Contact John Mauldin Print Version Volume 3 - Issue 23 March 12, 2007 The Plankton Theory Meets Minsky By Paul McCulley Today's Outside the Box will feature one of the better pieces written in the last few years by my good friend Paul McCulley. In his article "The Plankton Theory Meets Minsky," Paul shows the importance of why the problem with sub-prime mortgages will affect the entire housing market rather than just a small sector of it. He goes on to further point out that the excess liquidity in housing and the ability to borrow against home equity over the last couple of years was more than just the doing of the Fed as the loosening of credit lending standards played a significant role. This topic is important because it is at the heart of why I think a housing slowdown will affect the nation's economy. For a little background on Paul, he is a Managing Director at PIMCO where he writes a monthly commentary titled "Global Central Bank Focus." He is a very intelligent thinker but what I enjoy the most about Paul is his ability to take seemingly complex data and transform it into an easy to understand analysis. The sub-prime sector has been a hot topic as of late but I trust that you will find this piece to be an "outside the box" take on how it happened and what it will affect in the coming year. John Mauldin, Editor The Plankton Theory Meets Minsky By Paul McCulley Watching the on-going meltdown in the sub-prime mortgage market, which is triggering a sharp tightening of underwriting standards to these dicey credits, I was reminded of prescient writings by two serious thinkers: Bill Gross and Hyman Minsky. Both narratives go back a long ways, with something that Bill wrote in August 1980 - 27 years ago! - particularly poignant: "The Plankton Theory, like life itself, begins and ends in the ocean. Plankton, of course, are almost microscopic organisms that serve as food for higher life forms. Without plankton almost every fish and mammal in the sea could not survive, since most species depend upon other fish for their existence and plankton are the initial building blocks of the entire process. Logic would suggest, therefore, that in attempting to forecast the well being of the Great White Whale, Jaws, or even Jaws II, that one of the factors to consider would be the status and future outlook of the plankton. That, in one hundred words or less, is the Plankton Theory. Now, what possible significance could this have for the investment world? Plenty. Take for example, the area of real estate, especially that of single family housing. We're all familiar with the rapid escalation of home prices over the last 10 years. For most Americans, their homes have been the best and in many cases the only investment that they have made in their entire lives. Some have gone so far as to invest in several homes and have endured 'negative carry' on the cash flow in anticipation of leveraged capital gains a few years down the road. But where does it stop? Can housing continue to increase at twice the Consumer Price Index for the next 10 years? One way to measure might be via the Plankton Theory. In the case of real estate, the plankton would be the first-time buyer (perhaps a young married couple) with a desire to own their own home but with very little capital to carry it off. When the time comes that they can't pull it off - either through an inability to come up with a down payment, or to service the monthly mortgage - then the 'plankton' would disappear and the rapid escalation in housing prices would ease as well. For, unless the current homeowner has someone to sell his house to, he'll be unable to afford the house with the view or that extra bedroom, and the process would continue into the echelons of Beverly Hills and Shaker Heights. In the end, the entire market would wither on the investment vine and home prices would stop increasing at the same rapid rate. So to gauge the health of the housing market, look first at the plankton. Without their presence and financial vitality, the market's not going to repeat the experience of the past 10 years." Bill's call was a good one, as displayed in Chart 1: home price appreciation tumbled in the first half of the 1980s, as the homeownership rate fell: the Plankton Theory at work! Draconian Fed tightening at the beginning of the 1980s had something to do with it, too, of course, as the Plankton were priced out of the market by high interest rates, independent of the availability - or underwriting standards - for home mortgage loans. But the theory held: it's the first-time buyer, stretching to buy, that is the life's blood of vibrant property markets. And intrinsically, there is nothing wrong with a young family stretching to buy that first house; most all of us did, as did our parents (many with the aid of the GI Bill). Optimism about rising incomes and making lives better for our children is the cornerstone of the American Dream. But the human condition is inherently given to the Mae West Doctrine that if a little of something is good, more is better, and way too much is just about right. Such is the case in capitalist finance, as brilliantly diagnosed by both John Maynard Keynes and his disciple, Hyman Minsky. I first introduced Minsky to these pages way back in January 2001, just as the corporate sector was sinking into recession, taking the aggregate economy with it, and the Fed was initiating a massive easing cycle. Minsky, who passed away in 1996, was the father of the Financial Instability Hypothesis, providing a framework for distinguishing between stabilizing and destabilizing capitalist debt structures. He first articulated the Hypothesis in 1974, and summarized it beautifully in his own hand in 1992: "Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on 'income account' on their liabilities, even as they cannot repay the principal out of income cash flows. Such units need to 'roll over' their liabilities - issue new debt to meet commitments on maturing debt. For Ponzi units, the cash flows from operations are not sufficient to fill either the repayment of principal or the interest on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stocks lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. It can be shown that if hedge financing dominates, then the economy may well be an equilibrium-seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation-amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system. In particular, over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make positions by selling out positions. This is likely to lead to a collapse of asset values."