The End of the Beginning

Posted by D.D.Grant at 10:46 PM

"Defaulting middle-class U.S. homeowners are blamed, but they are merely a pawn in the game. Those loans were invented so that hedge funds would have high-yield debt to buy." Satyajit Das in an interview with Jon D. Markman, The Credit Crisis Could Be Just Beginning

In what follows I revisit the theme I touched on recently, namely the way in which all the focus of the current credit crisis is being laid at the door of the subprime bubble and by implication on those Americans who entered into one or other of the less than prime mortgages. Let's not forget the hoopla around the spread of home ownership in recent years and the signal it gave that anyone who struggled to get a foot on the home ownership ladder was being a model American. Now there is a definite atmosphere being created that those unfortunate enough to have been on the lowest rung of the ladder are the ones whose 'irresponsibility' has been the cause of tipping the ladder. Let there be no doubt about it that this is a smokescreen, and one made all the easier by the shroud of hocus pocus that has been built around the technical aspects of the finance world.

Everyday life has a pretty good idea of how cause works and despite all the verbal alchemy things are no different in the case of the credit crisis. If anyone approached an auto collision by focusing on how the innocent party had invited the offending vehicle to bring it on we would rightly consider it silly. Similarly, the growth of the subprime mortgage market wasn't a result of some smart idea dreamed up by the homebuying public. It resulted from a premeditated strategy to extend the market for mortgage credit. It wasn't the ordinary homebuyer who invented this mind boggling range of products. On the contrary the various players in the market vied to outdo each other in the next esoteric product they could come up with. All of this went on with the blessings, some would say encouragement, of the FED. Listen for example to Alan Greenspan speaking at the Community Affairs Research Conference in April 2005:

“Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country. With these advance in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers.”

The question then arises of the driver for these marketing innovations. We hear lots about the world having been swimming in liquidity. Note however that not many speak of this as being awash in cash. The truth is that the creation of 'liquidity' stemmed from the development of a range of financial products by the investment community, products massively built on leverage and the off-loading of risk through instruments that to all intents are one or another variety of insurance policy. The problem is that whereas insurers have a long experience of the statistical possibility of the risks they cover actually occurring and know full well that 'runaway' risks are absolutely rare - even mass auto pile-ups or 'out of control' forest fires have a limit as to how far they will go - no such predictability comes with the markets. No one ever heard of 'unwinding' in the case of the ordinary business carried by insurers.

Everyone in the financial markets however had better have heard of the great crashes that have been a recurrent feature in the history of that world. If not they have no business being in business. In practice of course what happens is that every generation cooks up one or another 'theory' that they've got things under control and it won't happen again, "the business cycle has been mastered" and so on, only to be proven wrong each time. These theories are invariably nothing but rationalization of the foolhardy risk taking, what has become known as 'exuberance'.

When in mid-August Goldman Sachs announced that a “25 standard deviation event” had caused the value of its quantitative fund to drop 30%, the implication was that the subprime mortgage crisis had caused the market to behave in some wholly unexpected pathological manner, normally to be anticipated only two or three times in the history of the universe. In reality such “25 standard deviation events” happen two or three times a decade and are perfectly normal. The abnormality, in which the market lost its mind, was in Goldman basing its reputation and its investors’ wealth on such obviously inadequate mathematical techniques. When markets lose their mind, Martin Hutchinson

Given this it is truly outrageous that those who will suffer most in real practical terms from the operations of the credit freewheelers are now being set up as the first link in the chain of cause of the crisis. The truth is that this line is being pushed more as a move to justify the rescue of the speculators by public funds than as a real explanation. It is hoped that gushing of crocodile tears for suffering homeowners will garnish enough sympathy so that the financial world can be pulled from the fire of its own creation, while at the same time it keeps the spotlight pointed elsewhere. And make no mistake about it, it is the financial industry that will benefit from any of the measures contemplated so far. Who after all will benefit from the publicly funded rescue of the debts owed to the mortgage lenders, (even if it's only through the 'liquidity enhancing' measures of the FED or through tax breaks)?

The other aspect of this turn of events is that it acts as an impediment to the understanding of the real causes. Could it be that this is yet another convenient result for those who have gained most from the whole affair? After all, failure to unravel the system of real interconnections that have ended as this 'unwinding' leaves the door open for an equally profitable repeat in some future period.

Blame the Victim Rules the Subprime Debacle

Posted by D.D.Grant at 2:04 AM

Anyone get the impression as I do that the scene is being set for placing the blame for the economic crisis on those hapless people who were so inconsiderate as to put everyone at risk by actually taking advantage of what they saw as the opportunity to get their piece of the pie? Yes folks, the reason the wheels of high finance are now gumming up is you or your neighbours utter selfishness in wanting a decent roof over the heads of your families. How thoughtless and unpatriotic of you to throw caution to the wind.

Max Wolff notes the mindlessness that has become a feature of commentary on the financial crisis where mouthing "subprime" a sufficient number of times seems to absolve anyone from actual analysis. The following from Credit Backwash August 21, 2007

"Every day we watch people blame sub-prime. Sub-prime is neither contained nor, is it the essence of present trouble. Discussing sub-prime as the cause of asset re-pricing has become ubiquitous. I would liken this line of explanation to the way that American urban violence is often discussed as "gang related" or "drug related". In short, it is a lazy catch all employed to avoid scratching below the surface. ..."

The truth is it seems that it's not only in the housing mortgage sector that 'liar loans' have been the fashion.

"A huge credit bubble exists and extends far beyond sub prime mortgage distress. The global bubble is enormous and has many sub-component bubblettes. The internationalization, integration and expansion of finance extended and distributed the effects of overly cheap and easy credit. Innovation of new products, thin opaque markets in credit vehicles and voracious appetite for leveraged yield have transformed balance sheets and portfolios. This mountain of gas soaked rags was ignited by the credit concerns in sub prime. Now the credit bubble is burning. Years of euphoria, easy money and asset inflations built to dizzying heights. Massive, cheap and easy debt was taken on to buy houses, currencies, bonds, equities, mortgages, leveraged loans, credit default swaps, real goods and services. Credit burdens were taken lightly, rolled over, bundled and sold. As long as lenders, buyers, ratings agencies and faith held, bubbles formed and swelled. The size, volatility and interconnectedness of international asset inflation was unprecedented. The downturn has been similarly correlated. Sub-prime credits and the collateralized mortgage obligations comprised of them deflated- the match was struck. The fire is never really caused simply or exclusively by the match that lights it.

All these innovative new mortgages were written because there was great money to be made in bundling them into mortgage backed securities (MBS) and collateralized mortgage obligations (CMO). Lenders cashed in on a "originated to distribute" bonanza. All types of finance companies wrote mortgages- and many other types of credit contracts - only to sell them off. A popular final destination was in collateralized obligations. This industry swelled as trillions of dollars in mortgages were written over the past few years. Every obstacle to further lending was innovated around to allow profits to continue to flow. The risks of all this lending were less pressing as mortgages loans were made to be sold- not held. All the available credit bid up house prices and led to the false conclusion that houses were always safe, appreciating assets. Questionable loans and sub-prime mortgages were sold and reconfigured into AAA rated product. Risk vanished from consideration and discussion. Transformed mortgages became credit vehicles and were sold all over the world. Part of the mad dash now involves finding these hidden gems hiding on books and ascertaining their real value."

Meanwhile over at the Pundit's Blog Brent Budowsky tells it to America straight: Gilded Age Crime: Poor Go Homeless, Wealthy Get Bailouts

"Is it right that the new racket on Wall Street is that banks make bad loans, sell them to hedge funds and private equity firms, many of whom are virtually unregulated and untaxed, who then complain about their pain after they foreclose on average Americans for falling a little behind their payments?

It is good that today the Fed cut the prime by 50 points, but it is bad, and terribly wrong and unjust, that in the last week the Fed has essentially used Americans' money to bail out the wealthy who made the profits, while doing zero for the foreclosed and homeless.

When the banks, hedge funds and private equity firms make bad deals, they keep the personal profits, while the corporate profits are protected by bailouts. Meanwhile, when the average Americans in the middle class, or the poor, fall a little behind, they get the boot, they lose their jobs, they are thrown into the street without homes and often without food."

And don't ya just love the reasoning on RESPONSIBILITY that goes with the line of argument that runs, subprime borrowers who made bad decisions based on insufficient knowledge of what they were getting into should BE HELD RESPONSIBLE for those decisions even if this means losing their homes. Who cares if they're on the streets since that won't affect the economy. All they do is produce products services. But investors who made bad decisions based on insufficient knowledge of the real values of their investments should .... NOT BE HELD RESPONSIBLE for their decisions and should be bailed out by the taxpayer. They must at all costs be protected from losses. Their coupon clipping and 'premia' are essential to the economy.

I think this is known as one law for the rich and another for the poor.

Paulson Gives Bottoms Up On Subprime Crisis

Posted by D.D.Grant at 11:26 PM

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.

Margin of Errors

Posted by D.D.Grant at 3:19 AM

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 Dot.com 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?

Speculation and The Housing Bubble

Posted by D.D.Grant at 11:32 PM

Most of us have, or at least think we have, a pretty good idea of what speculation means when applied to the stock market. Financial advisers will give us various rules the first among which is to speculate only with money the loss of which won't be a catastrophe for your portfolio and assets in general. But what form does speculation take in the housing market?

At first glance we think we know the answer to this too. It's obvious in the statistics after all. Just look at the sales in the non-owner-occupied category and there you have it. Formally, in other words, we think of speculative buying in the housing market as involving those units bought by investors, either with an eye to the fastest possible capital gain in a rising market, or for the rental market with the same ultimate intention of realizing a capital gain through resale.

It is not usually the case that a property bought for owner occupation is considered a speculative purchase. However, in the period of a bubble such as the present subprime bubble, (actually, as we are daily learning, it's a general housing bubble), it can be said that in fact a proportion of owner occupier buys have a greater or lesser speculative component. This will have a tendency to be amplified in the course of the bubble. The main indicator of whether this speculative component is present will be to whatever extent the buying decision is being made on the basis of the profits to be had from a rapidly rising market. Anyone with a home that serves current needs perfectly well and even has a substantial percentage of equity built up who then sells with a view to cashing out this equity and leveraging it into a more expensive home is speculating. Worse still, they are speculating against the advice of the staid investment advisor mentioned earlier. For who can afford to lose a home should the speculation not pan out without it being a catastrophe? The position is no different in essence to that of someone stricken with margin madness in a stock market bubble. And the consequences when the bubble bursts are likely to be the same: the margin call that cannot be met from evaporating gains or the mortgage adjustment that cannot be met from increased equity.

Unfortunately, a whole fairytale about the home being the "biggest investment you will make in life" has taken hold almost universally in the last few decades. This idiotic idea may be wonderful copy for the Realty world but it is disastrous for the homeowner. And it is especially disastrous for those homeowners who could have traded down and thereby could now have cash in hand ready to take advantage of the coming bargains at the bottom of the cycle.

Read twice: Don't speculate with an asset the loss of which would be a catastrophe.

Credit Suisse Mar 12 2007 Mortgage and Housing

Posted by D.D.Grant at 2:55 AM

The Credit Suisse research report, Mortgage Liquidity du Jour: Underestimated No More, is a must-read for anyone who wants a thorough look at the US Housing Market. The report considers the deteriorating conditions in the mortgage market and their effects on the homebuilding industry and the resale-homes market, indicating that problems are not restricted to the subprime area or entry-level housing only.

The report considers recent trends in the prime, Alt-A and subprime markets and summarizes current guideline and regulatory changes and their effect in contracting the mortgage market further. The conclusion drawn is that tightening liquidity puts current builder inventory backlogs in further jeopardy.

Looking at the performance of current mortgages and the impact on new home sales it estimates that there are approximately 565,000 homes in the foreclosure process and goes on to consider possible projections of the effect on new and existing home sales, concluding that 50% of the subprime market is at risk of default.

The pdf report can be downloaded at Bill Cara's site where there is also a detailed commentary.