8 June 2007

Roubini at the AEI- the trouble is here, finally.

Desmond Lachman (summing up): … that we’re in for a pretty rough ride, and I’d be as bold as to say that I think that this issue is going to be the issue in the 2008 election campaign.

Alex Pollock [0:22:36]: Thank-you Desmond. I thought issues were floated on Wall Street, not bodies. … ah, Nouriel …

Nouriel Roubini [0:22:43]: Thanks. Like Desmond I’d like to actually discuss how the fallout of the subprime meltdown is going to have some implication for the economy. I think that’s one of the crucial things because right now there is this debate ongoing between the consensus that says that the economy is going to experience a soft landing and the alternative view that it might actually experience a hard landing in the form of either a growth recession or actual recession. I’m certainly of the latter view.

I’m a little bit curious that we’re talking only about subprime mortgages because if you think about it, we are literally in a subprime economy, and I’m not talking about it just metaphorically, but think of it, we have dozens of millions of, for example, subprime credit cards, and even before you default on your subprime mortgage you’re going to default on your credit cards, there are dozens of millions of subprime auto loans. And today there was a report [2] on Bloomberg that S&P says that autoloans, subprime auto loans are sharply increasing in terms of default rates. And there was another piece today,[3] I actually thought it was interesting that suggested, you know, that twenty percent plus of all the loans that financed the purchase of a Harley-Davidson’s hogs are also subprime and the default rate for today, the delinquencies has gone, since last year, from two and a half percent to five percent today.

[24:06]: So the point is we’re talking about subprime mortgages, but it’s auto loans, it’s credit cards, it’s all sorts of other things. There’s a whole economy that is subprime, and as I’ll point out also, it’s not just subprime, the spillovers are going to all other parts of the mortgage market and all other parts of consumer credit, and also to corporate creditors.

I think that, you know, the consensus view again, I think has been that somehow felt since last summer, because a bunch of people were worried about the housing recession and its deepening, about the subprime mortgages and the trouble coming of it, and the risk of a hard landing … The consensus was wrong then, then they discovered there was a subprime problem, and now what they’re telling you is that it’s just a niche problem and there’s no contagion from housing for the rest of the economy and no contagion from subprime to [???] mortgages and so on, so I’d like to address some of these consensus views and make some points on why they were wrong then and they’re going to be wrong again now.

[0:24:58]: First point. Consensus tells us since last fall that the housing recession is bottoming out. I have a long paper [4] that was distributed around … I’m not going to be able to go into details of it. Essentially it says that we’re nowhere near close to the bottom of the housing recession. In the typical housing recession housing starts fall by fifty percent approximately. And in some of the deeper ones over sixty percent. We’re down only thirty percent. There’s a long way to go. And any indicator you have right now from the housing market, whether it is building permits, whether it is the housing starts, whether it’s construction, whether it’s completions, where is the demand for new homes, it’s just heading south. The glut of existing and new homes is becoming worse by any standard — unprecedented. The price pressure is downwards.

[0:25:45]: The official numbers are not showing it all to you. The Case-Shiller number came out yesterday, now showing falling prices, but a lot of it is actually seller side incentives that are not measured. You know when you get a forty thousand dollar free swimming pool when you buy a four hundred thousand dollar home, that’s a ten percent price cut that doesn’t show up in any one of the official numbers. So home prices are already falling today. At the rate it’s closer to ten percent, even if the official number is telling you otherwise.

So if you look at any indicator of the housing market, before we even talk about subprime or mortgages, it’s a disaster. This is going to be the worst housing recession we’re going to have since 1960. That’s my view of it. And I cannot flesh out the details of it right now.

[0:26:25]: Second point. The consensus now says — OK, yeah now we are in a subprime problem — now everybody just, whenever they say the words "subprime" they attach to it the term "meltdown" or "carnage." It’s just become almost automatic, when three months ago they were not even talking about the problem, but now the consensus is that it’s just a niche problem, it’s only subprime, it’s not the rest of the mortgages. But think about the reckless lending practices that were essentially being used for the last four or five years. You have zero downpayments, no documentation of assets or income, what people refer to as "liar loans." Interest only mortgages. Teaser rates. Negative amortization. Option ARMs. Was it only subprime? Look at the numbers — was subprime, was Alt-A, was piggyback loans, was home equity, was also a good chunk of the option ARMs. Subprime, near-prime, prime. If you look carefully, the numbers, I would argue that about fifty percent if not more of all originational mortgages for the last couple of years would be things I would consider as reckless — as just toxic waste.

[0:27:31]: So that’s what’s happening. Of course the rate at which Alt-A and other stuff is going to defaulting and get in trouble is going to be later. It’s going to start with subprime and going to go to all the other stuff. But the idea that this is just a niche, that subprime is only ten percent of the stock of mortgages and therefore it’s not a problem is just nonsense. OK.

Additional point. Now people are recognizing, where there’s a total mess in subprime, there’s also a credit crunch in subprime (guess what, about thirty of the lenders have already gone bankrupt [5] in the last three months), but again the problem they say is only a niche problem, it’s going to be a mini credit crunch only for the subprime section, and so on.

The reality is otherwise. When you look at the whole series of indicators and the chart [6] that Desmond showed about … now loan officers are getting more worried by tightening stardards. They’re not tightening standards only for subprime. They’re doing it across the board.

[0:28:19]: The borrowers now are facing a credit crunch, regulators are now, they were asleep at the wheel for six years, under the ideology they should not regulate markets … they let this thing fester and grow. So now they’re cranking on the other side. We’ve seen it every time before. Where we’ve seen all this sort of boom and then bust. And then there was a nasty credit crunch, and we got a recession in 1990.

This time around it’s going to spread — it’s going to spread from subprime to other mortgages, it’s going to spread to consumer credit, first subprime, and it [most problem??] among consumer credit, and to the rest of the economy.

[0:28:52]: Fourth point. People say, you know, the residential mortgage backed security market is still kind of OK. So, as long as it’s OK, then there’s going to be financing and all the rest. I think there’s already evidence that actually, that there have been massive losses in the CDO [7] market, and in a recent study [8] by Rosner and Mason show [9] that if you’re going to have a significant interruption in the CDO market then the whole financing base for the residential MBS market is, figure about 1.33 trillion dollars of issues of new residential mortgage based securities last year, is going to essentially falter. So that’s the kind of thing we’re facing.

Securitization helped the growth of this credit boom and bubble, and this squeeze now on the other side is going to create a mess on the other side around.

[0:29:35]: Additional point. People say there is no contagion to corporate credit risk. You know, those spreads are still relatively low. We’ve seen actually ripple effects and guess what, in a matter of two weeks the CDS speads for firms such as Goldman Sacks, Merrill Lynch, Morgan Stanley, went from triple-A to near junk rate. You have effects on CDX spreads,[10] on Itracks, on CMBX [??], the commercial mortgage backed securities, and so on. If you look at the numbers, and there is a study that has been done by my colleague at Stern, Ed Altman, [11] who is the world leading expert of corporate defaults, based on firms and economic fundamental default rates for corporates today should be around two and a half percent, historically they are around two and a half percent. Last year they were only around point six percent — twenty percent of what they should be given current fundamentals. Why? Well there’s just a massive amount of liquidity coming from Private Equity, levered institution, lots of firms that are under distress are being refinanced out of court, they don’t go through Chapter 11, but under serious distress there is tons of junk that is being issued right now.

[00:30:38]: Once the party is over, and I would say the party is going to be over soon, corporate profitability will be shrinking, all these problems are going to be coming to the surface. You’re going to be seeing massive increases in corporate defaults (back to normal and worse) and then the spreads are going to go through the roof. You’re going to see the contagion is going to take a few months.

Additional observation. Until now, people said, this is just a housing recession. It’s not effecting the rest of the economy. That’s actually incorrect. We don’t have just a housing recession, it’s getting worse. we have an auto sector recession, we have a manufacturing recession, we have every single component of investment that has been falling since Q4. Residential investment was falling twenty percent, but in Q4 investment in equipment and software by corporations has been falling, and given the numbers on capital goods order, last month the ones that came out this morning, it’s getting worse in Q1. People said, yes maybe the construction / residential sector’s doing terrible, but the non-residential construction’s doing great. Yeah, it was growing twenty percent in Q2. Then it went from twenty percent in Q2 annualized growth rate to fourteen percent in Q3, and it became negative in Q4. And now it’s getting even worse. So the idea of there being a decoupling between real estate, residential and the rest of the construction sector was also nonsense.

[0:31:56]: You know Janet Yellen, President of the Federal Reserve Bank of San Francisco said [12] that whole bunch of ghost towns out in the West.[13] So if you have a bunch of ghost towns in the West, why would you want to build shopping centers, offices there. Obviously, with a delay of a quarter or two, there is going to be a link between a collapse of residential and the rest of the construction sector, always happens, so why would there be a decoupling this time around.

[0:32:17]: Now so we have a housing recession, we have an auto recession, we have a manufacturing recession, we have every single component of investment — residential, non-residential, equipment, inventory is collapsing — and people said, we’re not going to have a hard landing until the consumer is faltering, and consumption is seventy percent of GDP, and the consumer is resilient. Trouble is that consumption depends on four things:

it depends on job generation / income generation,
depends on interest rates,
depends on wealth, and
depends on debt servicing ratios.
We are already seeing massive losses of jobs, is going to accelerate in housing, in manufacturing, that’s going to slow down job and income generation. There’s right now interest rates on official mortgages don’t mean anything, you have now a credit crunch, and once there is a credit crunch there is adverse selection … so the price doesn’t go up, what cuts is the quantity, so you don’t see it on the price, it’s on the quantity of credit shrinking, so what houses are facing right now — a credit crunch.

[0:33:13]: Until now the households were consuming more than their income, negative savings, because they were using their homes as their ATM machine. As long as home prices were going up, you could keep up with this party. Right now home prices are falling, and home equity withdrawl was at a 700 billion dollar annual rate in 2005, Q4 it is down to 270. In the meanwhile debt servicing ratio is going up. This year alone you are going to have one trillion of ARMs that are coming to maturity and being reset at much higher interest rates.

So the issue is the consumer is on the ropes, is being squeezed, and now we have two consecutive months of retail sales that is pretty much flat. So that’s what we are facing right now.

[0:33:51]: So the point is that this argument that it is just a small housing recession, mostly a small subprime problem, doesn’t have any basis. What we’re facing right now is a serious situation which the economy is spinning into a recession; a good chunk of the economy is already in recession, the rest of it is going to enter it by next quarter. And the Fed is telling us, like the consensus, we’re going to have two and a half percent growth, this quarter and next (first half of the year) and three percent in the second half of the year. We went from a growth of 5.6 in Q1 lst year to 2.6 to 2 percent to 2.2 in the fourth quarter. Now the consensus has it this quarter has at least two and a half percent, but how could it be? I mean, that 2.2 percent number for Q4 was before the subprime collapse, before we had the lousy number of consumption, before we had the collapse of capital spending and investment by firms. How could the consensus tell you that the growth rate this quarter is going to be better than last quarter? It just doesn’t add up in no way or form.

[0:34:49]: Now will the Fed come to the rescue? In spite of what they say? They’ll try to come to the rescue. Is it going to make a difference? No difference at all. Once you have a glut of capital goods, what the Fed does doesn’t make any difference. In 2000 the Fed was behind the curve — they worried until November of 2000 about inflation rather than growth, like today there was a tightening bias, then from November to December they went from tightening to easing and two weeks later on January 3rd they announced that open after New Year had collapsed, and they cut rates in between meetings. And they slashed rates very aggressively.

[0:35:24]: Did they avoid the recession? No, they put a floor under it. And the simple reason why is that, you know, the Fed rate went from six and a half to one, long rates fell six hundred basis points. And real investment fell by four percentage points, as share of GDP, between 2001 and 2004, why? once you have a glut of capital goods and tech goods, this time around housing and consumer goods, what the Fed does doesn’t make any difference. It puts a floor, of course, on the recession, but the idea that you could just stimulate the economy that way doesn’t make sense. You know, once until you work out this glut and it’s going to take years to work out the glut of housing, the same way it took five years to work out the glut of tech, we’re not going to see a recovery. So the Fed is going to cut rate … are we going to avoid a hard landing? My answer is no. So, I think that’s the problem we’re facing today. [0:36:11]

Alex Pollock: Thank-you, Nouriel, I think thank-you, uh, for that incisive outlook. The co-author of the paper [8] you cited, Josh Rosner is with us today, Josh, thanks for coming. Good to have you. Let’s go on to Chris. …


Notes and References

[1]: "Mortgage Credit and Subprime Lending: Implications of a Deflating Bubble", Event, American Enterprise Institute & Professional Risk Managers’ International Association, March 28, 2007.

[2]: "Subprime Defaults May Spread to Auto Bonds, S&P Says", by Mark Pittman, Bloomberg, March 26, 2007.

Bonds backed by automobile loans may be hurt by rising subprime mortgage defaults as people with poor credit struggle with their household debt, according to Standard & Poor’s.

Capital One Financial Corp., Wachovia Corp., Wells Fargo & Co., and other lenders have lent more funds to people with bad credit scores in the past few years to sustain growth, S&P said today in a report by analysts led by Mark Risi. The loans are also for longer terms, increasing the probability of default, the analysts said. About 68 percent of 2006 subprime auto loans were due in five years or more, Risi said.

“There could be some fallout from subprime in auto loans,'’ Risi said in an interview. “We don’t have much data yet. We’re still in collection mode. It’s probably going to be hard to say for a while.'’

[3]: "The Subprime Economy: Subprime Meltdown Spreading from Mortgages to Subprime Credit Cards, Subprime Auto Loans and Harley Davidson’s Hog Loans", Nouriel Roubini, RGEMonitor blog, March 29, 2007.

[4]: "The US Housing Recession is Still Far from Bottoming Out", by Nouriel Roubini and Christian Menegatti, March 2007. PDF, available as "Roubini-Menegatti Paper" at [1].

[5]: Like so many others, Roubini is citing Aaron Krowne’s The Mortgage Lender Implode-O-Meter without attribution.

[6]: "Mortgage Credit and Sub-prime Lending: Implications of a Deflating Bubble", by Desmond Lachman, PPT deck, available as " Lachman Presentation" at [1]. Roubini may be referring to Slide 17 - Rising Delinquencies

[7]: Collateralized Debt Obligation (CDO).

[8]: "Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions", by Joseph R. Mason and Joshua Rosner, Draft paper. From site page of "Where Did the Risk Go", Hudson Institute Event held May 3, 2007. The earlier draft Roubini is mentioning would be the one at this Feb 15, 2007 Hudson event.

[9]: "Subprime shakeout could hurt CDOs: Complex structures helped fuel mortgage boom, but may suffer losses", by Alistair Barr, MarketWatch, March 13, 2007.

These complex structures, which are similar to a mutual fund that buys bonds, helped fuel the U.S. mortgage boom in recent years by purchasing some of the riskier parts of MBS that other investors didn’t want.

They could now do the reverse, according to a recent study by Joseph Mason, an associate finance professor at Drexel University’s business school, and Joshua Rosner, a managing director at research firm Graham Fisher & Co.

[10]: "Credit Derivatives Primer (PPT slide deck in PDF)", by Aaron Brown, Association for Financial Professionals, 2005. I hope this helps

[11]: "Conference Call Today with Ed Altman, Leading Expert on Corporate Distress and Default", Nouriel Roubini, RGE Monitor blog, February 13, 2007.

Ed Altman, a colleague of mine at Stern, is recognized as the leading world academic expert on corporate defaults and distress. His papers and books were the seminal work on the determinants of corporate distress and default, and recovery rates given default.

[12]: "Housing slowdown creating ‘ghost towns’: Fed president says some effects of rate hikes still in the pipeline", by Alistar Barr, MarketWatch, October 16, 2006.

[13]: Twist was way out ahead on this story. See her August 16, 2006 post "Welcome to the Empty Streets of Vacantville".

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