The black hole in financial markets
By David P Goldman
Subprime mortgages were the beginning, not the end, of a global financial
crisis, and in recognition of this fact equity markets have crashed. The
proximate cause of this week's retreat in equity markets to the lowest levels
since the 1990s was the collapse of loans to American commercial real estate,
which in turn implies the collapse of insurance companies and pension funds.
Americans who relied on private pension funds, whether through their employer
or insurance companies, will lose part or all of their pensions.
That is why it is so difficult to rescue General Motors, which has said that it
may not last the year without official help. Not only stocks, but many of the
fixed-income assets owned by insurance companies have fallen by half during
2008, including commercial mortgage-backed securities, and the capital
securities of some
commercial banks. Citigroup's preferred shares issued last March traded on
November 20 at 50 cents on the dollar.
The problem now becomes self-feeding. The collapse of equity and credit values
destroys the value of corporate pensions, requiring corporations with defined
benefit plans that still cover 20 million workers to divert profits to their
pension funds. The impairment of the credit of insurance companies, in return,
eliminates a major source of long-term credit provision.
Spread on AAA-rated commercial mortgage-backed securities
About US$800 billion of commercial mortgages has been packaged into bonds,
owned mainly by insurance companies and pension funds. As the value of
commercial real estate collapsed, the equity prices of insurance companies
collapsed as well, by more than two-thirds between September 20 and the
November 20 market close, while bank stocks fell "only" by half.
Standard & Poor's 500 life and health insurance sub-index
Even more alarming than the collapse in equity prices is the collapse of the
credit of some of America's largest insurers. It now costs more than 10
percentage points above the benchmark London interbank rate to buy five-year
credit protection on the Hartford group, for example.
Cost of 5-year credit protection (basis points above London interbank rate) for
Hartford Financial Services.
Like subprime loans, more than a third of which are in default, commercial real
estate loans bore "outlandish" forecasts for growth and property appreciation,
Bloomberg News reported on Thursday. Two multi-hundred-million dollar loans to
developers in Arizona and California were near default this week, Bloomberg
reported, provoking the latest round of selling of commercial mortgage-backed
securities. These loans (and many others) assumed double-digit revenue growth
on the part of the borrowers, which makes them as dubious as the so-called
liar's loans in the residential mortgage market.
Americans are beginning to understand how much of their economy depended on the
housing bubble. Shopping malls sold goods to consumers who took on more debt
because the appreciation of their homes made them feel wealthier. Office
buildings filled with workers who sold real estate, processed home mortgages,
and traded mortgage-backed securities. The US economy appeared to prosper by
purchasing goods from China, and then borrowing the money back and using it to
buy homes at higher prices. This, to be sure, exaggerates the problem, but the
point nonetheless is valid.
The collapse of housing prices in the US leads to a collapse of consumer
spending, which with a slight delay leads to a rise in unemployment, which in
turn erodes the value of commercial property, and so forth.
Now that American equity prices have retreated to levels not seen since 1997,
it is a fair question to ask whether the profitability of the US economy was as
strong as the market seemed to think. During the tech boom of the late 1990s,
to be sure, the market was willing to buy stocks with no visible profits at
all. During the 2000s, financial companies comprised about 40% of all corporate
profits, and these turned out to be largely illusory.
American equity returns over the very long term seem disappointing. An investor
who bought the S&P 500 index in 1950, and sold it on November 20, would
have earned a real compounded annual return of just 2% after capital gains tax
(excluding dividends). An investor who bought at the peak of the 1960s equities
boom in 1965 and sold on November 20 would only break even after inflation and
capital gains tax.
The chart below shows the compound annual return to an investor who bought the
S&P 500 index at each date shown, and sold at the November 20 close.
In short, Americans have discovered that what they thought was a stable net
worth (home equity and an equity portfolio) was no such thing, and that such
obligations as pensions and life and health insurance are far less secure than
they thought. The shock has forced a sudden shift in their behavior towards
precautionary savings, which is why the US economy appears to have fallen off a
cliff in October.
The US Treasury is the only entity in the United States with an unchallenged
capacity to borrow, and the rush into precautionary savings was reflected in
the largest-ever increase in government bond prices - by more than eight points
for the 30-year bond - in American history. For the time being, the likelihood
is that global demand for precautionary savings will keep Treasury yields low,
even while the US government finances an unprecedented deficit - perhaps as
large as $2 trillion during calendar 2009.
The liquidation of risk assets in favor of safe assets, and the shift from
consumption to savings, will continue until Americans have restored some part
of their lost wealth. Given that incomes will decline (through rising
unemployment and lower compensation), Americans will be swimming against the
current as they try to repair the household balance sheet. That portends a very
long and painful economic downturn, worse than the 1979-1982 crisis that
preceded the Ronald Reagan reforms.
President-elect Barack Obama is the only man in town with a checkbook, and by
virtue of the Treasury's near-monopoly of financial power, will take office as
the most powerful peacetime president in US history. Faced with the collapse of
private pension, health care and financing systems, Obama will have every
reason to use his mandate to socialize medicine, pensions and many other
aspects of US economic life. The American economy may be hard to recognize
afterwards.
David P Goldman was global head of fixed-income research for Banc of
America Securities and global head of credit strategy at Credit Suisse.
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