Monday, March 24, 2008

Sorry, I Wasn’t Pessimistic Enough!

Sorry, I Wasn’t Pessimistic Enough!

By Martin Hutchinson | 17 March 2008

On August 27, 2006 this column suggested that US house prices would fall by 15% nationwide, peak to trough. On March 11, 2007 this column suggested that the total bad debt loss from the mortgage crisis would be about $1 trillion. At a meeting at the American Enterprise Institute Wednesday, it became clear that in both cases I was not pessimistic enough. Sorry!

I was probably closer on the bad debt loss. At AEI, Nouriel Roubini suggested that the total credit losses from the housing meltdown would be about $3 trillion, but on inspection his figure included credit cards, credit default swaps and a whole host of other non-housing items. From housing alone, Standard and Poors has now admitted to $285 billion among financial institutions (plus untold amounts among investors such as pension funds that are not financial institutions) while Goldman Sachs, generally somewhat optimistic, has proposed a figure of about $500 billion. I believe that both those figures are low, but that my original $1 trillion figure, which included losses to investors of all types, may be only modestly low. The final figure might be closer to $1.5 trillion, or about 13.5% of the $11 trillion pool of mortgage loans.

The house price decline from top to bottom will now pretty clearly be larger than I predicted. The decline in 2007, according to the Case-Shiller index, was almost 10%; more ominously, in the fourth quarter of 2007, prices were dropping at a 20% annual rate. It thus seems unlikely that the overall decline in house prices will be limited to 20%, and more probable that when prices finally turn, they will have dropped 25-30%, with drops of as much as 50% in some heavily speculative markets such as much of California. This is an exceptional outcome by US standards, ranking with the 1930s as a house price downturn, but it must be remembered that in Japan Tokyo house prices dropped by over 70% from their 1990 peak before stabilizing.

The depth of house price declines has a near-exponential effect on mortgage defaults, since a borrower can walk away from a home mortgage without declaring bankruptcy— the transactions are generally non-recourse. Roubini estimates that if house prices decline 20% 16 million mortgages would be "under water" with principal amount greater than the value of the underlying asset, and that 50% of those underwater mortgages will default. If house prices decline 30%, 21 million mortgages will be underwater, with the same percentage defaulting.

At the lower price decline, that seems to me a little pessimistic. A borrower who can make payments on his mortgage, and whose house is temporarily worth 5% or even 10% less than the mortgage is unlikely to default, if only because he has to live somewhere and moving costs, let alone real estate brokerage are substantial (he would also damage his credit rating.) Thus once we get beyond the universe of people who should never have had a mortgage in the first place, a moderate decline in house prices does not necessarily hugely increase defaults. However as price declines approach the 25-30% level, let alone the 50% that is possible in California, the percentage of mortgages defaulting is likely to rise sharply.

It is clearer now than it was a year ago that losses in housing debt will not be isolated. They will lead to losses in credit cards, leveraged corporate loans, automobile loans and most areas of the credit economy. Even emerging market debt, at first sight insulated from the problem, is in practice endangered by its concentration in Latin America and Russia, both dependent either on the US economy itself or on the high oil prices to which US easy money policies have led. Finally credit default swaps, with an outstanding volume of an extraordinary $50 trillion, appear to be an accident waiting to happen. Thus a mere $1.5 trillion in housing debt losses may indeed produce total losses of $3 trillion or more when collateral damage is included.

Not all of those losses will be felt by financial institutions, although the extraordinary appetite for risk that such institutions have exhibited over the past decade suggests that a high proportion of them may indeed come to rest in the financial area. If that is the case, we have a problem: the total capitalization of the US banking and brokerage system is only about $1 trillion.

The Bear Stearns intervention on Friday was a first symptom of what we can expect. (The Northern Rock disaster in London was a case simply of appallingly inept regulation of a bunch of hyper-aggressive used car salesmen who moved into the home mortgage business.) Bear Stearns, while not without its reputation for sharp elbows is a major house with an important market position. Bear Stearns was more concentrated in the mortgage business than several of its competitors, but that may simply have led the tsunami now approaching the world’s financial system to reach Bear Stearns first.

If Roubini is anything close to right as to the total size of the disaster, and it spreads as appears likely to areas beyond mortgages, then there is no reason to believe that any of the world’s major financial institutions is exempt, although in practice some of them will have been exceptionally conservative in their adoption of new financial techniques or will have concentrated their business in areas such as emerging markets that are relatively less affected.

As the mortgage blow-up has shown, many of the "modern finance" techniques that have been designed in the last 30 years have shown themselves fatally flawed. Of all such innovations, probably the one posing most current danger for the world’s financial system is the credit derivatives market.

Like most modern finance products, credit derivatives were marketed as hedges. A bank could reduce its credit exposure to a particular borrower by entering into a contract whereby another bank would make payments to it if the borrower fell into bankruptcy.

Needless to say, once Wall Street’s trading desks got hold of credit derivatives, all thought of hedging was lost. Instead of selling a credit exposure once, banks sold it 10 times, or even 20. Instead of selling credit exposure to another bank or an insurance company, who would be able to handle the credit exposure and could be relied upon to pay up in case of trouble, credit derivatives traders sold credit derivatives to hedge funds, private equity funds and any riff-raff that walked in off the street.

As a result, the credit derivatives market is a time-bomb waiting to explode. It will remain quiescent while credit losses on the underlying loans are low or moderate, but at some point rising credit losses on the underlying loans will be multiplied by the credit default swap mechanism to produce a payment requirement that is several times the size of the underlying defaulted loans. Theoretically, that mega-payment requirement would be offset by mega-profits in other corners of the web of counterparties. In practice, the losses are likely to be large enough to cause counterparties to default, particularly if they are "men of straw" such as hedge funds, so the profits will prove ephemeral while the losses prove all too real. Losses of even a modest fraction of a $50 trillion principal amount would bring down most of the banking system.

It is in this context that the Bear Stearns crisis must be viewed. When the Knickerbocker Trust went bankrupt in 1907, J.P. Morgan was able to bail out the banking system because the Knickerbocker had limited relationships with other banks. Even when Drexel Burnham went bankrupt, the authorities were able to solve the problem by allowing a two-stage process, whereby the expansionist Michael Milken and other top management were removed in March, 1989, while the institution continued to do business on a sharply reduced basis before its final bankruptcy in February, 1990. This was hard on Drexel’s shareholders, who might well have salvaged something substantial from the wreckage if Drexel had been forced into Chapter 11 early enough, but it was good for Drexel’s network of counterparties, who were given time to get out.

As the above discussion has shown, the network of counterparties for a major house such as Bear Stearns is now many times the size and complexity of that constructed by Drexel and poses huge systemic risk. Bear Stearns may not be too large to fail, and it has no depositors requiring insurance of their money, but its network of interlocking obligations is far too complex and extensive to allow it to cease payments.

The Fed is doing everything it can to stave off disaster, but frankly, it is not rich enough. With assets of about $800 billion, having instituted $400 billion of rescue programs in the last week plus unspecified intervention with Bear Stearns, it is pretty nearly tapped out. It does of course have available a further source of liquidity, the Federal printing press. With inflation already moving at a brisk trot, use of that source will replace an incipient recession with a deeper and highly inflationary recession.

Thus the participants in the AEI seminar were misguided in touting Treasury bonds as the last safe haven. In an era of inflation, long term Treasury bonds yielding less than 4% are not a safe haven, they are a guaranteed route to loss, particularly for any investor so unfortunate as to pay tax. The fact that five year Treasury Inflation Protected Securities now yield less than zero, even though the inflation figures on which they are based are comprehensively fiddled, is a sufficient indication of the incredible laxity of current monetary policy. Of course, since house prices peaked at about 45% above their equilibrium level, a 30-40% burst of consumer price and wage rises, perhaps two years at 15% inflation, may be just what is needed to bring house prices and incomes back into balance. In an era of very cheap money, all investments are overvalued (the stock market still has much further to fall) but Treasury bonds are perhaps the poorest buy of all.

This is not a pretty picture. The losses to come are probably large enough to wipe out the banking system, and the interconnected network caused by modern finance is sufficiently fragile that the failure of any one major house, if carried out through normal bankruptcy processes, would be sufficient to bring down the world economy as a whole.

It is as if the US power grid had been installed without fail-safe mechanisms, so that a local outage caused by a snowstorm in Vermont or a hurricane in Florida could cascade through the whole system and wipe out power service for the entire United States. Needless to say, failsafe mechanisms have been put in place precisely to prevent such an occurrence. When we dig ourselves out from what seems likely to be an unprecedented banking system catastrophe, we will no doubt design similar mechanisms to prevent contagion throughout the banking system. They will destroy much legitimate business, just as did the 1933 Glass-Steagall Act, which de-capitalized the investment banks, making it almost impossible for companies to raise debt and equity capital for the remainder of the 1930s.

The barriers to new business caused by the new control regulations will be the last but by no means the least of the enormous costs imposed on mankind by the crack-brained alchemists of modern finance.



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

No comments:

Post a Comment