Mortgage Loans – A $9 Trillion Crisis by Steve Blumenthal, CMG Capital Management
“I think the government solution to a problem is usually as bad as the problem and very often makes the problem worse.” – Milton Friedman
A close friend bought a $1 million condo but he did something very unusual, he borrowed the mortgage loan in Yen instead of dollars. This can be confusing so let’s try to simplify and cut to the chase. Loans from both countries were offered at low favorable interest rates but he believed that the U.S. dollar would move higher relative to the Yen so he borrowed in Yen. Since he lives and works here in the U.S., his daily life is based in dollars. Not only does his home appreciate in terms of dollars, his living is made in dollars and the food he buys is in dollars.
Since he took out that loan, the dollar has appreciated 50% against the Yen. This means that it will take just $500,000 to pay back the one million Yen based mortgage. Good news for my friend as he can, if he wishes, walk down the street to his local bank and refinance his mortgage (but this time based in dollars). However, both he and I believe the dollar is going even higher – for now. So he is sitting tight.
Of course, his decision doesn’t come without risk. The dollar could continue to appreciate or it could decline in value against the Yen. Such are the risks we take.
Here is the main point of today’s OMR:
According to the Bank of International Settlements, non-bank borrowers outside the U.S. have borrowed, in dollars, $9 trillion. This is an increase of $4.5 trillion since the financial crisis and it places that $9 trillion on the wrong side of the dollar bet.
The broad trade-weighted dollar strengthened 12.3% since last June. Tack an extra 12.3% on top of $9 trillion and you can see how the borrower is beginning to get squeezed. I, along with a number of other forecasters, expect the dollar to continue higher. If I’m right, this is going to get a lot worse.
The dollar debt is an example of how the Fed’s tightening will impact the world economy. This is a pressure cooker and the pot is starting to boil.
Included in this week’s On My Radar:
- The $9 Trillion Dollar Question
- Margin Debt is High and Rolling Over
- El-Erian says low liquidity biggest market risk -CNBC
- Trade Signals – New All Time High, Trend Evidence Remains Positive
The 9 Trillion Dollar Question
A close friend bought a $1 million condo but he did something very unusual, he borrowed the mortgage loan in Yen instead of dollars. This can be confusing so let’s try to simplify and cut to the chase. Loans from both countries were offered at low favorable interest rates but he believed that the U.S. dollar would move higher relative to the Yen so he borrowed in Yen. Since he lives and works here in the U.S., his daily life is based in dollars. Not only does his home appreciate in terms of dollars, his living is made in dollars and the food he buys is in dollars.
Since he took out that loan, the dollar has appreciated 50% against the Yen. This means that it will take just $500,000 to pay back the one million Yen based mortgage. Good news for my friend as he can, if he wishes, walk down the street to his local bank and refinance his mortgage. However, both he and I believe the dollar is going even higher – for now. So he is sitting tight.
Of course, his decision doesn’t come without risk. The dollar could continue to appreciate or it could decline in value against the Yen. Such are the risks we take.
I mention my friend as an example to further look at a much bigger risk that surfaced this week. According to the Bank of International Settlements, non-bank borrowers outside the U.S. have borrowed, in dollars, $9 trillion. This is an increase of $4.5 trillion since the financial crisis and it places that $9 trillion on the wrong side of the dollar bet.
If you live in Europe and your assets and income are based in Euros, then the dollar’s gain against your Euro means it will take more Euros to pay off your debt.
When you throw around numbers in trillions, it all can become a bit foggy; yet, $9 trillion is a potential powder keg of trouble. It is no wonder that the Group of 20 finance ministers last week urged the Federal Reserve to “minimize negative spillovers” from potential interest rate increases.
Why does this matter? Should the Fed decide to raise interest rates as expected this year, there are significant and potentially explosive unintended consequences. The $9 trillion dollar problem will become much bigger.
Let’s reverse the clock back a few years and shift continents. U.S. interest rates were lower than the rates in much of Europe so non-U.S. borrowers living in London, Paris, Germany or Greece, decided to take out loans from U.S. Banks at low interest rates but priced in dollars not Euros. A lot of people liked that idea.
Today, U.S. interest rates are lower than they were then but they are now higher relative to the rates in most of Europe. Additionally, the U.S. is at or near the end of QE and posturing to begin to raise rates while Europe is at the beginning of QE with short-term rates now negative in a number of countries. The U.S. economy is relatively strong while austerity continues in Europe, unemployment is very high and deflation has taken hold.
Ok – back to that $9 trillion problem. Think about what would have happened to my friend if the dollar declined against the Yen. He’d need to come up with more dollars to pay back his Yen loan. That is what is facing those folks who borrowed in dollars vs. Euros. They’ll need to come up with more Euros to pay back in dollars because their Euros are worth less.
The broad trade-weighted dollar strengthened 12.3% since last June. Tack an extra 12.3% on top of $9 trillion and you can see how the borrower is beginning to get squeezed. I along with a number of other forecasters expect the dollar to continue higher. If I’m right, this is going to get a lot worse.
The dollar debt is an example of how the Fed’s tightening will impact the world economy. This is a pressure cooker and the pot is starting to boil.
“The G20 finance ministers have urged the Federal Reserve to “minimize negative spillovers” from potential interest-rate increases. With the collapse of the Swiss/Euro Peg, they have been stunned into the realization of cross-currency borrowing. For decades, bankers have been marketing loans in different currencies as a means to reduce interest rate costs. However, once the bankers sell these deals, they just walk away.
The collapse in the Swiss/Euro Peg has exposed the amount of mortgages and loans in Swiss being found in Britain to Greece. This is a drop in the bucket. The amount of debt issued in dollars has grown by 50% since 2007 and has now reached some $9 trillion. This the total amount owed in dollars by non-bank borrowers outside the USA. If the Fed raises interest rates as anticipated this year for the first time since 2006, higher borrowing costs for companies and governments, along with a stronger greenback, will create the greatest economic collapse in modern times.”
-Martin Armstrong – G20 Leaders Plead with Fed Not to Raise Rates
As the Fed raises interest rates, with negative short-term rates in Europe, the money will flow into U.S. dollars further accelerating its advance. The Fed is quickly finding itself “between a rock and a hard place” as my father used to always say.
Yesterday this crossed my desk from Charles Schwab’s webcast – Investing implications of a strong U.S. dollar:
“The U.S. dollar should continue to advance, fueled by a strong economy, the shrinking U.S. trade gap, and the expectation of rate hikes by the Federal Reserve. Schwab’s experts believe the bullish trend could last for at least another year.”
More from Armstrong:
“We expect the dollar outright will advance further as the Fed is forced to tighten while the European Central Bank continues to monetize with negative interest rates buying in failed sovereign debt. Of course, Japan extends its record stimulus as well leaving the USA the only game in town. The pegs of China will have to go as the dollar rises China will have to let go of the balloon or be dragged even higher into the sky without a footing. The pegs in the Middle East and Denmark will also have to go as more and more capital concentrates into the USA.”
Yes, further dollar advance will help my friend. The Yen’s decline is rapidly paying down his mortgage. Good for him yet not such good news for the $9 trillion that sits on the wrong side of the dollar trade. Oh, the problems that come with leverage.
As I mentioned last week, debt has grown by $57 trillion since the 2008 financial crisis. What risks? The point is the world is way out over its skis. With the cyclical bull market aged, valuations high, margin debt high and debt extreme, the simple message is that risk is material. If you can “Vanguard it”, hold your nose and stay the course, then expect low returns over the next ten years and a very bumpy ride. I don’t think most clients can stay on that ride, especially if the next recession brings a 40% correction shortly before they need their money.
Alternatively, put in place a stop-loss risk management process. Studies of past overvalued bull markets suggest that a trailing stop loss exit point at 10% below the one-year high has been a good way of capturing the majority of gains without taking the full brunt of a cyclical bear. When such stop loss level is hit, increase bond exposure to iShares 20+ Year Treasury Bond (TLT) or SPDR Barclays 1-3 Month T-Bill ETF (BIL) until a new uptrend materializes. Alternatively, consider iShares MSCI USA Minimum Volatility ETF (USMV). When the European debt crisis shook U.S. stocks in 2012, the S&P 500 lost 11 percent and USMV lost about half that amount. Expect smaller upside but better downside.
As you probably know by now, I favor Big Mo and a 13/34-Week EMA as they may guide my hedging and allocation sizing via a disciplined process. See Trade Signals below. For now, the weight of evidence says the trend remains favorable.
Sub-prime and CDOs were a problem in 2005, 2006 and 2007. $9 trillion in debt is a big one too. It is one potential trigger that may set up the next great buying opportunity. For now, as Art Cashin likes to say, “Best to stick with the drill – stay wary, alert, and very, very nimble.”
Here are a few links on the topic:
- http://business.financialpost.com/2015/02/13/the-9-trillion-question-can-the-world-weather-a-fed-rate-rise/
- http://www.bloomberg.com/news/articles/2015-02-13/-9-trillion-question-is-how-tighter-fed-will-impact-world
Margin Debt is High and Rolling Over
I thought about margin debt when I read a quote this week from David Stockman. David is a former businessman and U.S. politician who served as a Republican U.S. Representative from the state of Michigan (1977–1981) and as the Director of the Office of Management and Budget (1981–1985) under President Ronald Reagan.
“The Fed is caught in a time warp and fails to comprehend that the game of bicycling interest rates to heat and cool the macro-economy is over and done. The credit channel of monetary transmission has fallen victim to “peak debt”. The main street economy no longer gets a temporary pick-me-up from cheap interest rates because balance sheets have been tapped out.
The only actual increases in household debt since the financial crisis has been for student loans, which are guaranteed by Uncle Sam’s balance sheet, and auto loans which are collateralized by over-valued vehicles. Stated differently, home equity was tapped out last time; wage and salary incomes have been fully leveraged for years and households have nothing else left to hock.
So households now only spend what they earn, meaning that the Fed’s interest rate manipulations — which had potency 40 years ago — have no impact at all today. Keynesian monetary policy through the crude tool of money market rate pegging was always a one-time parlor trick.”
With homes no longer serving as ATM machines, many have turned to borrowing from their investment accounts. Whether borrowed to buy more stock or borrowed to cover additional spending, margin debt has reached extreme.
Every once in a while I post a chart on “margin debt”. Like available cash, margin debt can be used to buy stocks. Such demand can fuel stock prices higher. Problems tend to occur when you reach extreme. Evidence suggests we have reached such point.
Today, overall margin debt is higher than it was in 2000 and 2007. What I’m watching for is a turn lower from its peak. Chart 1 shows the current level of margin debt. Chart 2 looks at where margin debt is relative to a 15-month trend. Concerning is the recent drop below that trend.
The orange lines (red arrows) mark previous periods in time when margin debt as a percentage of GDP dropped below its 15-month moving average line. Except for a head fake in 2011 and 2012, it has done a pretty good job at calling the prior market peaks.
Further, this adds pressure to the liquidity problem Mohammad El-Erian expressed this week.
El-Erian says low liquidity biggest market risk -CNBC
NEW YORK Feb 17 (Reuters) – Mohamed El-Erian, chief economic adviser at Allianz SE, said Tuesday that Ukraine and Greece are major market risks, but that the biggest risk is the “illusion of liquidity.”
“The biggest risk is this illusion of liquidity,” El-Erian told cable television network CNBC. “The major concern is that you get a change in the paradigm, and then people discover that there isn’t enough liquidity to reposition.”
El-Erian said that the lack of liquidity could result in a market selloff, although he said such a scenario was not his “baseline.”
“If people no longer believe that we are in a low-volatility, improving U.S. economy, geopolitical shocks become too big. If all that changes, then you’re looking at at least a 10 percent correction, and at that point, there is going to be a question of what holds.”
Curbs on banks’ ability to take risks and an increase in technology-driven trading have resulted in dramatic upswings in volatility that have put post-crisis financial markets to the test in recent months.
A selloff in stocks and lower-rated bonds last October was worsened by a lack of banks and market-makers able to step in and buy assets that were being dumped.
El-Erian also said that, while the risks surrounding Greece’s finances and continued conflict in Ukraine were significant, a Greek exit from the euro zone would not be cataclysmic for the global economy, though it would create “short-term chaos.” (Reporting by Sam Forgione; Editing by Alden Bentley and Nick Zieminski)
Trade Signals – New All Time High, Trend Evidence Remains Positive
Trend remains positive, the Fed supportive and sentiment neutral. I’m keeping a very close eye on my trend indicators (Big Mo and 13/34-Week EMA) as risk remains high. Following are the usual weekly charts.
Included in this week’s Trade Signal:
- Cyclical Equity Market Trend: Cyclical Bullish Trend for Stocks
- Volume Demand Continues to Better Volume Supply – Bullish for Stocks
- Weekly Investor Sentiment Indicator:
- NDR Crowd Sentiment Poll: Neutral Optimism (short-term neutral for stocks)
- Daily Trading Sentiment Composite: Extreme Pessimism (short-term bullish for stocks)
- The Zweig Bond Model: The Cyclical Trend for Bonds Remains Bullish
Click here for the full piece.
Concluding thoughts
It is the massive amount of government involvement in potential solution and, in many cases, around the globe, it is government’s mismanagement of resources and poor stewardship of capital that the very governments are attempting to fix. Personally, I think Friedman is right.
“I think the government solution to a problem is usually as bad as the problem and very often makes the problem worse.” – Milton Friedman
All the currency gamesmanship creates tension and with debt the common denominator, I personally don’t believe more debt and higher taxes is the answer. My best guess is that a sovereign default wave is fast approaching.
I’m heading to Penn State this weekend to support my oldest daughter as she dances in a 48 hour dance marathon called THON. The energy level is high and for now the feet are feeling good. I’ll be crutching in with my torn ACL and hope that gets me to the front of the line. Nearly 15,000 will pack PSU’s Bryce Jordon Center and the music will be rockin. I danced in THON in 1982.
In 1982, Penn State Heisman Trophy winner John Cappelletti spoke to the dancers about losing his brother, Joey, to leukemia ten years earlier. The event that year raised more than $95,000 and the following year, the sum of $131,000 was raised. Remember those days of big hair and gym shorts? Not a good look.
Last year the students raised more than $13 million for children with cancer. A wonderful thing!
I’ll be thinking about my dad in the stands in the very early morning hours tossing a football with me and my friends as we dance. I’m setting the alarm to show up and surprise my daughter in the wee hours. That’s when it’s likely to be the toughest. No football allowed but I’m hoping a good hug will help.
Have a great weekend. Here’s a toast to good hugs.
Wishing you the very best.
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
