Rohatyn's Warning on America's Indebtedness

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Three decades
ago, New York City was facing bankruptcy. The Federal Government
refused to bail out the city. This led to a famous headline in
the New York Daily News: "Ford to New York: Drop Dead!"

The man who
was called in to restructure the city’s debt was Felix Rohatyn.
He was a bond expert. He earned his keep that time. He created
bonds through something called the Municipal Assistance Corporation.
The bonds were instantly dubbed "Big MACs." The city
did not officially have to declare bankruptcy.

he wrote an article for London’s Financial Times. The article
is not on-line except to subscribers, but Bill Fleckenstein has
provided some choice extracts. His
comments are good, too.

to punctuate my claims about the prospective train wreck I’ve
been warning about, in Thursday’s Financial Times, Felix
Rohatyn, the financier and former chairman of New York’s Municipal
Assistance Corp., penned an article titled "America: Like
New York in the 1970s but worse." It reads, I should note,
like many columns I have written:

spinning out of control, fueled by an unchecked increase in
the deficit. An accounting system that indiscriminately mixes
expenses with capital assets, ignores contingent liabilities,
and makes Enron look conservative. A social structure sharply
divided between "haves" and "have nots."
An administration locked into denial on the assumption that
"the markets will always be there for us." A political
system paralyzed as public finances careen toward catastrophe.
That was New York City in the early 1970s; it could be America
tomorrow. America’s out-of-control federal budget deficit, rapidly
growing domestic and foreign debt, and off-the-books Social
Security and Medicare liabilities look eerily similar to the
fiscal situation that faced New York nearly 30 years ago. .
. .

Next, he
set the stage for how we’ve been able to live so far beyond
our means:

So far,
the willingness of the central banks of China, southeast Asia,
Japan, and Europe to finance U.S. deficits has allowed the administration
of George W. Bush and the Federal Reserve to pursue a policy
of cheap money, low taxes, large deficits, and reliance on a
speculative stock market and property bubble to create economic
growth. This may not last forever, and either the willingness
of the foreign central banks to carry U.S. debt — or their
capacity to do so — could be impaired.

Some time
before that moment is reached, the markets would begin to react:
The dollar could fall further precipitously, interest rates
would shoot up, and we would have to deal with a national crisis,
which could develop into a global crisis.

(He also
notes that given the current political situation, we may not
be able to count on foreigners in a moment of crisis.) Even
though this path is quite possible, it doesn’t mean that we
will indeed have a crisis. However, folks need to be aware of
the risks.

on, he rebutted Alan Greenspan’s contentions that basically
all is well, noting the rot I have vapored on about so often:

Alan Greenspan,
chairman of the Federal Reserve, said recently that the huge
rise in consumer debt in America posed no risk, as it had been
matched by a rise in the value of property and stock portfolios.
However, those are just the circumstances that brought about
the speculative bubble of the late 1990s and the stock market
collapse that followed. The U.S. at that time was in a much
stronger financial condition than it is in today. America was
running huge budget surpluses instead of the current deficits;
its sovereign debt was declining instead of soaring; the currency
was strengthening, not weakening.

Massive debt
is what forces the FED’s hand every time there is even a hint
of recession. The FED doesn’t want an avalanche of defaults. It
creates money. So, the value of the dollar keeps declining. This
leads to asset bubbles.


When the
increase in price of an asset takes place because credit is flowing
into that class of assets, there is risk that the process will
become a speculative bubble. It works like this. Lenders lend
money based on the market price of an asset. As money flows into
the class of assets, the price goes up. This persuades borrowers
to borrow more money, based on a minimal down payment ("margin").
Lenders see that the price of the asset is up, so they are willing
to lend more money. They are confident that there is plenty of
demand for the asset, should the borrower default on the loan.
Put another way:

The huge
rise in consumer debt in America poses no risk, as it had been
matched by a rise in the value of property and stock portfolios.

There is
a tendency for manias to push up prices when a particular class
of assets becomes popular. Borrowers think, "I can make a
bundle by putting little money down, borrowing the rest, and selling
later." Lenders think, "This class of assets is rising
in price, so my money is safe. The borrower will repay. If he
doesn’t, I’ll take ownership of the asset."

The tulip
mania of the early seventeenth century is the classic account
of such a bubble. Tulip bulbs rose to astronomical prices. Then
they collapsed. The expected future return was no longer able
to sustain the asset price. The emu/ostrich bubble in the 1990’s
is another example. When the rise of an asset’s price is not based
on the rise in expected net earnings, it’s a bubble market.

Real estate
today is an asset bubble. Rents usually won’t cover mortgage/tax/insurance
costs. But real estate can conceal the bubble longer than any
other class of asset because it can be occupied by the borrower.
He pays his mortgage on an asset that has lost 20% or more of
its value. He doesn’t want to lose his credit rating. If it is
residential real estate, he doesn’t want to lose his home in a
foreclosure. Surely, his wife doesn’t. So, he pays more in mortgage,
taxes, and insurance than it would cost him to rent a comparable
property. He is in fact paying an ego premium. This allows him
to pretend that he made an error by buying too late.

expose such self-deception. People lose their jobs. They can’t
pay their mortgages. They are forced to move. This is when the
true value of local real estate is exposed for all to see. The
"For Sale" signs go up like dandelions in spring.

When real
estate prices leap by over 20% a year in a region, you know you’re
seeing a bubble. This is happening in Los Angeles and Boston.
It is the time to sell and rent or sell and move. When the bubble
ends, buyers get locked into their jobs because they must pay
their mortgages. They lose mobility geographically, which reduces
career mobility.

Buyers think
"I must buy now." They think the market will never stop
rising. But prices always do stop rising. There is always a hard-pressed
seller who has to walk away from ownership. You buy the other
guy’s mistake. You shop for mistakes.

Of course,
those who want "just the right home" shop for a narrow
class of available assets. Here, liquidity is low, so there may
be no immediate seller. Shoppers pay premium prices because of
a lack of choices. But if you shop mistakes, there are always
bargains available. Find a mistake that you can fix or live with,
and offer the seller a rock-bottom price. Hard-pressed sellers
will accept the offer.


When you
think it’s the last train out, buy a bus ticket. When you think
you’ll never be able to buy one of these again, rent one. Wait.
You’ll see one like it soon enough.

You may have
read John Templeton’s prediction that 20% of home owners will
lose them in the next downturn. He thinks the real estate bubble
will not last. I agree.

Of course,
if you don’t want to live in one of the homes sold by a member
of that 20%, this lack of liquidity won’t do you any good. You
will buy an illiquid asset for top dollar. This is why residential
real estate tends to resist price reversals. High prices conceal
the reality: if you ever have to sell, you may not be able to
. . . at the price you expect.

If you rent
for a year and spend time shopping, you will find someone with
a need to sell. You will save as much or more money on the purchase
that you spent in rent.

This is not
true of a region where there is net in-migration. In this case,
the price of real estate isn’t rising because people are taking
on more debt in order to "skin the creditors." Prices
are rising because of increased demand from people with cash who
are bidding up prices. This is especially true when the new bidders
have pulled money out of homes sold in mania markets. In NW Arkansas,
Californians are streaming in with lots of money. This market
is not a bubble. It is a permanent lifestyle change that people
with money are willing to pay for. It is credit-induced, but the
credit is being injected into the real estate markets where the
newcomers just sold their homes.

When oil
or gold or some other resource is discovered in a region, local
real estate prices go up. This is not mania-induced. It is expected
income-induced. It is not driven by easy money. It is driven by
expected future earnings. It reverses only if the supply of the
resource runs out or its price falls.

If real estate
is rising because a region is becoming more productive — Shanghai
ten years ago comes to mind — then the rise is not a bubble. But
if the value of a region’s output is based on easy money, then
the bubble will pop. If I lived in Shanghai, and I had lots of
money, I would move to some smaller city where the growth is just
beginning. A recession in China will hurt Shanghai more than it
hurts one of the "new cities."


Felix Rohatyn
went through New York City’s crisis and made his reputation. There
will be other Rohatyns in days to come. But the best way to take
advantage of a popped bubble is with cash. He who bought a condo
in New York City in 1969 probably lost. If he bought it in 1975,
he won.

When we hear
that Rohatyn is worried, Templeton is worried, and Buffett is
building cash, I think we should not get pulled into a mania.
You will be able to buy cheaper later. Shop for owners’ mistakes,
not assets’ features.

5, 2004

North [send him mail]
is the author of Mises
on Money
. Visit
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