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The US Follows Japan Into A Balance Sheet Recession: What Do Investors Know and Why Is It That Policymakers Appear Clueless?
BoomBustBlogger and Director of Research at Paisley Financial, Mario Ricchio, writes on the abject futility of QE during a balance sheet recession. That is where I, and he, believe the US and Japan are right now. See my video take on this from a real estate perspective here. You can download Mr. Ricchio's report via this link, but in the mean time I would like to highlight some of the not so common sense remarks that I came across in such.
The report relies heavily on the conceptual framework of a U.S economy in a balance sheet recession. Our main thesis rests on the belief that until U.S households repair their balance sheets and generate real income growth, they are in no position to drive a self-sustaining economic recovery. Monetary policy (including quantitative easing (QE)) produces limited results in generating real economic growth--- since the demand for credit and the lack of qualified borrowers remain the issue not the supply of funds. Instead, expansive fiscal policy, through increased government budget deficits, exists as the primary lever to raise economic activity, transfer real financial assets to the private sector, and ease the pain of the deleveraging cycle.When the U.S housing bubble burst, the effects reached far beyond the decline in home prices and in construction-related employment. The nature of the economic landscape changed. As home values began their descent in 2006 against a backdrop of record mortgage debt, household net worth plunged primarily through a loss of home equity (see exhibit 1). Consumer attitudes shifted from conspicuous consumption to frugality. After several decades of leveraging up the balance sheet and living beyond their means, households started the process of deleveraging characterized by: debt minimization and reduction, increased personal savings, and lower consumption (see exhibit 2). The balance sheet recession commenced and how we look at the economic cycle must change.
THE PRECURSOR TO A BALANCE SHEET RECESSION
A debt-financed asset bubble precedes a balance sheet recession. Consequently, we begin by paraphrasing the thoughts of legendary hedge fund manager, Ray Dalio, on the cycle leading up to the collapse. A healthy economic expansion starts with a private sector (corporate or household) agent holding minimal debt. The private sector begins to see income rise at the pace of GDP. At this stage of the economic expansion, the majority of aggregate demand comes from cash-based income.
For example, let’s assume the private sector spends $1,000 of cash income (which contributes to the economy); now someone else has $1,000 of income. As the economy expands, the private sector feels more optimistic and decides to leverage up the balance sheet by going to the bank and borrowing $100 per year against $1,000 of income....
FEATURES OF A BALANCE SHEET RECESSION
DEBT MINIMIZATION
Since asset prices decline (eg. house prices) well below the value of corresponding liabilities (eg. mortgages), balance sheets become impaired (eg. negative equity or negative net worth). In order to repair balance sheets, the private sector moves away from profit maximization to debt minimization2. The deleveraging cycle ends up reducing funding needs. Unfortunately, with no borrowers, the economy loses aggregate demand equivalent to the sum of un-borrowed savings and debt repayment3 . Even in a zero interest rate environment, the private sector refrains from taking on added liabilities (see exhibit 3). This outcome renders monetary policy ineffective by creating a liquidity trap.
On this very salient point, I must chime in with my own analysis and opinion...
September 1st, 2007: The very first post on BoomBustBlog tells the whole story for the next 6 years!
Thoughts on the US Publicly Traded Homebuilders - BoomBustBlog
I noticed that many pundits are focusing on single family residential market, most likely because it is in the news so often. It is bad, very bad. I am an ex-residential real estate investor who sold off in 2005 due to fundamentals that were totally out of whack. It appears that many do not see how precarious the commercial sector has become, with many deals being done at 2-5% cap rates (net profit yields) in Manhattan and many major metro areas, which is absolutely ridiculous considering the risk and illiquidity of these deals. The compensation for these deals are coming no where near justifying the risk. I am sure the excessive liquidity coupled with significant demand caused the cap rate compression, but the buyers fell for it assuming liquidity and demand would continue for some time. Well, corporate liquidity has just dried up, and many are stuck holding the bag with buildings that are yielding as low as half that of treasuries, yet easily quadrupling the risk. Some are even selling at lower cap rates in successful flips (reference the Blackstone purchase of Sam Zell's portfolio, which was totally overpriced, yet Blackstone managed to flip much of the portfolio over to speculators, some of which actually flipped it over to someone else at a profit – ALL in a period of a few months). This has now become nigh in impossible, but in an attempt to raise the cap rates, commercial rents have skyrocketed to all time highs in the major metro areas, causing significant pressure on corporate profits (I have inside knowledge of this affecting MAJOR public and private firms who are looking to expand and are getting squeezed).
And now, on to small residential (single family and 1-4 family residential)…
For those who really have a life and do not have the time to read building company annual reports, here is a bullet list of tidbits that all will find interesting, particularly in light of today's mortgage environment (pardon if their is info that you are already privy to, this is a comprehensive summary, but I am sure everybody is to find something that is of illuminating):...
_________________________________________________
Reggie's grassroots analysis:
The S&P index severely understates the glut in housing and the downward pressure on pricing. It uses the repeat sales methodology which only includes houses have that have been sold at least twice, which excludes all new construction. So the homebuilder’s product which is being slashed in price with butcher knives and cleavers don’t even show up in the index, and these homes must be slashed enough to sell in a slow market that no longer has cheap credit, has much competition in excess supply, and no longer has the phantom appraisal pricing which helped sustain the bubble in the first place (more on this later).
The index also fails to include anything but single family detached and semi-detached housing, so coops and condos aren’t included in the mix. This means that areas like Manhattan and Brooklyn, South Miami and Las Vegas, DC and Cally are severely under counted. The mere act of excluding condos (the worst victim of boom time speculation) instantaneously makes things look a lot better than they are.
Also excluded are properties who experienced larger than median jumps in pricing, which where considered to be investor properties (benefiting from significant renovation in anticipation of resale). Investor properties constitute a very significant amount of the current prime and sub-prime defaults now.
Mentioned earlier was the push from appraisers eager to win new business. In the residential investment game, you (as in bank, mortgage banker, mortgage broker, real estate broker, investor, seller, and everyone in between) push the appraiser to come in with the highest value possible to allow you to a.) get the biggest loan possible, b.) obtain the most preferential pricing/terms (lower LTV) possible, c.) get as much from the sale as possible, or d.) all of the above. In the comparable valuation game, you pick comparables and adjust them for particulars to come up with a valuation. Once that inflated value is actually recorded in the city register, it's inflated value is used to further hyper-inflate other deals, and the upward spiral continues. The appraiser, in the boom times, picked the highest prices (which were inflated) to get a highest price (which itself was inflated) that is added into the records to make (guess what???) higher prices. Throw the petrochemical fuel of very cheap money and easy credit NINJA loans and it is easy to see how this housing boom was more than a boom, it was a speculative explosion in real asset prices that usually average 1%-3% a year in appreciation doing about 12%-100% in many places.
The caveat is, this works both ways. When the appraisers get busted for being too aggressive (and threatened with litigation and discipline - if you read the articles, they have been passing the buck saying they were pressured into inflating numbers) they start getting overly conservative and do the opposite. The banks also stop looking the other way since they may actually have to use their own money to fund/keep these loans instead of the OPM method of MBS/CDO fame. So now, the guys are looking for the lowest average prices in an attempt to be conservative, and the process reverses itself.
Now, we haven't even gotten to the commercial sector yet, where the real money is thrown around. Speculation and credit underwriting lite is coming home to roost in a sector near you.
October 2007
Straight Talk From the Homebuilder CFO: The Coming Land Recession, Pt IThursday, October 11th, 2007
December 2007
Do you remember when I said Commercial Real Estate was sure to fall?Thursday, December 20th, 2007 by Reggie Middleton
My first post on my blog in September warned about the coming drop in real estate prices. I revisited the topic a couple of weeks ago, as I prepared the research of a short position in the sector. Well, we are almost done with the research and the position and I will release a summary of the research and the performance (expected and actual) of the position after Christmas.
Check this out from January 2008
The Commercial Real Estate Crash Cometh, and I know ... - BoomBustBlog
A couple of weeks ago I informed BoomBustBlog.com readers that I was working on a big project concerning commercial real estate short candidates. I stated last year that I was sure CRE was headed down, hard. Well, I am now ready to start releasing the results of my research over the next week or so. Unfortunately, the market has moved against the subject of my research fiercely as I was completing it, but it appears to be far from over. Who is the subject of that research, you ask? General Growth Properties (GGP). I have actually seen this company pop up in the media and a few discussion groups from time to time, but they have no idea what the management of this company has been up to. First, a little background on how I got here. Those who are not versed in commercial real estate valuation are urged to read my quick and dirty primer on CRE valuation .
I told members of my analytical team to screen the commercial real estate trust, service, and development sector for the usual suspects, starting with the the guys that purchased Sam Zell’s flipped properties from Blackstone. I made some of the companies available via blog post and download: 
Commercial Real Estate Cos. (43 kB). Forest City Enterprise Peer Comparison (198.98 kB), Vonardo Realty Trust (146.49 kB). After and exhaustive screen and resultant short list, we chose GGP. I then instructed the team to canvass local and national brokers (4), databases (5) and data aggregators (several) to get the most precise localized rental and expenses figures possible. This data, as well as purchase dates, prices, management actions, capital improvements, etc. were used to plug into models such as this 33 page illustrative example, 
GGPs Woodlands Village (612.34 kB), to ascertain the true value of GGP’s portfolio. We also measured and valued their development operations, joint ventures, CMBS financing, off balance sheet vehicles and master planned communities. Sum total, I now have roughly 2 gigabytes of “REAL” valuation data on my servers covering 260 properties owned or partly owned by GGP. A this point, I may know more about their operations than they do.
What is more telling is the window of understanding this opens into the commercial real estate space in the US. It is my opinion that most are extremely over-optimistic regarding the prospects for this space.
And here we are Now, in 2011...
The “American Realist” Says: Past as Prologue – Re-blown Bubble to Pop Before the Previous Bubble Finishes Popping!!!! Wednesday, May 18th, 2011
In the post that followed said appearance, Reggie Middleton ON CNBC’s Fast Money Discussing Hopium in Real Estate, I ran down what I perceived to be the major risks of real estate in the states today, and that is a departure from the fundamentals and bleak macro outlook. During the Q&A at Roubini's crib, where I was actually guilty of accusing Nouriel of being too optimistic (I know, that's probably a first - but if anyone were to do such it would probably end up being me), participants were suggesting in a rather optimistic fashion that if a hard landing or recessionary environment were to come it would presage a time to buy assets at value prices. Of course, that is assuming those assets that you got very cheap didn't then proceed to get much cheaper. Nouriel replied exactly as I would have (and have in the past, particularly during my Keynote at the ING Valuation Conference in Amsterdam), and that was that it simply cannot taken as a given that assets prices will cyclically snap back in a year or even two. Now, I do have an investment strategy that I plan to pursue in regards to real estate, but it is quite different from what I see being bandied about today and over the last 8 years or so. To wit (as excerpted from the link directly above):
... It is the reporting company’s responsibility to report, not to obfuscate. The big problem with this “hide the market marks” thing is that markets tend to revert to mean. Unless said market values fundamentally catch up with said market prices, you will get a snapback. That is what is happening in residential real estate now. That is what happened in Japan over the last 21 years!!! That’s right, it wasn’t a lost decade in Japan, it was a lost 2.1 decades!
This has been the first balance sheet recession that the US has ever had, but there is precedence to follow. Japan had a balance sheet recession following their gigantic real asset bust. They made a slew of fiscal and policy errors, which essentially prolonged their real asset recession (now officially a depression) for T-W-E-N-T-Y O-N-E long years! For those that may have a problem reading that, it is 21 long years.What did the Japanese do wrong?
- They refused to mark assets to market
- They attempted to prop up zombie banks
- They failed to promptly clean up NPAs in the banking system
- They looked the other way in regards to real estate value shenanigans
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He definitely seems to know his stuff when boxed into the housing market. However, he regurgitates the same "We're exactly like Japan! We are going to be A-okay(after a little deflationary pain)!" argument when looking on the larger scale. Japan ran an account surplus, a massive one. America runs an account deficit, a massive one. Granted, being the reserve currency basically grants you the right to run a deficit without failing. However, the odds of that being worth around $5T per year is laughable.
I go back to the same "He is arguing over what color they should paint the kitchen while the house is burning down" example. It just doesn't matter what the housing market does at this point anymore than it matters what new product Apple introduces at this point. History is littered with examples of how this ends. History is littered with "experts" who explain how this time is different. History is littered with examples of how the hyper currency devaluation takes time to truly play out.
But, again, he knows his stuff when it comes to the housing market. Oh, and he made a great call on RIMM before anyone was on that bandwagon.
I'm goona watch for you; apparently you're paying attention. always a dangerous tendency. No, serioiusly. agree. The bows are 15 degrees down in that cold, cold, Atlantic; and we're supposed to have a support group to discuss whether this resembles the SS Carpathian; I don't think so. Fucking thing is made of steel and it's filling up with water; you discuss the details, I'm oughta here.
"Japan" is a country; whatever that means. It has "people:". Aside from that t here is absolutely nothing in common with the US. Nothing. There is nothing to be gained by studying this "comparison". Reggie is a good guy, he's giving 'em hell over the on going bullshit in real estate, and commercial real estate; this kind of comparison is like honey for the human mind; people just do it naturally; but there's nothing there. If you want to understand the US situation study the real history of the US and the real statistics of the US. Let the Japanese worry about Japan.
This biggest difference between Japan and the USA is Japan cares about employment while it is an historical axiom that leaders here could give a rats ass about "jobs jobs jobs." thats y we r so worse off in a policy sense than japan. I will be watching the price of farm commodities very closely over the coming weeks to see if the depression paradigm is about to be confirmed. If corn drops say 50 percent in that time then indeed its full on Hoover.
Reply for Reggie; my bud. Hey, Reggie, these are awful easy questions, dude. What do Investors know" ans. they don't know shit. "why do policymakers appear clueless"-ans. they are clueless. too easy.
While I agree our monetary policy has been similar to Japan's, I think there is something significantly different than Japan in US policy, which will affect our decline and our recovery, make it different than Japans.
Even while Japan was deflating slowly from real estate bubble and propping up zombie banks for decades their middle class working folks were doing OKAY! Yes they lost real estate wealth, but they had decent jobs and did not have too much personal debt hanging over them. The portion of GDP going to labor was still signficant. So while the things the big money folks and traders look at, the price of real estate and Nikkei kept going down, the standard of living of the Japanese middle class was doing pretty damn well considering.
There are many objective analysis of this easily available on the internet, but I knew it without even looking at numbers by just talking to Japanese civil engineers that work in same industry as me over the last 20 years, by talking to Americans spending time in Japan, and shoot by just looking at the pictures coming from the horrible earthquake and tsunami. Did you see all those nice, new cars. Nice houses, nice infrastructure. Did you see the nice clothes on everyone, including all the old retired people that are legion in Japan. Did you see any red-neck yokel run-down rural areas like we have in SC, MS, AL etc or any ghettos, any ramshackel migrant worker towns like in Inland Empire....just compare diaster photos, conditions of houses, cars from Katrina and from Japan.
In US, the great recession has also been the great de-coupling, the great re-distribution. While it had been already happened, it accelerated in 2008. The few lucky, talented, crooked, extra smart ones, highly educated in right field, whatever, that are rich are getting richer and the regular boring workers that used to make up the balk of the middle class or getting poorer. And the sanitation workers that used to be make enough to buy a house and raise a family of four without wife working are now Latinos that MSM pretends does not exist, but the are American poor...the butchers at meat plants that used to be well-paid mostly white guys are now "unseen" poor Latinos working their butts off to barely survive. We have so much more poverty amony working people than before, jobs that once gave one a middle class life style now just barely feed the family, and yet it is ignored.
Our GDP and bank policy and real estate price trajectory may be similar to Japans, but I think the distribution of that GDP amongst the population will cause us to be different...US consumers over next 15 years will in no way be like the Japanese consumer over the last 15.
Japan did suffer on many macro economic fronts, and they made mistakes and have some corruption also, but overall, as a civil engineer, even with our housing bubble occuring during their continued real estate deflation, I would have far better off as a civil engineer in Japan than in US, as many middle class Japanese in general were
http://seekingalpha.com/article/288071-the-myth-of-japan-s-lost-decade
http://www.theatlantic.com/international/archive/2011/02/the-myth-of-japans-lost-decades/71741/
a counter point
http://www.forbes.com/sites/johntamny/2011/04/23/the-myth-about-the-myth-of-japans-two-lost-decades/
Great analysis, Moneymutt. Always enjoy your posts. I think you hit the nail on the head with this one. Europeans are similar to the Japanese. There is just not the kind of poverty there that one sees in America. Counterbalancing the American dream is always the American Nightmare that haunts just about anyone who depends on a salary.
maybe I'm projecting, but I think Americans are, in general, less secure, than middle class in Europe and Japan on average, what that translate to in macro-economic trends, I know not, but its got to make a difference....I guess we have an upside from the fact few make it but really every country has rich of some sort, I'm not seeing how they lose out on innovation or inspiration of high life.
I think we have two basic models to chose from, those provided by Japan and Germany and the like, that have very competitive high end exports, succesful businesses even while their workers make good wages/benes, their govt provides good social services, education is available to all, and they have plenty o regulations, envrionmental rules, .....or we could go the third world route (which I don't even count China in anymore), make our products competive internationally by keeping wages low, and encouraging businesses to come here or stay here limiting regulations, allowing lots of corruption by eliminating policing of fraud, white collar crime, keeping taxes low, and allowing them to pollute....I think its pretty obvious we have opted for the latter, while Japan and Germany, inspite all the hits they have taken, have done really well for their regular folks by going for the former.
The difference between the US and Japan? We have minorities sucking away energy...they don't. We'll crash and burn because we have no national cohesion. 1/4 of our population are ingrates, leeching ingrates. That's the difference between us and Japan and why they made it and we won't.
My other comment is sarc on/sarc off in case anybody was wondering.
Of course Japan has minorities...its population is nearly 100% Asian!!! Or did you simply (or simple-mindedly) mean "people who look different than me"?
Reggie Middleton might be a great analyst, he says he is, but I sure wish he could write.
Time is precious. The blather, unreadable script and self promotion make reading his stuff absolute Torture.
Maybe someone else could translate into 10 easy points?
With all due respect, the subject is complicated, the subject is important, and yes, time is precious.
If you have comprehension problems, why would anyone bother wasting their precious time trying to condense this down to pablum for you?
Reggie has made money for a lot of folks on this blog, and kept others from losing even more...at no charge, thank you very much.
Some of us even enjoy his writing - even his self promtion is fun. Someone once said "it ain't braggin' if you can do it", and that saying often comes to mind when I read Reggie's post.
Keep up the good work, RM, and thanks for sharing!
I've felt the US would mimic Japan when the real estate mess began to unfold in 2007. The economy was falsely propped by real estate for too long. New areas of growth are required (i.e innovation). But even this will be difficult given the ease of transferring (& copying) means of production. Silicon Valley cant save the US this time around. Japan suffered from anemic growth prospects and so is the US. But they are trying the same ineffective methods to resolve the situation. It will fail.
herd Obama wants Americans to refinance their home loans held by fannie/freddie to 4% and get loose
.
thats alot of money
nice work RM. And adding insult to injury, Florida homebuilders are building and trying to sell NEW HOMES in the midst of HUGE existing and shadow inventory. I guess the adage "a sucker is born every minute" is as true today as it has ever been!
When P.T. Barnum said that, world population was ~1 billion. Now at 6 billion, it would be logical to say 6 suckers born every minute, yes?
Or even 6.94B minutes
http://en.wikipedia.org/wiki/World_population
A lot of people aren't going to make it through the next 20 years I'm afraid.
Reggie, gloomy stuff indeed. If RE prices continue to slide, which we all believe they will. Buying that chalet in Tahoe will be within my grasp in 10 years if my USD still buys anything. Hopefully our currency will be the new Yen after the Euro implodes and I can use it all to buy up hard assets before it goes the way of the Zimbawian dollar.
Reggie hits it on the head. This trend is going to continue for a another 3 to 6 years if you look back on other house bubbles. The fed is prolonging the problem. Sooner or later we must pay and the longer this goes on the more we are going to pay.
Correct me if I am wrong but the Fed paid off the toxic mortgages that were held at the banks when this started. So we bailed out the banks, paid off the mortgages and now will go after the homeowners to redo their mortgages and pay them yet again. What a racket. They just need to leave the market alone let those fail that are going to fail and move one.
Never going to happen. They just want my grand daughter to pay for it, the traitors.
blah blah blah blah blah let's get this pos market back to 1250 so we can short the fk out of it again.
hamp hump chump dump, .....another program,
more schtimulus,
more fraud,
let them eat houses.
good stuff!
Coupled with Peak Energy which will create a hard ceiling for any recovery to take off. Once a recovery happens and demand for energy increases the price will rise as it did in 2008. Then the economy will tank again due to increase input costs for everything.
However, the money needed for large scale, comprehensive energy exploration only comes when the price of energy rises. A real catch 22.
Welcome to the collapse.
Welcome to the rebalancing.
At least the Japanese encourage hari-kari by the political bosses. Coming up will be Premier #8 in the past five years. They all have ideas and no solutions. So 33% underemployment is the new normal.
This is not Japan. This is America. We never change horsemen in the middle of an apocalypse.
Their squires though, come and go as needed. Especially ones of the economic variety.
We are Japan, with a reserve currency that is going to die.
Can you say "liquidity trap"? I knew you could. Yes, ignoring food and fuel, deflation will reign, just stop eating. FUBAR, SNAFU, etc.