Friday, February 29, 2008

Are We Are On the Gold Standard? Yes, We Are on a De-Facto Gold Standard

Is the US on the gold standard? Officially no. Is the US going to go on a gold standard? At this point the probability is close to 0%. Should the US be on the gold standard? Because the answer to question #2 is basically 0%, why waste the breath to debate the issue. Afterall, the people that read this blog and myself do not get invited to those meetings.

But, I would argue that when economic times get tough, like now (and the 1970s), we move to a de-facto gold standard (minus all the monetary policy issues). The value of one dollar remains one dollar, but the value of gold changes. That is a gold standard. Anytime we measure the value of our currency against the value of something else, we have a “something else” standard. By the way, if you do not like gold then pick oil and now you have an oil standard. Regardless of what the Fed tells you or what the government statistics show the value of the dollar is going down (i.e. inflation is going up). The price of gold is not being pumped up, the reason the price of gold is going up in dollars is because the value of the dollar is going down.


As an aside, if you know what you are doing you can make more dollars (return on your investment) adhering to the de facto “gold standard” then you can in most other investments.

So what is the price of gold in dollars going to do in the near term? Probably go up because the value of the dollar is probably going to go down as the Fed continues to drop rates to fight a potential recession. An interesting question to ask is will the value of the dollar go up if the world slides into a recession? The reason I ask is regardless of all its perceived shortcomings the US dollar is a “safe-haven” currency when the world is in turmoil. That could mean that if the world slides into a recession the value of the dollar would go up.

Text in bold is my emphasis. From Market Watch:

With the U.S. dollar tumbling and inflation surging, gold continues to break record highs and might surpass the psychologically key $1,000 level before the end of March.

Gold prices have surged some 16% in the past two months and 22% in the past three months.


Gold is generally viewed as a safe-haven investment and a hedge against inflation. The turbulence generated by the subprime and credit crises, the increasing likelihood of a U.S. recession, persistent dollar weakness, and rising inflation make owning gold a no-brainer for many analysts. . . . .

. . . . "The talk of yet another rate cut and the dollar continuing to spiral down is all it will take," he said.

He expects $1,000-an-ounce gold in the back months within a week or so and in the spot market within two or three weeks as long as the dollar continues to slide.

"Stops are also likely heavy at that level [$1,000] since it is so psychological," Kerr said. He thinks gold will break $1,000 and then hit a wall around $1,150 to $1,200 an ounce.

In testimony to Congress, Federal Reserve Chairman Ben Bernanke sent a clear message Thursday that he intends to cut benchmark interest rates further to support the flagging economy. The Federal Reserve's next meeting is on March 18.

Gold faces some resistance around $970/$975 and short-term conditions are tipping into overbought territory, said Jon Nadler, senior analyst at Kitco Bullion Dealers.

However, "the metal could fulfill the four-digit value -- if not in the period leading up to the Fed meeting -- then after the certainty of the half point or so rate cut that is widely expected to come," Nadler said.

Burton R. Schlichter, director of trading at New World Trading, agreed that despite the overbought conditions in the gold markets, $1,000 an ounce is within range.

"I think it [gold] could be there by the end of next week," he said. "The debate whether or not gold will hit $1,000 an ounce sounds very similar to the debate we had in crude oil. It's not a matter of if but when and I think it's real soon."

Technically, if gold can trade over $900 an ounce over an extended period of time, it will trade at or above $1,050 an ounce by the end of March, Schlichter said.

"I see gold, and in fact all things commodity, to continue to move and trend to the upside," said Zachary Oxman, a senior trader at Wisdom Financial. "Funds and speculators continue to desire to be long commodities."

The two biggest drivers for gold prices are the weak dollar and inflationary pressures, Oxman said. Secondary drivers are slowing economic growth and a flight to quality.

Weakness in the U.S. dollar boosted gold's investment appeal. Gold, like many commodities, is denominated in dollars, and a lower U.S. currency makes it more affordable in other currencies.
The dollar remained under heavy selling pressure Thursday, tumbling to fresh record lows against the euro and the Swiss franc. . . .

. . . . .One primary driver for gold "has been increasing investment demand [and institutional investment demand] being confronted by static supply and falling supply from many major gold producers," such as South Africa, O'Byrne said.

South Africa, the second largest gold producer, is suffering severe electricity shortages, which have forced many miners to operate below capacity and revise downward their production forecasts.


"China is the only major gold producing country to have increased production in recent years with production falling in other major producers such as Australia, Canada and the U.S.," O'Byrne said.

"The fact that between 2000 and 2007, global mined gold fell 6.7% despite bullion prices moving from about $270 an ounce to more than $850 an ounce is very bullish," he said. . . .

. . . . . "We need to keep a lookout for possible signs of a 1980's style gold mania emerging among average investors -- the group that usually decides that when gold makes it on the front page of the newspaper, then it is a proven winner and the time has come to jump onto the bandwagon," Nadler said. "We've seen the pattern with real estate not that long ago."
(I agree with this statement. When the average investor gets into a market big it is time to get out.)

Tuesday, February 26, 2008

Foreclosures Were Up 57% and Repossessions Were Up 90% In January

In case you have some illusion (or should I use delusion) that the housing market is going to turn around in the second half of 2008, it looks like the “the beat goes on”. Text in bold is my emphasis. Text in bold is my emphasis. From Bloomberg:

Bank seizures of U.S. homes almost doubled in January as property owners failed to make higher payments on adjustable-rate mortgages.

Repossessions rose 90 percent to 45,327 last month from the same period a year ago, RealtyTrac Inc. said today in a statement. Total foreclosure filings, which include default and auction notices as well as bank seizures, increased 57 percent.

``The most troubling thing is that we are seeing more and more of these properties actually going all the way through the process and going back to the banks,'' Rick Sharga, executive vice president of Irvine, California-based RealtyTrac, said in an interview.

Defaults among subprime borrowers and those unable to meet rising payments on adjustable-rate loans drove foreclosure filings to the highest since August and the second-highest since RealtyTrac started keeping records. About $460 billion of adjustable mortgages are scheduled to reset this year, raising minimum payments for borrowers, according to New York-based analysts at Citigroup Inc.

More than 233,000 properties were in some stage of default last month. Total foreclosure filings increased 8 percent in January from December, RealtyTrac said.

Nevada, California and Florida recorded the highest foreclosure rates among the 50 states, said RealtyTrac, a seller of U.S. foreclosure statistics with a database of more than 1 million properties.

The rate of foreclosure filings in Nevada continued to lead the nation, with 6,087 properties in default or having been repossessed. That's 95 percent more than in January 2007 and 45 percent less than in December.


California had the highest total number of default and foreclosures with 57,158 properties facing possible seizure last month. That was more than double the year-earlier figure and was up 7 percent from December.

Florida had the second-highest number of homes in default or foreclosure with 30,178 in January, more than double the figure for the prior year and 3 percent less than in December.

Arizona, Colorado, Massachusetts, Georgia, Connecticut, Ohio and Michigan rounded out the top 10 states worst off in terms of missed payments and property seizures, RealtyTrac said. . . . .

. . . . . U.S. home prices fell last year for the first time since the Great Depression. That made it more difficult for homeowners to sell or refinance properties encumbered by mortgages that may be higher than the value of the houses themselves. Sales of existing homes fell last month to the lowest in at least nine years, the National Association of Realtors said yesterday.

The median price of an existing home fell 4.6 percent to $201,100 from January 2007. The median for a single-family home dropped 5.1 percent to $198,700, and condominium and co-op prices fell 1 percent to $220,400.

Banks may be forced to resell as many as 1 million foreclosed properties this year, adding to a glut of inventory and forcing prices down even further, Sharga said.

January was the sixth straight month with more than 200,000 foreclosure filings, RealtyTrac said. The fourth-quarter total of 642,150 filings was the most since the company began records in January 2005. More than 1 percent of U.S. households were in some stage of foreclosure during 2007.

Monday, February 25, 2008

The Monetary and Fiscal Stimulus Packages Probably Won't Work in the Long Term

It is apparent that the various monetary and fiscal stimulus packages may not ultimately work in the long run. Clearly, lowering rates by the Fed has had very limited effect so far. What rabbit will our Uncle Sam pull out of the hat when everyone spends their checks this summer? Lastly, although people like to talk about the various mortgage rescue plans, it does not appear like this has had any major effects on the housing market. I suspect that there are fundamental structural changes occurring in the US economy that are larger than can be effected by the government or the Fed. I wonder where we are headed? Text in bold is my emphasis. From Bloomberg:

Even if Ben S. Bernanke, George W. Bush and Congress win the battle to avert a recession this year, they risk losing the war to strengthen the economy for the long term.

Growth will get a boost in the second half of this year as consumers spend some of the $107 billion in tax rebates passed by Congress and signed by Bush this month. The U.S. may suffer a letdown afterward as the kick from the stimulus wears off, leaving the economy vulnerable to its underlying weaknesses: a retrenching financial industry, indebted consumers and slowing productivity growth.

``This is not a one- or two-quarter phenomenon,'' says economist Neal Soss of Credit Suisse Group, who worked as an aide to former Federal Reserve Chairman Paul Volcker. ``This is not a V-shaped event. It's a slow-growth scenario.''


Fed officials see growth picking up to more than 2 percent next year as inflation ebbs to 2 percent or below. Fed Chairman Bernanke, 54, is slated to discuss the central bank's forecast in testimony to Congress Feb. 27 and 28.

So far, the Fed's deepest interest-rate cuts since 2001 haven't helped the financial markets or the economy. What they have caused is an increase in inflation expectations, with the price of gold soaring to a record $958.40 an ounce last week.

``The Fed is trying to stabilize the financial markets, the real economy and the price level with a single interest rate,'' says Louis Crandall, a former Fed official who's now chief economist at Jersey City, New Jersey-based Wrightson ICAP LLP. ``That's not easy to do.''

What's more, say economists Soss and Ethan Harris of Lehman Brothers Holdings Inc., policy makers face structural changes in the economy that aren't so susceptible to the traditional tools of interest-rate and tax cuts. As a result, Soss sees the economy expanding just 1.3 percent in 2008 and about 1.5 percent in 2009. Harris is even more pessimistic. He sees growth easing to 0.9 percent in 2009 from 1.1 percent in 2008 and 2.5 percent in 2007.

Fed officials acknowledged in the minutes of their last meeting Jan. 29-30 that they were having trouble getting ahead of the credit squeeze in financial markets.

The financial industry is curtailing credit and conserving capital after a decade-long boom in profits went bust in the third quarter. Following mounting losses on past loans, banks have already taken write-offs of $163 billion since the beginning of 2007.

A Fed survey released Feb. 4 found that banks had become stingier in granting credit during the previous three months. Fed officials say they expect that to continue, making it harder for the central bank to stimulate the economy through lower borrowing costs.

``The Fed's policy tools may not be very well suited to deal with this particular situation,'' Robert McTeer, former Dallas Fed president and a fellow at the National Center for Policy Analysis in Dallas, said in a Bloomberg Television interview Feb. 20. ``The Fed can give liquidity to the markets, but the Fed cannot do much if the markets are afraid of solvency risks.'' (The Fed is fighting the last war, i.e. Great Depression, with weapons designed to fight the last war, not this war.)

Consumers, until now the driving force behind the expansion, are feeling the squeeze. While households will get a short-term boost from the coming tax rebates from Washington, their longer-run finances look shakier.

Households reduced their savings rate to virtually nil in December from close to 10 percent of disposable income 15 years earlier. That trend may reverse as credit becomes scarcer and home prices fall.

Credit-card companies are adopting stricter lending standards and making it harder for consumers to borrow, says Robert McKinley, president of Ft. Myers, Florida-based Cardweb.com, a research organization that tracks the industry.

That comes on top of the hit homeowners are taking from the drop in housing prices, which fell 7.7 percent in 20 metropolitan areas during November from a year earlier, according to the S&P/Case-Shiller price index.

Allen Sinai, chief economist at Decision Economics in New York, calls the pullback by consumers ``a seismic shift. For several years, the growth of consumer spending is going to be significantly below its long-run average of 3.5 percent.''

Consumers have also been pinched by the rising cost of food, fuel and other necessities. Inflation, as measured by the personal consumption price index, clocked in at a 3.5 percent year-over-year rate in December, the highest for that month since 1990.

The increase is stoking fears of more to come. The yield on the 10-year Treasury note, which acts as a benchmark for mortgage rates, rose to 3.80 percent on Feb. 22 from 3.44 percent a month earlier, even though the Fed reduced its overnight lending rate by 1.25 percentage points during the period.

Behind the heightened inflation concerns: slowing productivity growth, making it harder for companies to recoup higher costs through increased efficiency.

Robert Gordon, a professor at Northwestern University in Evanston, Illinois, says the surge in productivity that began around 1995 was a one-time event sparked by the advent of the Internet. He pegs the underlying growth rate of productivity at about 1.8 percent, down from a high of 2.9 percent earlier this decade.

Nobel laureate Edmund Phelps says there's little the Fed can do when faced with such a structural change. ``We've had a series of booms, and it seems to me they are now over,'' says Phelps, an economics professor at Columbia University in New York. ``As a result, we're going to see a period of slower growth than in the past.''

The Definition of Stagflation

Currently people throw the word “stagflation” around a lot so it is a good idea to define the term. At this time the US runs a serious risk of sliding into a period of stagflation. Slow growth caused by the housing problems, credit crunch, slower consumer demand, etc.; monetary and fiscal polices that are trying to stimulate the economy out of a recession; and higher energy and commodity prices all lead to a potential period of stagflation. The ultimate problem with stagflation is that it is hard to get out of. This definition came from answers.com. If you don't like this one there are plenty of others to choose from.


Term coined by economists in the 1970s to describe the previously unprecedented combination of slow economic growth and high unemployment (stagnation) with rising prices (inflation). The principal factor was the fourfold increase in oil prices imposed by the Organization of Petroleum Exporting Countries (OPEC) cartel in 1973-74, which raised price levels throughout the economy while further slowing economic growth. As is characteristic of stagflation, fiscal and monetary policies aimed at stimulating the economy and reducing unemployment only exacerbated the inflationary effects.

A meatier definition and discussion can be found at Wikipedia:

Stagflation, a blend of the words stagnation and inflation, is a macroeconomics term used to describe a period of inflation combined with stagnation (that is, slow economic growth and risingunemployment, possibly including recession). The term stagflation is generally attributed to United Kingdom Chancellor of the Exchequer Iain MacLeod, who coined the term in a speech to Parliament in 1965.

Stagflation came to be recognized as a potentially important macroeconomic problem in the 1970s, when it afflicted many countries in the developed and developing world. Prior to the 1970s, the prevailing Keynesian school of macroeconomics assumed that inflation and stagnation were unlikely to occur together. Macroeconomists at that time believed that stagnation could typically be cured by expansionary monetary or fiscal policies, while inflation could be cured by contractionary monetary or fiscal policies. When both stagnation and inflation occurred at the same time, this called into question existing macroeconomic theories and also posed a dilemma for the standard policy remedies that had been used to stabilize the economy in the past.

Economists today typically offer two main explanations of stagflation. First, stagflation can occur when an economy is slowed by an unfavorable supply shock, such as an increase in the price of oil in an oil importing country, which tends to raise prices at the same time that it slows the economy by making production less profitable.
Second, both stagnation (recession) and inflation can be caused by inappropriate macroeconomic policies. For example, central banks can cause inflation by permitting excessive growth of the money supply, and the government can cause stagnation by excessive regulation of goods markets and labor markets. The global stagflation of the 1970s is often blamed on both causes: it was largely started by a huge rise in oil prices, but then continued as central banks used excessively stimulative monetary policy to try to avoid the resulting recession (stagnation), causing a runaway wage-price spiral.


Sunday, February 24, 2008

This Weekend’s Contemplation – The Smaller Footprint of the US Economy in the World Economy

The purpose of this really interesting article in the WSJ is to demonstrate why the world needs to re-shuffle the current G-7 (or is it G-8) meeting to exclude three European countries and include China, India, and one African country. But that is not the point of this post. This article summarizes the ever decreasing role the US plays in the world economy since the Asian currency crisis in the 1990s. Make no mistake the US is still very large and a force to be reckoned with in economic terms, but the footprint is getting smaller. If the US slides into a recession the remainder of the world is still sufficiently connected (the de-coupling argument) to the US that they will be affected. However, this may be the last time. What does this mean for your investment horizon? Text in bold is my emphasis.

There is a delicious irony in the fact that U.S. banks have sought equity capital from the sovereign wealth funds of Asian and Middle Eastern countries to repair the balance-sheet damage inflicted by subprime mortgage securities. These same countries helped finance America's housing bubble and subprime debacle.

Stung by the Asian financial crisis 10 years ago, central banks in developing countries began defensive actions to accumulate foreign-exchange reserves. Economies blessed with significant natural resources accumulated yet more dollars. The problem is their overflowing coffers contributed to a major misallocation of capital in recent years that is likely to continue.

During the past four years, the developing countries have run an aggregate current account surplus of nearly $2.5 trillion. In 2008 alone, the surplus will probably exceed $625 billion. These huge surpluses provided the global financial system with the excess liquidity that funded America's burgeoning current-account deficit and depressed bond yields four years ago. The decline of long-term interest rates encouraged America's residential property boom and spawned the reckless lending for subprime mortgages. This process -- of surplus savings in developing countries influencing financial behavior in industrial countries -- has now made a complete circle with Abu Dhabi, Singapore and China rescuing Citibank, Merrill Lynch and Morgan Stanley. It is also a complete reversal of 20th-century history.

In the past, financial crises often occurred in developing countries because of large interest-rate hikes in the U.S., or a suspension of capital flows from the old industrial countries. When capital flows ceased, the developing country's currency fell sharply, boosting interest rates and bankrupting highly leveraged local companies. Such crises occurred in Latin America during the early 1980s, Mexico in 1994, East Asia during 1997-98 and Argentina during 2001.

The current business cycle will go down in the history books as one which confirmed that leadership in the global economy is now shifting from the old industrial countries to the emerging market countries. During 2007, the developing countries produced over 52% of global growth, compared to 37% during the late 1990s. China alone produced 17.8% of global GDP growth last year, compared to 14.6% for the U.S. economy. The developing countries' share of total world output has risen to 29% this year from 18% in 1995. The World Bank is forecasting that the economies of developing countries will grow 7.4% this year, compared to 2.2% in the old industrial nations.

As a result of their large current account surpluses, the developing countries also account for 75% of the world's $6 trillion of foreign exchange reserves. They also have sovereign wealth funds with assets of $2.5 trillion. And there has been a huge expansion of developing-country stock markets during the past decade. Their market capitalization now exceeds $17.8 trillion, compared to $2.2 trillion in 2000. The capitalization of the U.S. stock market is $17.5 trillion.

In the decade before 2005, American consumers were the growth engine for the world economy, accounting for more than half of global consumer spending. The balance of power is now shifting.

In 2000, the consumer spending of the world's 17 largest emerging-market countries was equal to 48% of U.S. consumer spending; last year it was equal to 65%. At current growth rates, the developing countries could exceed U.S. consumer spending by 2015.


This consumption boom is changing global trade patterns. America's share of global imports has fallen to 14% last year from over 20% in 2000. The import share of the developing countries has grown to 40.6% last year from 33% in 2000.

The shift in the global balance of power has so far had only a modest impact on global institutions and governance. After the East Asian financial crisis, the U.S. promoted the creation of a G-20 forum, for finance ministers of developing countries to meet with the finance ministers of the industrial countries. The G-7 expanded during the late 1990s to include Russia -- but more needs to be done.

The G-7 should no longer consist of four European countries, the U.S., Canada and Japan. There should be only one European representative. The remaining three slots should go to China, India and one African country. There will be great protests from the Europeans at consolidating their position, but the current membership of the G-7 no longer reflects the changing reality of the global economy. The G-7 must adapt or become irrelevant.

Saturday, February 23, 2008

The NBER Business Cycle Dating Committee Is Starting to Talk Again

A couple of weeks ago someone was asking if the NBER Business Cycle Dating Committee is meeting again. These are the folks that officially define when a recession starts and stops. I seem to remember hearing that they met in December, but I could have been wrong. At any rate I found this article on the WSJ Online Economics dated about a month ago. Apparently they are beginning to at least talk again, after a very long dormant period.

The National Bureau of Economic Research’s Business Cycle Dating Committee, a usually dormant panel, started discussions this month — after a dismal employment report — about whether the U.S. is in a recession or entering one. The seven-member committee says it wouldn’t make any announcements about a recession until well after one has begun. But in interviews with Wall Street Journal reporters and other recent comments, some of the economists offered their individual takes:

Robert Hall, Stanford (Committee Chair): The December employment report was a “crystallizing event” that spurred the committee into early discussions of economic data, and monthly GDP figures are “not enough” to signal much. “At best the economy is flat right now. It stopped growing.”

Martin Feldstein, Harvard (NBER President): He says a recession is more likely than not in 2008, up from 50-50 odds last month.

Jeffrey Frankel, Harvard: “The primary concern has to be the domestic U.S. economy, and not the stock market,” he told the Boston Globe. “You have to guard against giving too much weight to Wall Street.”

Robert Gordon, Northwestern: The odds favor a recession starting late this quarter or next quarter, though “the best forecast now, based on guesstimates of first-quarter data, is that we’re not in a recession right now.”

David Romer, UC Berkeley: He’s not comfortable discussing a recession yet and only has “quibbles” with the Fed’s performance over the last six months. “If there are adverse shocks the Fed should do its best to offset them,” he said. “In general it would be good for the Fed to feel freer to move the funds rate a lot.” (Mr. Romer, along with wife and Berkeley professor Christina Romer, took Ben Bernanke’s spot on the NBER committee in 2002.)

Victor Zarnowitz, The Conference Board: Of the four monthly indicators tracked by the committee, two — industrial production and real personal income less transfers — appear to have peaked, in July and September, respectively. But, those peaks “can easily be reversed or moved through revisions,” he said. The other two — real manufacturing and trade sales and payroll employment — have not peaked yet. Monthly GDP peaked in September but “there are all kinds of problems” with that data. “There is no clear evidence of a peak. That’s my judgment. So no recession (yet), but it bears watching very, very closely.”

Commercial Building is Following Residential Construction

As is to be expected commercial building is following residential construction. This stands to reason that once the commercial side of the business has caught up to all the new developments there is no need to build more commercial sites. Text in bold is my emphasis. From the WSJ:

For the past several years, as residential construction nearly collapsed, commercial construction continued to grow, helping to keep contractors busy and regional economies growing. Now, nonresidential construction spending may be headed for a decline.

A recent report by the Census Bureau showed that spending on commercial construction projects -- hotels, office buildings, hospitals and other nonresidential construction -- was running at a seasonally adjusted annual rate of $671 billion in December. That was essentially flat with November and brings to an end 14 consecutive months of growth in spending on commercial construction.

Economists say the latest numbers reinforce concerns that the commercial building boom, exemplified by lines of construction cranes clogging cities all across the U.S., is coming to an end. "Even if we avoid a recession, nonresidential construction will go negative this year," says Edward Sullivan, chief economist of the Portland Cement Association, a North American trade group. "If there's a recession, it will go even more negative."

Already, a handful of projects have been stalled or canceled. . . . . For construction firms, the change means greater competition for work and lower profit margins. Ken Simonson, chief economist for the Associated General Contractors of America, said the contractors are starting to see increased bidding on projects from new rivals. "These are general contractors or subcontractors who until a year ago were busy on the nonresidential side," he said.

Competition for work is expected to be especially intense on government projects, which aren't likely to be scaled back as much as private projects. The U.S. Army Corps of Engineers throughout the year ending Sept. 30 is expected to award $1 billion in construction grants for 12 to 15 projects to transform military installations.

Private educational spending is expected to continue strong growth, largely because schools have committed funding through capital campaigns. "Any firm that is involved in school construction is going to have a good year," says Robert A. Murray, vice president for economic affairs at McGraw-Hill Construction. While public educational spending pulled overall spending for the sector down last month, bond measures in several states, including California and North Carolina, should provide reliable funding as the construction downturn hits other sectors.

One of the hardest-hit areas is expected to be retail, where companies such as Starbucks Corp. and AnnTaylor Stores Corp. have scaled back new store openings or announced plans to close existing stores. Retail stores averaged an annual 300 million square feet in construction starts in the past three years, and those numbers should fall by 12% to 15% this year, according to McGraw-Hill Construction.

Construction firms also are bracing for fewer office developments. "Although we have many projects that are in the budgeting phase ... I think there is a question mark as to whether some of that is going to go forward," says William Calhoun, executive vice president of Clark Construction Group Inc. in Bethesda, Md. . . . .

But even firms with a steady supply of institutional construction projects express concern about filling their pipeline beyond 2009. "We are all very, very aware of what's going on in the marketplace and very concerned about where it will go in the future," says Greg Nook, executive vice president at J.E. Dunn Construction Co. in Kansas City, Mo.

Friday, February 22, 2008

The Negative Feedback Loop of the Housing Crisis and the Credit Crunch

This article meshes well with the one below on how many home in the US are in a negative equity position. Text in bold is my emphasis. From the WSJ:

Economists have a term to describe what it means when things keep going from bad to worse: negative-feedback loop. One day's problems create a broad set of behaviors that only make the problems worse.

Consider housing. As home prices fall, more families see the values of their homes decline to less than the amount of money they have to pay back on their mortgages. That gives them an incentive to walk away from their mortgages and leave their homes empty, which puts more downward pressure on home prices, drawing more households into the loop.

Housing turmoil, in turn, causes consumers to pull back, hurting the broader economy, which puts more downward pressure on home prices. Banks, worried about mortgages going bad, tighten lending standards, shutting some new buyers out of the market and further depressing home prices.

Negative-feedback loops can be pernicious when an economy depends heavily on borrowed money. Total outstanding household debt rose to $13.6 trillion by the third quarter of 2007 from $7.2 trillion at the beginning of 2001 -- a 10% annual growth rate. Mortgage borrowing more than doubled in this stretch. One out of every seven dollars of disposable income earned by Americans now goes toward paying down debt -- near a record.

Corporate borrowing was modest for most of the decade, then started rising at double-digit rates in 2006 and 2007, amid a wave of private-equity buyouts and debt-financed share buybacks. Meantime, Wall Street juices returns by making investments with borrowed money.

Yale economist John Geanakoplos's concept of the leverage cycle shows how negative-feedback loops are driving today's economy. When times are good, credit is ample, causing the economy to heat up. When the cycle shifts, lenders tighten standards and become more demanding about the collateral they hold, feeding into the negative-feedback loops hitting the economy.

He says shifts in this cycle can happen suddenly, catching investors and policy makers off guard. "When the world seems more uncertain, everyone wants a lot of collateral and the economy goes from highly leveraged to no leverage very quickly," he says.

"When things go bad, people have to sell assets to raise collateral," says Gregg Berman, co-head of the risk management unit of RiskMetrics Group. Selling reduces the value of the very assets borrowers have used as collateral against loans -- such as homes. "The more leverage is built into the system, the more the cascade effect is magnified," Mr. Berman says.

Individual banks might be acting rationally when demanding more or better collateral. Trouble is, when every lender does this at once, it becomes self-destructive, triggering shock waves that threaten the banks themselves.

The trick for policy makers is to break the loop. "A macroeconomic downturn tends to diminish the value of many forms of collateral...reinforcing the propagation of the adverse-feedback loop," Federal Reserve Governor Frederic Mishkin said in a January speech. Aggressive Fed interest-rate cuts help by reducing the cost of all of this borrowing.

The psychology of risk aversion behind these negative loops is hard to alter once it sets in. That is why breaking the chain this time could be harder than anyone expected.

Nouriel Roubini is Suggesting That 10 – 15 Million People Could Walk Away from Their Homes

Dr. Roubini is back with some fairly pessimistic scenario on the fate of the housing market. As stated before Dr. Roubini tends to be one of the more pessimistic economist out there, but his comments have a basis in facts, and are always well presented. Whether you like it or not (or believe it or not) Dr. Roubini is painting the worst case scenario, which should directly effect your investment decisions. It does mine.

One of the issues in risk analysis is to define the worst case, determine how likely it is, and adjust your investments appropriately. The problem that Dr. Roubini, myself, and others on the internet is that we have figured out that the worst case scenario was very unlikely 12 months ago, but is now beginning to take shape and the probability of its occurrence is no longer negligible. Text in bold is my emphasis. From RGE Monitor:

The current housing recession, subprime meltdown and severe credit crunch in financial markets has many worrisome aspects. And while there is always a “crisis de jeur” - one day SIVs, the next day monolines, the next day TOBs or auction-rate securities - one needs to keep some perspective and consider which risks are first-order sources of stress for financial markets and which ones are of second or third-order concern.

I will argue that the most important first-order risk for financial markets derives from the likelihood that 10 million to 15 million households may walk away from their homes if – as likely - home prices fall another 10% in 2008 and further in 2009. When – in the summer of 2006 – this author argued that this would be the worst housing US recession in 50 years. and that home prices would fall – from their peak value – by 20% such predictions were taken as being nearly lunatic. Too bad that this author ended up being too optimistic, not too pessimistic, about the severity of this housing recession. Indeed, this will end up to likely to be the worst housing recession in US history – not just in the last 50 years – and home prices may likely eventually fall by 30%, not this author’s “optimistic” 20%. By now prices declines of the order of 20% are predicted by Goldman Sachs, Robert Shiller, MarketWatch chief economist Irwin Kellner and others; while Paul Krugman has suggested even a figure of 30%; and, according to Bob Shiller, in some markets home prices may fall by 40 to 50%.

So let us consider the implications for the household sector of price declines of the order of 20 to 30%. The math is simple as I will flesh out in this note: 10 to 15 million households will end up in negative equity territory and will be likely to default on their homes and walk away from them. Then, the losses for the financial system from this massive defaults will be of the order of $1 trillion to $2 trillion, a multiple of the $200 to $400 billion of losses currently estimated for mortgage related securities.

Let us consider next some of the details of this scenario and its consequences for the financial system…

In the last few weeks a spate of articles have appeared in the press noticing the alarming increase in default rates not just among subprime borrowers but increasingly near prime and prime borrowers. In particular it has been noted that the number of voluntary defaults, i.e. households literally walking away from their homes and mortgages has surged.

What is happening is just the consequence of rational economic behavior. In most US states mortgages are non-recourse loans; thus, if a home owner defaults on its mortgage the bank take over the collateral – the home – via foreclosure but once that happens it cannot go after the borrower for any difference between the value of the original mortgage and the current value of the property.

The fact that most mortgages are de jure non-recourse (and the fact that even those mortgages that are de-jure with recourse are de-facto non-recourse as the legal and other costs of going after the borrowers are excessive) has powerful implications: it implies that the borrower has effectively a put option that allows him or her to walk away from its home whenever the value of the home is below the value of the mortgage, what is technically referred to as negative equity.

Of course, not every home owner with negative equity will walk away from its home, i.e. send “jingle mail” (put the home keys of the home in an envelope, send it to the bank and walk away from the home). Reputational considerations and other factors may lead some home owners to keep on servicing their mortgage. But it is obvious that the larger is the negative equity in a home the greater is the incentive to do use “jingle mail”. Indeed, why should any rational agent continue to service a debt when the underlying value of the collateral for it is much lower than the value of the debt and the creditor cannot go after the debtor for the difference between the debt value and the value of the collateral?

Until recently there was a conventional wisdom and wishful thinking that home owners would not voluntarily walk away from their homes. This wishful thinking was based on a few flawed assumptions. First, most analysts did not even consider the possibility that home prices would fall so much that a large fraction of households would fall into negative equity; there was the delusion that home prices would go up forever or would never fall. Second, analysts did not consider how many of the mortgages originated in 2005-2007 were with little or zero down-payment and thus with little or no equity to begin with; the myth of the stable and non-defaulting home owner was based on a distant past when most borrowers put 10 to 20% down payment in their home and had substantial equity into it. Third, economic logic suggested that an agent with such a put option would walk away from its home and mortgage whenever in negative equity territory; so delusions that sentimental value would restrain home owners from defaulting had little economic rationale. So, now that home prices keep on falling and an increasing number of home owners end up in negative equity territory voluntary defaults and “jingle mail” are surging. Is there then anything to be surprised about?

How many households will end up in negative equity territory and will thus an incentive to walk away from their mortgages? The answer to this question of course depends on how much home prices will eventually fall from their peak. A recent analysis by Goldman Sachs suggests that if home prices fall another 10% in 2008 after having fallen by about 8% from peak in 2007 (based on the Case-Shiller/S&P index) about 15 million households will be in negative equity territory. There are other estimates that are consistent with the Goldman Sachs one. Calculated Risk
– a very well respected housing blogger – estimated that if home prices decline by 10% in 2008 the number of households with negative equity will be 10.7. But this estimate was based on a partial underestimate of the fall in home prices in 2007 relative to its 2006 peak (as the Case-Shiller data for all of 2007 were not available at the time of that estimate). Thus, the number of households with negative equity could be closer to 12 million. Calculated Risk also estimates that a cumulative fall in home prices of 20% implies 13.7 million households with negative equity while a 30% cumulative fall implies 20.3 million households with negative equity.
These figures are staggering considering that in 2006 the total number of households with mortgages was 51.2 million. So between 20% to 40% of households with mortgages may end up with negative equity in their homes and with a big incentive to walk away from their mortgages. Even the lower bound figure of 10 million households with negative equity (20% of those with mortgages) is huge.


How many additional losses will banks suffer if these many households walk away from their homes? If a bank ends up with a home that is worth less than the value of the mortgage the loss for the bank is at least as large as the difference between the mortgage value and the market value of the collateral. But losses are likely to be even larger: foreclosure is an expensive proposition for banks; and ending up with many properties that are not easily sellable in current illiquid housing markets where there is a glut of homes will imply further losses. Of course, the initial loss from a fall in home prices is taken by the household whose equity is eroded by the fall in home prices. But many of these households had very little equity to begin with; and once the fall in prices leads to negative equity and the borrower walking away from the home the further losses from falling home prices – i.e. all the negative equity in the home – is taken by the bank that originated the mortgage or – in the case of securitization – the investors that eventually bought the RMBS or CDOs related to that mortgage.

What is the size of these losses for financial institutions and investors? Again this is a complex estimate as it depends on how large in the fall in home prices and the recovery rate given default and foreclosure. The only hard estimate that I have found so far is one by Calculated Risk
. The way he puts it: “Assuming a 15% total price decline, and a 50% average loss per mortgage, the losses for lenders and investors would be about $1 trillion. Assuming a 30% price decline, the losses would be over $2 trillion. Not every upside down homeowner will use jingle mail, but if prices drop 30%, the losses for the lenders and investors might well be over $1 trillion (far in excess of the $70 to $80 billion in losses reported so far).”

What will be the consequence of losses of over $1 trillion and, possibly, as high as $2 trillion? That would wipe out most of the capital of most of the US banking system and lead most of US banks and mortgage lenders – that are massively exposed to real estate – to go belly up. You would then have a systemic banking crisis of proportions that would be several orders of magnitude larger than the S&L crisis, a crisis that ended up with a fiscal bailout cost of over $120 billion dollars. And the scary part of this scenario is that – with home prices likely to fall by 20% or more – this scenario of systemic banking crisis is becoming increasingly likely.

Thursday, February 21, 2008

Cartoon Thursday

I love good political cartoons. Unfortunately, I do not actively seek them out, but I recently found a ready source. Another blogger puts these up on his site fairly regularly. If you get a chance visit NYC Housing Bubble if nothing else just for the cartoons. Also the others parts of the site are fairly good as well. At any rate below are a few of the cartoons that made me chuckle (double click to enlarge).

Recession Comments from Martin Feldstein

As the head (or former head because I thought he stepped down) of the NBER (National Bureau of Economic Research) he chaired their business cycle committee that defines when a recession begins and ends. Therefore, his comments about the current situation in the economy are always interesting to read. By the way, the business cycle committee only meets when is needed. My understanding is that it met last December after years of not meeting.

With all that said as an introduction, the article belows explains in very understandable terms why this economic slowdown is different from the others and why the Fed's monetary policy is of limited value. You can tell by my color scheme that I consider some parts of the article more important than others. Red is the most important, followed by blue, and then just plain bold. Text in bold is my emphasis. From the WSJ:

Although it is too soon to tell whether the United States has entered a recession, there is mounting evidence that a recession has in fact begun. Key measures of economic activity stopped growing in December and January or actually began to decline. The collapse of house prices and the crisis in the credit markets continue to depress the real economy.

The sharp reduction in the federal funds interest rate and the new fiscal stimulus package may, of course, be enough to avert a downturn. Many forecasters still predict that the economy will just slow in the first part of this year and then rebound after the summer. But the hope that monetary and fiscal policies would prevent continued weakness by boosting consumer confidence was derailed by the recent report that consumer confidence in January collapsed to the lowest level since 1992.

If a recession does occur, it could last longer and be more painful than the past several downturns because of differences in its origin and character. The recessions that began in 1991 and 2001 lasted only eight months from the start of the downturn until the beginning of the recovery. Even the deeper recession of 1981 lasted only 16 months.


But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.

In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy.

The unprecedented national fall in house prices is reducing household wealth and therefore consumer spending. House prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion. No one can predict the extent to which the coming fall in house prices will lead to defaults and foreclosures, driving house prices and wealth down even further. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months.

But the principle cause for concern today is the paralysis of the credit markets. Credit is always key to the expansion of the economy. The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied.

The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment.

The collapse of the credit markets began last summer when the subprime mortgage crisis demonstrated that financial risk of all types had been greatly underpriced, that the market prices of complex financial assets overstated their true values, and that the credit scores provided by rating agencies are not to be trusted. Because market participants now lack confidence in asset prices, they are unwilling to buy existing assets, thus preventing current asset owners from providing credit to new borrowers.

The lack of confidence in asset prices also translates into a lack of confidence in the creditworthiness of other financial institutions, impeding the extension of credit to those institutions. And because financial institutions do not even have confidence in the value of their own capital and in the potential availability of liquidity, they are reluctant to make new lending commitments.

It is not clear what can bring back the confidence in asset prices that is needed for credit to flow again. Some analysts suggest that confidence would return if the financial institutions declare the true market value of their assets by restating balance sheets at the depressed prices at which they could be liquidated today. But this is not a practical solution, since many complex securities are no longer trading in the market. Forcing an actual sale of these securities at fire-sale prices in order to establish market values could also create unnecessary bankruptcies that would further impede credit flows.


The current situation has the elements of a Catch-22: The credit flows needed for economic expansion require confidence in the values of existing financial assets, but market participants may not have such confidence while the risk of recession hangs over us.

There is plenty of blame to go around for the current situation. The Federal Reserve bears much of the responsibility, because of its failure to provide the appropriate supervisory oversight for the major money center banks. The Fed's banking examiners have complete access to all of the financial transactions of the banks that they supervise, and should have the technical expertise to evaluate the risks that those banks are taking. Because these banks provide credit to the nonbank financial institutions, the Fed can also indirectly examine what those other institutions are doing.


The Fed's bank examinations are supposed to assess the adequacy of each bank's capital and the quality of its assets. The Fed declared that the banks had adequate capital because it gave far too little weight to their massive off balance-sheet positions -- the structured investment vehicles (SIVs), conduits and credit line obligations -- that the banks have now been forced to bring onto their balance sheets. Examiners also overstated the quality of banks' assets, failing to allow for the potential bursting of the house price bubble.


(Having worked through my share of bank examinations by the FED, FDIC, and the OCC, not to mention various state examiners, I found the comments above to be very interesting and largely true.)

The implication of this for Fed supervision policy is clear. The way out of the current crisis of confidence is not. We can only hope that those who predict nothing worse than a temporary slowdown are correct.


Wednesday, February 20, 2008

More Bank Losses to Come

Just in case you thought the loan losses were over and we would be back to normal by summer, it looks like there are more loans losses to come from areas outside of mortgages. When a bank's problem is loan losses, dropping interest rates really is not going to help much. Lower rates makes it cheaper for banks to borrow, but the loan losses will cause the banks to restrict lending no matter how favorable the rates. Looks like this credit crunch could last a while. Text in bold is my emphasis. From the NY Times:

Wall Street banks are bracing for another wave of multibillion-dollar losses as the crisis that began with subprime mortgages spreads through the credit markets.

In recent weeks one part of the debt market after another has buckled. High-risk loans used to finance corporate buyouts have plummeted in value. Securities backed by commercial real estate mortgages and student loans have fallen sharply. Even auction-rate securities, arcane investments usually considered as safe as cash, have stumbled.

The breadth and scale of the declines mean more pain for major banks, which have already written off more than $120 billion of losses stemming from bad mortgage-related investments. The deepening losses might make banks even more reluctant to make the loans needed to prod the slowing American economy. They also could force some banks to raise more capital to bolster their weakened finances.

The losses keep piling up. Leading brokerage firms are likely to write down the value of $200 billion of loans they have made to corporate clients by $10 billion to $14 billion during the first quarter of this year, Meredith Whitney, an analyst at Oppenheimer, wrote in a research report last week.

Those institutions and global banks could suffer an additional $20 billion in losses this year on commercial mortgage-backed securities and other debt instruments tied to commercial mortgages, according to Goldman Sachs, which predicts commercial property prices will decline by as much as 26 percent.

Analysts at UBS go further, predicting the world’s largest banks could ultimately take $123 billion to $203 billion of additional write-downs on subprime-related securities, structured investment vehicles, leveraged loans and commercial mortgage lending. The higher estimate assumes that the troubled bond insurance companies fail, a possibility that, for now, is relatively remote.

Such dire predictions underscore how the turmoil in the credit markets is hurting Wall Street even as the Federal Reserve reduces interest rates. Already, once-proud institutions like Merrill Lynch, Citigroup, and UBS have gone hat in hand to Middle Eastern and Asian investors to raise capital. “You don’t have a recovery until you have the financial system stabilized,” Ms. Whitney said. “As the banks are trying to recover they will not lend. They are all about self-preservation at this time.”

One of the latest areas to come under pressure is the leveraged loan market. In recent weeks the market for these corporate loans plummeted, driven by fear that banks have too many loans to manage. Prices have fallen as low as 88 cents on the dollar, levels not seen since 2002, when default rates were more than 8 percent. Loans to some companies, like Univision Communications and Claire’s Stores, are trading in the high 70s, analysts say.

“Price declines of this magnitude — over 10 points — were not supposed to happen in the leveraged loan market,” B of A credit analysts wrote in a report on Feb. 11.

When banks make loans, they hold them until they can sell the debt to institutional investors like hedge funds and mutual funds. But lately the market for this debt has seized up and many banks have been unable to unload the loans. As the value of this debt declines, lenders must recognize as a loss the difference in the value at which they made loans and the prices of similar debt in the secondary, or resale, market.

“This correction feels a lot deeper and wider and more prolonged than what we have seen historically,” said one senior Wall Street executive who was not authorized to speak to the media.

Many analysts say the financial health of many companies has not deteriorated as much as loan prices suggest.

“People don’t know what’s out there, they haven’t sorted out what’s good and what’s bad, so they are throwing all credit assets out,” said Meredith Coffey, director of analysis at the Reuters Loan Pricing Corporation. Median loan prices were lower than those in 2002 when defaults peaked, even though very few defaults have actually occurred.

There has also been a marked deterioration in the market for commercial mortgage-backed securities, which are commercial mortgages packaged into bonds.

To some, the troubles plaguing commercial mortgage securities seem a logical extension of the turmoil in the residential real estate market. But some strategists argue that the commercial real estate market is not as vulnerable as the housing market. The pressure to package loans that was so evident in the residential market never materialized in the commercial market, these analysts say.

Also, commercial loans tend to be made at fixed, rather than adjustable, rates, and are not usually refinanced for long periods of time.

Nevertheless, the cost of insuring a basket of commercial mortgage-backed securities has soared. Last October, for example, it cost $39,000 to insure a $10 million basket of top rated 2007 commercial mortgages (super senior AAA, in Wall Street language) against default.

Today that price has increased to $214,000. For triple-B-rated commercial mortgage backed securities, those which are riskier, the cost of protection during the same time has soared from $672,000 to $1.5 million.

The deterioration of the CMBX, the benchmark index that tracks the cost of such credit protection, “started off as a fundamental repricing and then it escalated into something much more than that,” said Neil Barve, a research analyst at Lehman Brothers. “We think there is some downside in a challenging macroeconomic environment, but not nearly what has been priced in.”

Goldman Sachs seems to disagree, with analysts predicting commercial real estate loan losses to total $180 billion, with banks and brokers bearing $80 billion of that in total and about $20 billion this year.

Current index figures suggest that the banks will face significant pain. Brad Hintz, an analyst at Sanford C. Bernstein & Company, calculated that Lehman Brothers has the highest exposure to commercial real estate-backed securities, with $39.5 billion, followed by Morgan Stanley, with $31.5 billion. (These numbers do not include hedges that the banks may have but do not disclose).

To be sure, a crisis on Wall Street also spells opportunities for patient bargain hunters. After all, markets that were trading at all-time highs have been reduced to rubble, suggesting that those willing to search for value will find it.

And last week, some hedge funds began to wade into the troubled loan market. But prices do not yet reflect any widespread rallies, and Wall Street still has to absorb losses reflected in these markets.

“The fourth quarter was terrible, but you had strong investment banking revenues,” Mr. Hintz said. “Now you’ve had a bad December, a worse January and an even worse February.”

Tuesday, February 19, 2008

The De-Leveraging of America

Call it what you like, but what you are seeing occurring at this time is the de-leveraging of the American consumer, the mortgage industry, and the banking system. It took us a long time to get to this point of debt and it will take a long time for this to unwind. The question is how quickly (violently) this unwinding will be. If you stop and think about it that is most of what is being discussed in the financial press and on the internet, the de-leveraging of America.

Note that the various policies of cutting rates, putting a hold on foreclosures, or creating a stimulus package are not working. Those policies and that thinking were created to fight the last war, i.e. the Great Depression. That is why those policies are not working. We have a new war of excessive debt, causing credit losses, which ultimately is leading to insolvency in the banking system. How do you fight that war? From the WSJ:

The specter of deleveraging still haunts the financial markets. Rightly so, for the removal of credit from the global economy is a process that feeds on itself. That means that the credit crunch could easily turn into something much nastier.

Before the deleveraging came the leveraging. Take the U.S. The ratio of all sorts of debt to gross domestic product rose to 342% at the end of September 2007 from 160% in 1975. Through 2000, debt increased by 2.4 percentage points a year faster than GDP. But after the turn of the millennium, the rate accelerated almost to 3.7 percentage points a year.

While it was happening, only a few sourpusses complained. Increasing debt was seen as a natural trend. As economies get richer, they have more need for debt-financed investments and inventories. But lending grew much faster after 2000 than even the most gifted apologist could explain away. It was a bubble, which has now been popped.

In a credit bubble, one thing leads to another. You can bid more for a house because banks are willing to lend more. So house prices rise, giving the banks more confidence about lending yet more. So you build an addition or buy a new car.

Multiply that by a few hundred million borrowers and presto, asset prices go up and economic growth is high. Banks rejoiced. They set up off-balance-sheet vehicles that piled on debt. Leveraged-buyout groups borrowed to take companies private; hedge funds borrowed to invest in assets. And so on.

In deleveraging, too, one thing leads to another. Start with a bank that has lost a few billion dollars on subprime mortgages. The bosses are likely to decide that troubled times call for higher capital ratios. That means calling in lines of credit. Some borrowers are forced to sell assets, pulling down prices. The banks then look at the value of their collateral and think: "Oh my god, it's not worth what we thought." They then cut their credit again -- giving another turn of the deleveraging screw.

The housing market was just the start. A series of debt mountains -- credit cards, car loans, LBO loans -- risk being leveled. The credit contraction strikes down financial arrangements that once looked solid -- from structured investment vehicles to auction-rate securities.

If the original debt helped fuel consumption, deleveraging will feed into lower economic activity. If the original debt fueled asset purchases, the consequence will be lower asset prices. There could be a dual effect because lower asset prices can make people feel poorer and less willing to spend money. This is especially the case with people's homes.

How far can this go? Historical parallels aren't terribly comforting. In Japan, a boom in the 1980s was followed by a painful deleveraging. Despite massive government borrowing and five years of a near-zero interest rate on overnight borrowing, the prices of shares and real estate declined by 40% to 70%. The U.K. did better in its deleveraging after 1990 -- house prices dropped by 40%, after taking inflation into account, but share prices rose.

Politicians and central bankers are alarmed by the rapid shift to deleveraging. There are limits to what they can do. Sharp interest-rate cuts may not be enough to make banks abandon their newfound caution in lending, especially if loan losses are rising. Higher government deficits may not help either. In a deleveraging world, the government may borrow so much it crowds out private borrowers seeking funds.

The deleveraging snowball will eventually reach the bottom of the mountain. Banks will start to see opportunities, and borrowers will become more courageous. But it could be a long and painful wait.

If You are Thinking of Buying a Home – Why Would You Do It?

The turmoil in the housing market is causing many buyers to just stand on the sidelines. And why wouldn’t you? Many of the mortgage apps are now failing because potential buyers can’t arrange financing. This is occurring because many potential buyers still think it is 2005 and not 2008. Also the people with money and good credit will not buy because they think they can get a better deal later. The real question that I have is how long does this need to go on before the American public realizes that a house is not an investment, but an asset. Then the issue becomes how much does it cost to carry the asset on your personal balance sheet? The issue of whether or not to buy a house is a cash flow issue and if you get appreciation on top of your purchase that is good luck. Text is bold is my emphasis. From the Reuters:

Home prices have plunged by 10 percent or more in some parts of the United States and interest rates on mortgages are at enticing levels, but many potential buyers are waiting for prices to fall further.

This psychology is helping prevent the hard-hit home market -- suffering one of its worst downturns in history -- from recovering, just as the spring, the peak home buying season, gets underway.

Rochelle Getzler, a housewife in Nassau County, outside New York city, and her husband, Abraham, have been on the fence for nearly a year, waiting for an opportune time to buy.
"I think it is too risky to buy right now," she said. "Yes, prices have come down, but they have come down from extremely high levels."


As is the case with a growing number of Americans, the Getzlers are also feeling the pinch of a weak U.S. economy: Abraham lost his job of over 20 years as a computer technician due to his company's efforts to cut costs. (If Abraham lost his job, why is he thinking of buying a house?)

Sharply higher gas and oil prices are also taking a toll on their monthly expenses.
"We have little wiggle room right now," she said.


"I think home prices are going to continue falling, so I see no compelling reason to buy a home right now when we can hold off and buy at a lower price later this year or early next year," she said.

Economists tend to agree. Housing markets in some parts of the country will suffer drops of more than 30 percent before the housing crisis is over, according to a report in December by Moody's Economy.com.


In Nassau county, where the Getzlers reside, and neighboring Suffolk county, prices peaked in February, 2006, should reach a trough in February, 2009, according to the report. In that time, they are expected to have fallen by 16.4 percent.

Punta Gorda in Florida and Stockton in California are the hardest-hit markets, with declines from peak-to-trough forecast at 35.3 percent and 31.6 percent, respectively, according to the report.

In 2008 alone, prices are forecast to drop from 1.2 percent to 7.7 percent, according to a report by Deutsche Bank.


The report forecast peak-to-trough declines of at least 9.8 percent, and perhaps as much as 29.5 percent, on average for 100 metropolitan areas in the United States.

Many regions succumbing to lower home prices were the biggest gainers during the housing market's heyday. Home builders overbuilt in these regions and speculators went on a buying frenzy, with lax lending standards stoking the flames.

Fast-forward to 2008 and the U.S. housing market is now in the midst of one of the worst slumps since World War II.

New home sales have fallen just over 50 percent from their peak in mid-2005. While that is above the 1987-to-1991 housing cycle downturn of 40 percent, it is slightly below the 1978-to-1981 drop of 56 percent, according to Citigroup.

The supply of new homes has grown to 9.6 months compared with a peak of 9.4 months in 1991 and 11.3 months in 1981. Existing home sales are currently at 1998 levels, down 30 percent from their peak, but the housing downturn lasting from 1978 to 1981 saw existing home sales fall just over 50 percent, Citigroup said recently.

"The economic fundamentals in housing are weak and I see no sign of a bottom," said Chris Mayer, director of the Paul Milstein Center for Real Estate at Columbia Business School in New York.

"People are also worried about their jobs and the economy, so there is also a psychological factor in play that has them in no rush to buy," he said.

Another major factor is that potential home buyers are finding it increasingly difficult to get a loan, he said.


Sunday, February 17, 2008

This Weekend's Contemplation - The 12 Step Program to a Financial Crisis

Although it is long the following is worth a read. The original post came from Nouriel Roubini's web site. If you are not visiting his web site on a regular basis you are missing out on some really good economic commentary. An important facet of about Dr. Roubini's posts is that they are dramatic, you may not agree with them, and he has no trouble taking a stand.

The original article is one of his posts. You do have to register to see the entire post, but reigistration is free for a trial period. Text in bold is my emphasis.

Why did the Fed ease the Fed Funds rate by a whopping 125bps in eight days this past January? It is true that most macro indicators are heading south and suggesting a deep and severe recession that has already started. But the flow of bad macro news in mid-January did not justify, by itself, such a radical inter-meeting emergency Fed action followed by another cut at the formal FOMC meeting.

To understand the Fed actions one has to realize that there is now a rising probability of a “catastrophic” financial and economic outcome, i.e. a vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe. The Fed is seriously worried about this vicious circle and about the risks of a systemic financial meltdown.

That is the reason the Fed had thrown all caution to the wind – after a year in which it was behind the curve and underplaying the economic and financial risks – and has taken a very aggressive approach to risk management; this is a much more aggressive approach than the Greenspan one in spite of the initial views that the Bernanke Fed would be more cautious than Greenspan in reacting to economic and financial vulnerabilities.

To understand the risks that the financial system is facing today I present the “nightmare” or “catastrophic” scenario that the Fed and financial officials around the world are now worried about. Such a scenario – however extreme – has a rising and significant probability of occurring. Thus, it does not describe a very low probability event but rather an outcome that is quite possible.

Start first with the recession that is now enveloping the US economy. Let us assume – as likely - that this recession – that already started in December 2007 - will be worse than the mild ones – that lasted 8 months – that occurred in 1990-91 and 2001. The recession of 2008 will be more severe for several reasons: first, we have the biggest housing bust in US history with home prices likely to eventually fall 20 to 30%; second, because of a credit bubble that went beyond mortgages and because of reckless financial innovation and securitization the ongoing credit bust will lead to a severe credit crunch; third, US households – whose consumption is over 70% of GDP - have spent well beyond their means for years now piling up a massive amount of debt, both mortgage and otherwise; now that home prices are falling and a severe credit crunch is emerging the retrenchment of private consumption will be serious and protracted. So let us suppose that the recession of 2008 will last at least four quarters and, possibly, up to six quarters. What will be the consequences of it?

Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with this severe economic recession…

First, this is the worst housing recession in US history and there is no sign it will bottom out any time soon. At this point it is clear that US home prices will fall between 20% and 30% from their bubbly peak; that would wipe out between $4 trillion and $6 trillion of household wealth. While the subprime meltdown is likely to cause about 2.2 million foreclosures, a 30% fall in home values would imply that over 10 million households would have negative equity in their homes and would have a big incentive to use “jingle mail” (i.e. default, put the home keys in an envelope and send it to their mortgage bank). Moreover, soon enough a few very large home builders will go bankrupt and join the dozens of other small ones that have already gone bankrupt thus leading to another free fall in home builders’ stock prices that have irrationally rallied in the last few weeks in spite of a worsening housing recession.

Second, losses for the financial system from the subprime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will not be only in subprime mortgages and the related RMBS and CDOs. They are now spreading to near prime and prime mortgages as the same reckless lending practices in subprime (no down-payment, no verification of income, jobs and assets (i.e. NINJA or LIAR loans), interest rate only, negative amortization, teaser rates, etc.) were occurring across the entire spectrum of mortgages; about 60% of all mortgage origination since 2005 through 2007 had these reckless and toxic features. So this is a generalized mortgage crisis and meltdown, not just a subprime one. And losses among all sorts of mortgages will sharply increase as home prices fall sharply and the economy spins into a serious recession. Goldman Sachs now estimates total mortgage credit losses of about $400 billion; but the eventual figures could be much larger if home prices fall more than 20%. Also, the RMBS and CDO markets for securitization of mortgages – already dead for subprime and frozen for other mortgages - remain in a severe credit crunch, thus reducing further the ability of banks to originate mortgages. The mortgage credit crunch will become even more severe.

Also add to the woes and losses of the financial institutions the meltdown of hundreds of billions of off balance SIVs and conduits; this meltdown and the roll-off of the ABCP market has forced banks to bring back on balance sheet these toxic off balance sheet vehicles adding to the capital and liquidity crunch of the financial institutions and adding to their on balance sheet losses. And because of securitization the securitized toxic waste has been spread from banks to capital markets and their investors in the US and abroad, thus increasing – rather than reducing systemic risk – and making the credit crunch global.

Third, the recession will lead – as it is already doing – to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans. There are dozens of millions of subprime credit cards and subprime auto loans in the US. And again defaults in these consumer debt categories will not be limited to subprime borrowers. So add these losses to the financial losses of banks and of other financial institutions (as also these debts were securitized in ABS products), thus leading to a more severe credit crunch. As the Fed loan officers survey suggest the credit crunch is spreading throughout the mortgage market and from mortgages to consumer credit, and from large banks to smaller banks.

Fourth, while there is serious uncertainty about the losses that monolines will undertake on their insurance of RMBS, CDO and other toxic ABS products, it is now clear that such losses are much higher than the $10-15 billion rescue package that regulators are trying to patch up. Some monolines are actually borderline insolvent and none of them deserves at this point a AAA rating regardless of how much realistic recapitalization is provided. Any business that required an AAA rating to stay in business is a business that does not deserve such a rating in the first place. The monolines should be downgraded as no private rescue package – short of an unlikely public bailout – is realistic or feasible given the deep losses of the monolines on their insurance of toxic ABS products.

Next, the downgrade of the monolines will lead to another $150 (B, I assume)of writedowns on ABS portfolios for financial institutions that have already massive losses. It will also lead to additional losses on their portfolio of muni bonds. The downgrade of the monolines will also lead to large losses – and potential runs – on the money market funds that invested in some of these toxic products. The money market funds that are backed by banks or that bought liquidity protection from banks against the risk of a fall in the NAV may avoid a run but such a rescue will exacerbate the capital and liquidity problems of their underwriters. The monolines’ downgrade will then also lead to another sharp drop in US equity markets that are already shaken by the risk of a severe recession and large losses in the financial system.

Fifth, the commercial real estate loan market will soon enter into a meltdown similar to the subprime one. Lending practices in commercial real estate were as reckless as those in residential real estate. The housing crisis will lead – with a short lag – to a bust in non-residential construction as no one will want to build offices, stores, shopping malls/centers in ghost towns. The CMBX index is already pricing a massive increase in credit spreads for non-residential mortgages/loans. And new origination of commercial real estate mortgages is already semi-frozen today; the commercial real estate mortgage market is already seizing up today.

Sixth, it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt. This, like in the case of Northern Rock, will lead to depositors’ panic and concerns about deposit insurance. The Fed will have to reaffirm the implicit doctrine that some banks are too big to be allowed to fail. But these bank bankruptcies will lead to severe fiscal losses of bank bailout and effective nationalization of the affected institutions. Already Countrywide – an institution that was more likely insolvent than illiquid – has been bailed out with public money via a $55 billion loan from the FHLB system, a semi-public system of funding of mortgage lenders. Banks’ bankruptcies will add to an already severe credit crunch.

Seventh, the banks losses on their portfolio of leveraged loans are already large and growing. The ability of financial institutions to syndicate and securitize their leveraged loans – a good chunk of which were issued to finance very risky and reckless LBOs – is now at serious risk. And hundreds of billions of dollars of leveraged loans are now stuck on the balance sheet of financial institutions at values well below par (currently about 90 cents on the dollar but soon much lower). Add to this that many reckless LBOs (as senseless LBOs with debt to earnings ratio of seven or eight had become the norm during the go-go days of the credit bubble) have now been postponed, restructured or cancelled. And add to this problem the fact that some actual large LBOs will end up into bankruptcy as some of these corporations taken private are effectively bankrupt in a recession and given the repricing of risk; convenant-lite and PIK toggles may only postpone – not avoid – such bankruptcies and make them uglier when they do eventually occur. The leveraged loans mess is already leading to a freezing up of the CLO market and to growing losses for financial institutions.

Eighth, once a severe recession is underway a massive wave of corporate defaults will take place. In a typical year US corporate default rates are about 3.8% (average for 1971-2007); in 2006 and 2007 this figure was a puny 0.6%. And in a typical US recession such default rates surge above 10%. Also during such distressed periods the RGD – or recovery given default – rates are much lower, thus adding to the total losses from a default. Default rates were very low in the last two years because of a slosh of liquidity, easy credit conditions and very low spreads (with junk bond yields being only 260bps above Treasuries until mid June 2007). But now the repricing of risk has been massive: junk bond spreads close to 700bps, iTraxx and CDX indices pricing massive corporate default rates and the junk bond yield issuance market is now semi-frozen. While on average the US and European corporations are in better shape – in terms of profitability and debt burden – than in 2001 there is a large fat tail of corporations with very low profitability and that have piled up a mass of junk bond debt that will soon come to refinancing at much higher spreads. Corporate default rates will surge during the 2008 recession and peak well above 10% based on recent studies. And once defaults are higher and credit spreads higher massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults. Estimates of the losses on a notional value of $50 trillion CDS against a bond base of $5 trillion are varied (from $20 billion to $250 billion with a number closer to the latter figure more likely). Losses on CDS do not represent only a transfer of wealth from those who sold protection to those who bought it. If losses are large some of the counterparties who sold protection – possibly large institutions such as monolines, some hedge funds or a large broker dealer – may go bankrupt leading to even greater systemic risk as those who bought protection may face counterparties who cannot pay.

Ninth, the “shadow banking system” (as defined by the PIMCO folks) or more precisely the “shadow financial system” (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that – like banks – borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don’t have direct or indirect access to the central bank’s lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities.

Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system – stressed by credit and liquidity problems - cannot be directly rescued by the central banks in the way that banks can.

Tenth, stock markets in the US and abroad will start pricing a severe US recession – rather than a mild recession – and a sharp global economic slowdown. The fall in stock markets – after the late January 2008 rally fizzles out – will resume as investors will soon realize that the economic downturn is more severe, that the monolines will not be rescued, that financial losses will mount, and that earnings will sharply drop in a recession not just among financial firms but also non financial ones. A few long equity hedge funds will go belly up in 2008 after the massive losses of many hedge funds in August, November and, again, January 2008. Large margin calls will be triggered for long equity investors and another round of massive equity shorting will take place. Long covering and margin calls will lead to a cascading fall in equity markets in the US and a transmission to global equity markets. US and global equity markets will enter into a persistent bear market as in a typical US recession the S&P500 falls by about 28%.

Eleventh, the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk. A variety of interbank rates – TED spreads, BOR-OIS spreads, BOT – Tbill spreads, interbank-policy rate spreads, swap spreads, VIX and other gauges of investors’ risk aversion – will massively widen again. Even the easing of the liquidity crunch after massive central banks’ actions in December and January will reverse as credit concerns keep interbank spread wide in spite of further injections of liquidity by central banks.

Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.

Based on estimates by Goldman Sachs $200 billion of losses in the financial system lead to a contraction of credit of $2 trillion given that institutions hold about $10 of assets per dollar of capital. The recapitalization of banks sovereign wealth funds – about $80 billion so far – will be unable to stop this credit disintermediation – (the move from off balance sheet to on balance sheet and moves of assets and liabilities from the shadow banking system to the formal banking system) and the ensuing contraction in credit as the mounting losses will dominate by a large margin any bank recapitalization from SWFs. A contagious and cascading spiral of credit disintermediation, credit contraction, sharp fall in asset prices and sharp widening in credit spreads will then be transmitted to most parts of the financial system. This massive credit crunch will make the economic contraction more severe and lead to further financial losses. Total losses in the financial system will add up to more than $1 trillion and the economic recession will become deeper, more protracted and severe.

A near global economic recession will ensue as the financial and credit losses and the credit crunch spread around the world. Panic, fire sales, cascading fall in asset prices will exacerbate the financial and real economic distress as a number of large and systemically important financial institutions go bankrupt. A 1987 style stock market crash could occur leading to further panic and severe financial and economic distress. Monetary and fiscal easing will not be able to prevent a systemic financial meltdown as credit and insolvency problems trump illiquidity problems. The lack of trust in counterparties – driven by the opacity and lack of transparency in financial markets, and uncertainty about the size of the losses and who is holding the toxic waste securities – will add to the impotence of monetary policy and lead to massive hoarding of liquidity that will exacerbates the liquidity and credit crunch.

In this meltdown scenario US and global financial markets will experience their most severe crisis in the last quarter of a century.

Can the Fed and other financial officials avoid this nightmare scenario that keeps them awake at night? The answer to this question – to be detailed in a follow-up article – is twofold: first, it is not easy to manage and control such a contagious financial crisis that is more severe and dangerous than any faced by the US in a quarter of a century; second, the extent and severity of this financial crisis will depend on whether the policy response – monetary, fiscal, regulatory, financial and otherwise – is coherent, timely and credible. I will argue – in my next article - that one should be pessimistic about the ability of policy and financial authorities to manage and contain a crisis of this magnitude; thus, one should be prepared for the worst, i.e. a systemic financial crisis.