The Insolvency Crisis: How we got here, and what to expect

 Skrevet av Garrett Johnson - Publisert 11.08.2007 kl. 10:32 (Oppdatert 12.08.2007 kl. 19:47)

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“For these ten marks I sold my virtue.”
- written on the back of German banknote, 1923
The news of the Federal Reserve injecting $38 billion into the mortgage-backed securities market didn't get a lot of attention yesterday, but it should have.
Since a third injection is unprecedented, as such infusions typically only occur during a crisis, investors are again left wondering just how bad the subprime situation is and questioning whether or not an emergency rate cut would even be enough to avert a possible true credit crunch.
It was the largest infusion by the Fed since the 9/11 aftermath. But it paled in comparison to the European Central Bank's two day infusion of 155 Billion Euros.

What does it all mean? To answer that we must dig deeper than the headlines and take a look back in time.

Irony is a dish best served cold

In late 1997 the hedge fund Long Term Capital Management was Wall Street royalty. With not one, but two Nobel Prize winners in economics on staff, they consistently generated 40%+ returns for their investors. Their mathematical models seemed to have conquered all the mysteries of high finance.

Then they lost $4.8 Billion in 1998 and nearly became insolvent.

On September 21, 1998, the Federal Reserve called 16 major Wall Street investment banks together for an unprecedented meeting to bail out the hedge fund that they had all lent money to. The reason was because LTCM had leveraged their portfolio to $1 Trillion, and there was a real fear that the bond market would seize up as creditors rushed to the exits. Some of that was already happening. 11 of those banks signed off on the bailout. The Federal Reserve pushed billion of dollars of liquidity into the markets - almost exactly the same as what the Fed did yesterday. Bear Stearns refused to participate.

Fast forward nine years. Three hedge funds run by Bear Stearns become insolvent. Bear Stearns has the nerve to ask its other investment banks, many of them part of the LTCM bailout in 1998, for its own bailout. Instead, they seize the assets of those hedge funds, and Bear Stearns is force to use $3.2 Billion of its own reserves to cover its losses.

But the irony doesn't end there. Yesterday Goldman Sachs, a participating member of the LTCM bailout team, announced their largest hedge fund lost 15% of its capital over the last month. It seems the Alpha Fund was using complicated mathematical models similar to what LTCM used.

Meanwhile, Merrill Lynch tried to sell the assets that they seized from Bear Stearns but failed because they couldn't even get 11 cents on the dollar for those mortgage-backed bonds.

Some are now predicting that half of the hedge funds on Wall Street will go bust in the next five years. At the same time, the debt markets have seized up.

What happened? How could the brainiacs on Wall Street make the same stupid mistakes less than a decade later?

To answer that, let's look at what happened during those nine years and how Wall Street works.

How we got here

Moral Hazard: refers to the possibility that the redistribution of risk (such as insurance which transfers risk from the insured to the insurer) changes people's behaviour.
The bailout of LTCM convinced many that there was a "too big to fail" condition that companies can meet where the Federal Reserve would always ride to the rescue. Meanwhile a financial instrument evolved from obscurity to being the dominant feature in the world of finance - asset-backed securities. These became important as the Fed dropped interest rates from 6% to 1% in 2001 and 2002, causing a " tidal wave of money moving into the bank deposit base". All that liquidity (a fancy name for "credit") needed to get loaned out in order to make profits on it, and the already booming real estate market (because of artificially low interest rates) was the perfect target.

Once those loans were made the banks could then bundle up a collection of mortgages into an ABS and sell it to the secondary mortgage market, traditionally a pension fund or insurance company. But with the exploding trade deficit, foreign nations were looking to recycle their surplus dollars back into American markets. Buying those mortgage-backed securities became a leading method of doing that.

When Fannie Mae and Freddie Mac got into an $11.3 Billion accounting scandal in 2004 (it took them five years before they actually filed again on time with the SEC), the burden of funding the real estate bubble fell to the ABS market. $2 Trillion in mortgages were created this way.

The moral hazard of this arose from the fact that the people selling the mortgages didn't have to worry about ever getting paid back because someone else was buying those mortgages and taking on the risk. What's more, foreign investors were unlikely of being fully aware of who was getting these loans. Credit standards dropped to ridiculous levels. Migrant farm workers were qualifying for $250K, no-down, interest-only mortgages. Money was being made by the boatloads. Speculators swarmed the business. Homeowners began extracting the equity from their homes even faster than their home values could rise, and using the money to buy expensive toys. In other words, using their homes as ATM machines.

It was a disaster waiting to happen.

Where we are now

A large percentage of those new mortgages were 2/28's - a low, two-year "teaser" interest rate, which then resets to a much higher market rate. As those mortgages reset, foreclosure rates spiked.
"Normal foreclosure rate in the United States is anywhere from 300,000 to 500,000 per year. Now the projected rate is 1.7 million," said Jessica Cecere, president of Consumer Credit Counseling Service.

Mortgage resets (in billions)

Foreclosures as of May, 2007

Of course, where the foreclosures have been so far isn't necessarily where the foreclosures will be in the near future (think "west").

Even insiders say that the real estate market won't bottom for another year.

Federal Reserve Chairman Ben S. Bernanke and U.S. Treasury Secretary Henry Paulson assured us that the subprime mess was "contained" and wouldn't spill out onto the general market. They lied.
"The subprime mess is now spreading to banks," says Nariman Behravesh, chief economist at Global Insight Inc. in Lexington, Massachusetts. "A lot of international banks, especially those in Europe, did invest a lot in the collateralized debt markets, especially the subprime situation here in the U.S., so they're suffering."
116 mortgage lenders have imploded since 2006. 11 hedge funds have imploded in just the last couple months. So have two european banks.

A rumor says that interbank lending completely shut down for several hours this week. Borrowing costs have skyrocketed.

Credit spreads between junk bonds and treasures have spiked higher.

Meanwhile the junk bond market failed to have a single new issue for the second week in a row. There is simply no demand for the product.

This isn't 1998 all over again. We've gone beyond that.
Today we do not have only a liquidity crisis like in 1998; we also have a insolvency/debt crisis among a variety of borrowers that overborrowed excessively during the boom phase...the recent sharp widening in corporate credit spreads is not just a sign of a liquidity crunch; it is a sign that investors are realizing that there are serious credit/solvency problems in some parts of the corporate system.
If you needed any proof that there is a credit crunch in America today, look at what is happening with credit cards.
In a form letter, Capital One told her the interest rate on her credit card was about to almost double—she’d been bumped up from a fixed 8.9 percent rate to a "variable rate that equals the prime rate plus 6.9 percent"—or about 15.8 percent. The letter blamed rising interest rates across the economy for the decision.[...]

As home prices across the United States have stagnated or fallen and consumers have tapped out the equity in their homes, banks have gotten more cautious about lending and have tightened their standards for new mortgages and home-equity loans. As a result, more Americans are shifting debt onto credit cards.
What makes this all worse is that this isn't just an American phenomenon. Spain is leading europe into an "inevitable" real estate bust. The U.K. is almost certain to follow, and their real estate bust could be even worse than America's in degree. Other countries such as France, Australia, and China are also facing the bursting of real estate bubbles.

What we can expect

Hindsight is 20/20, but forecasting what is to come is extremely difficult and unreliable.

However, every once in a while the insiders will give you a clue. For instance, just a month ago Treasury Secretary Paulson was in China begging for them to buy our mortgage-backed securities. China, of course, refused, but it gave a sign of just how bad things were going to get.

Another sign of things to come came from a reliable source.
Fannie Mae and Freddie Mac, once derided as white elephants of the mortgage market, are benefiting from the subprime-lending debacle and trampling just about anything in their way.

Now, the companies are getting praise in Congress after promising to spend at least $20 billion to keep the mortgage market afloat by purchasing loans made to people with poor credit histories or high debt burdens.

"The political tide is definitely running in their favor," said David Dreman, who manages investments including 12.8 million Freddie Mac shares at Dreman Value Management in Jersey City, New Jersey. The companies "are re-establishing their credibility," he said.
"Credibility" is not exactly what I would call it. Fannie and Freddie's combined portfolio amounts to $1.5 Trillion already. Freddie Mac recently revealed to have lost $550 million in the 3rd quarter of 2006, lost $480 million in the 4th quarter of 2006, and lost another $211 million in the 1st quarter of 2007. Fannie Mae portfolio could be several times worse. The mortgages they own are already risky and now they want to expand it as the real estate market melts down.
The Office of Federal Housing Enterprise Oversight estimates that 40.6 percent of Fannie’s portfolio, a total of $292 billion, is in loans for low-income borrowers, first-time buyers, and people living in mobile homes and economically distressed neighborhoods – all likely candidates for mortgage foreclosure. Freddie owns $68 billion of these loans, some 9.5 percent of its portfolio.

Unloading these properties is nearly impossible. Fannie has a Detroit house on the market for $7,000, despite the $59,000 outstanding on the loan. The property, repossessed in May, has been looted, with the kitchen sink and drainpipes stolen.
Is this really the companies that will bailout the mortgage industry? Companies loaded with massive defaults and an implied taxpayer bailout if they fail?

But the real clue about where we are headed comes from the actions the Fed took yesterday that I mentioned at the start of this diary.

The Fed "injected liquidity into the market" yesterday. The phrase sounds innocuous, but its not. What it actually means is that the Federal Reserve created short-term repurchase agreements in which they bought billions of dollars worth of mortgage-backed securities.

Since the counter parties in these agreements have to buy back those MBS's in a few days it is consider "market neutral", and the Fed's action with RePo's is nothing more that pump-priming the market. But is it really?

The Fed's bond holdings continue to grow every year. How can that be "market neutral" then?

If this still doesn't sound ominous then consider where the Federal Reserve gets its money from - thin air. Here's how it works:

a) the Treasury issues bonds

b) the Federal Reserve creates the money from thin air and loans it to the Treasury

c) the Federal Reserve then creates more money from thin air and buys those Treasury bonds back, thus becoming part of the Fed's bond holdings

And that's how money is created in America today. What's that? It sounds like a scam? Yes, but its legal (and very profitable to a small number of banks).

There are other ways that money is created money is created in America today, some less scary, some more scary. The problem is that the line between "money" and "credit" has been (intentionally?) blurred. Where once the two were very separate things, they now appear to be the same.

Somewhere between the blurring and the RePo's the Fed created a massively expanding monetary stock that is nearly out of control.

Of course the Fed stopped reporting the M3 a couple years ago, just as it was about to cross over 10% growth y-o-y. Then earlier this year the Treasury did something rather ominous - they outlawed the exporting of pennies and nickels. Why did they do that? Because the dollar has been so devalued by the massive expansion of the monetary stock that the metal content of pennies and nickels is worth more than their face value.

This has been very common in history when a government tries to "create wealth" through uncontrolled fiat money printing. The difference this times, as opposed to historical comparisons, is that in history the governments outlaw ownership of precious metals. Our government has so devalued the currency that they are outlawing the melting down of base metals. (our government outlawed private ownership of gold from 1933 to 1974)

Happy Birthday!

Which brings us to an ironic anniversary. While the Federal Reserve is busy monetizing debt by creating money out of thin air, today happens to be the 88th anniversary of the birth of the Weimar Republic.

The Weimar Republic in Germany has the dubious distinction of being most known for printing their currency into oblivion in 1923. How did they do this? Glad you asked.
When the government needs more money than its people are able or willing to lend it, it monetizes the debt. That is what happens in this country when the government runs a big deficit. The Federal Reserve (our central bank) "buys" as many bonds as necessary to stabilize the market. It prints money on the security of these bonds. Despite the facade of the government supposedly "borrowing," the net result is the creation of printing press money. (Actually these days the money is created in the form of new bank deposits--checkbook money--but the net result is exactly the same as if bills were printed.)

This is what happened in Germany. The government issued notes which were promptly discounted by the Reichsbank, i.e., the bank issued money on the "security" of these worthless notes. To compound the evil, the bank failed to raise its interest rate sufficiently. Businessmen found it very profitable to borrow money from the bank and buy up goods, shares and companies. Their debt was wiped out within weeks by the rapid inflation, and the businessman remained holding the valuable assets he had bought. The net result was a huge "private inflation" caused by the rapid expansion of credit. Even foreign exchange was bought with borrowed money, so that the Reichsbank actually financed speculation against its own currency. Yet the bank refused to raise interest rates, arguing that this would only add to the cost of business and thus would increase inflation!

Children playing with stack of worthless currency, Germany 1923

Woman burning stacks of worthless currency in her stove for heat, Germany 1923

That's not to say this is our destiny. I'm only saying that the Fed and Treasury have taken the first steps down that road. There is still plenty of time to turn back.

But if people aren't aware of the road we are standing on, if the idea is simply rejected out of hand without discussion, then how can the public's outrage stop the government from leading us down the road that they have already started?

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