101 comments on The Finance Round-Up: December 19th 2007
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101 comments on The Finance Round-Up: December 19th 2007
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Regarding the top article:
10-15% loss on the entire lot of loans seems pretty unlikely to me. You have to remember that the majority of real estate loans are prime loans and the average LTV is in the 50%s. Real estate might go down 10-15%(or more) but that doesn't mean you are going to take a loss on your loan. Commercial real estate still has delinquencies of <1% and losses next to nil. The subprime market is a disaster and losses will be severe there but it is still a small % of overall real estate market.
Nate, I think you are wrong about the sub-prime word, because the MSM talks about it to avoid talking about the much broader crisis in housing:
A couple of links, a light one and a hard one about “We are all sub-prime now":
http://calculatedrisk.blogspot.com/2007/11/upside-down-in-america.html
http://calculatedrisk.blogspot.com/2007/11/what-is-subprime.html
BTW, calculatedrisk.blogspot.com is the best US housing info website, IMHO.
prime, subprime, alt-a etc. if the average LTV is 50% that means the real estate market (assume 11 trillion is correct - I thought it closer to 13 million) is 5.5 trillion in equity and 5.5 trillion in loans. if the ENTIRE market drops 20% (and it of course could drop more), then that is 2.2 trillion off the top. On average this would represent a loss to homeowners only not to the banks who make the loans. Of course its the shape of the distribution that matters - are 20% of houses fully paid off and the rest have 20LTVs? Im sure I could find this datapoint somewhere. My main point is there is a great deal of equity in homes still held by individuals - the entire real estate market is not a loan. If prices go down it will certainly effect the economy, but it doesn't imply the entire banking system as insolvent.
I don't think that the author of the original article even talked about rising energy prices, and its negative effect on the values of large McMansions in outlying suburbs.
The problem is much wider than housing market debt, even if that includes subprime, Alt A and much of what is now prime. Lending standards for all manner of debt have seriously deficient in recent years. As if housing wasn't bad enough, we are seeing problems looming on the horizon for commercial real estate, credit card debt and car loans (to mention only a few). If equities fall, then we will also have a substantial problem with margin debt (which is more out of hand than in 1929).
The risk we are facing (IMO) is a downward spiral where assets are sold to pay off debts, but in doing so the value of assets is undermined, causing a further round of distressed sales. Many things - including real estate - could be sold for pennies on the dollar (with widespread debt default), as they were during the Great Depression.
Point of note. Today the margin requirement is 50%. In 1929 it was only 10%. Quite a disparity. We'd need to know the % of stocks currently owned on margin compared to 1929 to make a better analysis. But margin requirements are much higher today than then.
And the charts Ive seen showing the sheer magnitude of day trading/speculation as % of economy are more a function of our national addiction to maladaptive reward signals than leverage in equity markets.
Nate, we only know that all the letter-soup of commercial paper based and leveraged on top of Mortgages Based Securities (and later in CDO, ABCP, and SIVs), is bringing great banks to their knees and paying big interests not to the Fed, but to sheiks and chinise SWFs, etc. A little list of great american banks trying to keep their reserve requirements in place:
http://www.marketwatch.com/news/story/morgan-stanley-sets-57-bln/story.a...
By Paul Krugman;
Unknown housing territory
I’m still trying to work out the implications of this, but some thoughts about the size of the bubble: at an aggregate level, the housing bubble looks like something we’ve seen before. The rise in the price-rental ratio was somewhat larger than the rise that took place in Los Angeles in the late 1980s, but in the same general ballpark.
However, the aggregate numbers conceal some big differences among metro areas. According to the OFHEO data, prices in Houston rose only 26% over the last five years. But prices in Miami rose 115%. That is, the bubbles in the most bubbleicious areas were bigger than anything we’ve ever seen — and there’s every reason to think that the required fall in prices in those areas will be much bigger than anything we’ve seen since the Great Depression.
This is just an awesome adjustment. Add to it the subprime mess, and past experience with housing busts may give us little guidance as to how this all plays out.
Nate,
the margin requirement at the exchange is 50%, but what about all the leverage that is used it todays credit paper market? A google search "typical leverage in CDOs" resulted in numbers from 3 to 25 with 10 as mentioned being typical. The mess with this type of debt is widely reported, take
"Let's talk about ETFC - E*Trade Financial. Yesterday Citidel took a big equity stake in them, unloading $3 billion worth of mortgage backed securities - for $800 million.
That's 26 cents on the dollar, as I mark it."
source:
http://market-ticker.denninger.net/ 30/11/07
for example. These losses happen at the same time with (right now) possible losses in the stock market. Moreover,
does the typical speculator really use only so little leverage?
What I read over and over is that the typical hedge fund uses around 10 times leverage and if it is financed by
a fund of funds this fund uses leverage too. Taken all this leverage together the comparison with 1929 looks not far-fetched.
Im very concerned. More than concerned, Im scared. Im just trying to keep the facts straight - a comment was made about stock market leverage - I pointed out a factual difference in margin requirements, which is quite substantial. My take on all this is the economy will go south and create positive (bad) feedback mechanisms - it will be indirect depression instead of direct. But no one knows - all we can do is connect the dots as best we can and there are more and more new dots each week.
You make a good point about stock market margins, but I think that only applies to the "official" markets. Several brokerages have opened their own exchanges that are not covered by SEC rules, not to mention that much of the 680 trillion dollars of the derivative market is not covered by margin rules, and that's precisely where people have gone nuts with leverage. I'm sure part of the motivation for these "innovations" was precisely to get around the formal margin requirements. The net is I don't think we're that much better protected than we were in 1929. I will also note that many people put the start of the Great Depression in 1928. The stock market crash was spectacular, but it was a "feedback" more than a "forcing".
I think it is also important to note that many of the truly safe mortgages are money losers for banks. For example, I have very good credit, and I was able to get a mortgage back in 2002 at a very low fixed rate. The banks are making nothing off me. I mention this because I think we sometimes assume that because there are a lot of relatively safe mortgages out there that they will offset the bad mortgages. But you can't offset losses with something that doesn't make money.
The margin requirements restrict only money borrowed from the broker of record. They don't touch money borrowed from other sources - like money borrowed by hedge funds in yen at ridiculously low interest rates, for example, and then injected into the U.S. markets. This is the international BigBoyz equivalent of you taking a cash advance on your credit card and buying stocks with it. At any rate, the real leverage is in the debt markets. The average hedge fund borrowing short-term and investing in longer-term, ostensibly AAA-rated securities employs 14x leverage to juice the spread. All told, the derivatives market has ballooned to nearly $700 trillion and is easily 4x the size of the cash market it is ostensibly hedging. Straight-lining DTV as though the derivatives markets don't exist ignores 80% of the problem. This is why a blowup in subprime - which will surely spread as mortgage resets in Alt-A and prime kick in in the next few years as home prices continue to decline - ignited a bank run in England and has caused the credit markets to freeze. If this were a straight-line DTV problem, would the the ECB have found it necessary to flood the European markets with $500 billion?
Yup
the first hedge fund I managed had as our core strategy buying 10 year treasuries on 9 times leverage. When our black box got a buy signal we would buy 100 million 10 year notes (with 10 million in equity) and finance the rest overnight until the position closed. Based on the rules at the time, most brokerage firms would give us a 2% haircut for 2 Year notes and 5% haircut on 10 years, meaning we needed 2% and 5% margin respectively. But we put up much more collateral than was required - our strategy optimized the risk adjusted return of average monthly return / standard deviation. If the price on TREASURIES would ever have gone down 20% while we were long, all of our capital would have been gone. We made 5% in 1997, 94% in 1998 and 1% in 1999 and shut down that fund. But treasuries don't usually move that much. The point of this story is there needs to be a value-at-risk discussion when talking about leverage. If someone is leveraged 100-1 on something that moves 1 or 2 basis points per day, its completely less risk than being leveraged 10-1 on high yield bonds.
The vast majority of leverage currently is interest rate and currency swaps which TYPICALLY don't have huge moves. One never knows though...
Nate: IMO, pretty well everybody that uses high leverage feels that their situation entails low risk. LTCM felt their strategy was low risk. Supposedly currently JP Morgan has the potential to bankrupt the company 30 times over, so obviously they feel their strategies are low risk. The problem for the economy as a whole is that when the SHTF with these "low risk" strategies the average taxpayer has to pick up the cleanup tab, one way or another-this same taxpayer gains zero profit from successful hedge funds of this type.
Of course, if one's equity in a property is 50%, the value of the property has to drop by over 50% before lenders are at risk.
However, things are much worse than that in commercial property where the "equity" can be tiny. Banks have $212bn at risk in commercial property In the UK, property funds have declined substantially and some are making it difficult for investors to liquidate their holdings (e.g. ISA's etc.)
Austrian economist Ludwig von Mises summed it up many years ago:
http://online.wsj.com/article/SB119802116320237959.html
Now, Even Borrowers With Good Credit Pose Risks
By GEORGE ANDERS
December 19, 2007; Page A2
If the CA home sells for say $400,000, this couple would be hit for a tax bill on $435,000 in income, unless they file for bankruptcy, which is quite likely.
This couple is the topic of two articles in the Round-Up:
Financial degenerates
Mortgage-Relief Plan Divides Neighbors
Or they change the law which is quite likely.
Merrill Lynch estimates $500 billion of losses on residential mortgages. I think the tab now is already $80 billion and the confessionals keep on coming.
Throw in another $500 billion of losses in commercial real estate, private equity, leveraged buyouts and corporate junk. A tally of $1 trillion seems reasonable. Call it 6-7% of GDP. About twice the losses of the S&L mess from a generation ago.
As per point two, it has been clear for months to readers of the Finance Round-Up, and many others, that we're not talking about a subprime problem. Why that keeps on being brought up I don't know, other than it fits nicely in what media, politics and industry would like us to see: a small, manageable issue. Well, it is not, as is clear, once more, from the articles above.
Point one, commercial real estate, is addressed here: