The following commentary comes to us courtesy of Annaly Capital Management’s CEO Michael Farrell:
The title of my remarks today is taken from one of the most beautiful and mysterious passages in the New Testament, 1st Corinthians Chapter 13, verse 12. “For now we see through a glass, darkly; but then face to face: now I know in part; but then shall I know even as also I am known.” In the context of the Biblical passage, the sentence implies that in the present we only can have an imperfect view of ourselves, as if we were looking at our reflection in a distorted and cloudy mirror, and that we will only have complete self-awareness in the fullness of time. While we may have debates over how this applies in a theological context, I believe this concept of knowing the truth about ourselves now and in the future resonates in an economic sense as well.
In an economic context, this struggle for self-awareness is best summed up by Milton Friedman’s so-called Permanent Income Hypothesis, published in 1957, which in essence holds that people tend to make consumption decisions in the future based on what they consider to be permanent income today, and that any temporary windfalls, like lottery winnings, inheritances or checks from the government, will be disproportionately saved. Moreover, permanent income is based not just on current income but also on expectations for future income. Friedman concluded that lower wage earners, who typically have less transitory income, such as big bonuses or tax refunds, actually have a higher propensity to consume because their expectations can be more easily set by their current income. Higher income earners, in contrast, have a lower propensity to consume due to the more transitory aspect of their current income.
To me, in adapting Friedman’s permanent income hypothesis model to current economic conditions, the key determinant of consumption is an individual’s real wealth, as opposed to his or her current real disposable income. Even today, the vast majority of real wealth on the US consumer’s balance sheet is real estate which, in the post-War era, had generally always gone up in value. Permanent income is determined by a consumer’s assets; both physical assets like stock, bonds and property, and human assets like education and experience. The constant ebb and flow of these assets influence the consumer’s ability to earn income. Once a consumer makes an estimation of anticipated lifetime income, spending patterns emerge across the different needs and incentives available in the economy.
Today, this perspective on current income has proven to be nothing more than a reflection in a distorted mirror. While asset values were rising, households were fooled into thinking that the transient was, in fact, permanent, and they consumed accordingly. During Annaly’s earnings calls of 2005 and 2006 we discussed the larger market’s critical error in thinking that home price appreciation and improved debt service were the result of rising incomes and earnings performance rather than poorly underwritten liquidity in both the debt and equity markets.
As every American taxpayer knows, coming into 2005 the bulk of a family’s balance sheet was firmly entrenched in real estate. For most of the past 60 years, the US more or less supported a home ownership percentage of about 60% of the population. In the misguided drive to give the incremental buyer the opportunity to achieve the American Dream, that rate was lifted to about 70%. Not by growing personal income, but rather through creative financing techniques, enhanced through the largest unregulated insurance market in the world, the derivatives market. Since rising incomes did not sustain the home ownership rate, rising risk appetites filled the gap, some by government policy and some by private sector actions.
To demonstrate the distortion that took place in housing, check out Figure 2.1 from the second edition of Robert Shiller’s book “Irrational Exuberance.” Shiller tracked down US inflation-adjusted home prices, building costs, population and bond yields going back to 1890 and it is clear from the data that the 21st century bubble in home prices was caused by something other than supply-demand issues, income growth, expense increases or inflation. It came from debt formation.
Today, in the shadow of de facto unemployment rates of more than 17%, states and municipalities under growing pressure from shrinking revenues are raising taxes and slicing and dicing budgets across the country, impairing the long term growth of income. In the haste to stimulate a stuttering economy the Federal government is setting a course to further impair incomes as the need to service the sharply rising Federal debt will ultimately be met with frozen spending and then rising taxes and fees. In 2005, we described the future crowding out of the private sector with the growth of public sector debt, and we illustrated its distorting effect on economic conditions in our first quarter 2009 earnings call, “You can’t always get what you want.”
The dark mirror of Friedman’s concept of permanent wealth is stunningly demonstrated when looking at the year-over-year change in real consumption and real wealth since 1960. As the graph suggests, it is difficult to make future consumption decisions when the present is so, well, impermanent.
The distorted mirror of flawed statistics that is driving current policy and the electorate’s disfavor with those decisions can be summed up by the election results since 2006. Even as recently as the Scott Brown upset in Massachusetts, the electorate is not voting for a party or an ideology, it is voting to throw out incumbents linked to years of juggled books and misallocated, debt-fueled financial decisions.
To draw the circle back to Friedman’s Permanent Income Hypothesis: The voters have looked at their balance sheet, seen their primary assets collapse in value and know that their future lifetime incomes are going to be impaired via higher taxes to pay for this mess. In short, they are voting with their pocketbooks. With a vengeance. Politicians and policymakers who recognize this and are willing to bite the bullet and align with these values, are the winners for the foreseeable future.
These are indeed changes of Biblical proportions, and the economic data are only darkening the looking glass. Last week’s GDP release was a top-line positive, but to me there are many struggles ahead of us. There are about as many people receiving emergency unemployment benefits, 5.7 million, as there are on regular unemployment. The average duration of unemployment is over 29 weeks, a post-war record. Real incomes are down from their 2007 peak. The housing market is truly on life support, with a vast shadow inventory of homes on the path to foreclosure waiting to hit the market and over 95% of all mortgages needing some form of government guarantee. Mortgage delinquencies are still rising and the newest wave of option ARM resets is due to rise throughout 2010 and peak in 2011. Debt deflation continues in all sectors but government debt. The FDIC stepped up its rate of bank seizures in 2009 and shows no sign of slowing down, and the bank sector as a whole is still playing defense. Their loan loss coverage ratios have fallen to about 60% from a historical average of over 140%, despite increasing their reserves, and they are now sitting on as much cash on their balance sheets as they have in C&I loans. The mirror will become less distorted over time as the new statistics flow through the data to clarify the new decision-making processes and provide evidence of healing, but in the meantime it is going to be a long, painful adjustment for everyone.
In conclusion, this is not a pretty picture for our country, but it is an environment that rewards prudent balance sheet management and favors capital that can take advantage of debt restructuring and renegotiation and invest alongside governmental efforts to revive the economy.
Michael A.J. Farrell
Chairman, CEO and President of Annaly Capital Management, Inc.
February 3, 2010