Other than we know its bad and there is a coming recession I don't
pretend to understand the subject any more. One useful outcome is
that it kicks the Tibet riots out of the front page and probably out
of the news altogether by the end of this week. This finance meltdown
monster is the most improtant issue for the months to come and no G7
country can afford to antagonize China or let China ba****ng distract
them. The part about not antagonizing China comes with a double
whammy. China's hoard of USD paper, if moved into other securities
will kick from under the US Fed the basis to maintain the value of the
dollar. The global banking system goes down with it. The G7
countries are least able to tolerate this meltdown. The other whammy
is the US is still looking to China and the other SWFs to borrow from.
They have to play nice and Tibet is not it.
THE BEAR'S LAIR
Sorry, I wasn't pessimistic enough
By Martin Hutchinson
March 19, 2008
http://www.atimes.com/atimes/Global_Economy/JC19Dj01.html
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 US$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 & Poor's 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-****ller 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
tem****arily 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 costs, 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 cor****ate 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 pro****tion 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 im****tant market position. It 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.
No exemption
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, which
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 relation****ps 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 Michel 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.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com
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