Housing Doom is pleased to present the first installment of our unauthorized annotated transcript of the American Enterprise Institute’s October 30, 2008 seminar "The Deflating Mortgage and Housing Bubble, Part IV: Where Is the Bottom?" [1] This is the introduction by session moderator Alex Pollock. It uses a short slide deck.[2] The event site has numerous resources, including both an audio and a video recording of the 2 hour proceedings. There is as yet no official transcript.
Alex Pollock: [slide 1 -- refer [2] below] [00:00] … and welcome to the deflating mortgage and housing bubble Roman Numeral IV in our series.[1] [3] [4] [5] I’m Alex Pollock, a Resident Fellow at the American Enterprise Institute, and we have the same outstanding panel that we have previously had for our deflating bubble series, which by the way we fully intend to continue next Spring with deflating bubble Roman Numeral V [laughter] because this will still be going on by the Spring.
Now this panel has previously brought you notable insights into, and accurate pessimistic forecasts of the problems of what happens when you have the collapse of a really big financial bubble, which we had of course centered on mortgages but by no means limited to mortgages.
This conference is co-sponsored by the American Enterprise Institute and the Professional Risk Managers International Association, which is represented today by Chris Whalen, who’s on the other end down there, and Chris has been my partner in putting these together.
Before I introduce the panel, I want to share a few thoughts. We have the subtitle today is "Where is the Bottom," something we’d all like to know. I’ve seen a number of forecasts that suggest mid-2009 as a bottom for house prices and mortgages. Jeremy Grantham is at 2010. Where the bottom is is quite complicated by the fact that we now have a recession beginning and there will be what the Fed calls [6] the "adverse feedback loop" between the real economy and the financial system, but as to where is the bottom we’ll see what the panel says.
An interesting fact about this bust is, according to International Mortgage News, that federal lawsuits filed relating to the mortgage problems now exceed the total of lawsuits filed from the Savings and Loan Crisis of 20 years ago. So as always we know that a certain class of people benefit from any set of problems.
So let’s just, to begin with let’s look at the bubble. This [slide 2] is the Case-Shiller national house price index over its entire life at which it’s been calculated, starting in 1987 and running up to almost the present. This is a quarterly — this particular index they publish quarterly so the last real point up there — let me see if I can get this to work — that one is second quarter 2008. Here’s the peak in mid-2006 and that red line is simply the trend line drawn through the whole previous series up to 2000 — and if you just put a trend line through that and stretch it out you can see, as we all know, how far the prices … there’s some argument of course over which price index is best, but they have this pattern, this huge departure from the mean. And so if in a simple-minded way we say now we have corrected about 18 percent downward from the mid-2006 peak, and if you think that you’re going to meet back up with the trend-line in a year or so that would suggest about another 10 percent — that is 10 percent of the peak prices — to go. So that would be one way to look at them.
[slide 3] This is, as those of you who know me know, the Plank Curve.[7]
The Plank Curve is the behavoir of risk adverse short term investors and short term lenders when we pass a threshold of fear and uncertainty. And what results is — and this would be a kind word for it — a discontinuity. That is to say a disappearance of short term credit from the market. And that’s what we’ve been experiencing over the last year.
The theme that goes with this Plank Curve picture is a cartoon that I found in James Grant’s new book "Mr Market Miscalculates," [see also ... [8]]
and the cartoon shows a good looking young guy, obviously a Wall Street type, but he’s looking very harrassed and he’s on the phone, and he’s saying, "OK, OK, I’ll try it again. Please, Please Mr. Margin Clerk, Sir …" [laughter] "… would you extend my loan."
Now [05:00] this next one [slide 4] is the inverse of the Plank Curve. So if short term credit is withdrawn from assets that are going to private parties, this "L" on its side here … I hope you can all see this vertical line over here that happens in 2008, is deposits with Federal Reserve Banks not counting Reserve Balances, so what are people … look at here, these little bumps, I’m trying not to shoot you here, Chris, but these little bumps, these are little things like the 80s crisis, and then we’ve got this thing up here.
So what this says is, well, we’re not putting the money out in the Market, we want to hold our money in the form of liabilities of the Central Bank. So this is the institutional equivalent of putting your currency in the mattress.
And thinking of that brings us to [slide 5] the combined balance sheet of the 12 Federal Reserve Banks. And what I have done here is just compared July, the last date in July before the August 2007 panic, with October 15th of this year; so as has been well publicized, assets of the Federal Reserve Banks have more, have doubled from more than $800 billion to $1.7 trillion. This next line is the Treasury bills (oops! sorry) Treasury Bills in this balance sheet, obviously shrinking nearly to nothing and then of course other kinds or credit that didn’t exist before, including Maiden Lane LLC, which is the portfolio taken over from Bear-Stearns.
If you look down another line to this number this is deposits with the Federal Reserve by banks, and this is where you see the number that goes with that "L" on its side, of just keeping your money in the bank, and then I thought it would be fun to calculate the leverage of the Federal Reserve Banks, since of course their assets are greatly outstripping their capital, and they have run their leverage up from 26 to 42 times.
This is just a little history [slide 6] of what I consider to be bailout slogans: we had Bear Stearns of which the slogan is "Too Interconnected to Fail," which I think is legitimate. We had Fannie Mae and Freddie Mac, which was, note, "An Intervention to Save an Intervention," since Fannie Mae and Freddie Mac were themselves government interventions created to help the mortgage markets, so now we needed a big intervention to save the intervention. We had AIG, which I say the slogan is "Punish the Equity but Protect the Creditors;" Washington Mutual, "Punish the Creditors and Save the FDIC Fund." I had some interesting conversations recently European investors who owned Washington Mutual senior bonds and simply couldn’t believe that they were taking the trimming that they are. And finally the Paulson Plan, which started off as we all know as a buying assets plan and turned into a recapitalizing plan, which I had myself recommended and agree with, but there is a question, and my question up there — which I hope you can see — is, "Where is Jesse Jones?"
Now for those of you who don’t know who Jesse Jones was, he was in his day one of the most powerful men in the country. He ran the Reconstruction Finance Corporation during the 1930s when they were recapitalizing the banks, and made preferred stock investments in around 6,000 banks during the 1930s. And to do that well you have to have somebody running it who is knowledgeable, hardminded and a tough old guy, which Jesse Jones was. Well I just leave that question hanging in the air: where is the Jesse Jones who is going to run all this?
Turning to our excellent panel, we’ll hear first from Desmond Lachman, a Resident Fellow at AEI having previously worked as an economic strategist on Wall Street. Desmond’s research includes global currencies, emerging markets, multilateral lending institutions and of course the housing bubble. He and I have been reinforcing each other’s bearish outlook on this now since 2006 at least, and his pessimistic analyses have been correct, including his long-ago call that the housing bust would be a major issue in the 2008 Presidential election,[9] and here we are.
Next will be Nouriel Roubini, who is a Professor of Economics at the New York University Stern School of Business, as well as chairman Roubini Global Economics. He served as a senior economist for international affairs at the [10:00] Council of Economic Advisors, among many other assignments; has written and spoken provocatively as a super-bear on the housing bust, was the first to predict that losses and writedowns out of this generalized deflation of a financial bubble would exceed $1 trillion in losses, and you heard it here. And that was a call far in advance of others who have subsequently also made that prediction.
Tom Zimmerman [scroll down] will be our third speaker, bringing us fixed income securities market perspectives. Tom’s a managing director at UBS Investment Bank, where he manages mortgage credit and asset backed securities research, and he knows the most about the inside of mortgage securities, certainly, of anybody I know. His research has appeared in numerous fixed income reference works. A member of the UBS team voted first in the Institutional Investors survey, and he continues to present exceptionally detailed and insightful looks into the inside of the MBS world.
Our fourth speaker will be Chris Whalen, Senior Vice President and Managing Director of Institutional Risk Analytics. Chris brings us experience as an investment banker, research analyst and journalist, including on both the equities and fixed income side as well as risk management, as I mentioned. Chris has been my partner in organizing this series of conferences and it’s really a pleasure to work with him.
Our last speaker will be John Makin, who is both a visiting scholar at AEI, where he writes the very insightful monthly economic outlook, of which the latest is entitled "Panic," I believe … John … "More Panic." [laughter] "Panic" was the one before? … and now we have "More Panic"? John is also a Principle and the investment firm of Caxton Associates. He’s been an adisor to various US government agencies, the Ferderal Reserve and the Bank of Japan. He is the author of numerous books and articles, and the author of the prediction that the housing bust would lead to a recession, which has now indeed started.
Each member of the panel will speak from 12 to 15 minutes. After that we will give them a chance to react to each other, and then we’ll open the floor for your questions and we will adjurn by 4 o’clock, or whenever you questions run out, whichever happens first.
Thank-you all again for being here, and Desmond you have the floor. [12:38]
Notes and References
[1]: "The Deflating Mortgage and Housing Bubble, Part IV: Where Is the Bottom?", AEI Event Homepage, October 30, 2008.
[2]: "The Deflating Mortgage and Housing Bubble, Part IV: Where Is the Bottom?" (PDF Slide Deck), by Alex Pollock, AEI, October 30, 2008.
[3]: "Mortgage Credit and Subprime Lending: Implications of a Deflating Bubble", AEI Event Homepage, October 30, 2008. There exists a Housing Doom unauthorized transcript for this.
[4]: "The Deflating Mortgage and Housing Bubble, Part II: The Financial and Political Risks", AEI Event Homepage, October 11, 2007.
[5]: "The Deflating Mortgage and Housing Bubble, Part III: What Next?", AEI Event Homepage, March 12, 2008.
[6]: "Yellen says Fed taking on adverse feedback loop", Reuters, April 3, 2008.
[7]: "Reflections on the Mortgage Bust and the Inevitable Political Reaction", by Alex Pollock, Engage / AEI, March 19, 2008.
… The liquidity dynamic is shown by the graph of the Plank Curve shown here, which represents the amount of short-term credit available in the market as a function of uncertainty and fear. The name of the curve derives from the path of a man walking the plank.
[8]: "Mr. Market Miscalculates" — Book Forum, AEI, November 6, 2008.
[9]: "Subprime To Dominate 2008 Election", Housing Doom (part of the transcript from Subprime I), June 14, 2007.
"… But I don’t really need that in my case just to say that we are in for a pretty rough ride, and I’d be as bold as to say that I think that this issue [the subprime mortgage crisis] is going to be the issue in the 2008 election campaign." [0:22:36]
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