THE BEAR'S LAIR Sorry, I
wasn't pessimistic enough By
Martin Hutchinson
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-Shiller index, was almost
10%; more ominously, in the fourth quarter of
2007, prices were dropping at a 20% annual rate.
It thus seems unlikely that the overall decline in
house prices will be limited to 20%, and more
probable that when prices finally turn, they will
have dropped 25-30%, with drops of as much as 50%
in some heavily speculative markets such as much
of California. This is an exceptional outcome by
US standards, ranking with the 1930s as a house
price downturn, but it must be remembered that in
Japan Tokyo house prices dropped by over 70% from
their 1990 peak before stabilizing.
The
depth of house price declines has a
near-exponential effect on mortgage defaults,
since a borrower can walk away from a home
mortgage without declaring bankruptcy - the
transactions are generally non-recourse. Roubini
estimates that if house prices decline 20% 16
million mortgages would be "under water" with
principal amount greater than the value of the
underlying asset, and that 50% of those underwater
mortgages will default. If house prices decline
30%, 21 million mortgages will be underwater, with
the same percentage defaulting.
At the
lower price decline, that seems to me a little
pessimistic. A borrower who can make payments on
his mortgage, and whose house is temporarily worth
5% or even 10% less than the mortgage is unlikely
to default, if only because he has to live
somewhere and moving costs, let alone real estate
brokerage 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
corporate loans, automobile loans and most areas
of the credit economy. Even emerging market debt,
at first sight insulated from the problem, is in
practice endangered by its concentration in Latin
America and Russia, both dependent either on the
US economy itself or on the high oil prices to
which US easy money policies have led. Finally
credit default swaps, with an outstanding volume
of an extraordinary $50 trillion, appear to be an
accident waiting to happen. Thus a mere $1.5
trillion in housing debt losses may indeed produce
total losses of $3 trillion or more when
collateral damage is included.
Not all of
those losses will be felt by financial
institutions, although the extraordinary appetite
for risk that such institutions have exhibited
over the past decade suggests that a high
proportion of them may indeed come to rest in the
financial area. If that is the case, we have a
problem: the total capitalization of the US
banking and brokerage system is only about $1
trillion.
The Bear Stearns intervention on
Friday was a first symptom of what we can expect.
(The Northern Rock disaster in London was a case
simply of appallingly inept regulation of a bunch
of hyper-aggressive used-car salesmen who moved
into the home mortgage business.) Bear Stearns,
while not without its reputation for sharp elbows,
is a major house with an important market
position. 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
relationships with other banks. Even when Drexel
Burnham went bankrupt, the authorities were able
to solve the problem by allowing a two-stage
process, whereby the expansionist 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.
(Republished with permission from
PrudentBear.com . Copyright 2005-07 David W Tice
& Associates.)
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