Fed Tapering and Interest Rates

If Past is Prologue

Ruggles AFN September 2013

Federal Reserve Chairman Ben Bernanke let it slip a couple of months ago that the Fed might begin to “taper its asset purchases” this fall. “Asset purchases” in this case is a euphemism for the Federal Reserve buying our own U.S. Government debt. The Fed has been buying about $85 billion in U.S. Government bonds each month for quite some time, representing about 60% of total U. S. debt purchases. Yes, they do this by “printing money,” another euphemism.

Markets didn’t like the sound of Bernanke’s comment and immediately retreated, the Dow from a record high of over 15,000. Certainly, markets hang on every word Bernanke speaks, reacting to the actual words as well as to what they think he means. Bernanke says the Feds future actions will be “data driven.” Analysts believe the Fed could begin their “taper” as soon as September if data for August looks favorable.

Mortgage interest rates have risen a full percent this year. Despite this, home prices have advanced remarkably. The “Sequester Spending Cuts” are still in effect, adversely impacting GDP numbers, yet the economy marches forward showing surprising growth under the circumstances. The specter of another debt ceiling fight, as Republicans threaten to hold the debt ceiling hostage in an attempt to renegotiate ObamaCare, hangs like a pall over the economy while fears of a Syrian/Middle East engagement raises fears of a sudden spike on global oil prices putting the world economy in jeopardy. Still, the U.S. economy marches on. Many analysts believe this is a product of incredible built up demand in the U. S. economy.

Normally, “money printing” of this magnitude weakens a country’s currency, which occurred initially to the U. S.dollar. That had many folks upset, but resulted in an export boom led by refined fuels as dollar denominated trade became less expensive to foreign buyers. Another effect of a weaker dollar was that Chinese goods became more expensive here, resulting in the loss of about 10,000,000 jobs in China. Surprisingly the dollar has recently strengthened. Now Japanese and Korean auto manufacturers are feeling price pressure on exports to the U.S. while making them grateful they have manufacturing in the U.S.

But the Fed has vowed to take away the punch bowl before the party really gets started to mitigate the risk of market bubbles and destructive inflation, while calling it “tapering.” At some point, we ARE going to have to find out the real “cost” of money. Many fear the “rubber band” effect of releasing the lid on something that should have been freed long ago. Corrections rarely go directly to the point of equilibrium and most often overshot the mark before eventually finding the balance point.

So what is the “real" interest rate if we no longer had an artificially low Prime Rate and say 2.5% measured inflation? I’ve read analyst estimates of 4.5% to 5.5% once the rate is allowed to find its own level. If this is correct let’s hope we don’t have to endure a period of “rubber band effect” after the interest is allowed to “float” before the natural equilibrium is achieved.

Flash back to 1970, the year I entered the auto business. The Prime Rate was about 7% compared to the current 3.25%. A mortgage cost about 7.75% for a 20 year mortgage compared to the current 30 year 4.5%. But a 36 month car loan was 12% compared to the current Tier 1 rate of about 3% for a 72 month car loan. There were no credit tiers in 1970, with only the local finance loan company to charge a higher rate for higher perceived risk for certain borrowers. Perhaps the much higher spread at the time was how lenders accommodated those with less than perfect, but not awful credit, thereby charging the best borrowers “too much” while the less credit worthy buyers caught a break? I didn’t know any different as I had no other basis of comparison. At the time I thought things had always been this way.

The car loan rate stayed around 12% until it went higher, much higher around 1978. By then we were decrying 48 month car loans and complaining about “stagflation,” a weak economy along with inflation.

Paul Volcker, Fed Chairman at the time, appointed by President Jimmie Carter, fixed all of that. But this remedy was not without considerable pain. Many of us who have been in the auto industry for some time recall vividly when interest rates were allowed to keep pace with inflation after the wage and price controls of the 1970s were lifted. The horror of 20% floor plan interest and 16% interest rate car loans will never be forgotten by those of us who lived it.

Today’s auto dealers pencil out projections of what a doubling of their floor plan rate would mean to their business, as well as a 2 – 3% increase in Tier 1 finance rates. And OEMs roll on as if none of this could happen, pushing dealers to spend more and more on their facilities while the Internet puts ever higher pressure on gross profit margins.

No Smoking Gun? -- Financial Innovation

Mike Smitka

The appellation "luddite" rings nasty, at least to this economist. I am after all an erstwhile student of the history of innovation and am steeped in "IO", the economics of "Industrial Organization." But look as I may, I cannot find evidence—far less make a compelling case—that the recent spate of acclaimed financial innovation is beneficial.
Let me accept at face value the claims of innovation. Now securitization goes back decades, if not more. Bank letters of credit and bill discounting are both forms of credit insurance, and they go back centuries. So I'm skeptical that Wall Street has innovated rather than merely created an impenetrable smoke-screen of complexity.
Mind you, my skepticism is tempered by my own experience in finance, working on Eurodollar syndicate loans to Latin America in the late 1970s, in the first heady days of large-scale international finance since the collapse of such markets in 1914. For those too young to remember, every single one of those loans went bad, taking the economies of a continent with it—and giving regulators the option, which they failed to exercise, to shut down Citibank. Instead forbearance was the game of the day. But at the time they were marketed as safe. First, syndication allowed banks to diversify their risk, since the organizers could sell off the bulk of what were for the time very large loans, while those purchasing it were doing so in bite-sized chunks from different borrowers and different countries. Second, banks could hedge their funding and maturity risk, because while these were long-term loans (one I worked on to a "greenfield" Brazilian steel venture carried a 12-year term) the interest rate was reset every 6 months against LIBOR (the London Interbank Offer Rate). If interest rates bumped up a bit, banks wouldn't face the potential disintermediation that was at the time plaguing savings and loan banks. (Remember your history?—the plague is typically fatal. It's an appropriate adjective.) Banks didn't even need to boost their deposit base, but could borrow in the very same London market, arbitraging their good credit ratings (LIBOR) to lend on to Brazil (LIBOR+25bp at the peak of the bubble). Sound familiar?
Anyway, what are the claims made for securitization, credit default insurance and the like? The fall into two main camps, that these innovations lowered the cost of finance, and that they provided finance to borrowers who for one reason or another lacked access.
If we look at the macroeconomy, did firms go on an investment boom? No, to the extent that we'd label the last decade of growth "robust" (which requires ignoring what happened to wages), then the sources were consumption and exports. If all of these new products lowered the cost to borrowers, it's not there in the data, or at least not enough to show up without resorting to fancy econometrics.
How about access? Well, sure, lots of new borrowers got money up front, but we have incontrovertible evidence that those who received sub-prime "mortgages" couldn't handle the payments. (Not that a "3/27" ever made sense as a loan; such "mortgages" were never anything more than a bet that real estate prices would continue to appreciate). Now we're starting to see other sorts of borrowers. The most prominent right now is credit card debt, but commercial real estate loans are starting to go bad. Losses on local and state government debt, another area of innovation, will surely follow. So improved access turned out to be a short-run illusion. And this shouldn't be a surprise: back in antiquity, in the 1990s, it wasn't as though banks enjoyed zero rates of default on their portfolios. They took their chances, but generally were able to pay for their mistakes, rather than needing bailouts.
Innovation in finance ought instead to be looked upon as fool's gold, which can only be sold to the naive. (And remember the age of those "in the game"—naïve was apropos.) The essence of banking, and of finance in general, is the proper measurement of risks. We've had claims of a "new world" in finance since the days of the South Sea Bubble. But underlying cash flow analysis isn't a matter of rocket science, it's a matter of wisdom. Who knows what the risk characteristics are of a new product?—initially, no one. And how do you regulate it? Too little and too late. New products arise in the shadows, because finance is a very mature product, and there just isn't anything new under the sun.
To conclude: there is a smoking gun. It's too soon to tell, however, whether a conviction of involuntary manslaughter will follow. For those wielding the gun committed crimes against multiple economies, killed their employers and robbed the wealth of millions of unsophisticated citizens. But the outcome will likely be a mistrial: the defendant has bought off a lot of potential judges and jurors and remains able to buy expert witnesses sufficient to shout down the prosecution.

No More Clanging Clunkers, No More Sales

Mike Smitka

What, now that the clunkers program has clanged to a close? In a couple days we'll see what total August sales were like – I'm risking bytes of criticism writing now – but I'm afraid it will be back to business as normal. Afraid, because normal this year has been an SAAR of 10 million or less. The level of enthusiasm makes it clear that sales have been pulled forward; it'll be payback time. The problems run deeper: cars were affected by the bubble, and not just housing.
A recent NBER working paper by Atif Mian and Amir Sufi of the University of Chicago bolsters the argument that I've made in earliers notes. My analysis was based solely on an analysis of sales and scrappage data relative to the vehicle stock; they started out with data on 266,000 individuals in the Equifax credit rating database. (Don't worry – they couldn't actually look at individual records, but instead had to extract information from data that Equifax had already sanitized and then mildly aggregated.) But combined with data on geography and housing prices and demographics, they could paint a picture of where prices had gone up, areas where housing supply was "inelastic" so that shifts in demand showed up as higher prices rather than more construction. They could then look at who borrowed: not those with in places where prices moved little, but those who were in "hot" markets, and who started out with lower incomes and/or lower credit scores. And did they ever tap the equity; credit records made it clear that these people were also buying a lot of vehicles, vehicles they earlier had not been able to afford. But those same locations are ones where mortgage holders are now under water (see Federal Reserve data on credit conditions, illustrated by maps color-coded at the county level). They're losing their houses and their cars, not buying new ones. In other words, there was a bubble in the auto market as well, people buying on credit backed by unrealized capital gains.
That really is not news, though it makes for sobering and poignant stories (see the New York Times series on the Beth Court neighborhood in Moreno Valley, outside LA). But what Mian and Sufi show is that behavior didn't change much in the many urban areas where there was no run-up in housing prices (I'll append a graph I created from the Case Schiller real estate index that illustrates the contrast). In other words, the big boom in car sales came from the same people who were splurging on home renovations and vacations by pulling equity out of their houses. Well, that equity isn't there to the tune $1 trillion in California alone (data from an August 13th study by First American CoreLogic). In Nevada 45% of homeowners have negative equity of 25% or more of their mortgages; in California, 25%. These people aren't buying cars anytime soon. So while house prices may have bottomed out – and the recession ended – that doesn't mean the good times will roll again.
That's not only because of all the people who lost everything (or soon will, given that 5% of the labor force has now been unemployed for over 27 weeks, and another 2% for 15-26 weeks). On average the rest of us are worried. State and local governments are only now cutting their budgets; commercial real estate hasn't hit bottom yet. There are a lot of pink slips yet to be distributed. So there's no reason to think those of us who were more conservative in our habits are suddenly going to loosen pursestrings that long have been tight. Let's be honest with ourselves; if we're thrifty, it's by necessity: home equity is what we have from paying down the mortgage, not because the spot of mother earth we occupy was suddenly worth megabucks

The graphs below look at housing prices relative to the CPI index, real GDP and nominal GDP. One focuses on four of the metropolitan areas with the greatest run-up in prices, a couple of which have come back to earth, and then some. The other highlights cities where there was comparatively little change. I left the scale the same on both, which results in a lot of blank space on the second one, plus it's hard to read because the graphs lie more or less on top of each other. Which is the point it is meant to illustrate.

Here's a link to a powerpoint from a talk I gave yesterday (Aug 25, 2009) that includes additional material.

Click to enlarge!

Click to enlarge!

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Follow the Money

The news today is of efforts to cut the cost side of the OEMs, Chrysler of course but also General Motors. Is this good news? To frame that question we need to do two things. First, what of the revenue side? Second, what of the overall value stream? – after all, the OEM slice is a quarter or less of total, not including the aftermarket, consumer finance and so on. The way I read it, we do not yet have any good news, because focusing on costs while revenues slide is chasing a will-o'-the-wisp. And the upstream and downstream segments are on the brink of a deep precipice – but I'm not sure which side of the brink.

To my mind, the key variable at the moment is the residual (resale) value of a vehicle. As long as it remains low, it cuts into the arteries, and staunching the bleeding is hard. A low residual value means that purchasers are more likely to be "under water" on their current vehicle, with a trade-in value less than their loan balance. A low residual value means that leasing is dead, and a straight loan has to be priced higher, to cover the poor value of a vehicle as collateral (never mind the current recession-driven risk that the borrower's income may disappear). And a low residual value means that even if the buyer will pay cash (or has equity in their current car), they will shy away from a great vehicle in favor of one that because of its nameplate will hold its resale value. [I will post this before digging up sample numbers, say of a Toyota Titan and a comparable GM pickup – comments, please!] If the 4-year-out resale value of one vehicle is 50% of purchase price, and of another is 30% – well, no OEM can afford to discount their vehicles up front enough to offset the different.

So how to pull up residuals? Unfortunately the cutback in fleet sales at GM is too recent to have cut the flood of used cars that has depressed their residuals over the past several years. [Or so I assume -- ADESA or various used car guides could provide data.] In a year or two the impact would have been tremendous, had the recession not intervened. After all, GM has the car of the year and good ranking in the JDPowers quality surveys. (Ditto the combination of VEBA and retirees hitting age 65 to handle legacy costs on the cost side come 2011.) But luck was not with them. Maybe the biggest help the government could give is using its purchasing dollars not on new vehicles but on 2-, 3- and 4-year old vehicles to pull up their resale value.

Low residuals hurt other portions of the industry. If a dealer closes its doors, the normal franchise agreement obligates the OEM to repurchase inventory at cost. For the bank that finances this inventory ("floorplan") that is crucial. No bank is prepared to accept 200 cars on a lot when a loan forecloses. But if GM faces Chapter 11, it would no longer be obligated to make dealers (or their lenders) whole. Now if the residual value of GM vehicles was high, lenders could at least figure out what such collateral would be worth. As it is, no lender in their right mind would extend additional financing to a GM dealer (much less a Chrysler dealer). And no dealer would order a new car. That means that these companies will have zero revenue, because even if consumers flock to dealership lots, GM sells cars to dealers, not consumers.

That's of course the downstream viability story: GM may not have any dealers left, due to the collapse of financing, and they certainly won't have dealers buying cars. Costs cuts can never offset such revenue cuts. Of course if GM goes, and there is a massive firesale, Honda and others will face crisis, too, because consumers will have the choice of a new GM vehicle at 50% off – who knows? – and why in such a situation would you buy a used Honda? or a new one?

Now the upstream parts sector is in as bad of shape, maybe worse. While GM is closed they will be ordering no parts (remember that the factories of parts firms employ about 3x the number of manufacturing jobs at GM and its peers). With no orders, no revenue. Now the strategic imperative for suppliers the past decade was to diversify their customer base. But how can they keep their factories open if Honda and Toyota are 25% of their revenue, and GM and Chrysler 75%? And how can they fund the engineering effort on new vehicle models and basic R&D needed to garner orders for vehicles launched in 2012 and 2013, when sales will hopefully have rebounded? I don't think they can. My own feeling is that the downward spiral is not letting up. The tide is still building, and the whirlpool is getting harder to escape.

So, even if a bailout is arranged that temporarily keeps GM out of bankruptcy, if the downstream and upstream both collapse, well. I want to avoid thinking about what that might look like, and how the industry could start up again. But my quick attempt to follow the money suggests it's flowing down the drain, and the flow is slowing to boot.

thanks to DR and JJH and TK for stimulation

I will try to add numbers later

Back to the Beginnings

Well, today came the first steps towards the de facto reorganization of GM without going through the de jure process of bankruptcy court. The game has switched from softball to hardball ... squash. No more finesse, whoever has the most power wins. It's not GM's bondholders and it's not the UAW. But it may be the collapsing economy that proves the most powerful, not the Obama administration.

Arguing that issue will take time -- my outline is 5 single-spaced pages, not the sort of thing for which a blog is suited. Instead let's do a little applied IO (industrial organization), beginning about a century back. The auto industry evolved in a manner familiar from that perspective, at least in its stages if not the overall process.

After the formative years of playing with multiple technical standards and marketing strategies, as well as corporate structures, Henry Ford latched onto a combination that worked. He assembled parts and sold his Model T to dealers, collecting money up front, and paid suppliers in arrears. Vanadium steel alloys and ultimately the moving assembly line enabled him to push down the weight of his car, and up the speed of assembly. Inventory turns, all that -- though since the old man hated accountants, there are no books to trace the financial evolution of the firm. In any case, he soon dominated the market, in the US, in Europe, in Asia.

Now Henry owned the firm, or at least he did after forcing out the other shareholders, something he'd done twice before in the forerunners to the Ford Motor Company. (He was not a nice man.) No one could dissuade him from his policy of ever-lower prices as he improved the basic model and (for many years running) lowered his costs. But there was a bottom to how low he could push costs, and others began attacking his position from upmarket. GM succeeded, and the Model T began a gradual decline, until in 1926 Ford was forced to pull it from the market while he rushed the development of the Model A. By the time he launched it in 1927, Chrysler had also emerged as a player. Monopoly power made Henry insensitive to the shifting market, and the lack of outside shareholders meant there was no restraint on his whims. Ford was free to give away market share; if he wanted to bankrupt his firm, that was his business.

Fast forward 50 years for a variation on that story, to which I will provide another spin. From the early 1950s into the early 1970s GM was the dominant firm in the US auto industry (and with the exception of Japan, number one or two in the markets that mattered outside the US). For twenty years running it was the most profitable manufacturer (and often the most profitable firm) in the world, earning a 20% return on assets. But with just over 50% of the US market, antitrust considerations constrained additional expansion; it had to allow Ford and Chrysler a share of the market. Through price leadership it could nevertheless coordinate pricing policy with them; its economies of scale were considerable, and it was the low cost producer. The other two firms thus wanted to avoid a price war; though they could set prices below GM's umbrella, they could not be unduly aggressive.

Eventually such high profits did encourage new entry. Via imports the Scandinavians had a modest presence, as for a while did British, Italian and French firms. Of course there was also American Motors, an amalgam of US firms that emerged -- or rather merged -- after WWII. More successful was the German firm VW, particularly when a fad for small cars swept the US in the late 1960s, making the Beetle a hit. But as had happened in the late 1950s, the small car fad passed and the market for that low-profit segment shrank. Detroit was relieved, because if they all entered, it would have been a bloodbath: flooding the market with low-margin products was not an attractive business proposition. When there was another swing towards small cars in the late 1970s, following the first and especially the second oil crisis, VW stumbled and it was Japanese firms that captured the small car market. Again, the Detroit Three wisely sat on the sidelines. But US government policy worked against GM and the others. Ronald Reagan's VER ["voluntary" export restraint] policy effectively asked the Japanese government to organize a cartel to raise prices in the US. Carter's CAFE [corporate average fuel economy] standard and the earlier Clean Air Act bolstered the position of these new entrants, because they favored small cars and imports. The profits of the VER and the breathing space of other policies gave the Japanese time to build a distribution network and to move upmarket. We know the rest of the story.

Back to substance: over the next quarter century GM steadily ceded market share to these and other entrants. (At present 14 firms assemble vehicles inside NAFTA -- ignoring equity ties, two are Korean, three German, three are Detroit-based, and six are Japanese.) Doing so was rational. GM could have lowered profits to preserve share. But why should it do so when it was so dominant? The modest increment garnered by the new entrants was no more than a burr on its side, and shareholders would rightly have screamed if it gave up its bounteous profits that it earned on its 50% share of the market in an effort to scare off these entrants. Henry Ford was irrational in his strategy. But GM was rational in its refusal to fight. Making way for fringe firms to enter the market is the only sensible strategy for a dominant firm.

Eventually a dominant firm thus will cease to be dominant. So it was with GM, though it hung onto the most profitable segment, light trucks, and did well thereby. That would be the end of the story if downsizing was easy in the auto industry. Even then it might not have mattered had GM not had to shoulder pensions and especially healthcare obligations for its increasing numbers of retirees. Such aspects must await another post.

Let me reiterate the central point. GM's management certainly made many mistakes. This included such bone-headed investments as Saturn, billions spent on automation and other hoped-for "magic bullets" that ignored basic operational competence, and an overarching role for people with a background in finance rather than manufacturing, engineering or marketing. Nevertheless its core strategy was consistent with earning high levels of profits for its shareholders. Indeed, it was sufficiently successful in this that going into the current recession it was Toyota that was mimicking GM in its strategy in North America, rather than the other way around. Another year or two of breathing room would have made all the difference.