Friday, March 16, 2007

Subprime crisis: from sushi to meatloaf

"The sub-prime carnage is now front page news on every possible media; soon enough it may be even become cover story on People magazine as even Britney Spears will soon be asking about it." Nouriel Roubini

David Seaton's News Links
If you are too young to to have clear memories of the cold war it will be impossible for you to imagine how all embracing it was. Bush and Cheney have been trying to "recreate" the cold war's tension in their "Great War On Terrorism" (GWOT), but they don't even come close. It went from horizon to horizon. Like living in the same room with a dangerous animal... for both sides.

So, when the Soviet Union went down there was a huge sigh of relief. Instead of thinking that if such a huge and powerful system could collapse, any system could collapse, that collapse was in the nature of huge and powerful systems, there was a sense of "victory" accompanied by euphoria.

To give you an idea of the period, in 1992, sober and reputable Francis Fukuyama published, "The End of History and the Last Man", where he wrote, "What we may be witnessing is not just the end of the Cold War, or the passing of a particular period of post-war history, but the end of history as such: that is, the end point of mankind's ideological evolution and the universalization of Western liberal democracy as the final form of human government." In real life people only say things like that when they sniff cocaine.

Meanwhile in the United States, during the 80's, while the Soviet Union was preparing to collapse, amazing things were happening in the world of finance. The definitions of money and value were revolutionized. The symbol of this revolution was the "Junk Bond" and its Lenin was Michael Milken. A new way of looking at money and the ways to use it was born.
The film that symbolized this revolution was Oliver Stone's, "Wall Street".

Simultaneously, the power of computers began its geometric increase that has become so familiar to us over twenty years later. This increase in computer power made it possible to calculate financial risk in a much more sophisticated way. So everything was in place: euphoria and new ways of creating value seemingly out of thin air.

The result was that huge amounts of money appeared in the newly deregulated world and began to move at a dizzying speed. It became easier and easier to borrow money, in increasing quantities, at lower rates and for longer times. People who had heretofore worked hard to make ends meet, to own their own home and to send their kids to school, began to feel "rich". In fact the only thing they really owned was the house they lived in, whose theoretical value was increasing daily and against whose "paper" value they contracted real debts. It looks as if the party may be over and as in the "Crash of 29" creditors may panic and call in their loans... with devastating and unpredictable knock on effects.

Politically this will mean that a lot of people, with a good education and brilliant prospects, who thought they were rich will suddenly feel that they are poor, they will make a lightning fast voyage from sushi to meatloaf.
Normally people take too much credit for their successes and often blame themselves too much for their failures. It takes a very wise man or woman to look in the mirror and to see a fool and then to shrug this vision off.

Many will feel betrayed by the very system they thought they understood and knew how to game. This declassing and sudden insecurity is often the origin of much bitterness and political agitation... normally it offers opportunities for the far-right. The left must be prepared to offer solid analysis and strong support, both moral and material to the victims of what appears to be a severe fall to earth for the "nouveau pauvre"... or risk being swept away by their rage. DS

Leap of faith? How a fiasco of easy home loans has tripped up America - Financial Times

Abstract: Victoria Wagner, credit analyst at Standard & Poor's, the ratings agency, says some subprime mortgage lenders dramatically lowered their standards amid "the so-called democratisation of credit", granting loans that contained many levels of default risk. These included a lack of income documentation and no downpayment. Ms Wagner calls this kind of risky lending "unprecedented". Now buyers (...) are falling behind or defaulting, as interest rates that started relatively low go higher and home prices in some parts of the US stop rising. So far the problem has remained largely contained within the subprime sector. It may stay there but concern is growing that difficulties could spread throughout the housing market and then, perhaps, the wider US economy. The first way the subprime decline could impact on the housing market is if a flood of foreclosed homes came up for sale and pushed down prices in areas where the supply of homes is already high because demand has dropped off. "The big question is, how quickly will housing prices adjust lower as delinquency rates rise?" says Richard Gilhooly, senior fixed income strategist at BNP Paribas. Analysts at Lehman Brothers project that mortgage defaults could reach $225bn during 2007 and 2008 and perhaps go as high as $300bn. "The risk that they impact the broad housing market and begin to weigh upon prime borrowers is very real," they say. (...) Delinquency rates for subprime adjustable-rate mortgages, the riskiest kind, hit 14.4 per cent. The numbers could get much worse because many who bought homes face "resets" in their mortgage payments; the low rates that tempted them in will revert to higher, market-determined rates. Lehman estimates that more than $900bn of mortgages will hit a reset in the next two years.(...) Still, it is far from certain that the subprime ailments will infect the broader housing market. Steven Wieting, economist at Citigroup, suggests that the problems are likely to affect financial institutions and their investors - as indeed they already have - more than consumer sentiment and the economy at large. But if the marginal buyer - someone able to buy a house only if conditions are right - is knocked back, that could at best slow a recovery in the housing market. At worst, it could lead to recession. David Rosenberg, North American economist at Merrill Lynch and a perennial bear, says: "This housing downturn is far from over and the full impact across the economy has notbeen felt . . . As with most bubbles, this one started with loosening credit guidelines, excessive price appreciation, classic performance-chasing [and] speculative fervour, and nowends in lawsuits." Whatever the impact of the subprime fiasco on the wider economy, it is already deeply painful for many Americans.(...) One way the subprime shake-out could lead to systemic problems across the capital markets is if investors who had little idea they might own such mortgages suddenly discovered that they did. These holdings would probably be through complex structures called collateralised debt obligations - packages of asset-backed bonds. Investors in CDOs - say, pension funds in Europe or Japan - may be inclined to act more quickly when they detect subprime exposure than would a group that was already well aware of the risks in their CDOs. One problem is a lack of information. CDOs are rarely traded and difficult to value. As a result, buyers are often reliant on credit ratings to know when to sell. However, credit ratings regularly lag market prices, meaning that losses can be greater than necessary when the credit rating downgrade finally comes. Josh Rosner, managing director at Graham Fisher & Co, an investment research firm, says: "Because many buyers of CDOs can only hold investment-grade assets, they may continue to hold deteriorating and increasingly illiquid assets as long as credit ratings have not been downgraded." This means that when these investors eventually sell, they may also be forced to accept large losses in a fast-moving market. The heavier the losses, the less likely investors are to want to return, a classic case of "risk aversion". Such risk aversion is already clear among the commercial and investment banks that had provided funding to subprime mortgage lenders. Those banks cut off credit lines to New Century Financial and Accredited Home Lenders, pushing both close to bankruptcy filings. With equity investors in subprime (and even prime) mortgage lenders offloading their shares - "then asking questions later", according to David Hendler, an analyst at CreditSights - some industry executives say the selling appears irrational and panic-driven, another signal of growing risk aversion. Angelo Mozilo, chief executive of Countrywide Financial, a leading mortgage lender, said on television this week that investors were dumping shares of home loan groups with little regard for a lender's actual fiscal health. "This is now becoming a liquidity crisis," he declared, adding: "It's going to get uglier." The ugliness could spread if lending standards to companies, hedge funds, private equity groups and others come under review.A broad tightening of credit requirements by lenders could have ramifications throughout the markets.(...) As well as affecting US mortgage borrowers, a credit crunch could make hedge funds that use large amounts of borrowed money cut their debt, perhaps selling assets en masse in order to do so. If that led prices to fall, the effect could feed on itself as others scrambled to limit losses. Companies, particularly weak ones, could find it hard to refinance existing debt - potentially leading to a sharply higher incidence of failure, which would further rock credit markets. The worry is that such a wave of "deleveraging" could swell, with few investors both willing and able to start buying and halt the decline in asset prices. "There is an elevated risk of a financial market crisis during the next two months," says T.J. Marta, fixed-income strategist at RBC Capital Markets. "There is a concern that as liquidity tightens, the wheels could fall off." Signs exist that investors have adjusted leverage levels in recent weeks. The yen is tending to strengthen whenever other markets show weakness, an indication that "carry trade" investors - who borrow in yen at low interest rates to finance purchases elsewhere - are at best nervous about their exposure. Steven Wieting, economist at Citigroup, points out that banks have tightened lending standards, at least for mortgages, according to the latest quarterly survey by the Federal Reserve. But he notes that the shift followed a period of easy loan availability, which continued even after mortgage delinquencies began to rise. There seem few signs of investors leaving the debt markets. The huge quantities of capital looking for a home, which have powered the ability of private equity to announce ever larger leveraged buy-outs, have not dried up. Still, analysts worry that the subprime meltdown could be the catalyst that brings the era of easy access to cheap debt to a close.(...) One area where the impact of the subprime mortgage shake-out is already clear is the equity market. Each day on Wall Street seems to bring fresh news of specialist lenders collapsing and fears about possible problems elsewhere, such as at the investment banks that have big subprime holdings. The result is dizzying volatility. Financial stocks have been down since worries over the subprime sector began in earnest in mid-February. The big equity sell-off of February 27, though in part the result of concerns about a possible economic slowdown in China, also demonstrated subprime anxieties in the US. The financial sector took among the biggest tumbles that day, with some banks down by as much as 8 per cent. The power of fear has remained visible this week. Goldman Sachs shares failed to budge even after the bank reported another quarter of stunning earnings on Tuesday - and Goldman does not even have much of a subprime business. Lehman Brothers, which does, saw its shares initially plunge 5 per cent when it reported record results on Wednesday but suggested that it was seeing some impact from problems in the subprime market.(...) "The current battle involving Wall Street firms' subprime exposure and investor perception of contagion risk rages on without any end in sight," says Michael Hecht, a Bank of America analyst. "This is occurring in spite of positive commentary from both Lehman and Goldman Sachs that the sky is not falling." One fear surrounding the investment banks is that while subprime might not be that big a problem on its own, a flight from risk could mean that other profitable Wall Street businesses - such as the packaging of prime mortgages, credit card loans, student loans and other liabilities into securities - would dry up. David Viniar, Goldman's chief financial officer, says such securitisations have been a key part of Wall Street's profit growth. But he adds that he does not think the current subprime problems will derail that growth. "The concept of securitisation, which I think of as the ability to [divide] up credit risk so you can put it in the hands of people who want it as opposed to people taking parts of risk they don't want, has been an important development over the last several years," he says. "It has been good for all of the capital markets - and I still think it will be an important financial tool that will be used, although I think the subprime market will be smaller." The wild ride played out in the larger market as well on Wednesday, as the two main schools of thought (subprime is a disaster versus subprime is no big deal) fought it out, leading to big swings in the main indices. One of the biggest fears among market watchers now is that the worriers will win, whether based on fact or fear, and push stock prices beneath levels that have held even in the face of recent heavy selling pressure. For the Dow Jones industrial average the recent bottom being watched by the market is 12,050, which was hit on March 5. If that level is breached, the theory goes, the rout could quickly turn vicious, with selling begetting more selling and reason going by the wayside. READ IT ALL

No comments: