become an accepted part of investor portfolios — it is now a well accepted asset class. While indeed emerging markets have done much to raise their creditworthiness, the achievement is less praiseworthy when we recognize that almost all financial assets have now become mainstream. Our enthusiasm should be tempered by the realization that it is the shortage of collateralizable new real assets rather than the improved creditworthiness of old borrowers which is causing financial markets to rediscover the latter.

    The attention can also be self-fulfilling. If refinancing is easily available, no borrower will default, allowing lenders to believe that a "structural" change has brought down the credit risk associated with hitherto untrustworthy borrowers.

    The attention a market gets can be flattering. A number of commentators have noted that emerging market debt has become an accepted part of investor portfolios — it is now a well accepted asset class. While indeed emerging markets have done much to raise their creditworthiness, the achievement is less praiseworthy when we recognize that almost all financial assets have now become mainstream. Our enthusiasm should be tempered by the realization that it is the shortage of collateralizable new real assets rather than the improved creditworthiness of old borrowers which is causing financial markets to rediscover the latter.

    The attention can also be self-fulfilling. If refinancing is easily available, no borrower will default, allowing lenders to believe that a "structural" change has brought down the credit risk associated with hitherto untrustworthy borrowers.

    A related danger is that small changes in excess liquidity could have large changes on the price of illiquid assets, with large attendant effects on valuations. If and when the imbalance between desired savings and realized investment is corrected, these asset markets could experience large swings.
    This also suggests that the fate of emerging markets and U.S. households are inextricably linked. Which comes first, the collapse of B.R.I.C. or U.S. household balance sheets? When will it ever happen?

    How soon we forget, we've already had a dry run. Our favorite Telegraph UK reporter Ambrose Evans-Pritchard wrote a couple of days after Ferguson on June 32, 2006 in "No mercy now, no bail-out later" about another kind of brick, one that was at the time flying as global central banks attempted to take away the punch bowl:
    As Ben Bernanke knows all too well, monetary policy is like pulling a brick across a rough wooden table with a piece of elastic. Tug, tug, tug: nothing happens. Tug a little harder: it leaps off the surface and knocks your teeth out.
    The result was frequently reported at the time this way:
    Fed Steals Punchbowl, Party Ends, Hangover Starts

    Move along, people. There's nothing to see here. Move along.

    There's nothing mysterious or sinister behind the declines we've seen recently in global financial markets. The Federal Reserve has taken away the punchbowl it spent two years pouring absinthe into. The party is over, and the guests are staggering off to endure skull-cracking hangovers. So far, so predictable.
    As it turns out, not so predictable. The party started again. I'm reminded of several false head-fake crashes of the NASDAQ in 1999 before the final event, as the Fed pulled the brick off the table. It moved a bit, markets corrected, the Fed stopped pulling, the party picked up again, then the Fed started pulling again. This tug-of-war game between the Fed and the speculators went on until Q2 2000 when the panic finally started.

    Which brings us to our main story. Another reader wrote in to ask me to comment on John Mauldin's letter to readers this week, A New Definition of Rich (be sure to sign up for John's excellent newsletter).
    I am in South Africa as this week's letter is being sent out; so it is with some irony that the letter is focused on a topic that generally concerns only US-based investors, although what the SEC does has an effect on regulatory bodies abroad. This is a letter you may want to forward to your friends and associates.

    The Securities and Exchange Commission (SEC) has posted a new proposed rule that would raise the minimum net-worth requirement needed to invest in private funds from $1,000,000 total net worth to $2.5 million liquid net worth. This is a major change, and it means that some 7% of American households will no longer be able to invest in private offerings. In my opinion, it is likely to become law in the not too distant future unless there is significant public comment. This week we look at the proposed rule and some of its consequences, as well as a very interesting proposal by SEC commissioner Roel Campos.

    It may surprise readers to know that on a practical level I agree with the thinking that it requires a certain level of sophistication to invest in unregistered private offerings. This is the field I work in, and I can confirm that hedge funds are not for unsophisticated investors. They can be quite complex and involve different sets of risks than other types of investments... I also think it is philosophically wrong to limit the choices of investors based simply upon assets. The rich have advantage enough without limiting the choices of those with less assets.
    The punch line?
    If the original amount were adjusted for inflation, the net-worth requirement today would be $1.9 million. The SEC proposes to raise that limit to $2.5 million in investment assets, so your home or primary business real estate would not be included in the $2.5 million. This would reduce the number of investors eligible to invest in hedge funds by about 88%, or to just 1.29% of American households. Since they are proposing that the amount be adjusted for inflation every five years starting April 1, 2012, that would suggest to me they are considering adopting the proposal as early as April of this year, although there is no way to be certain, as comments could alter the proposals.
    John consults to the hedge fund industry. From an interview with John earlier this week:
    MONEYWEB: Yes, it’s interesting. If you’re away for a while you do see it with a different pair of eyes. Your involvement in the hedge fund industry as a consultant on the one hand. Do you actually run hedge funds still?

    JOHN MAULDIN: No, I mean, I’m a consultant with a fund of funds, but mostly we analyse other funds and help clients find investments that would be appropriate for their portfolios. I’ve got worldwide partners and Plexus is my partner in South Africa, but I’ve got partners in every part of the world, really, but Australia. And so you can have different funds. Depends on the regulatory scheme and what’s appropriate for different investors. But different parts of the world and different investors get access to different funds. So it’s complicated to keep up with, but all of our partners cooperate with each other, doing research. So worldwide there’s actually quite a number of people doing research, looking at hedge funds, kicking tyres, trying to find investments that make sense.
    iTulip's interest in hedge funds is only journalistic, so we're not as expert as John. Maybe that's why we may see the idea behind this proposed legislation differently. It may be about protecting investors, or maybe there is another more likely explanation–given the timing and the likely impact. Maybe the S.E.C. is not worried about the 1.3% of investors who are currently accredited that may or may not be getting shorn by USIPs, who are soon to become unqualified, a few thousand souls who will be "protected" from hedge funds if this legislation passes.

    Let's consider another possibility. From iTulip June 19, 2006:


    Hedge funds vs. central bankers
    June 19, 2006 (Niall Ferguson - LA Times)

    Will inflation, deflation or recession win in the coming months?
    IT WAS SUPPOSED to be a summer of love — or at least of low volatility. Just two weeks ago, London hedge fund managers headed to the country for Hedgestock, a two-day event billed as "a Festival of Networking for the Hedge Fund Industry." As at Woodstock, the Who topped the bill. The difference was that at Woodstock, the audience was high, whereas at Hedgestock, only their net worth was high.

    The bigger the party, the bigger the hangover. By the close on Wednesday, there wasn't a single stock market in the world that hadn't fallen. Emerging markets, including Brazil, Russia and India, took the biggest hits. Along with China, these were supposed to be the BRICs — Big Rapidly Industrializing Countries. This month they dropped like bricks.

    ... apparently uncoordinated global tightening of monetary policy effectively shears the hedgies. For years they have been making stupid money by borrowing from central banks at near-zero rates and taking long positions in any market with momentum. "Too accommodative" central banks meant one-way bets and low volatility. Now it costs to borrow, and volatility is back.
    (Curiously, the article is not available in the LA Times Archives. The June 19, 2006 article is bracketed by Ferguson's Jul 24, 2006 "WWIII? No, but still deadly and dangerous" and his Jun 5, 2006 "Condi the Mutant" but no "Hedge funds vs. central bankers." A google search of "hedge funds versus central bankers" turns up only iTulip's reference from June 2006.)

    What would be the immediate impact of this legislation? To freeze the current pack of USIPs in place. By shrinking the pool of investors by 88%, the S.E.C. in effect cuts off a large supply of capital to the industry. If this passes, the party really is over. Not only will few if any new funds be created, but–depending on how the legislation is written–potentially many hedge funds will not be able to raise fresh capital from existing investors, either. The S.E.C. cares about the 9,000 hedge funds and growing that have developed a collective ability to influence credit markets to the point where they can effectively defeat the Fed's attempts to reduce credit and resulting inflation risks. Cut off access to capital and the influence of the hedge fund industry in the availability of credit declines.

    This is how bubbles can be popped by a new administration of the government that created them in the previous administration. Recall the interest rate hikes which the Fed undertook nine months before the NASDAQ crashed. Tug, tug, tug... After
    pulling the elastic tight, the Fed waited for the brick to fly when someone tapped it, when a so-called "random exogenous event" set the "risk brick," if you will, flying off the table. In the case of the NASDAQ bubble, tax loss selling in April 2000 was the "tap" that sent the speculative market brick flying. The Fed stood ready with rate cuts to help repair the damaged area, and keep the negative wealth effect from spreading credit and price deflation into the so-called "real economy." This anti-USIP legislation, layered on top of many rate hikes over a period of more than a year, will likely act in the way increased margin requirements might have acted at the height of the NASDAQ bubble, if the Fed had instituted them. If the Fed had done that, a likely result? A NASDAQ crash, and one that could be blamed on the Fed–causal–which is probably why the Fed didn't do it. Greenspan learned his lesson in 1994 when he, "purposely tried to break the bubble and upset the markets in order to sort of break the cocoon of capital gains speculation," in the stock market. The Fed blew up the bond market instead. Increasing margin requirements during bubbling stock market, like cutting off funds to USIPs during a credit bubble, is like giving the "risk brick" a swift kick into speculators' teeth. Is this anti-USIP legislation a Bernanke maneuver, albeit enforced by the S.E.C., akin to Greenspan's ill-fated 1994 stock market speculation control policy? If this legislation passes a fresh sources of capital to USIPs are cut off, a severe market reaction seems likely.
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    Last edited by FRED; 02-02-07 at 01:08 PM.

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