[0:51:56] … What floor are we on? – Tom Zimmerman [followed Roubini]
Doom Transcripts: Index & Guide
AEI’s subprime seminar series is of intense historical interest, and therefore Housing Doom is pleased to (finally!) present a complete unauthorized transcript for the American Enterprise Institute’s March 12, 2008 event "The Deflating Mortgage and Housing Bubble, Part III: What Next?"1 The event site has a variety of resources including a summary and both an audio and a video of the proceedings. There is as yet no official transcript.
Table of Contents
[link navigation works best when full article displayed]
- 0:00:00 – Alex Pollock intro
- 0:08:31 – Desmond Lachman presentation
- 0:21:42 – Chris Whalen presentation [panelist was called away after this and didn't participate in the discussions]
- 0:37:18 – Nouriel Roubini presentation
- 0:51:56 – Tom Zimmerman presentation
- 1:09:12 – John Makin presentation
- 1:24:23 – Panel Responses
- 1:27:55 – Q&A
- 1:28:27 – John Serrapere question
- 1:29:38 – Bert Ely question
- 1:33:15 – Mark Lazerson question
- 1:35:33 – Martin Hutchinson question
- 1:36:31 – Dave Torrison[ph] question
- 1:40:12 – Angelo Ferrer[ph] question
- 1:43:45 – John Schwitz question
- 1:49:46 – Chuck MacKen[ph] question [responses also served as panelist summaries]
- 1:58:21 (end)
Alex Pollock: [0:00:00] Ladies and Gentlemen we will come to order, if people could take their seats … Hi John …
Welcome to all to our conference today, the short title of which is "Deflating Bubble III." Deflating Bubble I, which was a year ago, and Deflating Bubble II, last October, were both very pesimistic about the outlook for the unwinding of the great housing inflation and its accompanying eflorescence of mortgage debt. These conferences were much more pessimistic than were most official views at the time.
The pessimism has been proved correct by events, and now, bringing the same team back again, we bring you Part III: What Next?
Are we anywhere near the bottom of this correction, or bust, or are we still heading downwards? And what are the interacting financial, economic and political implications?
As before, this conference is jointly sponsored by the American Enterprise Institute and the Professional Risk Managers International Association, and on behalf of both, we’re very glad that all of you are here. I’m Alex Pollock of the AEI, and I’ll introduce our outstanding panel in just a moment.
In 1994, a document entitled "The National Home Ownership Strategy" of the Clinton administration advanced2 the following interesting ideas: that financing strategies fueled by creativity should help home buyers who "lack the cash to buy a home or the income to make the payments" buy a home nonetheless.
I should hasten to say, however, that this was a bipartisan idea that lasted over many administrations. A good deal of creativity, of course, was indeed applied to this market, and such strategies were successful, albeit as is now apparent with quite different results than were expected.
I don’t need to review the obvious financial distress the deflation of the housing bubble has unleashed, and that we’re living with each day. Along with reporting multi-billion dollar losses, Fannie and Freddie Mac, for example, have called this, "the most severe housing dislocation in decades," and "one of the most severe downturns in American history," respectively.
Fannie added to that comment that its primary focus is now "protecting our capital and mitigating losses." As this statement indicates, the focus of the market has shifted, in the famous saying of Will Rogers: "from return on capital to return of capital."
When this view becomes widespead, as it has, markets become illiquid, or even "frozen," a term increasingly used. The remarkable special lending programs of the Federal Reserve bear witness to this effect.
A year ago, we often heard that banks and thrifts were not part of the subprime mortgage problem, but they are deeply involved in the wider deflation of the housing and mortgage bubble.
Profits of all FDIC insured financial institutions fell 84 percent in the 4th quarter of 2007 from the same quarter in 2006. Problems with home equity loans and loans to real estate developers, among other assets, are increasing.
Option payment ARMs retained on financial institution balance sheets with large amounts of negative amortization already booked as profits representing non-cash income are likely to represent another wave of delinquencies in an environment of seriously falling house prices.
And how far will the prices fall? Well of course we’d all like to know that. Goldman Sachs has forecast the peak-to-trough fall in house prices to be from 20 percent to 25 percent. On a starting aggregate value of US real estate of $22 trillion, [0:05:00] a 20 percent fall would be about a $4.5 trillion reduction in household wealth.
And what would a 20 percent fall in house prices do to bank credit?
Of all FDIC insured financial institutions, 48 percent of total loans, and 47 percent of total assets are based on real estate. For the smaller banks and thrifts, those with less that $1 billion in assets, 67 percent of the loan portfolio is based on real estate.
So let me confidently predict that interesting times will continue; financially, economically and politically, as a result of the momentous 21st Century housing and mortgage bubble. And for more elaboration of "What Next?" we’re going to rely on our panel.
And the panel will go this way across the table from your left to right. We’ll hear first from Desmond Lachman, who’s a Resident Fellow at AEI, having previously been a Wall Street economic strategist. His research includes global currencies, emerging market economies, multilteral lending institutions and the housing bubble. Desmond and I have been reinforcing each other’s bearish outlook on this topic since 2006.
Our 2nd speaker will be Chris Whalen, Senior Vice President and Managing Director of Institutional Risk Analytics, to which he brings experience as an investment banker, research analyst and journalist, including work in both equities, fixed income and risk management, and Chris has been my partner in organizing this series of conferences.
3rd speaker will be Nouriel Roubini, who’s a Professor of Economics at New York University’s Stern School of Business, as well as Chairman of Roubini Global Economics. He’s served as a senior economist for International Affairs at the White House Council of Economic Advisors, among many other assignments, and written most provocatively as a "super-bear" on the housing bust and its economic implications.
Tom Zimmerman will be our 4th speaker, bringing us fixed income securities market analytical perspectives. Tom is a managing director at UBS Investment Bank where he manages the firm’s mortgage credit and asset-backed securities research. His research has appeared in numerous fixed-income reference works, and he’s a member of the UBS team voted 1st in the International Investors’ survey of fixed income analysts.
Finally we’ll hear from John Makin, who’s both a visiting scholar at AEI, where he writes the insightful Economic Outlook Monthly essay, he’s also Principal at the investment firm of Caxton Associates. He’s been an advisor to various government agencies: the Federal Reserve and the Bank of Japan, the author of numerous books and articles, including those last fall predicting that the housing bust would lead to a recession starting early in 2008 or late in 2007.
Each member of the panel will speak for about 12 minutes or so, after which we’ll give the panel a chance to respond to each other. We’ll then open the floor for your questions and we will adjourn by 4 o’clock.
So again let me welcome all of you, and Desmond you have the floor.
Desmond Lachman: Thank-you very much Alex,[slide3 1] and once again I’d like to compliment you on having conceived of this idea long before most people had heard about subprime mortgages or asset-backed securities or delinquencies or the like.
I know you want me to be very brief, and if I were to be really very brief I would just tell you that what I think about the housing market — I’m often reminded of the story I was told about what went on during the Iranian Revolution in 1979. People on the street, when they would ask one another how they were doing, they would say badly, but not as badly as tomorrow. And I’m afraid that that’s where I come out on this housing story.
But what I want to do first is, I just want to put it into a little bit of perspective. As Alex has mentioned, this is the worst housing bust that we’ve had in decades. I don’t want to go back to the ’30s, but certainly it’s the worst that we’ve seen.
But I think that what’s very important about this housing bust is it’s not occurring in isolation. [slide 2] That this is a very negative shock, but there are at least 3 other very negative shocks to which the US economy is being subjected right now.
The first, of course, is the Credit Crunch, which is partly associated — clearly associated — with the housing bust. [see slide 8 -- out of order] But just the huge amount [0:10:00] of deleveraging that we’ve seen going on for the last few weeks is telling you that this is really serious, that constraining credits is certainly going to be constraining the economy.
In addition what we’ve got is we’ve got oil prices, for whatever reason, are now around about $110/bbl. We’re talking about roughly doubling of oil prices over the past year. That in the past would have been a sufficient shock to really damage the US economy.
And then 3rd, of course, is that the equity prices are plunging, non-government bond prices are not doing too well, so the amount of wealth that is being wiped out by the equity prices, I calculate that to be roughly equivalent to what has been wiped out on the housing in the past year. So that’s just another $2.5 trillion.
Why I’m concerned about this is, of course, because [of] what the Fed would call "adverse feedback loops," that what we have is we have a housing bust and a credit crunch causing a recession, which I think has begun already [in] December, and I think that the only realistic discussion is "how severe and prolonged is this recession going to be?" I don’t think that one can seriously argue that there isn’t a recession at this stage of the game.
But once we get the recession, what the recession is going to do is it’s going to weaken the housing market further, it’s going to weaken the credit crunch, so we’ve got this feedback loop. And I’ll conclude at the end of my presentation just by saying that I don’t think that orthodox policies are going to get us out of this mess. I think that policy has to be a lot more aggressive, but it’s also got to be a lot more imaginative to break us out of the cycle, and the options aren’t the greatest when one thinks about them.
Let me just move on to the issue of the housing bust [slide 3] as it’s occurred right now, just to summarize I’ve just put up a few charts.
The first is that housing is just … housing activity, these are starts, just falling off a cliff. [slide 4] That that last year we were declining about 20 percent. A year, that just takes off 1 point of GDP. We’re not quite yet at the low points that we hit in 1990, but we’re certainly on the way there.
More distressing is the idea of what’s happening to housing prices. [slide 5] Housing prices at national level, the common view was that there was no way that these could decline. Well, what we’re looking at is we’re looking at housing … the latest numbers on Case-Shiller is saying that house prices are falling by 9 percent year-on-year of the past year, but what is even more disturbing is the last quarter, is they’re going down at a rate of 20 percent. And this is, as Alex mentioned, it’s already wiped out $2.5 billion [probably meant to say "trillion"] in wealth. What it also means is that a lot of people are going to be going into negative equity, which just means that you’re going to get a very serious increase in foreclosures that is going to complicate the credit crunch now going on.
Just this next chart just puts it in a slightly different way. [slide 6] The blue line is just looking at real house prices adjusted for inflation. We’re now declining around about 15 percent on an annual basis. And if you look at the red line, that is just telling you what the bubble was before. We’re just making a slight dent into the bubble. So as I’ll argue a little later, I think that we’ve got something like another 20 percent still to go.
Other aspects of what’s occurred so far is that if you’ve had losses on the banks just mounting. Literally when we met last time this year I recall the subprime issue had just broken, but Chairman Bernanke, in his wisdom, assured us that this was a contained, small problem.
Later on it was a $50 billion problem, and later on it was a $150 billion problem. The G7 itself released a communiqué after their meeting, indicated that this was a $400 billion problem, and Goldman Sachs is talking about $500 billion, and I’m just talking about what is occurring on the mortgage side. So this is really a big deal.
As I mentioned, foreclosures is the other aspect that’s occurring. [slide 7] And foreclosures already are running at something like 1.5 million units / year, and with the negative equity I fully expect them to go a lot higher.
Let me now just mention where I think we are going. [slide 8] As I did the time before, I think that a good place to start is: What is the situation in the housing market right now? And one of the characteristics [0:15:00] of the housing market is that this is a market that doesn’t clear. [slide 9] This is a market where denial is the name of the game. Nobody really wants to recognize that their house is not worth what they thought it was. And they won’t reduce the price. So what we get is we get instead of the house prices falling to market clearing, what we get is we just get indications of either vacancy rates, which usually run at something like 1 1/2 percent, are now running at 2 1/2 percent, [slide 10] or unsold inventories of houses round about 5 million units are unsold. [slide 11] It’s around about 1 1/2 million units too many, and we’re at 10 month inventories. This is a huge number.
Now of course, lower level of construction activity will eat into those inventories over time, but I don’t see this occurring. This is going to take at least a year and a half, two years before you’ve cleared that kind of backlog. That’s why I don’t think that there’s much hope, certainly not in 2008.
Another chart just indicating the idea of the bubble is the affordability ratio, [slide 12] which is a good way of looking things, is that if you look at the house price in relation to income, historically it was around about 3.2, it peaked at about 4.5 — this chart needs to be a bit updated, but we’re not very far from the 4.5, so this chart alone would tell you that you would expect that the ratio has to drop by at least by 25 percent, and in my view the fact that we’re heading into recession that’s going to be prolonged, it’s not going to be the income that’s rising, it’s going to be the house price that is falling.
We’ve got a situation of excess supply right now, but I think it’s worth asking ourself — What is going to happen to demand? [slide 13] If demand were increasing and we had excess supply it wouldn’t be so bad, but what I would suggest is, for a variety of reasons, we’ve got excess supply right now, and demand is going to be evaporating.
I’d just remind you that in 2006, [slide 14] around about 40 percent of all mortgages made were either subprime or Alt-A. Well, most of those non-bank originators who were making those are no longer with us, so we’re certainly not going to get them providing the support, and then when I look at the intentions of banks, that the Fed runs a survey, [slide 15] a quarterly survey of what banks’ intentions are … I notice that they’ve got a right panel to this chart because the left panel couldn’t handle it, [laughter] that what got is we’ve gone … just look at the prime lending. They asked respondents — 40 percent of people making prime loans, forget about the subprime or the non-traditional loans, these people are saying that they’re tightening lending conditions. So I would have thought that the banks are tightening, the non-banks aren’t there, demand’s not going to do too well. [slide 16]
Another side is the adjustable rate mortgages. [slide 17] This starts from 2007, so the 12th month, we’re really around about the peak of this chart. This is going to be another draining factor, but it might not be as bad as before, because interest rates have come down so the difference between where the teaser rates were and where the resets are has been reduced, but nontheless it’s going to be another negative factor. And then as I mentioned before, you’ve just got a huge amount of foreclosures, which means that you’re going to get additional supply coming back on the market.
So where I’m left with all of this is that you’re certainly not going to get stabilization in 2008. [slide 18] I’m not sure at what point in 2009 — I’m not sure I want to be a hero and anticipate an upturn in 2009, I think that it drags on, like, to the middle of 2009 and the kind of situations, I’ve just mentioned a few, that I think that housing activity continues to contract at around about 20 percent, which means we’re going to lose another point of GDP, it’s going to be a drag on the economy … on the GDP. I think house prices fall by at least 10 to 15 percent over the next year, and it’s not just me that’s thinking it, the only market that we’ve got in house price futures, that people trade the Case-Shiller index, and just look at the second column for the securities listed here. [slide 19] It’s getting from where 10 to 25 percent is the decline that the market is expecting [0:20:00] over the next 2 years.
So this is going to be just a huge amount of wealth that is now going to be destroyed. You’re not going to get the mortgage equity withdrawal or all the rest. I don’t see how the economy is not going to be in real trouble.
[crosstalk]
… 2 minutes … I’ll make just two more points …
One is, and I think this is important, is that last year what was occurring was that as the housing market was busting, commercial property was booming. So what we’ve got is that there was an offset. The previous chart [slide 20] is just indicating that we’re now getting the two moving in unison, so you’re really just going to see a lot of construction, unemployment and that’s going to be a drag. [slide 21]
Final point that I’d make is — I’ve just put it here — I think policy inaction is not an option, [slide 22] that the Fed has to get the interest rates down to zero in a pretty fast way, that it’s not too soon to think about a second stimulus package — the first stimulus package has been just offset by the increasing oil prices by $20, so you really need to prime this economy up. But I think that the most important thing, and I’ll leave it to the other panelists to talk about, is the unorthodox kind of ways that the Fed’s going to eventually have to bail out the banks. They’re going to have to bail out the housing sector.
I hope that I’ve set a sufficiently optimistic note to this talk … [laughter]
Alex Pollock: Thank-you for your uplifting message, Desmond. Chris.
Chris Whalen: Thank-you, guys. (… could I have the clicker? … Karen’s in charge …)
Thank-you, Alex. [slide4 1] I first want to thank Alex and our speakers on behalf of Professional Risk Managers International. For those of you who are not familiar with PRIMIA we’re one of the larger educational and member-focused organizations of risk managers in the world. We’ve got over 50,000 members now, and I’m a regional director here in the Washington DC Chapter.
Alex asked me, as I did in our first meeting, to kind of take a look at the banking industry and give a bit of context to some of the economic- and industry-specific analyses that you’re going to hear today.
Obviously for a lot of people they start off, when they think about subprime they think about real estate. But what I try and impress to my colleagues and clients is that this is really the death of an asset class. [slide 2] This is the death of securitized assets, some of which happen to have subprime mortgages inside them. But there’s a far wider effect now which is essentially preventing banks from securitizing anything, even things as benign as credit card receivables and auto loans are now in question, and this is precisely why the Fed announced yesterday this special collateral swap facility, where you can bring them securitized mortgaged assets, for example, and they will give you treasury bonds.
The reason for this is that nobody on The Street will lend against the securitized mortgage paper. It has zero collateral value. And for a broker-dealer, this is death.
You could say that this was done because of the rumors whirling around Bear Stearns, my former employer, but I would tell you that just about any broker-dealer that has any significant mortgage business is affected by this. They have inventory that they can’t sell and they can’t finance. And if you have to meet net capital rules or any other rules that a broker-dealer lives by, this is a big problem.
Now the other problem here is fair value accounting. I didn’t address this in my slides, but I’ve been going to war over this issue in the Press and the FT [Financial Times of London] last week — I have a letter that’s going to appear tomorrow, where I respond to the head of the UK version of the FASB.
And frankly we are scaring the hell out of people with fair value accounting. We pretend that the historical cost and an informed estimate are the same? … in terms of evidentiary weight and value? This is madness.
My view of fair value accounting, just quickly, is that it was an attempt to make the world safe for structured assets and derivatives. This was how the accounting profession and the spineless weasels at the SEC [laughter] basically were helping The Street sell over-the-counter unregistered paper. This is the problem.
The only way to deal with assets for which there is no quoted market — and I mean an aggressive liquid market — is a historical cost. And if there’s a fluctuation in those assets, you put it in the footnotes, where it belongs.
If you have a headline that says: "MBIA Takes $3.5 Billion Loss," but their cash impairment [0:25:00] is $200 million, most investors are going to look at the headline.
When the head of the Wisconsin Insurance Commission got and said, well they could write off all of their capital but they would still meet the solvency rules of the State, that’s telling you that there’s something wrong with the disclosure … Enough said.
We’ve already covered the National Homeownership Strategy. [slide 3] There’s an online version of my slides. If you click on that link you’ll go to a wonderful monograph by Joe Mason, who goes into the origins of affordability and creative financing that Alex already referred to in his remarks — (I’m going to skip over this [slide 4] ) –
Let’s talk about the banking industry. [slide 5] For those of you who want to get a concise, easy to read precis of where we are in terms of banks you should go to the FDIC website and download the quarterly report that they put together. It’s an extremely easy to understand and complete profile.
There’s a number of very interesting things in this last report. For example, trading losses. $10.6 billion in trading losses for the industry — the first time that the industry has posted a quarterly net trading loss since they’ve been gathering statistics on such things.
The other interesting thing that caught my eye was that the drop in profitability, the drop on return on assets, which is one of the main ways you measure bank performance, was largely concentrated in the large banks. This isn’t to say small banks aren’t having a hard time, but the steep … there was a 102 basis point drop in the industry’s return on assets, but there was only a 14 basis point drop in the median value for the entire 8,900 banks in the United States. So this tells you that the problem at the moment is largely concentrated among the larger institutions.
Now I’m going to show you some charts much like Desmond did, because I want to illustrate different types of banks and where we are in terms of time.
This chart [slide 6] is what we call Gross Defaults — this is charge-offs for those of you who are more familiar with the old fashioned term — and what we’re looking at here is a chart from March of 2000 through to the end of 2007. The blue line is Citigroup and the red line are the large bank peers. Now you might think to youself, "Gee, those lines are kind of different, Chris. What’s it about Citi that’s so unique?"
Well, Citi has a much more subprime orientation in their business model than most large banks. This is kind of a legacy of the Sandy Weill era. He didn’t like traders. Neither did Warren Buffett, so when they got together they went out and the shot every other trader. You know, they just said, "Raise you hands, count one-two one-two," and they shot everybody who said "two."
This left Citi with a very large focus on consumer exposure, as opposed to say someone like J.P. Morgan, who has much larger commercial / corporate exposure, in relative terms.
Both of them have large books on both sides, but Citi has a very pronounced subprime focus. This is manifest both in how they price their loans, and what we’re looking at here, which is charge-offs. This is actual losses against loan-loss reserves.
Now what you’ll also notice is that ‘06 / ‘07 were pretty quiet, even though we were sitting here a year ago tearing our hair out over subprime, ‘06 and ‘07 were in relative terms a trough for bank charge-offs, that is to say losses the banks realized against credits. Obviously we’re going to go up, but we’re starting from a very low base. And if Desmond and Nouriel and the rest of my colleagues up here on the panel are correct as to the magnitude of the adjustment, we’re going to go through those 2000 / 2001 levels pretty quickly, and I would suggest we’re going to go through the early ’90s levels pretty quickly in terms of loan losses.
To refresh everybody’s memory, in ‘91 / ‘92 timeframes, Citibank got up to about 3 1/2 percent chargeoffs against total loans and leases, and that nealy killed the bank. I think we could go higher than that. This is why I’ve said, both of the GSEs, Fannie & Freddie, in my opinion, are basically insolvent. If we get up to anything like 3 … 4 percent of total loans and leases nonperforming in the industry, I just don’t see how these lightly capitalized entities are going to survive without a restructuring.
Now the next chart [slide 7] — what we call: Loss Given Default. It’s a Basel term — don’t worry about Basel II, by the way, I hear Basel III is coming very, very soon [laughter] — Greenspan made a speech apparently to an audience paid for by Deutsch Bank, I don’t know how much they paid him, and he said they were working diligently on Basel III, and then the next day Nout Wellink, the the chairman of the Basel Committee said, "Maybe we need something new." So I guess these are both hints, right?
Anyway, Loss Given Default is essentially charge-offs less recoveries. In other words you’re looking at how well the bank gets it’s money back [0:30:00] after somebody defaults on a loan.
It’s a very interesting business model indicator, because as you can see the red line is the large bank peers, the blue line again is Citigroup. And you can see, mostly, large banks typically lose about 70 to 80 cents on the dollar when somebody defaults on a loan. And they go through workout, they go through bankruptcy and everything else and in general they do pretty well, for a large organization, in terms of remediating big credits. But look at ‘05. Look at ‘06. Look at how low that number got. You have these large banks who just barely know who their customers are. They use the law of large numbers for things like credit cards and consumer lending, and yet somehow or another the net recovery rate for some of these large banks got down into the 50th percentile relm. That’s extraordinary.
A little consumer bank will do that well all the time, because they actually know who their customers are. The walk into the branch, they say hello to them, when they get in trouble, they know. They might even reach out to that customer and try and help them work through their financial difficulties.
But mostly the large banks don’t do that. They just can’t. As Martin Mayer5 taught me years ago, "there are no ecomomies of scale in banking." If you know who your client is, you have to spend time with them, you have to spend resources in order to help them.
And what this chart [still slide 7] really shows you is that since about 2006, the loss rate, the Loss Given Default, has been climbing. That’s bad. My sense is by the end of this year going into ‘09, we’re going to see Loss Given Default for the large bank peer group well over 90 percent, and it’s going to stay there for a while. That’s credit card territory, that’s what we call subprime.
Now this is another interesting one, [slide 8] Exposure at Default, another Basel term. In plain English it’s just what we call unused credit lines. This is the unused lines that are available to the customer versus what they’ve already drawn. And so if you’ve got a credit card, you’ve got $10,000 in credit, if you’ve drawn $1,000 your Exposure at Default would be 900 percent. Because you could go take that other $9,000, file bankruptcy the next day. What this indicates in addition to where most of the large are, they’re at about 110, a little below, but look at the way it’s been trending down. Since ‘05, a combination of 2 things have been going on in my view:
- Customers have been pulling on credit lines, so they’re using the unused line;
- but banks are also pulling back on lines.
Some of you may have seen Citi cut off all of their customers in the UK. They have a little credit card affiliate called Egg that they bought a couple of years back. They just shut it off. They said to all the customers, "You can pay back your existing loans, but you can’t draw any new credit." They just shut it off.
This is a very interesting business model indicator, because if you look at specific banks, you can tell when they’re getting nervous, because this number starts to go down. They’re pulling in lines, because they want to protect themeselves from default.
We were talking about WaMu at lunch today. This is a chart [slide 9] that shows you the mortgage peer group versus WaMu. Now you’ll notice that the charge-off rate is much lower than the large banks. [For] the large banks we’re showing you everything, credit cards, commercial loans, mortgages, what have you. This is just the mortgage peer group defined by the FDIC. And you will notice that since March, about June of ‘05, the default rate for Washington Mutual has gone through the ceiling. Why do you suppose that is?
Well, it’s because they bought a wonderful little business called Providian, a subprime credit card issuer. And even though this is a tiny business, it’s less than 5 percent of the total loans and leases inside WaMu, it’s throwing off 1,000 basis points of default right now. 10 percent of total loans and leases. Great business.
Now the folks at WaMu have indicated they kind of like subprime, but I’ve got to tell you, I … it may have been cheap in ‘05, but it’s not a business I would have bought. And I think it’s illustriative of what it means to a fairly quiet bank like WaMu when you get into subprime credit cards.
Come to think of it, here we are with credit cards. [slide 10] As you can see the numbers are much bigger. The red line is the peer group, which includes GE, which is why you have that big spike, by the way, over 1,000 basis points, 10 percent of charge-off in one quarter. And then we have Bank of America’s credit card unit in the blue line. And as you can see again, look how benign everything was in ‘05 / ‘06. Things were great. No losses. No risk.
Now here we are heading north again, but again, ‘06, ‘07 really fairly quiet period in terms of defaults, even for credit cards, probably the lowest qualtity asset on a bank’s balance sheet.
Just quickly — Effects. [slide 11] Banks? We’ve wound the clock back 20 years. Banks can’t sell anything. People have to remember that securitization was about funding. Banks don’t have the funding [0:35:00] alternatives that the used to have. It’s almost like the Jimmie Stewart movie "It’s a Wonderful Life."
The banks are now islands. They communicate occasionally with other islands, but they can no longer fund themselves easily in the marketplace. And this is going to have a huge impact on the economy.
If the $3 trillion or so in private label securitizations are forced to liquidate without being replaced, this economy’s going to slow down and it’s going to stay slow until we figure out a way to fix it.
Risk preferences, [slide 12] I think we’ve talked about this. Investors are fleeing to cash and I think they are eventually going to flee the [US] dollar as this crisis develops, because they’re not going to want to hold anything in dollars.
And then finally, Alex asked me about some of the litigation [slide 13] going on in Ohio, where people are challenging foreclosure because when they do a securitization they don’t perfect the lien on the mortgage. They’ve tried to address this through federal legislation, but let me leave you with this image.
Banks are increasingly being sued under truth in lending claims. Chevy Chase Bank, for example, is fighting a really nasty litigation in Wisconsin that’s been appealed to the 7th Circuit. If that claim survives appeal, the trial lawyers are going to have a template for going after every lender that was playing at Alt-A and subprime. And it will be just like asbestos, they will come after them hammer and tongs.
But the most interesting issue is that once the borrowers are done suing the banks, the investors who bought the securitizations are going to be suing the bank too for suitability. And I think litigation expenses, the exposure from litigation, is going to become a significant factor in safety & soundness discussions going forward in the US, because the trial lawyers are looking for a new game. Consumer product litigation is basically over, and they see finance and financials as a new frontier. I actually can think of 3 very very high end litigators in New York City who crossed the street from doing corporate defense work to doing plantiff’s work for pension funds and other buy-side investors who are interested in exactly these kinds of claims.
So with that, I will stop. And I have to leave early today. I apologize. If you have any questions, please get in touch.
Alex Pollock: Thank-you, Chris. Nouriel.
Nouriel Roubini: Thanks, Alex, for inviting me.
I would like to talk about what’s happening in these housing and mortgage meltdown in the context of a broader picture of what’s happening to the US economy and the more severe turmoil in the financial and credit markets.
I certainly agree with Desmond. At this point the debate is not any more on whether we’re going to have a soft landing or a hard landing, but rather on how hard the hard landing’s going to be, meaning how severe the recession’s going to be. After Friday’s payroll numbers, even those remaining few optimists on Wall Street that believe we can avoid the recession this year have switched to the recession camp.
The trouble is that … I think that people are still optimistic, are too optimistic. Now the new conventional wisdom says that we’ll have a recession in Q1, Q2, is going to last only 6 months, and by the middle of the year we’re going to some moderate economic growth.
But if you compare the market and financial conditions today with those of, say, the last two recessions, the one that was in 1991 and the one in 2001, you’ll see that things are much worse today. And in the last two recessions, as you will recollect, have lasted 8 months each, 1991 and 2001, and now the consensus says this one is going to be a milder recession and a relatively milder recession than we had in the last 2 occassions.
I don’t believe that. I believe that this recession is going to be much more severe. It’s going to at least 12 months, and as much as 18 months, and the reason why I think so is that in at least 3 important dimensions, market and financial conditions today are much worse than they were in 1991 episode, and the 2001 episode.
And these 3 elements are as follows:
- First of all, we’re experiencing right now the worst housing recession in the United States since The Great Depression, and things are not only not bottoming out, but are getting much worse;
- Housing starts, the production of new homes, has fallen totally off the cliff by over 50 percent relative to the peak, but unfortunately the demand for new homes has fallen by even more, by about 60 percent, and therefore the excess supply of unsold homes — the gap between supply and demand is unsold inventory — has become huge, unprecedentedly high in both absolute terms and in measures of sales, and no wonder now home prices have already fallen in nominal terms by about 10 percent relative to the peak based on the Case-Shiller index;
- and as was pointed out at the beginning, we’ve had $22 trillion of value of homes that wiping out already $2.2 trillion from the value of the housing wealth.
But if you look at the numbers the way I studied them and analyzed them, this year alone you’re going to have at least another 10 percent fall in home prices for a cumulative 20, and before we bottom out the number [0:40:00] is going to be close to 30 percent.
So the total destruction of housing wealth is going to be of the order of 20 percent — $4.4 trillion — if it’s 30 percent $6.6 trillion. So I will discuss then the effects of this wealth shock on consumption and spending behavior.
More importantly we have a fall in home prices of 10 percent today, numbers, for example those at Mark Zandi of the Economy.com has developed, suggests there are already over 8 million houses are underwater, meaning they have negative equity: the value of their home is below the value of their mortgages.
If home prices fall by another 10 percent, cumulative 20, that number of underwater houses is going to be 16 million, and if home prices fall by 30 percent that number is going to be 21 million. We’re speaking of 21 million out of 51 million approximately houses with mortgages, or 40 percent of them might be underwater.
Now you don’t know how many of them are going to walk away. There’s a huge incentive, of course, with a non-recourse loan, to walk away, what persons refer to as "jingle mail," you put the keys into an envelope, you send them to the banker and you say, "Bye bye!" But a significant number of these people the mortgage is underwater and the price of the house has fallen are going to be underwater, and just to give you an idea of the potential losses we’re thinking about, today people are now pushing up their estimates of losses from subprime from, you know, $200 billon or $300 billon, to $400 billion or $500 billion in the case of Goldman Sachs. But think about the consequences of people walking away from their homes.
Suppose you are going to be conservative, and home prices fall only 20 percent rather than 30 percent. And suppose that only 50 percent of the houses that are underwater out of those 16 million — so 8 million — decide to walk away. And suppose that the average loss on a kind of a mortgage that has an average value of $250,000 is something like 50 percent, relatively conservative. Then you get a total loss of about $1 trillion. That is enough just to wipe out the capital of the entire financial system.
If you have instead bigger falls in home values, 30 percent, and therefore you have a basis of 21 million houses underwater, the losses could be $2 trillion. So that’s what we’re facing right now, a situation in which we could literally have an entire banking system being destroyed, destroying[ph] their capital and going bankrupt and have to be nationalized. So that’s what we’re facing today.
Second observation: in 2001 the cycle of the economy was untroubled, was the corporate sector, particularly the tech sector had a boom and then a bust. Today instead we know that the sector of the economy that is in trouble is the housing sector. The US consumer that is shopped out, has negative savings, is debt burdened. And as you know, private consumption is about 70 percent of GDP, while the tech sector, directly and indirectly, was only about 10 percent of GDP.
This US consumer, we know today, is buffeted by a series of nasty shocks. Home values are falling and Home Equity Withdrawal (HEW) has sharply dropped, therefore you cannot anymore use your home as an ATM machine. Oil prices are close to 110 [$/bbl] and the price of gasoline is going to be closer to $4/gal.
You have a major credit crunch that started in housing, is going to effect the consumer credit. The debt ratio for the housing sector has spiked from 100 percent to 156 percent, and that servicing ratio, with interest rates and resets and what-not, are sharply increasing.
All these, people said, did not matter as long as there was income and job generation. That was the last leg which was supporting consumption, but we know now for the last 3 months, employment in the private sector has been falling sharply, and this is the beginning. Employment is a lagging indicator of economic activity, so for the beginning of a recession, there’s already this sharp fall in employment, what’s going to happen down the line?
The point is, we’re in a situation which you have a housing sector, 70 percent of GDP where spending is totally on the ropes and it’s giving in and the falling consumption, you’ll have a severe effect on the recession, much more severe than 1991 or 2001.
Third factor that is very different today, rather than in the past: people talk of course now about the subprime disaster as subprime meltdown, but the reality is that we have a subprime financial system. You now, the rot went in subprime, first of all the same kind of reckless lending practice that were occurring in subprime — zero down payment, interest rate only, no verification of income assets and jobs (these liar loans or NINJA loans), you know, interest rate only, negative amortization, teaser rates, option-ARM — the same kind of jargon was occurring for subprime, for near-prime, Alt-A, prime loans, Jumbo loans, piggy-back loans, home equity loans. You know, 2/3rds of all mortgage origination in the last couple of years had this reckless characteristic.
Guess what? Default rates and delinquency rates are sharply rising across the board. It’s not just, any more, a subprime problem. And it’s not just problem of residential mortgages. We know [that the] same kind of reckless lending practices were occurring for commercial real estate loans, and that [CMBS] market has also completely fizzled out.
And, of course, if you have a bust in housing, with at lag of a few quarters you’re going to have a bust [0:45:00] in commercial real estate. No surprise — if you go out to Las Vegas, there are these entire Ghost Towns, empty developments with thousands of homes.
It was going build stores, offices, shopping centers, shopping malls, in this Ghost Town. Of course that part of the commercial real estate is going to follow housing, is going to bust. Think about the losses there on commercial real estate.
And it’s not just the residential and commercial real estate. We know that there has been a huge increase in consumer debt, is unsecured: credit cards, auto loans, student loans. We have a severe recession, people are losing jobs, not having income, you’re going to have a bust in that sector.
We know that’s not the end of the story. You have all these leveraged loans that were financing reckless: LBOs, that are now sitting on the balance sheets of the financial institutions instead of being worth 100 cents on the dollar, are now worth 80 cents in the dollar. That’s another severe problem.
You have the problem of the monolines and regardless of what the rating agencies are telling you, telling you that they are triple-A, that’s nonsense. When MBIA goes in the market and can borrow, issuing debt in interest rates of 14 percent, that is more [yield] than junk bonds, and where its credit default swaps are those equivalent of a firm that has double-B rating, saying that this is a triple-A firm is just a joke. I mean, rating agencies already lost its reputation on essentially rating, or misrating, these Asset Backed Securities, have lost it completely with the bond insurance. I mean, there is no sense, this should be downgraded today.
And by the way, people, when they talk about the bond insurance problem, they say, "Yes, they got in trouble when they insured the toxic stuff, but there’s the good part of their business — their insurance of the safe stuff, the muni bonds." But are muni bonds that safe? If you go back to 1991, that recession, at that time muni bonds were like junk bonds. Why? Because you had the severe increase in default rates by state and local government, especially local ones.
If you go all the way out to the West, you have localities that spend like crazy, increase their debt like crazy — their revenue base was based on what? Fees from developers, property taxes, sales taxes. All those things today are collapsing and their spending is mostly on salary on public employees that are unionized, and you cannot fire them, you cannot cut their wages. So what are they going to do? They’re going to default. Vallejo in California is on the verge of defaulting. Jefferson County in Alabama is on the verge of defaulting, and we see dozens of cases of muni bonds going belly up. The idea that these are safe is just nonsense. In a severe recession you’re going to see a severe increase in default rates, even by municipalities.
Add to that the fact that people say the corporate sector is fine. Default rates are very low. The corporate sector is profitable relative to 2001. Yeah, the average corporation is profitable, but guess what? In the last 2 years, default rates on corporate bonds were only 0.6 percent, with the historical average in ‘71 is about 3.8 percent in a normal year.
My colleague at Stern, Ed Altman, is the world leading expert in corporate defaults. In a typical recession, last two ones, default rates went above 10 percent, at peak, 15 percent. They’re starting now close to zero, and you’re going to have a massive increase in corporate defaults. Not only do the default rates go up in the recession, but recovery rates given default sharply fall. In a normal year you [undecipherable] recovery rate from corporate defaulted bond of 70 cents on the dollar. During a recession, it’s only 35 cents on the dollar. So you get a double whammy. Losses because the default rates are higher, and must less recovery rates.
And once the corporate default going to belly up, what’s going to happen to the $50 trillion of nominal value of CDSs on this corporate bonds, that have a base of only $5 trillion of corporate bonds behind them? The loss estimates go as high as $250 billion on that alone.
And it’s not just the distribution between those that sold protection and those who bought protection because, guess what, some of those who sold protection are going to go belly up, and those who thought they bought protection and were hedged were not hedged. So the gross exposure is much bigger.
When you add it up all together, 3 or 4 hundred billion of subprime is just really nothing compared to the size of the losses you are going to have in the financial system. I’ve had estimates that the minimum you’re going to get, including everything, is going to be $1 trillion, and the worst case scenario could be closer to $3 trillion, which would wipe out the entire financial system. That’s what we’re facing today, we’re just facing a systemic financial crisis in which essentially most of the securitized markets that we have discussed have totally seized up, most of the other markets are frozen, and monetary and fiscal policy is becoming increasingly impotent.
Guess what? We are on the way to essentially, whether we want it or not, nationalizing the entire financial system. [note: full marks for this prediction, which came to pass 1/2 year later on 9/18 2008] You think about what the Fed has been doing the last week alone, they decided essentially to switch about 60 percent of their assets of treasuries, about $700 billion of them, and buy essentially, in exchange swap them, for mortgage related assets of dubious quality. So that’s already happening. And that’s a form of a bailout.
Think about how much they …
Alex Pollock: … Nouriel … you have about 1 or 2 minutes left for the good news …
[laughter]
Nouriel Roubini: … but the only light at the end of the tunnel is the one of the incoming train. I fear it’s so. [laughs] I’m not sure if there is any good news. [0:50:00]
So maybe nationalization of the financial system is good news. That’s going to be the solution of most banking crisis. I mean, we’ve created a system which, as I said, you know, about half of the assets, if not more, of the Fed are going to be this mortgage related stuff. They’re going to sell them as safe treasuries.
We’ve used the Federal Home Banking system and increase their exposure as a way to bail out Countrywide, CitiGroup, and some of the major mortgage lenders. We have increased the portfolio caps for Fannie and Freddie. We’ve increased the cap for the conforming loans. Based on studies out there, Fannie and Freddie are already losing money, and may be insolvent.
So the effective fiscal bailout of the financial system has already started. And guess what? At the end of the day, there are going to be only two solutions:
- Either you force essentially the banks to reduce the face value of their mortgages to the value of the underlying home (if they do that, and even Bernanke now says that that’s what they should start thinking about it), if you do that, then you’ll have a massive loss of capital of the financial system — it’s going to be wiped out.
- If instead you tell the government you should go and buy these mortages from the bank, and pay them at the price that’s higher than their fair value, so for instance 70 rather than 100, you buy them at 80 or 85, of course the banks are not going to go belly up, and you’re not going to have to nationalize them, but effectively you’re first nationalizing a good chunk of the mortgage market, and you’re not only nationalizing it, you’ll have severe fiscal losses, because you’re buying something at 80 or 90 that’s worth 70, and unless you write down the value debt when you refinance the borrowers, they’re going to befault on you.
So that’s what we’re facing today. We’re facing a systemic financial crisis that we haven’t seen since the Great Depression, we’re seeing the most severe recession we haven’t seen in 30 years, and the outcome of it is going to be, whether we like it or not, a significant fiscal cost of fixing this mess.
Alex Pollock: Thank-you, Nouriel, I think. [laughter] Uh, Tom.
Tom Zimmerman: What floor are we on here? [laughter] [slide6 0] I was going to thank Alex for inviting me down here, but I don’t know … [laughter] I think I’ll retract that.
For the last few years, when I go to various mortgage industry affairs I’d be the viewed as the most bearish guy on the panel, but you know, [laughs] I can’t come … I can’t come close … wow …
Alex Pollock: … you can provide the correcting perspective …
Tom Zimmerman: I wish I could. I agree with part of this. I’m not quite as dramatic, I think, in my views than what we’ve just heard. But I think it’s pretty bad.
And I want to focus a little bit on this feedback loop we’ve talked about a little earlier, about how these declining home values feed into securitized products, and that feeds into bank balance sheets, which are going down, which means they tighten up lending, which means they … around around in circles …
So my bottom line is that I think as much as a free market person as I am, I think the Federal government is really going to have to get in here and, sometime within this year, by mid summer or in the fall, we probably will see some sort of subprime bailout. Because they don’t have any choice. I mean, I don’t think it’s the end of the world that we’ve heard here, but I think it’s really pretty severe, and I think each — it used to be each month, but now it’s about every day — it gets to the point where you really see that some outside force has to slow this thing down, because it really is getting out of control.
As one of my friends said, it’s one thing to stop the boulder at the top of the hill, it’s another thing half-way down. So we may be half-way down right now, so it makes it pretty hard to stop this thing.
Let me just take a look at … to get a perspective here. [slide 1] This is the size of the mortgage-backed securities market in America. And it’s roughly … total mortgages in the country are around $11 trillion. About 60 percent of it is securitized. That’s $6.6 trillion worth of MBS securities. Of that, $2.1 [trillion] is non-agency, the rest is with Freddie / Fannie.
The reason I bring this up is because what happened last Thursday really was an important watershed as far as I was concerned. Here’s what happened last Thursday [slide 2 -- use right mouse to correct rotation] This is the Fannie Mae current coupon. It’s the spread on the most liquid part of the mortgage-backed securities market. This is literally a $4 trillion market, the largest fixed income market in the world. Every central bank in the world owns this stuff. Every major bank in Asia and Japan and Europe have been trading Ginnies and Freddies and Fannies the last 20 years as almost, you know, slightly behind treasuries, [0:55:00] because they deal it as an Agency product.
Last Thursday people began to have doubts about what that credit was worth, and we saw spreads blow out in a dimension that we’d never seen before historically in these market places. You’ve got a $4 trillion market in mortgage-backed securities, Freddie’s, Fannie’s and Ginnie’s, — not Ginnie’s, but Freddie’s and Fannie’s — that people are really starting to question, and that’s why the Fed came in.
They … you couldn’t allow this to take place. I mean it’s one thing when the subprime market, the non-Agency market, goes down, it’s something else when people start saying, "Wait a minute, what’s this Freddie / Fannie thing worth?" If you pass this through to the consumer, and these spreads continue to widen out, and all of a sudden you’ve got a couple hundred basis points widening of Freddie / Fannie MBS, and you pass that to the consumer, you don’t have a 6 percent loan rate for the average American, you’ve got 8 percent loan rate. That’s not going to work. You think we had trouble before? Forget it. That’s … this can’t go on.
So this was a massive change in thinking, I think, in Washington, when they saw all this thing happen last Thursday. It’s calmed down a little bit, spreads are tightening a little bit, but part of the problem is that this was compounding of this bad news in the economy, bad news in the housing market, and then all the realization that Freddie and Fannie themselves have serious liquidity problems, some serious capital problems, and all those things.
So when people begin to … and then of course it didn’t help a week or so ago when there was a rumor out that, "Oh by the way, we hear that Treasury’s going to thrown a lifeline to Freddie / Fannie," and they came out and said, "Absolutely not, we have no relation to those guys." So I think I agree with Nouriel, I think that at some point they will have a close relationship, one way or the other, if not … I don’t know how. Some way the federal government will come in and help put this fire out.
This is a fire. [slide 3] You saw this chart earlier. Desmond had it and he showed it a longer term chart. I did the shorter term chart because what’s really important about the housing market right now is this thing is really falling apart fast. And we had a decline in HPA [home price appreciation] gradually for a while, it slowed down, then it went negative for a few quarters, and then look what happened. This is, like, 3rd quarter data point at, like, minus 7 or 8 percent on annualized basis. We’re 20 percent this last quarter, and it’s going south.
I mean, this is an accelerating thing. This is not slowing down, this rock is rolling down hill pretty fast. I think that’s the problem. It’s not that we have these issues, it’s that they’re accelerating day by day. That’s the problem, I think, what’s finally getting people’s attention.
It’s not like it’s sort of, you know, like in the middle of ‘07, 3rd or 4th quarter, "Ah, it’s bad, it’s ugly." This thing’s accelerating. I think that’s the issue. This is happened very fast.
Why is it happening fast now? [slide 4] Well, the first part of that slowdown, you know that great big housing bubble, and it broke and things started to slow down, well … We didn’t shut down … we didn’t shut down the non-Agency market — subprime and Alt-A market — until July and August of last year. So up until then you could still get a subprime loan, in June. And an Alt-A loan. Easy to get. Come July and AUgust, shut it down completely, and so all of a sudden that Agency market didn’t really shut down until, you know, late in the year. That’s what you saw in the 4th quarter.
Now what happens is later in the year Ginnie Mae … Ginnie, Freddie and Fannie decided to tighten up their lending standards, and of course all the banks are tightening up their lending stardards, that how you’re getting … it’s just now beginning to hit the marketplace, and we’re just now slipping into a recession.
So the bad pressure in this housing market, I think, is just accelerating as we go week by week.
This is an old chart I did about 4 or 5 years ago. [slide 5] And what we did back then was to take a look at housing prices and unemployment, and I must say that for the past 2 years no one talks about unemployment, it’s only HPA is all you had. But what this chart was showing us back then, and it’s still pretty true, is that in terms of unemployment, these are default rate multipliers … this is for the subprime world … If you take unemployment, increase it by 1 percentage point, you increase your defaults by about 20 percent — 20, 25 percent. Increase it 2 percentage points, like for instance going from 4 1/2 percent to 6 1/2 unemployment, which we’re probably going to do, that’s like a 40, 50 percent increase in default rates.
The problem is that the subprime market is already in recession. The kind of default rates we’re seeing right now are already recession levels. So when I talk to major investors and they say, "Ah, wait a minute, so all of your models are saying that you’ve got these depression level default rates already, what happens if we go into recession?" [laughs]
So now we have these conversations about "how high is up?" You’ve already got … "your model said 60 percent of these guys are going to default now, and now you’re telling me another 50 percent are going to default?" You say, "No, I guess that’s not going to work."
So now you’re going to have these discussions among major investors — What is the maximum number of these subprime borrowers that will default?
And so it’s no longer model driven, it’s now you’re the seat of your pants like, "Well, I don’t think more than 75 can go down." "I think 80." "No, I think 60." So that’s where we’re at in terms of mortgage analysis right now, [1:00:00] it’s "How high is up?" And I’ll tell you, we don’t know.
What happened recently? [slide 6] This is the only active marketplace for securities right now, apart from Freddie and Fannie in terms of private securities: subprime, Alt-A, etc., is the ABX. This is subprime-based indices. And it’s been bouncing around, not doing too well, and then guess what happened just recently? This is February 12th right here [points]. This is, like, the last few weeks. This thing is just falling off a cliff too.
The world’s suddenly gotten a lot worse in the last couple of weeks, not better. Extremely worse. The people who own these securities, trade these securities, they think something bad’s coming down.
This is a couple examples I want to show you of what … how this impact of this collapsing housing market feeds through into securities prices and then through into balance sheets. This [slide 7] is a chart of the 20 subprime securities that are in one of these ABX indicies — ABX-07-1. All of these securities were issued in the 2nd half of 2006.
This is our model. We guess that losses are going to be, like, 22, 23 percent of the outstanding balances are going to be lost at a 45 percent loss severity number. And if that’s the case, going across to the right, it shows you how many of those securities — the triple-A, the single-A, double-A, triple-A bonds — from those deals will be written down, knocked out, gone completely or partially written down. All the triple-Bs, almost all of them go, single-As, most of them. Triple-As, not too many, because you’ve got subordination. These guys go first. These guys go last. So it’s, you know, triple-A you’re not in too bad a shape.
Here’s 60 percent severity. [slide 8] OK, now all of a sudden you’ve got a whole bunch of triple-As are getting knocked out of here as well as the triple-Bs, forget those guys.
The problem, not the problem but the issue is, here’s the marketplace right now. [slide 9] This is, as of a couple of days ago, where these ABX bonds were trading, all 20 of them, here is the market value on that day. That little model I just showed you, here is the model that we typically use: 45 percent severity is where this market’s at right now, basically in terms of loss severities in subprime markets of about 45 percent loss severity. If you use that, you get these write-downs, which I showed earlier for just one section, but this is right where the data came from.
You put that into a model and it says, "Here’s the pricing that should should be for the ABX." And look at where the model says you should be, and where the market is at. Dramatically different.
Let’s got to 60 percent loss severity, [right columns of same slide] which is some sort of unheard-of number that might happen if you have a real depression, and you get prices, model-driven prices, that look a lot more like the marketplace.
So the market is telling us that this is really one hell of a cycle we’re in the middle of, and that they’re expecting enormous loss severities, enormous losses in these securities. But the problem is, what do you think it is? Between the 45 and 60 and where’s it at, and how does that affect your valuation of all these thousands of securities that are out there?
This is very difficult to guess. What’s happening right now is this loss number we’ve got over here of, you know, into the 20s or 30s over here … Right now, the losses that have occurred in these deals are about 1 percent.
Now all this collapse of The Western Civilization As We Know It is based on 1 percent losses. We’re forecasting 30-some percent losses to come, down the road. We don’t know what the hell they’re going to be. Nobody does.
So part of the problem that you hear frequently is, "How do these large banks and institutions value their inventory?" Well, you know, Chris was talking earlier this mark-to-market and how you deal with this thing. Believe me, this is a big issue.
I mean, these enormous battles are going on between the regulators, between the accountants, between these institutions, "What are these damned things worth?" I’ll tell you, nobody knows.
Now here’s the … If you take a look at all the triple-A subprime securities out there right now and the double-As, single-As, etc., these are all the subprime bonds that are out there right now, broken down by their rating. [slide 10] To hit, as you saw earlier, to hit these triple-B kind of bonds you need, like, 15, 12, 14, 15 percent kind of losses. Well that was only like 6, 7, that’s like 8 percent of the market out there.
The real disaster that took out all the CDOs, the first crisis in this business, the CDOs, they were all based on these guys, these triple-Bs.
So the first part of the crisis was when everybody realized, "Oh, guess what? These losses are big enough, high enough, to take out the triple-B bonds," and "Oh my God, the whole world’s coming to an end."
What’s happening now, that number we saw earlier, these losses that are creeping up for now, [1:05:00] you’ve taken out these bonds and you’ve started to hit the triple-A bonds.
The problem is all the guys who had triple-A bonds, and the guys who insured them, the guys like the monolines, the people who bought these super-senior triple-As and stuff, they all thought they were OK. They thought they were home free, because nomally the losses were down in here [must be pointing at the chart] somewhere.
We’re working our way up to a great big bunch of bonds up here who people thought they were home free. This is not Agency, this is all subprime stuff, this was triple-As that had worked out pretty well. But what’s happening is we’re now getting to the point where a great big chunk of bonds are coming at risk now. And that’s what’s happening to these markets, why they’re freezing up. Because you don’t know which … whether, "Is my bond going to make it or not? Oh, wait a minute, let me think about this."
Well, how do you value it? Well you go back to this model back here [briefly returns to slide 9], "Oh my God, what is that? We don’t know." So there’s a lot of uncertainty. Massive uncertainty out there.
Here’s the cycle. [slide 11]
[crosstalk ...]
… OK, 12 minutes, I’m almost there …
Here we go. Prices are falling. It changes our estimates of what these losses are: "OK, it’s not 12 it’s 14; it’s not 14, it’s 18; …" That causes the prices of the securities to fall, which means, "OK, now we’re not going to write off $5 billion, we’re going to write off $10 billion."
Capital gets depreciated, which means all the banks have to tighten their lending standards. Citibank just said, "We’re going to, we’re going to …" I don’t believe it. They said they’re going to reduce their exposure to mortgage securities by … no, mortgages, by $45 billion next year? We’re going to stop doing subprime lending? That’s what he said a week ago, right? Talk about tightening lending standards, and talk about a cycle that’s just getting under way and a rock rolling down the hill. Man, this is just beginning.
And what happens is people can’t finance their homes, prices go down, etc., etc., …
And we are right in the middle of this right now, and it’s just gathering momentum.
Here are a few of the ideas that the Fed and Treasury have floated so far. [slide 12] None of them have worked so far. The tried Operation Hope, that didn’t work. They got FHA Secure, that was a big program about 2 months ago, I think, and 1,500 loans have been … that they’ve done 1,500 loans so far? I was corrected in the meeting yesterday, it was 1,502, by the way … [laughter]
So Freddie / Fannie, who is going to be the great rescue, hope 5 / 4 months ago: we did an analysis of all the subprime loans outstanding 4 months ago. Freddie / Fannie standards would have accomodated 50 percent. After they tightened their lending standards 2 months ago, it went down to 23 percent. They tightened their standards 2 weeks ago, it’ll go to zero.
Freddie and Fannie, because of the capital constraints, are tightening their lending dramatically. They used to be the great hope for this problem? Forget it. They’re part of the problem.
In Congress right now, everybody’s talking about what to do: Dodd Committee, Frank Committee, etc., etc., … . Thanks to Alex, everybody’s talking about the Homeowner’s Loan Corporation. He was out there in front, he was one of the first guys who had a program out there, it may be the one that gets in play. Who knows? [laughs] It might work. I think it makes some sense.
But the problem with all these programs so far, and I didn’t hear Treasury Secretary … Undersecretary Steele’s comments Monday in the conference. "Absolutely we’re not going to help the bad guys. We are not going to help the guys who caused the problem."
Well here’s the other problem. [slide 13] … Subprime … Fraud, massive fraud in the subprime industry on the part of the homeowners. Investor / speculators? The data shows 5 percent, in subprime 15 percent, and in Alt-A, we know that’s baloney, it’s got to be twice or 3 times that amount. Ex-renters? Well, we took homeownership between 2000 and 2005 or ‘06 from 66 [percent] to 69. That’s 3 percent. What is it? 110 million homes … not homes but units out there: rentals and homes. That’s 3-point million people went into homes that probably can’t afford it.
Overextended? That’s everybody. So if you don’t want to take care of the people that made a mistake, and your program says, "we’re not going to help anybody out who did any of these 4 things," you might as well go home, because you’re not going to do it. And if you start to parse it, and try to figure out who the good guys are, and who the bad guys are, than forget it, your not going to get there either.
So it’s a big political problem to get over this hurdle. But if you don’t … my idea is you hold your nose and you do a Katrina-style thing. You just do it. Because if you get too technical here, you are not going to cover any part of the problem … you’re going to cover [only] a small part of the problem.
And I think … Did I make it? [laughs]
Alex Pollock: Thank-you very much, Tom. … John.
John Makin: Well, I’d like to [undecipherable] a 10 minute break to call my broker. [laughter]
It’s still only … 3:15, so there’s time for you yet.
Look, I think Desmond and Chris and Nouriel and Tom have covered the details of what’s going on very well. I’m going to try to put it into a slightly broader perspective. In other words, at this point in the game people say, "My God, how did we get here?" So I’ll try to elucidate that and then talk a little about the feasability of solutions.
You have in your packet the piece called "The Risk Cycle"7, February 2008 Economic Outlook. [1:10:00] I wrote that in mid-January, by the way. The problem with this, I think, for people who are in the business is that it’s been all too foreseeable, and that’s what gets scary here.
I guess when I wrote about the Latin American debt crisis in the early 1980s I had to have that chapter where you have The Phases of a Crisis, versus the shock, then there’s denial, then there’s panic and then there’s absorption and solution.
If I can time this out, I think probably the shock came in July / August, in the summer time, when the subprime market shut down. The denial phase went well into the fall. Remember at the October meeting, the Federal Reserve essentially said, "Heh, we’ve cut rates (I don’t know) 50 basis points, so we’ve already anticipated any problems that might come down the road, so don’t look at us for any more." 3 weeks later, Vice Chairman Kohn had to come up to New York and say, "OK, OK, we’ll do more."
But the … I think what Tom is ably describing, and Nouriel as well, and Desmond, are … the onset of the panic phase in this problem. That is, the realization on the part of people in the financial markets, and I’m there every … almost every day in the middle of it all, and every morning I talk to with our credit specialists who’ve for the last 6 weeks have said, "well, the markets are still frozen." And so … it’s really difficult to price any of these assets in a way it causes a transaction to occur, and I think Tom has ably laid that out.
So we’ve hit the panic phase, and I think what the panic phase right now is representing is fairly simple, and it’s indicative of what the Fed did yesterday. A rational investor now who is not a trader especially is going to say, "what should I do? Where do I put my money?" And the answer is Treasury securities.
And so it’s no accident that yesterday8 the Fed offered to swap $200 billion of Treasury securities for mortgage-backed securities, for which there’s relatively little market, which is a pretty radical move9, because the Fed has about $750 billion … there’s a good table in the Wall Street Journal today in Greg Ip’s very good article on describing what was happening. [I couldn't find Ip's table, but here's his commentary on 3/12 2008.]
And so the Fed, when you add up all the programs they’ve undertaken so far, and remember last Friday, they initiated a new $100 billion line of credit and an extended TALF facility, which had virtually no effect on the markets, and then by Monday was a very scary day, and by Tuesday the Fed was in with another $200 billion offer to exchange Treasury securities for mortgage backed securities, and the coverage of the offer included investment banks, and so-called "private label" mortgage-backed securities, i.e. other than the Fannie and Freddie securities.
So the proximate reason for that move was the acute distress at Bear Stearns, which is a broker/dealer, and a primary dealer, I should say, and they are distressed with respect to raising any cash.
So we’re kind of in the panic phase. How did we get here? Well very briefly, the question, I would say, and again it’s always been very frustrating to me … Up until January the question was, "Will the problems in the housing and credit markets spread beyond subprime and cause a recession?" Answer, in March … early March: "Yes." And I think it was … everybody’s indicated that we’re in a recession, even by lagging indicators like employment. And I will say that the degree of denial among Wall Street economists is certainly not a good thing, and not a very complimentary thing, because it was very clear that we were headed into recession. And to insist on having to cross the t’s and dot the i’s, and "Well, we won’t know until we have [1:15:00] enough evidence …" I think one analyst is still saying we’re not in a recession, and my joke is that the NBER will identify a recession before he fesses up.
It’s all moot at this point, it doesn’t matter, we’re in a recession. The problem with the recession is that — and I think the reason there was so much denial about the onset of recession — and oftentimes when I would say we’re going to have a recession, well, people would say, "The situation in the housing and the credit and the mortgage market is so bad, if we have a recession we’re all done for." That’s not a very effective argument against a recession, [laughter] but I heard it a lot.
And the other problem was that the Fed was cutting rates quite aggressively. Remember in January when we had a panic, I would call it, a panic on January 22nd, a Monday when a French bank was liquidating a large position that a broker … that a trader had lost a lot of money on. The Fed, which of course up until then we were thinking, "Oh, you know, the Fed’s going to cut by 20, or 25 or 50 at it’s meeting at the end of January." Well they cut by 75 that day and another 50 at the meeting.
So they cut rates by 125 basis point in January, and I think Tom’s vision of the rock rolling down the hill was sort of like they were trying to stop the rock after it had gained a great deal of momentum, and the rock just ran right over them. That’s 125 basis points of rate cuts.
Because the really … the problem is the rate cuts will in a year’s time will help the real economy, they’re not going to help the problems in the credit market.
And as we’ve said frequently at these sessions, the problem is simple. The price of housing is going down, as you’ve seen adequately demonstrated there’s a tremendous structure of credit, and securitized credit and credit that people can’t value that’s been leveraged and re-leveraged. It’s built on the premis that house prices do not go down.
If house prices go down, and then start going down at an accelerating pace, as Tom and Nouriel and and Desmond have indicated, that’s when you get a panic, and frankly that’s where we’ve been in the financial markets for the past couple of weeks. The valuation of these securities is consistent with a severe recession and a severe reversal in the credit markets, and so we’re into it now.
The problem, of course, with the Fed, is they have a two-pronged war to fight. They have the credit problem war to fight, and then they have the economy problem war to fight. Yesterday’s action was on the credit side, and again, most people after hearing these stories, if they believe it, what do they want to own? Treasury securities.
Well, that’s what everybody wants, and so again as I say the Fed supplied an extra $200 billion yesterday, which is what … It’s important to understand with the Fed. The Fed did not flood the system with liquidity, the Fed simply offered to exchange Treasury securities on their balance sheet, and you can bring mortgage securities on your balance sheet. You will not get a dollar worth of Treasury certificates [laughs] for a dollar’s worth of mortgage. And we don’t know what the so-called "haircut," or the discount will be, but I’m guessing it will be fairly substantial, because the Fed is taking problematic securities onto their balance sheet and their balance sheet is now, instead of roughly $800 [billion] in treasuries, it’s $400 [billion] in mortgage-backed and $400 [billion] in treasuries.
So all they’ve done is swapped, and now they’ve swapped the securities because there was a huge excess demand for people to own treasuries. They don’t own them, they borrow them and they’re on their balance sheets for 28 days, and then if that doesn’t work they’ll do it again, and they’ll extend the period and so on and so forth. "If 28 days doesn’t work, we’ll give you 60 days."
But this is really just reactive and it’s an attempt to contain the damage. It’s not going to solve the problem. Because at the same time we keep getting the economic news that says, "Heh, the economy is getting worse." Well why is the economy getting worse? Because credit conditions are getting worse. But what’s going to happen to credit conditions if the economy gets worse? Credit conditions get worse.
So you have a … what [the] Governor of Michigan has called, in a very sterile way, an "adverse feedback loop."
There’s a song in a new play called Spring Awakening that describes it better, and I cannot repeat the title of this song here, but those of you who have seen the play will get the idea [1:20:00] when you hear the song. And a euphemistic description is, "We’re in deep trouble here."
[laughter]
So what do we do? What the Fed has done, and Tom indicated that really the two approaches are monetize or nationalize. We’re at that stage now. So monetize is the Fed’s department. So monetize would mean that instead of swapping securities, when the Fed runs out of Treasury securities to swap for toxic paper, they start issuing non-interest-bearing government liabilities. That’s called "cash," I’ve got some of them in my wallet here. That is, the Fed prints money in exchange for mortgage-backed securities.
There will be interim steps, and the Fed seems to be insisting on reacting here, OK? like … "28 days? we’ll give you 60 days." … "OK, you want us to buy some Freddie and Fannie paper? OK, we’ll do that." But we’ll get to the monetization stage fairly quickly here becauses the dynamic of this problem is that it’s unwinding at an accelerating pace, which is what happens.
If you’re a mathematician, and when you have a 2nd order difference equation, then you parameterize it, there’s a key parameter that says whether the oscillations get bigger or smaller. [hand-waving on video] You want smaller, but we’re in the bigger stage here.
So we have a dynamically unstable problem in the financial system, which means it unwinds at an accelerating pace, and a reactive approach is very dangerous. Because look at where the Fed is here. The first reaction by the Fed was early in August where they extended their lending facility, and then they cut rates a little bit, and there was a huge explosive rally and we were good through the end of October.
Now, the Fed, in the middle of January, cut rates by 125 basis points, we were good until early February, and then it started to unwind again, and then that came in again and then the Fed came in on Friday with more credit facilities, and then they had to come in 2 days later with more credit facilities? And I just looked and the stock market’s flat now. Interest rates are back down and the dollar’s back down.
So it’s, I guess … Somebody was describing this, and "it’s like morphine, you need more every time, and it doesn’t work as well."
So the Fed will … and the Fed insists on being reactive, which again is the wrong way to handle a dynamically unstable downturn, but as a positive matter, as a prediction that’s what they will continue to do, but they will ultimately end up monetizing this problem.
[crosstalk]
… OK, 1 minute …
Their hesitation is understandable because this will entail a rapid drop in the value of the dollar. And the run out of the dollar is really not so much into other currencies as it is into our old friend Mr. Gold, and Mr. Oil. So if I’m storing wealth and I live in the Middle East or in Asia, I don’t want other currencies, I want gold or oil.
The other approach is the … we have the monetization, and then we have the nationalization approach that Tom and others have suggested. The problem with that is that I don’t really see it happening because of the …
- First of all it’s such a big problem, nobody wants to step up to it.
- Secondly, it would be difficult to get political consensus on it in an election year.
- And my astute colleagues here at AEI, who understand how politics works, say it’s not likely that we’ll get a legislative approach to this problem on the scale that would be required prior to the election.
So it will certainly make for good questions during the Presidential Debates, but I’m not sure we’ll get a solution.
So really it’s up to the Fed, and the Fed is going to have to get to monetization, and we’re just going have to hope that works until next February.
I’ll stop there.
Alex Pollock: Thank-you, John. I’m going to give the panel 5 minutes, just if anybody wants to react to anything anybody else said. … Yes …
Tom Zimmerman: … I just … One of the points that was brought up earlier was about this securitization process itself, and I think there’s no doubt that contributed to some of the transmission of the problems we’ve got. But my guess is that it’s not the complete death knell of the securitization process. I think it will … it is the death knell of very complex securities, I think, for some time. So transparency [1:25:00] and simplicity are the watch-words, I think, on The Street, and securitization markets, but I don’t think the securitization markets will go away.
Alex Pollock: … John? … Desmond?
Desmond Lachman: You know, I totally agree with Nouriel and John that we’re in deep trouble, and that it would be desirable to get a bailout at some stage but I’m not sure that, politically, one can do this in a preemptive way. I think that one’s really got to do it in a reactive way. One can only do this once the shareholders of these banks have been totally wiped out. I can’t see bailing out the shareholders being the result.
So I think that this is like perhaps a psychiatrist looking at a patient. The psychiatrist knows where you’ve got to end up, but there’s a process through which we’ve got to go through. I’m afraid it’s not going to be a pretty picture.
Alex Pollock: … Nouriel …
Nouriel Roubini: Yeah, I mean I would distinguish between a formal bailout that may occur somewhere down the line, maybe after the election, and the beginning of an effective bailout. The Fed has cut agressively rates, tried to have a steepening curve and let the banks make money. I wouldn’t be surprised if at the end of this cycle the Fed Funds Rate is closer to zero percent, rather than 1 percent. Went down to 1 percent in a shallow recession in 2001, so it’s going to be much worse.
We have extended massively the role of the Federal Home Loan Banking system in terms of their exposure. Some of the biggest mortgage lenders would have gone belly up if they hadn’t been helped by the system, thus taking significant credit risk.
We have now up to half of the assets of the Fed are going to be swapped … safe treasuries for things that are considerably more risky.
So it’s already a creeping thing, and now we’re wanting to extend the portfolio limits of Fannie and Freddie. Guess what? Maybe Fannie and Freddie are bankrupt. Then if they’re bankrupt, this delusion that went for many years that these were kind-of private entities under the order of maybe being Government Sponsored Enterprises, maybe we should not pretend that they are private. This is a joke at this point. Nationalize them, and let’s not have this pretense. Otherwise, people kept on saying "We should avoid Moral Hazard, we should make sure that the accounting is right, and it’s clear we’re not going to bail them out," and what-not. Turned out, is nonsense. The entire set of government institutions from the Fed to the Federal Home Loan Banks, from FHA to Fannie and Freddie, is now bailing out the mortgage market. It’s an informal bailout that’s going to end up being a formal bailout.
Alex Pollock: Let me just add, having thought a good deal about GSEs, Nouriel, I agree that, actually, you ought to either be a government entity or or be a really private company.
Nouriel Roubini: Yeah, …
Alex Pollock: … and nothing in between. The in between is a bad idea.
Let me, at this point, open the floor to your questions. Let me remind you how this works. You need to wait for the microphone. Please tell us your name and your affiliation, and then ask your question — keeping statements to a short statement if you feel you want to make one, and we’ll open up here. … Let’s start right here. And Karen, thank-you very much for wielding that microphone for us.
John Serrapere: My name’s John Serrapere, a strategist and portfolio manager for a large family office in Pittsburgh.
Last time we were here I think the market peaked, so maybe the word got out after we left, broke up, but what I wanted to know is, what assets will have the most constant trading in deflation, and what assets will have the most inflation. And I’ll just open it up to anybody. Where will prices go up, and where will prices go down?
[laughter]
Alex Pollock: Anybody want to try that one?
John Makin: … you want to know what to do with your money?
Alex Pollock: … yes …
John Makin: Buy treasuries.
John Serrapere: … [faint] … I want to know what’s going to go up and what’s going to go down.
John Makin: We all do.
[laughter] You know, I think I answered that question. Right now, everybody wants to own treasury securities, and nobody wants to own anything else.
Desmond Lachman: Just as a former South African, I really can’t resist saying that 2,000 years of history can’t be wrong. Just buy gold.
[laughter]
[cross talk]
Bert Ely: Bert Ely, banking consultant. I’m a little distressed at what I’m hearing today, because it kind of suggests prolonging the pain.
We’ve got a huge bubble in housing prices, the related debt and so forth. Housing prices are way out of whack with the income to support them. Isn’t it [1:30:00] really better to get this behind us as quickly as possible? To pull the Band Aid off as quickly as possible? Realizing that there are investors who are salivating, waiting to buy once prices drop enough.
And so aren’t we just better off just taking the medicine, at the same time making some important structural changes in housing finance in this country such as allowing covered bonds so that we don’t have as much securitization as we’ve had? … and I should say to significantly modify the Fair Value Accounting and put those reforms in place while we’re swallowing the inevitable bitter medicine?
John Makin: Bert, there’s a hedge fund called Peloton that had lots of capital. They made 80 percent last year. And they couldn’t wait to step in and buy mortgage backed securities in January. And they went out of business10 at the end of February.
[laughter]
And what I see is that … I hear about these pools of capital, but right now all they want to do is buy Treasury securities.
I think that your suggestion is perhaps something that would have been appropriate 2 or 3 months ago, but I think part of our problem is that these pools of capital … Let’s say you’re sitting on a pool of capital. The old Sovereign Wealth Funds — I mean … let’s see, they bought Citi at 31? Citi’s at 19.
There’s too many people who wanted to step up who just got their arms cut off, and now they’re just … either they are frightened, or they’re saying, "Why should I step up now? Let the prices come down some more." And they are.
So what we’ll see is a very strong shift toward liquidity preference, and just people sitting in cash without any incentive to move out of it. And again I repeat that yesterday’s Fed action was to satisfy a huge excess demand for Treasury securities, and a huge excess supply of everything else.
Alex Pollock: Anybody else?
Nouriel Roubini: Yeah, I mean last week I was at Abu Dhabi, Saudi Arabia, and Dubai, and these folks are starting to get nervous. They put already $100 billion in recapitalizing our banks, and the rate of losses is increasing at an escalating rate, and they are both willingness and ability to keep on recapping, is going to be limited because they are asking themselves, "When is the dollar bottoming out? When is the price of these equities in the financial sector is going to bottom out?"
The first thing that the Chinese Investment Corporation did, $200 billion, they put $3 billion dollar of it into Blackstone. They lost 50 percent of their investment, $1.5 billion, and there are all sorts of Chinese bloggers saying, "You idiots in the government, what have you done with our savings?" [laughter]
So, and their political influence. These people are … even in these authoritarian states, people are going to say, "what are we doing?" So they are going to make the economy more cautious.
Alex Pollock: OK, … right here please.
Mark Lazerson: Mark Lazerson, University of Bologna. Do you think it’s the Fed policy to vastly inflate the economy, watching the movements of the dollar, gold and commodities, to maintain nominal prices for housing assets?
John Makin: Implicitly, it is. It can’t be explicit, and the Fed can’t do enough to stabilize house prices, because they’re falling too fast and it would take too much money. But what they can do, what they’re trying to do, is cushion the impact on the value of securities that are tied to the value of housing.
And what they are thinking about primarily is the credit crisis and a rapidly slowing economy, and they have a bit of boilerplate in every statement that says "of course, we’re concerned about inflation, too." But that’s not going to be a good guide to their actions in coming months, because if you’re looking at a credit implosion and a serious recession, then ultimately you’re not worried about inflation.
Alex Pollock: … Desmond? …
Desmond Lachman: Just one point I’d make is that while the Fed has been cutting short-term interest rates, what’s been happening to the long term interest rates and the spreads is more than offsetting it. So that monetary conditions today are tighter than they were before we started the cycle.
The other point I’d make is I think one should really look at a place like Japan to see that inflation is really going to be our last problem. If I’m correct and Nouriel’s correct that we’ve got really a major recession ahead of us, [1:35:00] it’s inconceivable that [the] commodity bubble is not going to be bursting, and it’s also inconceivable that you’re not going to have downward pressure from slack in both the labor and product markets, that we’re going to go back to worrying about: How we can get interest rates negative in real terms when we’ve got, probably, price deflation ahead.
Alex Pollock: I have a question here … just wait for the microphone, please.
Martin Hutchinson: On the inflation question …
Alex Pollock: … could you identify youself? …
Martin Hutchinson: … sorry. Martin Hutchinson, I write a column called The Bear’s Lair, which has the approach to life you might guess.
[laughter]
On the inflation question, which I’m glad somebody raised, the British had this problem in 1973, with The Secondary Banking Crisis. And in 1975 they had 25 percent inflation. And as a result, while they lost most of the banks in 1974, the housing market didn’t have too much of a downturn, because by ‘76 / ‘77 everybody’s income had risen enough to meet the inflated house prices.
And I would suggest that actually that may well be the solution they’re aiming at here, in that you may well try to get with negative interest rates, double-digit inflation for a couple of years, and that solves the housing crisis.
Alex Pollock: Thank-you. I have a question here, and then I’m going to work my way back right here …
Dave Torrison[ph]: Dave Torrison[ph] with UST. How much will this … lets say we really do have a recession — how much is going to spread into the rest of the world in terms of the real sector? How much will spread over and spill over into world financial markets?
Nouriel Roubini: You know there is this debate about decoupling versus recoupling. I think that if the US just had a soft landing or a mild recession then you could say there is enough demand growth in the rest of the world for the rest of the world to decouple, but if you have a severe US recession, trade channels contagion into the financial system, weakening of the dollar, confidence is going to imply significant transmission.
Whether we like it or not, the US is still 25 percent of global GDP, and when the US sneezes the rest of the world catches a cold, and in this case it’s not going to be a case of common cold, but protracted pneumonia — the contagion’s going to be severe in my view.
You know, for the last few years the global economy’s been in balance. The US was the consumer of first and last resort; China, Asia, emerging markets were the producer of first and last resort; we were spending more than our income, running current account deficits. They [China, etc.] were spending less than their income, running current surpluses. And that means that there is not enough global demand, that is domestic and private, to sustain global demand in the world if there is a sharp contraction of US demand.
The US consumer spends $9.5 trillion in consumption. The entire Chinese consumer spends only $1 trillion. And, you know, the [momentary gap in tape] consumer spends $600 billion, and in Europe, Germany, Japan, real wage growth has been anemic and real consumption growth has been anemic, and most of their export growth has been the driver for their economy.
So the idea that there’s all these engines of growth abroad, and they’re going to be enough to sustain the global economy, I think, is kind of wrong causality. A lot of that growth was based on net export growth, certainly for China. So I see a severe US recession having significant effects on the rest of the world, with outright recession in places like Europe, UK, Spain, Portugal, Italy, Ireland, you name it.
Alex Pollock: Do you want to add something, Desmond?
Desmond Lachman: I just totally agree with Nouriel, but I’d just add that Europe and Japan and being hit by similar kind of shocks that the United States are — the commodity boom is hitting them, they’ve got to be dealing with currencies that are appreciating at alarming rates. That has to be something that is pretty bad. And then what you’ve also got to consider is that a lot of the toxic waste that we were producing in our mortgage industry, half of that stuff is sitting somewhere abroad.
So it’s [only] got to be a matter of time before you’ve got their banks getting there. I just don’t buy the decoupling story, I’m actually worried that the fact that the United States is now going into different mode, that we just really don’t have the aggregate demand globally. So that this isn’t going to be a US phenomenon, this is going to be a global phenomenon.
[crosstalk]
Tom Zimmerman: I’d just like real quickly to add to that, though. In addition, it wasn’t just a US housing boom. It was a world-wide housing boom … The housing prices in the UK, in Spain, … It was a world boom. And I think we’ve already seen the effects in Spain and some other markets. So it’s not just the downdraft from the US economy going south, but I think we’ll see some other housing markets around the world collapsing. They’ll also have an impact.
Alex Pollock: I think it’s a great point. We need to keep in mind on the housing [1:40:00] boom, that it was an international event, as well, of the new century. So you’ve been waiting patiently back here, please …
Angelo Ferrer[ph]: Angelo Ferrer[ph], retired, ex-IMF. I don’t know whether, in fact, either my comments or the question that follows is adequately posed in the institution, and in the building, and the panel, but I’d like to suggest that if we’re talking about, say, nationalization, or monetization, we’re talking about explicit shocks for explicit shocks.
We should also consider, I suppose, the implicit shock that comes from an election year. And the question I would like to pose to the panel, if they would answer it, is … We are at the end of an 8-year cycle, politically, which started with the 3rd quarter recession, or downturn, in the Clinton administration. And now we are in a situation where we’re likely to get a new administration:
- What is the kind of policy advice, in sharing terms, between night watchman role played by a present administration and the one that may or may not come about in the future?
And I say this because the economy has not figured out, at all, either on the McCain side or certainly on the Obama / Clinton side, in any real sense of the word. So is this something that maybe as economists, and as political commentators, we need to ask what we can do for this?
Alex Pollock: I’m going to give the panel a chance to answer that, but I want to tell everybody first … In October we’re going to have Deflating Bubble Roman Numeral IV, and that timing is so that we’ll be right at the height of the Presidential election contests, and we’ll have a lot more to say about your question.
But for today, anybody want to take that up? …
John Makin: There’s a political problem here. In other words, during the campaign, if the problem is as large as we think it is, I think that the candidates will avoid it as long as they can.
[laughter]
If I were advising anyone, I would say, "Let’s not go there right now."
And so I … that kind of reinforces my idea that the rhetoric will certainly pick up by the time whoever the candidates are are debating in September and October. If we’re right, there’ll be a great deal of distress, and the mail that Congress is getting, which is running 9 to 1 against bailouts, will have flipped pro-bailouts.
But in terms of the kind of a nationalization solution, is a legislative solution. We don’t have the means to do it.
And the Congress effectively is out of business by July of this year, in an election year, and they’re back in business in February of 2009. The new Administrations comes in in January, and get cranked up in February, and so on. So my conclusion is simply that: yeah, it’s nice to talk about it, but action is going to be a long way off.
Alex Pollock: So Presidential debates — Deflating Bubble IV; and, Congressional action — Deflating Bubble V. … Question here and then Chuck[ph] I’ll get you.
John Schwitz: This is addressed to Professor Roubini …
Alex Pollock: … you’ll identify yourself …
John Schwitz: I’m John Schwitz, I’m an operational risk manager. I was sitting in the back, so your insights were flying at the speed of light. So I’m asking for two insights, one on the causal factor, and one on a forecast.
- What is the contributing factor of this conservative administration’s $1.4 trillion cumulative budget deficit? and,
- Will the dollar go the way — and to looking into the future — will the dollar go the way of sterling? [the UK currency]
Nouriel Roubini: Well, let’s put it this way. In terms of fiscal problem, I think that we have — I mean leaving aside the long term issues, I mean entitlements and whatever not — we have a short term kind of fiscal mess. This past year the fiscal deficit was only $150 [billion]. For the coming fiscal year they’re expecting $410 [billion], and the $410 [billion] does not include Afghanistan and Iraq, that’s already $500 [billion].
And then, I wouldn’t be surprised [if] you’re right. The bailout money might go up after the election, but maybe before the election we have another stimulus package, because we’re going to be [1:45:00] in a severe recession, so you’ll have, maybe by October, another $100 billion, that was $600 [billion], and there are estimates about the loss of revenues are based on just a mild economic slowdown, not on a severe recession. So you add that one, another $100, $150 billion and you have a deficit by next year of close to $750 [billion].
That’s why, you know, somebody like Bill Gross says, "In a couple of years we’re going to have a budget deficit of $800 billion," and all that before you even start thinking of bailing out the mortgages of the banking system.
We’re speaking about just the implications of a severe recession, a couple of stimulus packages. If you add that one [brief skip in recording] … you know, well over $1 trillion. How many … this is the fiscal time bomb we are facing right now. And relative to the dollar, you know, about most of the US fiscal deficit for the last 7 years has been financed 100 percent by non-residents, they are holding by residents of treasuries, has been, you know, zero in terms of increase in net exposure, you know. They are all over the existing position, but most of the deficit has been financed from abroad, and about 55 percent of all treasuries are now held by non-residents, and that question becomes also to know who’s going to lend us another $1 trillion when we have a fiscal credit mess and the dollar is tumbling, and so on. And so, the implication for the dollar are of great concern, I would say.
John Makin: Well, Nouriel, estimates of the budget deficit sound like Joe Stiglitz’ estimates of the cost of the Iraq War, which I guess are now at $3 trillion.
Look, a budget deficit of … let’s say it goes to $400 or $500 billion, for a $15 trillion economy, is inconsequential relative to the consequences of worrying about a budget deficit and doing nothing.
So the budget deficit will go up. It will go to something like 3 or 4 percent of GDP. We’ve been there before.
Japan, in their decade of difficulty, went to 7 or 8 percent of GDP, and a debt to GDP ratio over 100 percent. I hope you’re not going to suggest the tax increase like the 1997 Japanese tax increase, which in that environment, threw the economy into a sharp recession.
Finally, there is a bright side to this, that is there is a tremendous demand for treasuries in this environment, and so I guess I can say that the Federal government will be obliging the demand. It’s mostly domestic, but it will be obliging that.
And yes I agree that one of the by-products of this is that the dollar will weaken, both against other currencies, … It will weaken against other currencies until the decoupling scenario breaks down, and that’s why I think the euro, for example, hasn’t risen more rapidly, because it’s a matter of, "Well, OK, when the euro goes through $1.60, the European Central Bank will be facing some of the difficulties that the Fed is facing now."
But the dollar will go down in this enivonment, it’s just no … When people say, "Well, we should something about …," well, what do you want to do, raise interest rates? That’s not an option. But if the budget deficit gets to be $500 billion as part and parcel of dealing with the severe problems that we’re facing, so be it. It has to.
Alex Pollock: … Desmond? …
Desmond Lachman: … Yes, just I’m not sure that one can be that certain about the direction of the dollar over the longer run, because my understanding of the way in which currency markets work is that for the dollar to depreciate, it has to depreciate against another currency. And maybe a very strong euro is not consistent with the euro holding together as a currency bloc right now, that they’ve got very problematic parts, that Italy and Spain are already … look like they’re verging towards recession if the euro just keeps rising forever, what we’re really going to be having is we’re going to be having currency unit split. And I could be arguing the same thing for Japan, that a yen very much below 100 is not going to be consistent with Japan in the greatest of health.
So I don’t know that we’re really … I can see that there are reasons to see that the dollar short term is going to be under a lot of pressure, because of problems we’ve got in the financial sector. But as a longer term proposition, I’m not so sure, because I think it’s really a case of a race to the bottom between 3 pretty poor currencies.
Alex Pollock: … over here Karen …
Chuck MacKen[ph]: Chuck MacKen[ph], [unclear] lawyer. Two questions. One is more technical. We hadn’t heard the words, except in the introduction: "hedge funds." To what degree, as institutions, [1:50:00] as relatively opaque institutions, and some of them highly elaborate, we’ve seen the Carlyle thing last week, … To what degree are they amplifying …
Someone: … Carlyle was not a hedge fund …
[crosstalk, laughter]
Chuck MacKen[ph]: … the Carlyle, John, excuse me, … the Carlyle "fund" … forget it, "funds." Forget the definition of hedge funds …
To what degree are the opaque private funds magnifiers in the feedback loops? And I’m not making an argument, it’s a question. And the second question is, to try to end on a positive note, which may turn out to be a negative note: If you brought a highly analytical, smart, honest optimist into the room, what part of what you’ve said would they try to pick apart, and what would be the bid/ask, really, between you?
Alex Pollock: You want to start …om? [short gap in tape -- Zimmerman starts further down]
John Makin: … These are good questions. My reaction is simply that "hedge fund" has become a generic term for trouble. And Carlyle is a [laughter] leveraged buyout firm, and they had a very highly leveraged investment in mortgage securities that has gone bad.
[crosstalk]
… Look, anybody who has done leveraged purchases of securities that are related to real estate and mortages, either commercial or residential, was going to have a problem. And there are lots of people like that. I mentioned the Peloton hedge fund,[10] which tried to catch the falling knife.
I think, you know, the standard joke: What’s the difference between a hedge fund and and bank? … and the bank is more highly leveraged than the hedge fund.
I think you just have to distinguish among hedge funds. It’s a fee structure. The hedge funds that are invested in leveraged real estate products are going to have big problems, because the banks are going to pull their credit lines, and so they’re going to have to sell their stuff and close up, and we’ve seen some of that.
The macro-trading hedge funds as a group are up 6 or 7 percent already, because this is the great environment for macro-trading hedge funds. So I think that asset class is a heterogenious one. And the real issue is the one you focused on, is exposure to real estate is the problem.
What would a well informed optimist say? I mean, up until 2 weeks ago, they would say we’re not going to have a recession. J.P. Morgan’s got a very good economics team, and they have been saying all along that "… the real economic data are really not consistent with a recession, and we have to see more evidence." And to some extent they had a case. They would look at the claims data, unemployment claims data, and say, "we’ve only had one month of negative employment data."
And then when we got the data last Friday it was the classic recession-entry scenario. Well, we actually got a worse than expected number, and they went back and [laughs] revised the previous numbers downwards. So they kind of undercut the thing.
But I think the notion … the most resistance I have heard to this scenario is that we’re not having a recession. The argument about the problems in the credit sector are … people may be less pessimistic, but that’s been the argument: we’re not going to have a recession. And I think the reason that we’re talking about accelerating problems here is that — that argument kind of ended. And now the question is how bad is the recession’s going to be, and, you know, an articulate spokesman saying that we’re too pessimistic would say the recession’s not going to be too bad. And you can read that in J.P. Morgan’s weekly.
Alex Pollock: Tom, from a fixed income market analytical point of view, what would a well informed optimist argue against the pessimism?
Tom Zimmerman: I think part of it is this contagion is spread to some asset classes which we feel aren’t that … shouldn’t be that stressed, but they are. So you might say that this crisis will abate when people realize that some of these assets that are trading at 70 cents on the dollar really are 99 cents on the dollar assets.
And because this credit crisis has spooked everybody from buying anything, that when it turns around, it’s going to turn around with a vengeance, and all of a sudden you’d better be careful, because in 2 months it turns around and you’d be sorry you didn’t buy some of these cheap assets.
Yeah … it has gone overboard, this contagion to other sectors, and so you have [1:55:00] … we would say money-good assets that are trading very cheaply right now, and if you have a balance sheet, you should be buying them. So there are some very, very cheap assets out there right now, if you happen to have a balance sheet, have some cash, that you should put it to work.
The problem is, as John said earlier, that some people have tried this already and been beaten up. That’s what happened. Every time you take a look at the very cheap fundamental asset, and you know that it’s money-good, it just turns out to be 10 percent less the next day. That’s the problem.
But once it turns around, it could turn around with a vengeance at the right time.
Alex Pollock: Anybody else want to take up the case for the optimist? Nouriel, what would [laughter] an optimist say?
Nouriel Roubini: No, no, I agree with John. Until a month ago people say we’re going to have a soft landing. Now that the payroll numbers came out people say it’s going to be only a short and shallow recession that’s going to last 6 months. After the Friday number even J.P. Morgan says we’re going to have a recession called.
So the story is it’s going to be only 6 months, and the rest of the world is growing like crazy, China and the emerging market are doing great, and the Fed is aggressively easing, we’re going to have a fiscal stimulus, and we’re going to fix this problem through some fiscal bailout, so hopefully the combination of the policy response, the rest of the world doing great, and maybe the US consumer after all has been always been more resilient than people have expected them to be is going to lead us to just a minor contraction. And we get out of it easier than otherwise.
I don’t believe it, but that’s what the range of arguments is being made out of it.
Alex Pollock: Desmond?
Desmond Lachman: Just going back to the hedge fund issue, I think that you are raising an important question. Because what’s occurred over the last 10 years is that the traditional banking sector is a very much smaller part of overall financial intermediation; whereas 10 years ago it was, like, 50 percent, today it’s only 25. So it makes it very difficult for the Fed to be that effective, if it’s just dealing with the formal banking sector.
I’ve got a really very big concern about a credit derivative market which has exploded over the last number of years. You’re talking about $45 trillion of face value, and when you look at that market, 30 percent of the buyers and the sellers of those products are hedge funds.
So if you do get a problem in the hedge fund universe, you’ve got a real problem with the banks, who think that what they’ve done is they’ve offloaded their risk, but their risk is only as good as their counterparty is.
So I think that one has to be concerned, not simply with monies in the banks, but with the whole of the system.
Alex Pollock: Now if we had more time, I was going to ask any members of the audience who wanted to make the optimistic case to make it. But we are … it is 4 O’clock and we’re out of time. I’m sorry we haven’t covered all your questions. But I’m sure that members of the panel will be glad to stay for conversations.
Afterward, we hope to see you all for "Implications of a Deflating Bubble" Roman Numeral IV in the middle of the election season, and let’s show our appreciation to the panel.
[applause]
Thank-you all for coming. [1:58:21]
[1]: "The Deflating Mortgage and Housing Bubble, Part III: What Next?", AEI Event, March 12, 2008.
[2]: "Remarks on the National Homeownership Strategy", by Bill Clinton, American Presidency Project, June 5, 1995. [I am unable to find the 1994 document itself]
[3]: "Housing Bubble III Seminar" (PDF Slides), by Desmond Lachman, AEI, March 12, 2008.
- Title
- The Housing Bust is not occurring in isolation
- The Housing Bust is in Full Swing
- Housing Starts [SAAR == Seasonally Adjusted Annual Rate]
- Most Intense House Price Deflation In Over A Decade
- US Real House Prices
- Subprime 60-Day Delinquencies by Mortgage Vintage Year
- An Adverse Feedback Loop
- Excess Supply in the Housing Market
- Homeowner Vacancy Rate
- Inventory-sales for completed product pierces 10 months’ supply
- Affordability Went Bust During The Housing Boom
- Housing Demand Will Continue to Contract in 2008
- Estimated Purchase Dollar Originations, 2006
- Net Percentage of Domestic Respondents Tightening Standards for Residential Mortgage Loans
- Net Percentage of Domestic Respondents Reporting Stronger Demand for Residential Mortgage Loans
- Adjustable Rate Mortgage Reset Schedule
- No Stabilization in Housing Market in 2008
- House price Declines Implied by Case-Shiller Future Contracts
- Net Percentage of Domestic Respondents Reporting Stronger Demand for Commercial Real Estate Loans
- Residential and non-residential construction spending
- Policy Inaction is Not an Option
[4]: "Deflating Mortgage Bubble" (PDF slide deck), by Christopher Whalen, Institutional Risk Analytics, March 12, 2008.
- Title
- The Risk of Subprime
- Subprime Causation
- Subprime Symptoms
- Q4 — US Banking Industry
- Gross Defaults
- Loss Given Default (%)
- Exposure at Default (%)
- Mortgage Sector Defaults
- Credit Card Sector Defaults
- Effect: Banking Industry
- Effects: Risk Preferences
- Effects: Litigation
- Contact Information
[5]: "The Vigorish of OTC: Interview with Martin Mayer", Institutional Risk Analytics, June 12, 2008.
[6]: "The Deflating Mortgage and Housing Bubble; Part III: What’s Next?" (PDF Slide Deck), by Tom Zimmerman, UBS, March 12, 2008.
- Title
- Outstanding Mortgage Securities
- Agency MBS Market at Risk? [try right-mouse to rotate]
- Home Prices Are Collapsing
- Phases in Housing Downturn
- Default Multipliers and Loss Severities for Subprime as Function of HPI and Unemployment Rate
- ABX Prices Have Fallen Sharply [you can say that again
try right-mouse to rotate] - Writedowns: ABX 07-1 Projected Losses versus Break Evens (45% Severity)
- Writedowns: ABX 07-1 Projected Losses versus Break Evens (60% Severity)
- ABX Model vs. Market
- Outstanding Subprime and Alt-A MBS Securities
- “Vicious” Housing / Mortgage / Credit Cycle
- Government Rescue Attempts
- Why We Need a “Katrina-Style” Bailout
- (legal stuff)
[7]: "The Risk Cycle" (PDF), by John Makin, AEI, February 2008.
[8]: "Fed Seeks to Limit Slump by Taking Mortgage Debt", by Scott Lanman, Bloomberg, March 12, 2008.
[9]: "Is Bernanke Running out of Ammunition?", Calculated Risk, March 17, 2008.
[10]: "London hedge fund Peloton liquidates $2bn flagship fund", by Nikhil Kumar and Stephen Foley, Independent, February 29, 2008.
