It seems that the major news media are piling in to convince the public that: the mortgage situation is a 'crisis' equivalent to the S&L problems of the 1980s, and; the US is virtually in a recession already, with the reality of said recession only a few months off.
Monday's Wall Street Journal featured a front page piece entitled "U.S. Mortgage Crisis Rivals Savings & Loan Meltdown."
The article begins with the passage,
" Over the past decade, Wall Street built a market for more than $2 trillion in securities sold globally and backed by loans to U.S. homeowners on two long-accepted beliefs and one newer one. The prevailing logic: The value of the American home would never fall nationwide, and people would almost always make their mortgage payments. The more recent twist: Packaging mortgage loans and turning them into securities would make the global economy more resilient if anything went wrong."
I don't know about you, but I never believed the first premise. Over time, over all regions, yes, if money supply and the economy continue to grow, real estate values should continue to rise.
But recessions occur. Money supply will, on occasion, tighten. No asset ever experiences a totally strictly monotonic rise or, for that matter, fall, in value.
In fact, the initial genius of the CMO, or collateralized mortgage obligation, as it was first used in the 1980s, was to solve the historic problem of regional weakness in the US housing markets. Rather than have entire regional banking franchises crater, as, say, Bank of New England and Shawmut did, in the New England area, during the 1980s real estate crisis, CMOs would allow regional diversification of Fannie- and Freddie-backed mortgages, with the added benefit of creating various tranches of the securities with respect to maturity, yield and risk.
The root of the current dilemma appears to be poor underwriting of risk by mortgage originators, often, it appears, abetted by fraudulent applications, encouraged by freelance mortgage brokers. However, the latter are no excuse for companies like Countrywide and their ilk for throwing caution to the wind and offering subprime mortgages without qualifying the borrowers against the higher, non-teaser rates, where a two-tier variable rate product was offered.
The securitization of these questionable loans is not, per se, the cause of the problem. But, yes, once the loans were made, their inclusion in securities with other asset classes caused an opaqueness that hasn't helped the financial system.
Still, nobody put a gun to any investor's head and forced her/him to buy a CDO containing subprime mortgage assets. Adult investors freely chose to buy them.
When many of these adults chose to buy, say, technology stocks in the late 1990s, and subsequently learned that they were overly optimistic about many of the so-called "dot com" companies in which they bought equity positions, nobody rushed to bail them out then.
It wasn't, even really a crisis, per se. The 9/11 terrorist attacks on the World Trade Center also affected markets during the aftermath of the technology stock bubble. Greenspan's Fed eased rates in order to facilitate economic conditions to restore employment, not merely to reflate equity asset values.
"An examination of the resulting crisis shows that it is comparable to some of the biggest financial disasters of the past half-century.
So far, the potential losses look manageable compared with the savings-and-loan crisis of the 1980s and the tech-stock crash of 2000-02. But the housing debacle could yet take years to work out, thanks to the sheer complexity of it. Until the mess is cleaned up, investors will remain jittery and banks will likely hold back on all kinds of lending -- a credit crunch that is already damping global growth and could tip the U.S. economy into recession."
There it is. The linkage with recession. And the solemn pronouncement that investors will be "jittery," and banks will "hold back on all kinds of lending."
But this isn't true. A colleague of my business partner's just secured a mortgage on a condo in Southern California! At something less than 6%, at that!
Doesn't sound like a 'hold back' on loans to me.
Next, the Journal piece attempts to size the current mortgage-originated situation. Using a chart labeled "How Big Is It," a comparison is made to the 1982 LDC debt crisis, the 1986 S&L crisis, the 1992-2003 Japanese bank crisis, and the 2000 tech bubble. According to the chart, the current mortgage problems are in the $150-400B range.
The relevant article text reads,
"House prices are down by 0.5% to 10% now, depending on the measure used. If they fell 30% -- what it would take to restore their historic relationship to inflation, rents and incomes -- $6 trillion worth of housing wealth would be wiped out. Measured against the size of the U.S. economy, that is less than what was lost in the stock market between 2000 and 2002. Initial guesses at total losses on subprime and similar mortgages range from $150 billion to $400 billion.
The latter figure would equal about 3% of U.S. annual economic output. That is similar to the losses suffered by S&Ls and commercial banks between 1986 and 1995. But it is less than half the scale of Japanese bank losses in the wake of that country's burst stock and real-estate bubbles.
The current crisis, though, differs in crucial ways from the recent tech-stock bust and the S&L crisis.
For one, it centers on assets -- houses -- that, unlike stocks, most people have bought with borrowed money. On average, mortgage debt amounts to nearly half the value of houses. In recent years easy credit has allowed many to borrow up to the full value of their homes, making them more leveraged than any hedge fund."
While the text admits that the value of the current dilemma is far less than that of the Japanese bank crisis, the chart apparently chooses the highest allegedly forecast level of bad loans to claim that this current situation is the worst, at 3% of GDP.
I have yet to see a figure as high as $400B of losses estimated by anyone. The most I have seen is $250B.
Further, the article is not completely correct in comparing home loans to individuals with hedge fund asset values.
Homes are 'consumed,' and not, per se, primarily viewed as mark-to-market trading assets. Hedge funds, in contrast, are completely viewed as tradeable assets whose values must be marked-to-market.
Additionally, the subprime portion of bad mortgage loans is evidently about 2% of all mortgages, or some 15% of subprimes, which are, themselves, only 15% of outstanding home loans. There are other defaulting mortgages that are not subprimes. These are the ones, it seems, that feature the two-tier, step-up rate structures. Thus, the oft-mentioned rate resets aren't actually for subprimes. Those mortgages, I have read and heard, tend to be issued at a higher rate. The teaser-step-ups were not typically offered to subprime customers.
The Journal piece also states,
"At the end of 2006, the value of all homes in the U.S., excluding rentals, peaked at 153% of gross domestic product (or about $21 trillion) -- the highest level in at least six decades. By Sept. 30, that had edged down to 150% of GDP as home prices began to drop. With huge inventories of unsold homes soon to swell with foreclosed properties, that is likely to continue.
Falling home prices make consumers poorer and less ready to spend, and they make it harder to borrow against home values -- even if consumers are current on their payments."
But housing is a local market. To state a nationwide figure for home values relative to GDP is to imply a consistently rising national market. Nothing could be further from the truth. Everyone who knows much about the real estate woes currently affecting America would also know that there are several 'hot spots,' such as parts of Florida, Southern California, and Las Vegas, which have seen outsized property value increases. In fact, it's been claimed that all of California became overvalued, as Californians began trading houses with each other at ever-increasing prices.
Can you blame them, if national banks such as Wells Fargo, BofA, and Citi signed off on the rising values as collateral for their mortgage loans?
Then the Wall Street Journal piece turns to investors,
"Ken Guy, finance director of King County, Wash., says the county's investment pool bought short-term IOUs called commercial paper backed by several SIVs because they appeared to be low risk. "We relied heavily on the ratings agencies," he says. About 10% of his $4.8 billion fund was invested in such paper. When the mortgage-backed assets held by the SIVs suddenly started going bad, some of his investments were downgraded all the way to "default."
"How could this have happened so quickly?" Mr. Guy wondered with colleagues. "How could these be downgraded from top to bottom in a day or two?" Such questions have been raised repeatedly.
"We've seen an unprecedented decline in market liquidity, really beyond what we thought possible," says Noel Kirnon, executive vice president in charge of structured finance at Moody's Investors Service, one of the two large ratings firms.
"Ratings on SIVs are significantly impacted by the market trends...even when the underlying portfolio maintains its credit quality," says a spokesman with Standard & Poor's, the other large ratings firm.
The complexity of mortgage-backed securities is making banks more vulnerable to losses than expected. It turns out banks didn't manage to shed so much of the risk of lending by packaging mortgage loans into securities and selling them to investors. Instead, they kept a large portion of the risk in various forms, including pieces of the CDOs they helped bring to market."
Again, weren't all of these investors, and banks, professionals? Don't they get paid to make these assessments correctly? We're not talking about illiterate, marginally-employed consumers being hoodwinked into buying low-end homes with subprime loans.
Then the article discusses possible implications of bank loan losses,
"Because everyone from auto dealers to Main Street banks now depends on securities markets as a source of credit -- as opposed to banks -- such moves could make it more difficult for consumers and companies to get money.
Banks are also wary of lending to one another. They are trying to keep as much cash as possible as a cushion against potential losses, and they are worried that their counterparts could go belly up. As a result, they have been charging each other much higher interest rates. Those rates, in turn, affect monthly payments on millions of credit cards and mortgages in Europe and the U.S.
Asset prices stop falling when markets conclude that all the bad news has been factored in. At that point, so-called vulture investors pounce. But most are holding back because they think banks and SIVs could yet be forced to sell more of their holdings of subprime-backed securities into a market with few buyers."
This is all probably true. I have written about the counterparty risk several times in the past few months. It is this risk that is really 'seizing up' credit markets- not a lack of money. And banks have the ability to move questionably-valued loans and securities into their investment accounts, should they choose to. This obviates their continuing need to value these assets at market prices. Doing so would also send a signal to the market that these institutions will not be holding 'fire sales' on these assets, which, again, would tend to put a floor under valuations, and ease counterparty risk concerns.
Finally, the piece admits that perhaps this isn't all going to pitch the US into a recession- barely,
"In spite of the gloom, the economy may avoid recession. Housing comprises a much smaller share of the economy than business investment, which dragged the U.S. into recession in 2001. Also, the rest of the world is stronger than in 2001, boosting U.S. exports. For the entire U.S. economy to contract would probably require a broad decline in consumer spending, which hasn't happened since 1991.
And, while financial problems are serious, they aren't -- at least yet -- on a par with those of the 1980s, when many major banks would have been insolvent had they valued their Third World loans accurately. There is, indeed, a possibility that the opacity of today's mortgage securities means markets may be factoring in far larger losses than will actually occur. Though the Fed is still worried about inflation, it has plenty of room to cushion the economy with additional interest-rate cuts.
But after years of living off the debt-financed increases in the value of their homes, U.S. consumers are in uncharted territory. "A lot of people, including me, have been saying that the country has been spending more than it's been producing, and that will have to come to an end," says Mr. Volcker. "The question is: Does it come to an end with a bang or whimper?" "
It's worth noting, as I wrote here, that the Journal article is in conflict with one of its own more illustrious editorial contributors, David Malpas. Malpas wrote in an earlier WSJ editorial,
"The bearish view is that Americans live, breathe and spend their houses and mortgages. Yet the July 31 consumer confidence survey by the Conference Board jumped to 112, the highest in the six-year expansion. Data and theory show clearly that houses are not the be-all and end-all of the economy. Jobs matter more. For many, the value of future employment is much greater than their home equity. The low jobless claims and unemployment rate -- clear signs of a strong labor environment -- raise confidence and likely future wages. This outweighs changes in wealth, whether from declines in house prices or the stock market, especially for lower-income workers.
Nor has consumer spending been dependent on "cashing in" on the housing boom. The increase in mortgage equity withdrawals in 2004 and 2005 funded big net additions to household financial assets, while consumption growth remained steady. Mortgage equity withdrawals slumped throughout 2006, yet consumption growth was particularly fast in the fourth quarter of 2006 and the first quarter of 2007."
So, it's simply not true that all housing price increases got recycled into the economy as spending as if homes were and are "ATMs."
With regard to Volcker's concerns, even he can be wrong on occasion. As I commented here, Nobel Laureate Edward Prescott wrote in the Wall Street Journal in December of last year, in an editorial entitled "Five Macroeconomic Myths,"
"5. Government debt is a burden on our grandchildren.
Theory and practice tell us that the optimal amount of public debt that maximizes the welfare of new generations of entrants into the workforce is two times gross national income, or GDP. This assumes 1% population growth, 2% productivity growth, 4% real after-tax return on investments, and that people work to age 63 and live to age 85. Currently, privately held public debt is about .3 times GDP, and if we include our Social Security obligations, it is 1.6 times GDP. In either case, we could argue that we have too little debt."
I then commented,
"Mr. Prescott actually make the point, subsequently, that government debt is a necessity if one has a long-lived population that is not growing rapidly. In effect, the more older, non-working people a society has, the more productive assets it needs with which to generate wealth in order to pay for those retired people. It's the reverse of how most economists present this situation.
Rather than hand-wring about debt and retirement, Mr. Prescott implicitly assumes a preference for creating wealth, then assess whether the right debt levels are in place to most efficiently do that in the given context.
What I liked most about his piece is how, at a stroke, he removes most of the bases for those who assert we have a government debt problem, a savings problem, and a looming retirement-affordability problem."
So, although well-intentioned, Volcker's concerns are misplaced. The US economy constitutes the world's most vital, productive engine of growth, into which we should want to throw as many resources as we can, in order to build value for our aging population's future financial needs.
Finally, as if in silent complicity with the Journal, CNBC anchors have been pestering their guests and hosts for weeks to agree that the US now teeters on the brink of a recession.
It seems the less well-informed and educated about economics they are, e.g., Mark Haines, Steve Liesman and Maria Bartiromo, the more bug-eyed and insistent they are in their badgering everyone with whom they speak as to when we can expect the looming US recession to begin.
Despite all this hand-wringing and alarmist wolf-crying, the US economy is still growing with modest levels of inflation. Payrolls continue to grow, as do wages. Recent advances in information technology have moderated the sort of inventory-excess recession that used to plague our economy with dismaying regularity.
Investors make mistakes. Someone is always on the losing end of an asset exchange which, eventually, results in one of the asset rising further in value than the other. Sometimes, one falls. But unlike Dutch tulips, the assets at the root of the current US economic asset weakness are real, tangible, and have intrinsic value.
What we appear to have is a question of the timing of asset values, rather than declining employment, wages, or spending. That doesn't necessarily lead to recession, and, depending upon the concentration of asset value loss, maybe not even a crisis.
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