Submerging Credit Markets

**DOR** · 28 Sep 11,, 11:21

Here's something I wrote in August 2007, that was published the next month. Bear in mind it is written with a Hong Kong business readership in mind.
--DOR

Economic Insight September 2007

Submerging Credit Markets

One of the things I need to bear in mind when writing this column is the lag time between when the light bulb goes off, and when the issue hits your desk. What seems to be a good topic may be old hat by the time it his your desk. So, with that in mind, will the September reaction to America’s credit crunch be (a) “I’m glad that little scare is over!” (the optimistic scenario); (b) “How long is this going to last?” (the mid-range scenario); or (c) “Didn’t we just go through this 10 years ago?” (the nightmare scenario).

[Sept 2011 comment: I should have said, 80 years ago ! ]

A decade back, liquidity vanished when it became apparent that central banks had swept the last hard currency out of their vaults in a vain attempt to shore up indefensible exchange rates. This time, there is no lack of money, which gives us some small bit of relief. Rather, risk has been very badly mispriced, and as a result, risk-holders expecting to pass on the debt they hold are slashing prices while buyers are demanding bigger and bigger premiums.

First, the background. Subprime lending makes funds available to borrowers who wouldn’t get it any other way. In theory, poor credit risks pay more to borrow, as a reflection of the higher risk of default. Contrary to media reports, not all subprime lending is for real estate. Indeed, a very significant portion would be for the purchase of automobiles, furniture and other big ticket durable goods. Still, mortgages are a very large share of the total.

In the real estate market, subprime loans increased dramatically in the first half of the decade, nearly quadrupling (to $600 billion in 2006) in five years. Defaults tend to peak when such loans are 3-4 years into the repayment cycle. Interest is typically fixed at an attractive rate in the first two years, then rises sharply (to, say, five percentage points above a benchmark rate such as LIBOR). Put together a combination of rapidly increasing loan volumes, quickly approaching peak default dates and much higher interest rates than 3-4 years ago and it should be apparent that this problem isn’t going to go away just yet.

Why did risk get so badly mispriced? After the highly unusual investment-led recession of 2001, the benchmark Fed Funds interest rate was slashed from 6.5% to 1.0% and held there for a year. In combination with more innovations such as securitization, on-line loan approvals and no-doc loans (in which borrowers, for a price, do not have to document their incomes), borrowing soared and the housing market boomed.

Rising home prices and low interest rates gave consumers a sense of rapid wealth creation (rather than asset price inflation). To realize the benefits, they borrowed more which led to a very strong increase in imports. That fueled trade surpluses abroad, which central bankers socked away in reserves. Those reserves were largely in the form of US Treasury Bills, which helped hold down US interest rates which fed the cycle.

What is also missing from much of the discussion is that this problem isn’t really anything new. Auditors in the US Federal Deposit Insurance Corporation (the agency that backs deposits in US banks) warned about risks from subprime lending as early as 1997, and various banking related US government agencies updated the warning in subsequent years. The FDIC is rightly concerned because the banks it insures are exposed to the higher risks involved in lending to subprime borrowers (directly or through syndication), buying high yield subprime loans, or by buying asset-backed securities comprised of such loans.

What next? Meltdown is one option, but probably not the most likely. Rather, we are probably going to see a recession in the US. As the accompanying graphs illustrate, banks are reducing the portion of their loans given to consumers, and that tends to coincide with an economic softening. The ratio of past due mortgages to total mortgages is rising, as are real interest rates. And, new home buyers are wary, in a way they haven’t been before as shown by the vacancy ratio.

[2011 comment: Oh, the naivety, oh the embarrassment! I was SUCH an optimists back then ! graph omitted.]

**editec** · 04 Oct 11,, 11:49

Do not blame yourself.

You were projecting possible outcomes based on the way cap[italism normally works.

But the moment the BANKS were at risk, then socialism for the rich reactions went immediately into effect.

The machinations that the FED and TREASURY went though to save the banksters from complete meltdown were outside the normal range of economic response.

FWIW, the banksters are still sitting on debt instruments of dubious value and ignoring that fact because if they acknowledge it by writing them down, then their outstanding debt-leverage is way out of line with the CAP rates.

Look, the median housing price in the USA is now about $150K down from about $180 (you might check that, it may have been higher)

Meanwhile the median family income has dropped down from about $57K to about $48K in the last three years or so.

IF the standard of income to house price ratios that existed for generation went into effect, then the median house price in the USA OUGHT TO BE about $100K (TOPS!!).

And if the market is truly corrected that means that the value of RE still have a might long way to fall, thus making those debt instruments that are based on those RE valuations completely overpriced.

The only think keeping these banks asolvent is the fact that the market has seen the government take extraordinary (posdsible illegal) steps to shore them up.

TARP was really the promise by our FED and Treasury to keep those banks solvent.

The US taxpayer took on responsibility for these bad debts the banks had while allowing the banks to keep the good debts.

If we'd allowed the game to be played by the standard rules of capitalism there wouldn't be a bank open in the USA.

**snapper** · 04 Oct 11,, 12:59

Dexia to be broken up and refinanced and Morgan Stanley insurance rates rise:

"Dexia, the Belgian/French bank, is in talks to be rescued and reconstructed - just weeks after passing European regulators' health tests (the vaunted "stress" tests) with flying colours."

"And creditors' wariness seems all the odder, given that Morgan Stanley has a chunky $182bn of liquid assets, twice the amount cash reserves as a proportion of assets that it held in the dark days of 2008.

And it also has almost 10% Tier One capital under the more demanding Basel lll definition, that won't be enforced till 2018 (if you haven't the faintest idea what I'm banging on about, just take it for granted that this is supposed to mean that Morgan Stanley is solid)."

BBC News - Can we afford to heap bank losses on creditors?

Here we go!

**editec** · 04 Oct 11,, 14:36

Not remotely conversant on the state of European banks, but here in the USA these "stress tests" are, I suspect, based on dubious debt insturment valuations and risk asessments.

Q: How does one evaluate risk in a state of constant flux?

A: If recent history is our guide, then one posits the risk and hopes emerging events and revelations don't flux it up.