17 March 2007

Why the subprime bust will spread

By Henry C K Liu

Years ago when the US debt bubble spread over to the housing sector, warnings from many quarters about the systemic danger of subprime mortgages were categorically dismissed by Wall Street cheerleaders as Chicken Little "sky is falling" hysteria. Even weeks before bad news on the housing finance sector was shaping up as a clear and present danger, adamant denial was still loud enough to drown out reason.

Both Federal Reserve chairman Ben Bernanke and Treasury Secretary Henry Paulson, two top officials in charge of US monetary policy, continue to provide obligatory assurance to the nervous public that the United States' economic fundamentals are sound in the face of a jittery market. Days before being delisted from the New York Stock Exchange, shares of the collapsed New Century, a distressed subprime mortgage lender, were recommended by a major Wall Street brokerage firm as a "buy". That firm is now under criminal and regulatory investigation.

On the pages of Asia Times Online over the past two years, I have tried to put forth the rationale for the inevitability of a US housing bubble burst, pointing out reasons that the resultant financial meltdown will be much more widespread and severe than has been generally acknowledged.

On September 14, 2005, I wrote in Greenspan, the Wizard of Bubbleland:
History has shown that the Fed, more often than not, has made wrong decisions based on faulty projection. Greenspan has been rightly criticized for letting a housing price "bubble" develop, equating it to the one that swept technology stocks to stratospheric levels before bursting in 2000. Greenspan argues the Fed's role is to mop up after bubbles burst, since bubbles are hard to spot and deflate safely. But accidents are also difficult to predict, and that difficulty is not a good argument against buying insurance. There is no doubt that there is a price to be paid for every policy action. But the price of prematurely slowing down a debt bubble is infinitely lower than letting the bubble build until it bursts uncontrollably. In finance as in medicine, prevention is preferable to even the best cure. All market participants know pigs lose money. And a monetary pig loses control of the economy.
Alan Greenspan, then Fed chairman, notwithstanding his denial of responsibility in helping through the 1990s to unleash the equity bubble, had this to say in 2004 in hindsight after the bubble burst in 2000: "Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."

By "the next expansion", Greenspan meant the next bubble, which manifested itself in housing. The mitigating policy was a massive injection of liquidity into the US banking system.

There is a structural reason that the housing bubble replaced the high-tech bubble. Houses cannot be imported like manufactured goods, although much of the content in houses, such as furniture, hardware, windows, kitchen equipment and bath fixtures, is manufactured overseas. Construction jobs cannot be outsourced overseas to take advantage of wage arbitrage. Instead, some non-skilled jobs are filled by low-wage illegal immigrants.

Total outstanding home mortgages in the US in 1999 were US$4.45 trillion, and by 2004 this amount had grown to $7.56 trillion, most of which was absorbed by refinancing of higher home prices at lower interest rates. When Greenspan took over at the Fed in 1987, total outstanding US home mortgages stood only at $1.82 trillion. On his watch, outstanding home mortgages quadrupled. Much of this money has been printed by the Fed, exported through the trade deficit and reimported as debt.
The most popular of all derivative products is the interest-rate swap, which in essence allows participants to make bets on the direction interest rates will take. According to the US Office of the Comptroller of the Currency (OCC), interest-rate swaps accounted for three out of four derivative contracts held by US commercial banks at the end of 1999. The notional value of these swaps totaled almost $25 trillion; 2-3% of that ($500 billion to $750 billion) reflected the banks' true credit risk in these products. Monetary economists have no idea whether notional values are part of the money supply and with what discount ratio. As we now know from experience, creative accounting has legally and illegally transformed debt proceeds as revenue.

The 2005 OCC report "Condition and Performance of Commercial Banks" shows that loan demand in the US grew at 11% in the first quarter of 2005 while core deposits grew at 7%, producing a 4-percentage-point gap. That meant that US banks' loan growth was not fully funded by deposits. The report identified possible risks as: cooling off in housing markets accompanying slower loan growth; past regional housing-price declines lingering; and credit-quality problems in housing spilling over to other loan types. Not a comforting picture.

Derivatives of all kinds weigh heavily on banks' capital structures. But interest-rate swaps can be especially toxic when interest rates rise. And since only a few business economists predicted a jump in rates for the first half of the year when 1999 began while yields in fact rose 25%, these institutions found themselves on the wrong side of an interest-rate gamble by 2000. Moreover, as interest rates rose, US banks' income diminished from interest-rate-related businesses such as mortgage lending. Interest-sensitive sources of income were the revenue disappointment in 2000, as trading was in 1999. The banks' response was to lower credit requirement for loans to increase interest-rate spread.

On Greenspan's 18-year watch, assets of US government-sponsored enterprises (GSEs) ballooned 830%, from $346 billion to $2.872 trillion. GSEs are financing entities created by the US Congress to fund subsidized loans to certain groups of borrowers such as middle- and low-income homeowners, farmers and students. Agency mortgage-backed securities (MBSs) surged 670% to $3.55 trillion. Outstanding asset-backed securities (ABSs) exploded from $75 billion to more than $2.7 trillion.

Greenspan presided over the greatest expansion of speculative finance in history, including a trillion-dollar hedge-fund industry, bloated Wall Street-firm balance sheets approaching $2 trillion, a $3.3 trillion repo (repurchase agreement) market, and a global derivatives market with notional values surpassing an unfathomable $220 trillion. Granted, notional values are not true risk exposures. But a swing of 1% in interest rate on a notional value of $220 trillion is $2.2 trillion, about 20% of US gross domestic product.

This practice of borrowing short-term at low interest rates to lend long-term at higher interest rates, known as "carry trade" in bank parlance, when globalized by deregulated cross-border flow of funds eventually led to the Asian financial crisis of 1997, when interest-rate and exchange-rate volatility became the new paradigm. Today, there are undeniable signs that the same interest-rate risks have infested the US housing bubble in recent years. And the Fed's traditional gradualism, now revived as "measured pace" in raising the Fed Funds Rate targets in response to rapid asset-price inflation, has had little effect in curbing bank lending to fund rampant speculation.

In 2005, Greenspan repeatedly denied the existence of a national housing bubble by drawing on the conventional wisdom that the US housing market was highly disaggregated by location, which was true enough. Disaggregated markets are normally not exposed to contagion, a term given to the process of distressed deals dragging down healthy deals in the same market as speculator throw good money after bad to try to stem the tide of losses. But the bubble in the housing market was caused by creative housing finance made possible by the emergence of a deregulated global credit market through finance liberalization. The low cost of mortgages lifted all US house prices beyond levels sustainable by household income in otherwise disaggregated markets.

Under cross-border finance liberalization, negative wealth effects from asset-value correction are highly contagious. For example, the Dallas Fed Beige Book released on July 27, 2005, states: "Contacts say real-estate investment is extremely high in part because the district's competitively priced markets are attracting investment capital from more expensive coastal markets." The nationwide proliferation of no-income-verification, interest-only, zero-equity and cash-out loans, while making financial sense in a rising market, is fatally toxic in a falling market, which will hit a speculative boom as surely as the sun will set. Since the money financing this housing bubble is sourced globally, a bursting of the US housing bubble will have dire consequences globally.

Through mortgage-backed securitization, banks now are mere loan intermediaries that assume no long-term risk on the risky loans they make, which are sold as securitized debt of unbundled levels of risk to institutional investors with varying risk appetite commensurate with their varying need for higher returns. But who are institutional investors? They are mostly pension funds that manage the money the US working public depends on for retirement. In other words, the aggregate retirement assets of the working public are exposed to the risk of the same working public defaulting on their house mortgages.

When a homeowner loses his or her home through default of its mortgage, the homeowner will also lose his or her retirement nest egg invested in the securitized mortgage pool, while the banks stay technically solvent. That is the hidden network of linked financial landmines in a housing bubble financed by mortgage-backed securitization to which no one until recently has been paying attention. The bursting of the housing bubble will act as a detonator for a massive pension crisis.

On September 29, 2005, I wrote in The repo time bomb:
Commercial banks profit from using low-interest-rate repo proceeds to finance high-interest-rate "subprime" lending - credit cards, home equity loans, automobile loans etc - to borrowers of high credit risks at double-digit interest rates compounded monthly. To reduce their capital requirement, banks then remove their loans from their balance sheets by selling the CMOs (collateralized mortgage obligations) with unbundled risks to a wide range of investors seeking higher returns commensurate with higher risk. In another era, such high-risk/high-interest loan activities were known as loan-sharking. Yet Greenspan is on record as having said that systemic risk is a good tradeoff for unprecedented economic expansion.

Repos are now one of the largest and most active sectors in the US money market. More specifically, banks appear to be actively managing their inventories, to respond to changes in customer demand and the opportunity costs of holding cash, using innovative ways to bypass reserve requirements. Rising customer demand for new loans is fueled by and in turn drives further down falling credit standards and widens interest-rate spread in a vicious cycle of unrestrained credit expansion.

Again, on October 27, 2005, I wrote in How the US money market really works:
When asset prices rise, it reflects a change in the money supply/asset relationship, meaning more money chasing the same number of assets. Thus when asset prices rise, it is not necessarily a healthy sign for the economy. It reflects a troublesome condition in which additional money is not creating correspondingly more assets. It is a fundamental self-deception for economists to view asset-price appreciation as economic growth. A housing bubble is an example of this ...

Money now, especially virtual money, is created quite independently of Fed action, and money creation has become much less sensitive to interest-rate fluctuations. This explains why the measured pace at which the Fed has been raising the Fed funds rate target has little direct or immediate effect on the housing bubble.
On January 11, 2006, I wrote in Of debt, deflation and rotten apples:

In the US, where loan securitization is widespread, banks are tempted to push risky loans by passing on the long-term risk to non-bank investors through debt securitization. Credit-default swaps, a relatively novel form of derivative contract, allow investors to hedge against securitized mortgage pools. This type of contract, known as asset-back securities, has been limited to the corporate bond market, conventional home mortgages, and auto and credit-card loans. Last June [2005], a new standard contract began trading by hedge funds that bets on home-equity securities backed by adjustable-rate loans to subprime borrowers, not as a hedge strategy but as a profit center. When bearish trades are profitable, their bets can easily become self-fulfilling prophesies by kick-starting a downward vicious cycle.

Total outstanding home mortgages in the US in 1999 were $4.45 trillion, and by the end of 2004 this amount grew to $8.13 trillion, most of which was absorbed by refinancing of higher home prices at lower interest rates. When Greenspan took over at the Fed in 1987, total outstanding home mortgages in the US stood only at $1.82 trillion. On his 18-year watch, outstanding home mortgages quadrupled to $8.821 trillion by the end of third-quarter 2005. Much of this money has been printed by the Fed, exported through the trade deficit and re-imported as debt [in the capital account surplus]. Given that new housing units have been about 5% of the US housing stock per year, at the rate of about 2 million units per year, the housing stock increased by 100% over a period of 18 years while outstanding mortgages increased by more than 400%.

The Bank of Japan's zero-interest policy, combined with general asset deflation in the yen economy, has caught the Japanese insurance companies in a financial vise. Both new loan rates and asset values are insufficient to carry previous long-term yields promised to customers. Japan does not have a debtor-friendly bankruptcy law, as the US has. At any rate, insurance companies, like banks, cannot file for bankruptcy in the US. As a regulated sector, insurance companies are governed by an insurance commission in each state, which normally has a reinsurance fund to take care of unit insolvency. The funds are nowhere near sufficient to handle systemic collapse. The same happened to the US Federal Deposit Insurance Corp in the 1980s.

The insurance sector in the US will face serious problems as the Federal Reserve again lowers the Fed Funds Rate targets and keeps them near zero for extended periods. Several segments of the insurance sector, such as health insurance and casualty insurance, are already in distress for other reasons. Government-insured pension schemes are under pressure as troubled industrial giants such as General Motors default on their pension obligation, along with the airlines.

In the era of industrial capitalism, a low interest rate was a stimulant. But in this era of finance capitalism flirting fearlessly with debt, lowering rates creates complex problems, especially when most big borrowers routinely hedge their interest-rate exposures. For them, even when short-term rates drop or rise abruptly, the cost remains the same for the duration of the loan term, the only difference being that they pay a different party. While debtors remain solvent, investors in securitized loans go under. Credit derivatives have been the hot source of profit for most finance companies and will be the weapon of massive destruction for the financial system, as Warren Buffet warned.

Again on February 16, 2006, I wrote in The global money and currency markets:
In the United States, when house prices have generally tripled in less than a decade, it is evidence that the value of the dollar has declined by a factor of three in the same time period. Consumer prices have not risen by the same amount because of outsourcing of manufacturing to low-wage economies overseas which also acts as a depressant on domestic wages. Imbalance in the economy appears if wages and earnings have not risen proportional to prices.

A homeowner whose house has increased 300% in market price while his income has risen only 30% has not become richer. He has become a victim of uneven inflation. He may enjoy a one-time joyride with cash-out financing with a new mortgage, but his income cannot sustain the new mortgage payments if interest rates rise, and he will lose his home. And interest rates will rise if his income increases, because that is how the Fed defines inflation. Thus when his income rises, the market price of his home will fall, giving him an incentive to walk away from a big mortgage in which he has little equity tie-up. This can become a systemic problem for the mortgage-backed security sector.
That, dear readers, is why the US subprime mortgage bust will spread and cause severe damage to the global finance system.

Henry C K Liu is chairman of a New York-based private investment group. His website is at www.henryckliu.com.

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