Sunday, November 18, 2007

Calculating Inflation

The John Mauldin newsletter this week makes me wanna go "Anarchy burger! Hold the government..." (just like the good old punk rock days, pat on the back for those who know what I'm talking about, although this might be too old school and before they wuz cool HAHA)

It's intriguing to read things from those who have been around in the markets long enough to comment on how the "good old days" differs from the "brave new world". John Mauldin is always very good at this, and he does it like a true straight-talking Texan who never tries to bedazzle an audience with unnecessary detail and technical language. There's a reason why poor people have been finding it harder and harder to survive in this country while official statistics continue to suggest nothing out of the ordinary. This article is fly, and it will teach you a thing or two about the obfuscation in government statistics (Inflation figures emphasized)... especially if you are contrarian, and perhaps by nature are disinclined to believe politics and politicians, then it will make you quite dandy, and gives you something to be politically incorrect with at dinner parties and cocktails.

That one paragrapher, about shifting from the fixed basket arithmetic calculation of CPI, to the variable basket geometric calculation--and the relationship between that decision and how much politicians wanted to lower social security and welfare payment burdens... sure seems to make sense!


How do You Spell Stagflation?
November 16, 2007
By John Mauldin

How do You Spell Stagflation?

I wrote this summer that it was likely that we would see inflation as reported in the Consumer Price Index rise dramatically in the fourth quarter. This is due to the very low year over year comparison numbers of last years fourth quarter. We got the CPI numbers yesterday, and we did indeed see a rather uncomfortable rise in inflation, just as I predicted. "Headline" inflation is at 3.5% over the last 12 months, well above anybody's comfort level, and "core" inflation (inflation without food and energy in the numbers) is at 2.1% over the same period.

It is likely to look worse in the coming months, at least in the statistics. To see why, let's go the table below from the Bureau of Labor Statistics who creates the CPI.

The monthly numbers are the index for inflation. Since the base is from 1982-84, we can see that sometime last year prices doubled over the last 25 years. But it certainly feels like it has been more. We will look at how those numbers are created in a minute, and whether we can attach much credulity to them.

Now, here is what to notice in the table. The number for December is the same as the number for October. Since the beginning of this year we have seen a steady rise almost every month. If you assume inflation is running at 2%, this would mean that the November number would yield a 3.8% inflation rate and would be closer yet to 4% for December.

If you extrapolate the inflation of the past two months for the next two months, that would take inflation slightly over 4% as we go into the next two Fed meetings. Yes, we all know the Fed prefers to look at core inflation, but at some point you do have to pay attention to the headline number.

Today, in a speech in New York, Federal Reserve Governor Randall Kroszner said policy makers probably won't need to reduce interest rates further to help the economy weather a "rough patch" in the coming year.

"The current stance of monetary policy should help the economy get through the rough patch during the next year, with growth then likely to return to its longer-run sustainable rate," Kroszner said. Data consistent with such growth "would not, by themselves, suggest to me that the current stance of monetary policy is inappropriate."

The risks are roughly balanced between inflation and growth in his opinion. However, futures prices still suggest that the market expects an 84% chance of a rate cut at the December 11 meeting.

Cooking the Inflation Books

Just for the record, I want to state that I know as does nearly everyone else who pays attention to the CPI statistics that they are bogus. They do not reflect the real world that you and I, gentle reader, live in. So, while it may look like I take them at face value, I do so only because the Fed pays attention to the number, (nod, nod, wink, wink) and makes policy based upon it. So, let's look at how the calculation of the CPI has been politicized and how much of a difference it makes, and then go on to the expectation for statistical inflation in the near future.

John Williams writes an excellent monthly letter on all types of government statistics called the Shadow Government Statistics at One of the things he points out that during the Clinton administration, the way the BLS calculates inflation was changed. He calculates his own inflation number using the old pre-Clinton inflation model. Using that methodology suggests that inflation is at 7%. And if you use other methods, inflation might even be substantially higher. Look at the chart below.

Since the CPI is used to calculate the increase in Social Security payments and a host of other items, calculating inflation is important. I the early 1990s the arguments in the press was that inflation was over-stated. Michael Boskin, chief economist in the first Bush administration and Alan Greenspan were among the chief proponents for a new methodology of accounting for inflation.

Quoting Williams: "Up until the Boskin/Greenspan agendum surfaced, the CPI was measured using the costs of a fixed basket of goods, a fairly simple and straightforward concept. The identical basket of goods would be priced at prevailing market costs for each period, and the period-to-period change in the cost of that market basket represented the rate of inflation in terms of maintaining a constant standard of living.

"The Boskin/Greenspan argument was that when steak got too expensive, the consumer would substitute hamburger for the steak, and that the inflation measure should reflect the costs tied to buying hamburger versus steak, instead of steak versus steak. Of course, replacing hamburger for steak in the calculations would reduce the inflation rate, but it represented the rate of inflation in terms of maintaining a declining standard of living. Cost of living was being replaced by the cost of survival. The old system told you how much you had to increase your income in order to keep buying steak. The new system promised you hamburger, and then dog food, perhaps, after that.

"The Boskin/Greenspan concept violated the intent and common usage of the inflation index. The CPI was considered sacrosanct within the Department of Labor, given the number of contractual relationships that were anchored to it. The CPI was one number that never was to be revised, given its widespread usage.

"Shortly after Clinton took control of the White House, however, attitudes changed. The BLS initially did not institute a new CPI measurement using a variable-basket of goods that allowed substitution of hamburger for steak, but rather tried to approximate the effect by changing the weighting of goods in the CPI fixed basket. Over a period of several years, straight arithmetic weighting of the CPI components was shifted to a geometric weighting. The Boskin/Greenspan benefit of a geometric weighting was that it automatically gave a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price.

"Once the system had been shifted fully to geometric weighting, the net effect was to reduce reported CPI on an annual, or year-over-year basis, by 2.7% from what it would have been based on the traditional weighting methodology. The results have been dramatic. The compounding effect since the early-1990s has reduced annual cost of living adjustments in social security by more than a third."

Then to confuse the process even more, the BLS uses something called hedonics, from the root word hedonism. Essentially, the adjust the price of an item based on the "pleasure" or increased value you get. Thus, they don't price automobiles based on the sticker price, but on what you get for your money. If the manufacturers load in more items like new electronics or anti-locking brakes that were not standard the year before that means you are getting more value for your dollar, so therefore the price in terms of inflation goes down even though you may be paying the same or even more to get out of the car show room.

The same is true for computers. We clearly get more power every year, so for the BLS the price of computers are going down, although it seems to me that the price I pay for a top of the line computer is about the same as it was five or ten years ago.

If the government mandates an additive to gasoline that costs 10 cents more, that is not included in the inflation numbers, because we get a new, improved gasoline that pollutes less. Supposedly the pleasure of breathing cleaner air reduces the costs to our pocket book, or something like that.

My health insurance costs have tripled over the last ten years, and I know that is the experience of many of my readers. Yet, the BLS has medical costs rising by less than 50% for the last ten years. Their data suggest the cost of housing has risen by about 30% over the last ten years. Again, that is not the experience of many of my readers.

Social Security expenses are $657 billion per year. If Williams is right (and I think he is) that under the old methodology that expenses would have risen by a third, then that means we are spending $200 billion a year less. Add $200 billion to the deficit. And then watch politicians panic.

I am not one to suggest conspiracy, but if the CPI reflected the real world, the US government would be spending far more money on Social Security and a host of other pension programs. The crisis we will be experiencing in about 8 years would have already hit us. Thus, there was an incentive for leaders to find economists who could argue for new, more "progressive" methods for calculating inflation. Notice that this was done by the BLS without any protest from Congress.

None of this was done behind closed doors. The BLS, to its credit, is extremely open about how it calculates CPI, and you can get an enormous amount of detail on their web site about prices of things like tomatoes in very part of the country going back for decades.

But the way we calculate the CPI is not going to change. No administration will want to go back and add in an extra 4-5% a year to Social Security and other government pension programs. So, let's return to the prospects for a rise in the CPI in the near future, which will have policy implications for the Fed.

Gaming the Producer Price Index

On Wednesday, we got the Producer Price Index. After the above notes on the CPI, it will probably not come as a surprise that there may be some problems with the PPI. The PPI rather oddly has the price of energy going down in October. PPI is important, as it is in indication of the trend of inflation in consumer prices in the future.

As friend Bill King notes:

"Since June, BLS has energy prices declining in all three PPI stages: finished, intermediate and crude. For June finished energy goods the index is 160.9, for October 159.5; the intermediate prices are 179.9 vs. 178; for crude it's 238 vs. 232.9. BLS has energy prices DOWN 3.64% since July!!

"Oil has rallied from ~$75 to the mid-90s since July 9. Over the same period, gasoline has rallied from $1.95 to $2.35; heating oil has rallied from $2.15 to $2.55; natural gas has fallen from $8.50 to $8.25."

That means that inflation in the PPI numbers may be less than the table below, which is bad enough. Notice the increase in the change of year over year inflation in the index over the last 8 months.

Another table shows "core" PPI, without energy and food, and you find that core PPI is flat. Again, we are seeing almost all of the real inflation in food and energy. But with a falling dollar, do we expect food and energy prices in the US to fall as well, since much of the price of food and energy is determined on international markets?

Consumer Spending is Up, but then Again, It May Be Down

Headline consumer spending came in up 5.2% year over year, which suggest a very respectable growing economy. But retail sales were only up 0.2% in October, which is below inflation. In other words, retail sales fell in October in real terms. But digging deeper into the numbers, we find a problem. Remember food and energy. As Greg Weldon points out, it is unlikely that US consumers bought 16% more gasoline than they did last year. The increase in spending for gasoline was all related to price. Ditto for food.

John Williams says the same analysts who want to use core inflation should also use core retail sales. And if you take out food and energy from retail sales, you find consumer spending to be flat in October. There were multiple categories like home furniture, music, electronic games, etc that were in outright declines. Most interestingly, online sales actually dropped last month. Annual sales growth dropped to its lowest number in years.

FedEx warned today that its earnings would be down due to fewer shipments and higher energy costs. The number of containers coming into the US is down. Retailers are expecting a very modest Christmas season.

So, we come to the question: Is the economy slowing and thus the Fed will cut, or is inflation rising which will force the Fed to sit tight?

A Two Dimensional Problem

I recently spent some time with the very brilliant Columbia Professor Graciella Chichilnisky (the economist whose work created the carbon credit markets, among other things). We got to talking about the problems the Fed is facing, and she gave me a very interesting insight from a paper she had written a few years back. I am going to try and re-create it, though I am sure I will take some of the potency away in trying to put it in my simple terms.

Assume that you have an individual living in a two dimensional world. For them there is only length and width, but no height. Then let's draw a line between two exactly opposite points above and below that two dimensional world and connect them with a line. At the precise point where the lines meet in the two dimensional world, to the individual in that world, it appears that both points are exactly the same. Two things which would clearly be opposite to anyone living in a three dimensional world would be equal in a two dimensional world.

The Fed faces a problem something like that. They are living in a two dimensional world, working with two dimensional tools (they can cut rates or raise them) but the problems they face are multi-dimensional.

If they cut rates, the dollar will fall and import prices rise, and it will also likely have negative effects on food and energy prices. If they do not cut rates, the markets will simply throw up as it will interpret that as a Fed which is not concerned about a slowing economy.

Not cutting rates risks an economy that could easily slip into recession due to a growing risk of a credit crisis turning into a credit crunch. Usually, that means that inflation will fall. Usually, but not always.

The Fed is faced with a problem I predicted four years ago in this letter and in Bull's Eye Investing, as the Fed dramatically eased monetary conditions in an effort to fight deflation. In a word, stagflation. That terrible moment in time when an economy slows (is stagnant) yet inflation is high, limiting the monetary authority's ability to act.

With a clearly slowing economy, a credit crisis, and rising inflation, they have no good and clear choices. Whatever they do is likely to create problems in a multi-dimensional real world. I still think they cut, as core inflation is still close to their comfort zone. But if core inflation starts to rise, they will have to act. Or at least should.

Saudi Justice

I usually avoid controversial matters, other than economics and finance, but I came across a story which I think deserves attention. It seems that a 19 year old young lady in Saudi Arabia was gang-raped by six armed men. They got between one and five years in prison. Because she was in a car with a man who was not related to her, she was given a sentence of 90 lashes. Because she appealed and a higher court ordered another trial, the court then more than doubled the sentence to 200 lashes.

"A court source told the English-language Arab News that the judges had decided to punish the woman further for 'her attempt to aggravate and influence the judiciary through the media.'" Her lawyer had his credentials removed for defending her. This is simply barbaric. It is an affront to any civilized thoughtful person. Where are the protests? Are we to believe that the Saudi royalty condones such acts?

I hope that other writers will use this in their letters.

New York, Toronto, Europe and Thanksgiving

This week I had to take a quick one day trip to Toronto. Changing my ticket ended up costing me six times the original round trip ticket. To add insult to injury, I got in a taxi at the Toronto Airport. It used to cost about $50 Canadian dollars to get a ride to downtown. The price has risen to $60 and then throw in a $10 tip. A few years ago, this would cost me about US$35. Today it was $70. I offered the taxi driver 3 twenty dollars bills and a tip, but he pointed out that the exchange rate made my US$60 only worth about Canadian $55. Sigh.

I am going to have to go to New York again in a few weeks to attend the Minyanville BBQ picnic and charity fundraiser. South African business partner Prieur du Plessis will be there, but I am going because his wife Isabel has demanded my attendance. And a European trip late in January is shaping up.

There will be no Thoughts from the Frontline letter next week, as it is Thanksgiving, and I am going to take the day off and spend it with the kids. They are all seven coming back home. I know that it will not be too far into the future when they are going to get scattered and having them all under one roof at the same time is something to be savored. I will make prime and smoke turkey, with mushrooms and all the fixings. I do so love Thanksgiving. Friends and family, food and Cowboys football, great wine and laughter. It just doesn't get any better.

I hope those of me readers in the US have a good Thanksgiving as well. Have a great week.

Your thinking about how the world will change analyst,

John Mauldin

Friday, November 02, 2007

Wall Street's House of Debt

The Bear's Lair: Level 3 Decimation?

By Martin Hutchinson

October 29, 2007

Martin Hutchinson is the author of "Great Conservatives" (Academica
Press, 2005) -- details can be found on the Web site

There's a mystery on Wall Street. Merrill Lynch last week wrote off $8.4
billion in its subprime mortgage business, a figure revised up from $4.9
billion, yet Goldman Sachs reported an excellent quarter and didn't feel
the need for any write-offs. The real secret of the difference is likely
to be in the details of their accounting, and in particular in the murky
world, shortly to be revealed, of their "Level 3" asset portfolios.

Both Merrill and Goldman have Harvard chairmen - Merrill's Stan O'Neal
from Harvard Business School and Goldman's Lloyd Blankfein from Harvard
College and Harvard Law School. Thus it's pretty unlikely their
approaches to business are significantly different - or is a Harvard MBA
really worth minus $8.4 billion compared with a law degree? (The special
case of George W. Bush may be disregarded in answering that question!)

We may be about to find out. From November 15, we will have a new tool
for figuring out how much toxic waste is in investment banks' balance
sheets. The new accounting rule SFAS157 requires banks to divide their
tradable assets into three "levels" according to how easy it is to get a
market price for them. Level 1 assets have quoted prices in active
markets. At the other extreme Level 3 assets have only unobservable
inputs to measure value and are thus valued by reference to the banks'
own models.

Goldman Sachs has disclosed its Level 3 assets, two quarters before it
would be compelled to do so in the period ending February 29, 2008.
Their total was $72 billion, which at first sight looks reasonable
because it is only 8% of total assets. However the problem becomes more
serious when you realize that $72 billion is twice Goldman's capital of
$36 billion. In an extreme situation therefore, Goldman's entire
existence rests on the value of its Level 3 assets.

The same presumably applies to other major investment banks - since
they employ traders and risk managers with similar educations, operating
in a similar culture, they probably have Level 3 assets of around twice
capital. The former commercial banks Citigroup, J.P. Morgan Chase and
Bank of America may have less since their culture is different; before
1999 those institutions were pure commercial banks and a substantial
part of their business still lies in retail commercial banking, an area
in which the investment banks are not represented and Level 3 assets are

There has been no rush to disclose Level 3 assets in advance of the
first quarter in which it becomes compulsory, probably that ending in
February or March 2008. Figures that have been disclosed show Lehman
with $22 billion in Level 3 assets, 100% of capital, Bear Stearns with
$20 billion, 155% of capital and J.P. Morgan Chase with about $60
billion, 50% of capital. However those figures are almost certainly low;
the border between Level 2 and Level 3 is a fuzzy one and it is
unquestionably in the interest of banks to classify as many of their
assets as possible as Level 2, where analysts won't worry about them,
rather than Level 3, where analyst concern is likely.

The reason analysts should worry is that not only are Level 3 assets
subject to eccentric valuation by the institution holding them, but the
ability to write up their value in good times and get paid bonuses based
on their capital uplift brings a temptation that few on Wall Street
appear capable of resisting. Both Goldman Sachs and Merrill Lynch are
reported to have made profits of more than $1 billion on their holdings
of Level 3 assets in the first half of 2007, for example, profits on
which bonuses will no doubt be paid at the end of their fiscal years.
Given that we have had five good years on Wall Street, years in which
nobody has known the amount of Level 3 assets on banks' balance sheets,
and no significant media waves have been made questioning their
valuation methodologies, it would not be surprising if many banks' Level
3 assets had become seriously overstated, even without any downturn
having occurred.

When Nomura Securities sold its mortgage portfolio and exited the US
mortgage business in this quarter, it took a write-off of 28% of the
portfolio's value, slightly above the 27% of the portfolio that was
represented by subprime mortgage assets. Were Goldman Sachs's Level 3
assets similarly value-impaired, it would result in a $20 billion
write-off, more than half Goldman's capital, leaving the bank severely
damaged albeit probably still in existence.

Defenders of Goldman Sachs and the rest of Wall Street will insist that
less than 27% of their level 3 assets are represented by subprime
mortgages yet that is hardly the point. Subprime mortgages, estimated to
cause losses of $400-500 billion to the market as a whole, though only a
fraction of that to Wall Street, have been only the first of the Level 3
asset disasters to surface. There is huge potential for further losses
among assets whose value has never been solidly based. These would
include the following:

* Mortgages other than subprime mortgages. With the decline in
house prices accelerating, the assumptions on which even prime mortgages
were made are being exposed as fallacious. As house prices decline, debt
to equity ratios increase, and for mortgages with an original
loan-to-value ratio of 90% or more quickly pass the 100% at which a
mortgage becomes uncovered. If the value of conventional mortgages
decline many securities related to them, currently classed as Level 1 or
2 assets, will become un-marketable and descend into Level 3
* Securitized credit card obligations. $915 billion of credit card
debt is currently outstanding, the majority of it securitized, and its
default rate is likely to soar as the full effects of the home mortgage
market's crack-up spread to the credit card area. The risks in Level 3
portfolios derived from this asset class arise particularly in the areas
of complex derivatives and manufactured assets based on credit card debt
* Leveraged buyout bridge loans. After a hiccup in August, the
market in these has reopened recently, although around $250 billion of
them still remains on banks' balance sheets. The value of a leveraged
buyout bridge loan that has failed to find a pier to support the other
end of the bridge is very dubious indeed, even though these loans are
being carried in the books at or close to par. As the value of
underlying assets declines and the cash flow fails to match debt
payments, the deterioration in credit quality of these loans will
* Asset backed commercial paper. The amount of asset backed
commercial paper outstanding has dropped from $1.2 trillion to $900
billion in the last three months. This financing structure was always
unsound; it was basically a means of removing the assets backing the
commercial paper from bank balance sheets, and always faced the problem
of a severe mismatch between asset and liability duration. The $100
billion vehicle intended to rescue this market has found a mixed
reception to say the least. It is likely that as credit conditions
deteriorate, the assets underlying ABCP vehicles will increasingly find
themselves on bank balance sheets, where they will prove to be almost
completely unmarketable.
* Complex derivatives contracts. Even simple interest rate swaps
and currency swaps caused large losses in the last significant credit
tightening in 1994, although most of those losses were suffered by Wall
Street's customers rather than Wall Street itself. The more complex
transactions that have been devised during the last twelve giddy years
are much more likely to prove impossible either to sell or to hedge.
Goldman Sachs reported that in the third quarter of 2007 its profits on
derivatives used for hedging more or less matched its losses on subprime
mortgages. It is likely in reality that the bulk of those profits were
incurred through model-based write-ups of value on contracts that were
within the Level 3 category - after all, Goldman's Level 3 assets
increased by a third during the quarter. It's not much good shorting to
match a long position you don't like if your hedging shorts prove to be
impossible to close out.
* Credit Default Swaps, the global outstanding value of which in
June 2007 was $2.4 trillion, according to the Bank for International
Settlements. These are a relatively new instrument, the efficacy of
which has not been tested in a downturn. It appears likely that the
value in banks' books of their Level 3 credit derivatives contracts
bears no relation whatever to reality. As discussed above, the
incentives have been all in favor of inflating it.

The capital underlying Wall Street, at the top, is not all that large -
a matter of a few hundred billion. Given the piling of risk upon risk
that has been engaged in over the last few years, and the size of the
losses in the mortgage market alone that seem probable - my own estimate
last spring of $980 billion looks increasingly likely to be somewhat
below the final figure - it appears almost inevitable that in a bear
market in which liquidity dries up and investors become skeptical, Wall
Street's capital will be wiped out. Only the commercial banks like
Wachovia and Bank of America whose investment banking ambitions have
been largely thwarted and portfolios of Level 3 rubbish are
correspondingly lower are less likely to disappear.

Given the size of the overall figures involved and the excessive
earnings that Wall Street's participants have enjoyed over the last
decade, a taxpayer-funded bailout of Wall Street's titans would seem
politically impossible, however loud the lobbyists scream for it.

In the long run, that is probably a blessing for the US and world