It Can't Happen Here! Hmmm, Yes, Ah-Huh....

I received a great critique from my old associate - Odysseus - that deserves its own posting. Yes, I know he was the one who thought up the Horse but you have to admit it was a clever idea and if those stupid people had just listened to me ... but I digress.
My response follows his comments.

Greetings Cassandra,

A good first effort; I like your style - you make good use of humour and the "stats" bolster your arguments.

However, I believe that you have chosen to look only on the present weaknesses in the market not on its resilience or how it differs from markets of the past. Not every market downturn is destined to be the end of life as we know it!

My concern is that some of the counter arguments (which have some cogency) are not addressed or commented upon. Let me mention a few:

a) The mortgage position is very sensitive to timing. If I took out a mortgage prior to 2005 I am probably still ahead of the game although my new found wealth did turn out to be ephemeral. This is also true in the U.S. market where there is little evident distress in anything written prior to 2003.

b) The total amount of sub prime mortgage losses cannot ever reach even a fraction of the losses that were sustained in the dot com meltdown. The dot com losses in value ( peak to trough) were in excess of 10 times the loss estimates for the sub prime sector. The market shrugged those off in part because they were so widely distributed.

c) Mortgage defaults defy economics in that people seldom exercise their default option preferring to continue to make payments even when the debt exceeds the equity. Selling costs are substantial and people have to live somewhere.

d) With some limited exceptions, it has not been the banks that have fuelled the dumb mortgage market in the U.S. It is the Countrywides and other broker-like operations that have created this mess aided by the brokers that help them fund it with structured credit that was bought largely on trust of the ratings process. But that debt is almost 30% foreign owned and otherwise widely distributed.

e) I think there are a lot of unpleasant facts and you cite many of them. The Chinese buy U.S Treasuries with their surplus partly because they have to. Their fear is that if they do not do so the urge to 'protect' against Chinese imports will get political support. Loss of that market would create great credit issues in China where capacity has largely been created by leverage.

f) The key issue that you identify is liquidity. This is probably one of the least understood elements in risk management and it is very significant that the ECB and the Fed are reacting by pumping in liquidity. Remember however that the banks are better capitalized, better organized and have not led the way in the crappy mortgage game. Moreover, although it cannot be denied that the equity markets were overvalued (witness the absurd P/E levels) there is also no doubt that corporations are far less leveraged than they were in the last quarter of the last century. You cite the private equity people and rightly so but they are a fraction of the market even now and those that lose on these (eg the Chinese Government) can afford to learn the lesson.

g) Funds have to move somewhere. In these circumstances rates will be held down by the central banks and pension funds and other institutional investors will have to stay the course.

I was thinking of an article on this topic myself except my title was "Chicken Little or a Little Chicken" with the theme that it was time for caution but not panic. Your advice to run for the hills brings the question "which hills?"

Looking forward to continuing the discussion.

Odysseus
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Hi Odysseus,

Thanks for taking the time to read the first posting and providing your thoughts and comments. And now down to business - I believe the best way to respond is to annotate your points one by one. I hope the style is to your liking.

Odysseus
My concern is that some of the counter arguments (which have some cogency) are not addressed or commented upon.

Let me mention a few:

a) The mortgage position is very sensitive to timing. If I took out a mortgage prior to 2005 I am probably still ahead of the game although my new found wealth did turn out to be ephemeral. This is also true in the U.S. market where there is little evident distress in anything written prior to 2003.

Cassandra
You are correct, as the adage goes “timing is everything”. However, in the UK market, the timing issue is not of when you took out a mortgage but when was the last time you paid down your mortgage principle or when will your interest rate change.
1. According to the UK Council of Mortgage Lenders (CML), at the end of May 2007, 17 ½% of all extant mortgages are “interest only”; this is up from 14% at the end of 2006.
2. Two million household’s 2-year fixed rate mortgages “mature” every 12 months. That’s 18% of all UK mortgages every year. Each of these needs to be renegotiated and re-priced.
3. The pricing issue in the US is not only a sub-prime issue. A Fannie Mae chart I studied last week showed that resets on adjustable rate mortgages in the US will not peak until the December 2007 / January 2008 time-frame.
It seems to me that, in terms of potential loan defaults, the worst is still yet to come. If the markets are experiencing all of these serious issues now, when ARM resets have just really begun, what’s to prevent a far worse meltdown of financials after ARM resets hit their peak?

Odysseus
b) The total amount of sub prime mortgage losses cannot ever reach even a fraction of the losses that were sustained in the dot com meltdown. The dot com losses in value ( peak to trough) were in excess of 10 times the loss estimates for the sub prime sector. The market shrugged those off in part because they were so widely distributed.

Cassandra
Once again you are correct, but the issue, in my view, is not about size of the losses in the mortgage market, sub-prime or otherwise, v. the dot.com bust. Rather, it is about our over-extension, across the board, in the credit markets. By any measure, the average household in the UK and the USA is too much in debt and the pinch is only starting to be felt.

The catalyst may have been sub-prime but we are also seeing an amazing jump in interest rates on “jumbos” in the USA – from circa 6.25% to over 7.75% in the last month. Indeed, I checked with my local WAMU office (they holds the mortgage on our US house) and asked what a $1,000,000 mortgage would run and was given a rate of 11.2%!! They told me they are seeing more and more people selling their larger more expensive homes and buying homes that can be financed with conformed mortgages or are paying down their existing floating rate mortgages to levels that allow them to re-mortgage with a conforming product. This is driving down house prices on the larger more expensive homes in the area. His concern is that falling demand for expensive houses will lead values to fall. Rising rates eventually could lead to more foreclosures, which would add to the supply of similar-priced houses, sending their values lower, creating a vicious circle of falling prices and rising foreclosures. I believe that there is the possibility that this is the case we will be facing ‘ere long.

One of the quotes I did not use in this article was from Yale economist Robert Shiller who said in 2005, "Once stocks fell (in the dot.com crash), real estate became the primary outlet for the speculative frenzy that the stock market had unleashed. Where else could plungers apply their newly acquired trading talents? The materialistic display of the big house also has become a salve to bruised egos of disappointed stock investors. These days, the only thing that comes close to real estate as a national betting obsession is poker."

Odysseus
c) Mortgage defaults defy economics in that people seldom exercise their default option preferring to continue to make payments even when the debt exceeds the equity. Selling costs are substantial and people have to live somewhere.

Cassandra
Okay, three in-a-row spot-on points by you – ready for my third rejoinder? I agree that in normal times, people will keep paying everything they can to keep their homes. What I am forecasting is not a normal time but rather a property crisis like those of the mid-‘70s, in the UK, the mid-80s in the US “oil patch” (the one that took out Texas Commerce Bank) and in the early-‘90s in both the US & UK markets. If you examine the foreclosure (repossession) rates they were substantial:

UK 1975-1977 135,000 homes - 2.08% of all mortgages
UK 1990-1993 248,000 homes - 2.53% of all mortgages

Now, bear in mind that consumer debt in the UK has trebled since 1992, that the median size of a mortgage has gone from £39,200 in 1991 to £124,488 as at May 2007 (3.17 times) while median family income has grown from £13,671 to $28,848 (2.1 times). Add to this that liquidity, despite the billions the Fed, European & Asian central bankers have poured into the system in the last week, is still growing thinner by the day and the issue of re-pricing and re-negotiating that I mentioned in my response to you first point and you see why I believe this “squeeze” will have a nasty ending.

Odysseus
d) With some limited exceptions, it has not been the banks that have fuelled the dumb mortgage market in the U.S. It is the Countrywides and other broker-like operations that have created this mess aided by the brokers that help them fund it with structured credit that was bought largely on trust of the ratings process. But that debt is almost 30% foreign owned and otherwise widely distributed.

Cassandra
Sorry but here I disagree. The banks may not have fuelled some of the sub-prime market (although Countrywide and others are being held up by drawing on their bank lines) but WAMU, BOA, JPM/Chase, Citibank, and every regional have helped to fuel the excessive amounts of jumbos and second mortgages. The “structured credits”, CDOs/ CLOs, across the spectrum, have been affected by the contagion, even if not all are actually infected with sub-prime debt because the bloom is off the rose in terms of the validity of the rating process that lured investors to consider them equal to corporate debt (I had commented in my article about the imprudence or naiveté of their investors in these “products”.) The fact that a certain percentage are foreign owned means that the contagion is spread across the globe – witness the collapse of IKB – and is no real comfort. In so many ways it looks much like all the crisis we have lived through.

Odysseus
e) I think there are a lot of unpleasant facts and you cite many of them. The Chinese buy U.S Treasuries with their surplus partly because they have to. Their fear is that if they do not do so the urge to 'protect' against Chinese imports will get political support. Loss of that market would create great credit issues in China where capacity has largely been created by leverage.

Cassandra
Okay, we are back on track and you are right about the Chinese motivation but (sorry about another one!) they are learning that they do not have to buy exclusively or even predominantly US T’s. Their buying pattern has shifted in the last year due to issues regarding yield and the devaluation of the US$. According to the ECB, Europe has replaced the US in terms of inward investment. The Chinese in 2006 for the first time borrowed more in Sterling and in Euros than they did in Dollars. We may think that their options are limited but I think that those of the US, as the debtor nation, are even more limited.

Odysseus
f) The key issue that you identify is liquidity. This is probably one of the least understood elements in risk management and it is very significant that the ECB and the Fed are reacting by pumping in liquidity. Remember however that the banks are better capitalized, better organized and have not led the way in the crappy mortgage game. Moreover, although it cannot be denied that the equity markets were overvalued (witness the absurd P/E levels) there is also no doubt that corporations are far less leveraged than they were in the last quarter of the last century. You cite the private equity people and rightly so but they are a fraction of the market even now and those that lose on these (eg the Chinese Government) can afford to learn the lesson.

Cassandra
One more point on which we agree but no entirely. I think that the issue of volatility is the flip side of liquidity. It is what caused the liquidity, which was so “abundant” just 6 or 8 weeks ago, to dry up to such an extent that the Fed/ECB/BOJ etc. have had to pour in over $325 billion in three days to try and stabilize the banking system as well as the market. Having just been in one of the major High Street lenders at the core of their decision making process I can tell you that it, at least, does not fit the mold of “better capitalized, better organized“; they look remarkably like the same old hat – a bloated balance sheet, driven by consumer debt on the one hand and high-leveraged deals on the other. Talking to my colleagues at other High Street Banks, the pattern appears to be the same. I believe that the lessons that were so painfully learned over the past few decades are being forgotten, Basel II not withstanding.

In my talks with the FSA they have voiced concerns that our addiction to “models” has inured us to the realities of markets that do panic (the prescient Mr. Greenspan strikes again). The article in the FT of 15 August “Why computer models proved unequal to market turmoil” by Gillian Tett and Anuj Gangahar makes this exact point.

As to the USA, here is another quote I did not use “In sum, U.S. banks seem well positioned to withstand a modest decline in house prices, especially a localized decline. Still, empirical evidence from the United States and other countries indicates that declines in housing wealth can have severe macroeconomic repercussions, especially if banking system capital does become impaired. David Wheelock of the Federal Reserve of St Louis, October 2006."

Like Mr. Wheelock, I am not positing that Armageddon is necessarily the outcome of this crisis, only that this is not the time to be complacent and think that all is bright and beautiful. I know we share that belief.

Odysseus
g) Funds have to move somewhere. In these circumstances rates will be held down by the central banks and pension funds and other institutional investors will have to stay the course.

I was thinking of an article on this topic myself except my title was "Chicken Little or a Little Chicken" with the theme that it was time for caution but not panic. Your advice to run for the hills brings the question "which hills?".

Cassandra
Pardon, but I did not say, “run for the hills”. I was telling investors that they should “run away” from the equity markets, as the volatility was too much for the average player. I believe the proof lies in the intra-day volatility and the trading levels. This is not an arena for the average investor. I watched at the last melt-down whilst so many people saw their holdings in 401ks and other investments drain away before their eyes, always hoping that the market would lift the next day, the next week, the next month (I watched as one of my oldest friends, a skilled risk expert, rode their children’s college fund down to near oblivion waiting for the “correction” to end.) While I may not like the return in the cash market (I’m getting about 5% versus the 16% I earned last year in the equities market) at least I have maintained my investment principal intact for a future market.

You may think me “chicken” but I think I am calling for (and have made) a strategic withdrawal. To quote the old doggerel “He who fights and runs away, lives to fight another day!” The panic is not mine; it is the markets.

Odysseus, I want to thank you for your most thoughtful, provocative points but most especially for your taking the time to help get this forum up and running.

All the best to you, Penelope and Telemachus,
Cassandra