Friday, May 18, 2007

Paulson Gives Bottoms Up On Subprime Crisis

Since Secretary Paulson's remarks on the housing bubble in the Newshour segment for Thursday May 17, Treasury Secretary Discusses Wolfowitz, Chinese Economy , may have been drowned out by more salacious developments in the world of high level banking I give them here:

JIM LEHRER: One final question, and a third subject. How worried are you about the slump, so-called slump in the housing market in the United States right now? And what kind of damage, if any, is it doing to the economy?

HENRY PAULSON: Well, let me say this. As you've pointed out, we've had a major housing correction in the U.S. The U.S. economy had been growing at a rate that was unsustainable and, in housing, it had clearly been growing at a rate for a number of years.

That correction was inevitable; that correction has now been significant. We think it is near the bottom. It will take a while to work its way through the system. Fortunately for us, we have a very diverse, healthy economy. There are other things that are positive that are offsetting that.

We've had business investments start to pick up. They've got a very strong labor market, unemployment at quite a low level. We have good growth outside of the country. We've been talking about exports to China, but exports everywhere are picking up. The consumer remains healthy.

So my very strong view is that we are near the bottom and that this will be contained as -- the housing will be contained, and we're fortunate that we have a diverse, healthy economy.

The correction to which Sec. Paulson is referring is that beginning in 2006 when homebuyers courting default suddenly found themselves with no additional home equity to see them through. They also faced the additional obstacle to selling presented by a glut of inventory on the market. Refinancing options quickly evaporated as borrowers were unable to get appraisals matching the original purchase price of the home. But where is the evidence that would lead him to conclude that this is the extent of the correction that in his own words "was inevitable?"

The language Sec. Paulson uses is in itself instructive. All in the same breath he is able to say "we've had a major housing correction", "We think it is near the bottom. It will take a while to work its way through the system." and "we are near the bottom." The mixture of past present and future tenses doesn't exactly inspire confidence.

Another opinion can be found in the Credit Suisse Mar 12 2007 Mortgage and Housing Report which points out that "escalated delinquency rates on 2006 vintage loans are not being driven by the payment shock issue which is at the forefront of legislative and regulator debate, as rate reset has not yet occurred on these loans. As shown in Exhibit 42, [below but for a clearer image see the report] roughly $300 billion of securitized subprime mortgages (36% of outstanding subprime MBS) are set to reset in 2007 alone, with even more occurring in the non-securitized space. This, in our opinion, is the next shoe to fall and will likely contribute to additional delinquencies, foreclosures, inventory and additional pricing pressure." Perhaps this explains the hesitancy implicit in the Secretary's language.

As for the factors that are claimed to be "positive" and "offsetting," i.e., the "diverse, healthy economy", with "business investments start[ing] to pick up", "a very strong labor market", "unemployment at quite a low level", "good growth outside of the country", "exports everywhere are picking up", and the "consumer remain[ing] healthy", each in turn is in strongly disputed territory. At least with regard to the China trade Sec. Paulson admits that the administration have only "been talking about exports." So much less than a positive is this factor that talk of a developing trade war is more on the lips of commentators.

And for a glimpse of the kind of 'creative accounting' that is once again claiming impending losses as income visit the contribution by Aaron Krowne at iTulip Forums, Say Hello To Lendron . After noting that the breaking housing bubble has "already spread from subprime to other sorts of marginal lending, and mortgage lending in general, including 'Alt-A', prime second liens–which back home equity extractions–and any sort of high-LTV loan," this article draws attention to Pay Option ARMs, (adjustable-rate mortgages). These are the ones with the option of paying less than the normal monthly payment, the difference being added to the principal. Thus the label negative-amortization applied to these. And these offer the prospect of an even more explosive situation than the subprime meltdown.

What is startling is the way lenders or portfolio-holders of these treat negative amortization in their accounting, taking the negative amortization amount and adding it to earnings. There is a growing trend in which mortgage lenders and bankers with extensive involvement in this class of mortgage treat this as "capitalization of income from negative amortization" and show it as part of net income, as much as 72% in one particular case. We should all hope fervently that these are not the business investments that Sec. Paulson assures us are starting to pick up.

Monday, May 14, 2007

Betting the Bank, and then some.....

Who hasn't heard stories of inveterate betting men fully alert to the essential truth that everything in life is a wager. It's chilling to think that the progress of the subprime bubble may well depend on the progress of two flies on a window pane, but let's not forget the idea attributed to chaos theory of the connection between the flapping of butterfly wings and the tornado that topples an economy. (A fascinating area in which to see the dissipation of risk based on essentially the same notion is the apparently mundane world of Insurance and Re-Insurance where the losses from disasters are spread in a worldwide market. Mundane until it's recalled that the men in the London coffee-houses were themselves no stiffs when it came to a bet).

The wild frenzy of gambling that now grips the world is not only attested to by the 54 million casino visits made by Americans in 2004 to lose more than $78 billion on the turn of a card or the spinning the slots, in effect sophisticated mechanical flies. James Mackintosh in The unbearable obscurity of exotic hedge funds gives a truly hair-raising listing of the current trend in hedge fund products. These make the sorties into housing speculation of the American homeowner positively parochial. You start to get the flavor of the 'New Economy' on learning from Mackintosh, "As hedge funds move into the mainstream, managers are testing demand for ever-more exotic investments - and finding backers willing to stump up millions of dollars for funds putting cash into everything from football players, wine and art to aircraft leasing and carbon credits."

A telling clue to the unease of large investors in the plain old vanilla securities market can be had from the tendency of big institutions to ensure that their fortunes "will not move in line with shares, bonds and other traditional investments." Following on this in the recent period money has flowed to a range of 'exotic' funds. These include football funds that buy the rights to talented young players in the hope of profiting from transfer fees should these achieve star status; instead of boring old charts investors must assess the risks of injury, drug abuse etc. (American Idol Fund anyone?). Others include fund specialising in sugar, film financing, art and wine.

Ominously, given the level of consumer debt, there are also funds investing in defaulted credit card debts and partnering with collection agencies in recovering the debt. This in an era when some credit card debt carries interest approaching 30% and when the UK for example is beset with problems stemming from the practices of doorstep consumer loan companies. There was a time when this kind of debt was purely a 'family' affair. Perhaps these developments lend a new meaning to the expression 'gangster-capitalism.'

Enter the multiplier, never far behind. Not to be outdone, Orthogonal Partners is launching a fund dedicated to - investing in exotic hedge funds. "There is a wall of money chasing every opportunity in the alternative scene so you really want to be targeting new niches where you still have a scarcity of capital and inefficiencies that can be exploited," says Dan Gore, Orthogonal's co-founder.

A staid voice intrudes; 'Tracy Pearson, head of alternatives at London fund of hedge funds Forsyth Partners, says it is questionable how many of the exotic funds are really hedged. "If it is offshore and they can charge 2 [per cent a year] and 20 [per cent of profits] it is a hedge fund," she says. "We get all sorts of stuff, usually sent from a Yahoo e-mail account."'

Any day now I expect offers from Nigeria to arrive in my inbox; they may even be packaged with the scams offering to make me an instant multi-millionaire in exchange for help with repatriating the fortunes of some hapless tyrant. Hey, I just thought of a great hedge fund idea.

Sunday, May 13, 2007

'Too Much Like 1929'

Bernard Ber, an investment representative with CIBC in Toronto, has published an article that for its superior analysis deserves attention. (This originally appeared in Guest Commentary at but at time of writing has gone missing; this may or may not have conspiratorial implications depending on your temperament; I give an alternative link below). The opinion expressed, needless to say, is hardly the official position of the Bank and one wonders to what extent it is a view shared within the corridors. This writer obviously knows all those numbers and concepts on the currency exchanges that give us all such headaches (well, me anyway).

Of great interest is the thesis that the relationship between China and the USA today is a replica of that between USA and Britain on the eve of the Great Depression.

"The two major players in the world
financial system at that time were the United States and Great Britain. The
United States was the emerging industrial power, whereas Great Britain was the
mature and stagnating industrial power. ...

Now fast forward to today, and what
you see is China as the emerging industrial power and the United States as the
mature and stagnating industrial power."

Tuesday, May 8, 2007

Margin of Errors

Having argued in a recent post that the position of homeowners faced with foreclosure on being unable to meet rising mortgage payments coupled with stagnation or housing price decline, ( see Speculation and The Housing Bubble - "The position is no different in essence to that of someone stricken with margin madness in a stock market bubble."), I was gratified to read this take presented in detail in a comment by jm on a thread at Economist's View . The whole comment is reproduced here:

The real problem in the housing market is
that people are being allowed to speculate with nearly infinite leverage.

In what other market are people as
unsophisticated as the average home buyer allowed to make multi-hundred-thousand
asset purchases with so little cash up front, and without being adjudged capable
of understanding the implications of a margin call -- and more to the point, of
having the financial resources to withstand one?

As interest rates fell through the
last decade, homes began trading like bonds, except that no one would ever let
anyone, let alone the average home buyer, buy bonds with margin loans like the
mortgages being made today.

For decades the home ownership rate
in the US held within a very narrow band around 64%, but over the last ten years
has risen to 69%. That's 0.5 percentage points a year against the number of
households, meaning that the pace of new home buying has been at least 400,000
units a year above the rate of household formation, and that there are now 4
million more home-owning households than we'd have at the historical average
level. Is anyone out there going to claim that this is because the economy is
booming for people in the economic situations of those households?

I predict that, since wages
have risen very little since the late 90s, and home prices were already elevated
then due to the rising ownereship rate, prices are going to fall back to
late-90s levels or below. A lot of people are going to get very cruel lessons on
the risks of highly leveraged speculation in illiquid assets.

The awful evil of this is that it
could have been prevented just by enforcing in the mortgage lending markets the
same kind of standards that are applied to margin buying in the bond market. It
wouldn't have taken any explicit targeting of asset prices or judgments about
what did or did not constitute a bubble.

Posted at Economist's View by: jm Mar 31, 2006 8:24:05 PM

I am left wondering what is the mystery behind the inaction in the face of what could have been prevented so easily. One answer put forward so far is that fueling the housing bubble was a sure fire way of maintaining momentum in the economy in the face of looming recession and in the aftermath of the bubble. Another sees the Fed's cheap money policy as being more a result of being caught between a rock and a hard place than a policy of choice.

Meanwhile we are confronted with what to some are mixed signals everywhere. Reports of the Housing Bubble being a global phenomenon multiply. Yet the securities market appears to roar on oblivious. The common wisdom on bubbles, which I share for now, is that things can't go on forever. Yet there does seem to be a certain resiliency in the Global Economy. Could it be that there is something different about the new conditions of globalization that we are not seeing?

Wednesday, May 2, 2007

A New 'New Deal'?

If the unfolding contagion of the subprime crisis really has the potential to precipitate, (in the awkward translation of the Global European Anticipation Bulletin' No.14 report - see below.) 'America's Very Great Depression', then sooner or later the question of a "New 'New Deal'" must enter the discussion. And in the belief of many it is not only America's fate that is in the balance. If as many claim the money financing this housing bubble comes from global sources, the end of the US housing bubble could have disastrous consequences globally. If indeed 50% of “securitized” mortgage debt is held by overseas investors, the subprime meltdown could shake the entire global financial system.

While it is true that assessments of the extent to which the New Deal rescued America from the ravages of the Great Depression vary widely, in any case, on this occasion perhaps we can for once commit ourselves to learning something from history. And this at a time when there is an unmistakable undercurrent of hopelessness abroad in the land. It is salutary to recall that the most pessimistic reflections on the New Deal conclude that it was all for nothing and that the real 'saviour' lay in the dreadful carnage of the World War.

A few areas therefore that strike me as candidates for deliberation. The first question that comes to mind is whether America today is in a position to undertake a new New Deal. Much has been written about America's changed position in the world economy. Whether this change is reflected in international wealth production rankings, the structure of international trade, or national and international debt liabilities, the picture is very different from that faced by FDR. Among European economists some hold the view that Europe could 'de-couple' from the impact of a New American Great Depression. Such opinions would have been unheard of in earlier periods.

A second question concerns the power of the nation state to intervene in an era of privatization and the global free market. It is said that 'the market' is the best mechanism for the solution of all economic problems and that matters should be allowed to run their course. However, whatever merit there is in this idea must surely meet its limit if the consequences are large scale social disruption and the attendant disorders that threaten the very social order that such a market mechanism is claimed to uphold.

There are signs that the implications of an economic disaster are being taken seriously in the centers of power. Witness Senator Charles Schumer's recent remark that, “The subprime mortgage meltdown has economic consequences that will ripple through our communities unless we act.” Federal regulators have called on lenders to work with those borrowers unable to meet their high-risk mortgage payments to help them keep their homes.

And those who perhaps have the most at stake in the spectacle of millions of homeowners defaulting on their loans are showing signs of action. Several major lenders have already unveiled plans for a housing market rescue. Citigroup and Bank of America have together created the Neighborhood Assistance Corporation of America. This will provide $1 billion in subprime loans assistance to allow homeowners to refinance their mortgages and avoid foreclosure. The 30 year loans envisaged will carry a fixed interest rate one point below prime with no fees and with the banks paying closing costs. Washington Mutual has announced a $2 billion program to forestall the worst of the foreclosures impact and Freddie Mac has committed $20 billion with the same goal in mind, adding that the term would be extended to a maximum of 40 years from the existing 30 year limit.

Perhaps what we see in these moves is the beginning of a 'privatized' New Deal? Perhaps this also signals that we are reaching the end of the period of widening income differentials? Whatever the case where is the logic in waiting for a disaster to happen before the necessary response is called forth? Surely the time for a New 'New Deal' is now and not when the damage is done. Sure, the people at Citigroup, BoA and WaMu are acting in their own best interests. But, I have to believe that people of honour and integrity are in the majority on this shrinking planet, the opposing view being too terrifying to entertain. And if that's Utopian perhaps the time has come for this word to be rehabilitated.