Originally posted on sciy.org by Ron Anastasia on Mon 12 May 2008 02:00 AM PDT
Wanting to believe the worst is over
Posted
Updated
That Tin Pan Alley standard - Happy Days Are Here Again - has become synonymous with the Great Depression. In one of history's exquisite ironies, its first recording was released in October 1929, just before the big stockmarket crash that heralded the world's worst economic downturn. I couldn't help humming the tune over the past few weeks as a chorus of bank executives around the world announced, one after another, that "the worst is over".
First, in April, came the CEOs of most of the big Wall Street investment banks, who declared to a man that the worst of the global credit crunch is behind us; then, at the beginning of May, our own Gail Kelly, CEO of Westpac, the erstwhile head of St George Bank - which this week posted its first profit drop in six years because of rising bad debts and higher costs of funding.
One day after Ms Kelly joined the Happy Days choir, a discordant note sounded in the Home of the Brave and the Land of Free Lending. Bank of America, which agreed four months ago to buy the collapsed US mortgage business Countrywide for $US4 billion, said it may not guarantee more than $US38 billion worth of bad debts Countrywide had amassed. Now the stricken lender's portfolio has been downgraded to junk debt status, and the deal is in jeopardy. UBS, the doyen of Swiss banks, is sacking thousands of staff. Fannie Mae, the big US Government-backed mortgage buyer and seller, has announced its third consecutive quarterly loss and needs to raise $US6 billion in new capital. The worst of the credit crunch is over, right? Yet the cost of insuring the world's corporate debt is soaring. On most of the key indexes, credit default swaps - which pay a yield to investors who take on the risk of debt default - are widening. Never mind. It will all be fine if we all just believe. Faith would be so much easier to maintain if, every time the reassurances come, there wasn't another round of writedowns and losses by a major bank, or another outbreak of toxic debt.
Let's put the claims that "the worst is over" in context. The real reason why the global credit freeze eased just a little in recent weeks is because central banks around the world took extraordinary steps to thaw it. They've bailed out private sector banks, and they've been forced to stave off banking failures that threatened the entire financial system and the global economy. We've seen the near-collapse of Bear Stearns, one of the largest investment banks and stockbroking firms in the world. Stop and think about that: one of the world's major investment banks was on the skids. (Of course, it was too big too fail so the US Federal Reserve engineered a takeover). Ten years ago, when Long Term Capital Management nearly went broke - a single, $US 8 billion hedge fund - the then Fed Reserve chairman Alan Greenspan said it posed a systemic risk to the financial system. So how does the near collapse of a major investment bank rank on the richter scale of credit risk?
Then there are the lengths the central banks have had to go to in order to keep the wheels of finance spinning. Collectively, central banks have been pumping hundreds of billions of dollars into the financial markets to maintain liquidity. The scope and scale of the intervention has no precedent. Central banks are accepting a far wider range of collateral in return for loans to private sector banks agreeing to hold the collateral for much longer - in some cases for years. In the wake of the sub-prime mortgage meltdown, there was no market for residential mortgage-backed securities. Central banks have re-created it. They're letting investment banks and retail banks swap bonds and securities backed by mortgages for cash or - in the case of the Bank of England - gilt-edged Treasury bonds. We can debate the terms of these deals, and whether or not bailing out banks involves moral hazard (that is, it insulates them from the consequences of their own irresponsibility). The point is, the central banks' actions are a sign of continuing sickness in financial markets, not a return to health. But they, too, want to believe the worst is over.
Stock investors want to believe it. It's as if the equity markets are on prozac. The economic indicators are weak in the USA: sharemarkets rally; the Fed might cut rates again. The economic indicators are better than expected: sharemarkets rally; "the worst is over". Banks announce more writedowns and losses: sharemarkets rally; the bad news must all be out there.
The risk analyst Sayajit Das has had the most insight into the financial markets dimension of this meltdown. Well before the credit crunch hit, he was warning that it was coming and what would bring it on. So what's his take now? That what's happened so far is only phase one in a massive deleveraging of a world addicted to debt.
Banks around the world have so far suffered losses of between $200 billion and $300 billion. But that's not the biggest worry. Banks also set up separate funds - "virtual banks" - off their own balance sheets that housed thousands of billions of dollars in debt and assets. Known as conduits and Structured Investment Vehicles or SIVS, these funds worked a classic play during the good times, borrowing short at low interest rates and investing long, in bonds and securities that paid higher interest. But now it's all come undone. In the wake of the sub-prime mortgage crisis, the cost of short term funding has soared, and the market has all but shut down. Big investment banks had given implicit or explicit guarantees to many of the conduits and SIVs. So they've either had to bankroll them, or take their assets back onto their own balance sheets.
The result: banks are having to raise huge amounts of new capital and funding to cover their multi-billion dollar losses and this "involuntary asset growth". According to Das, the capital required is about 25 to 30 per cent of total bank capital, and it's not clear how they're going to meet that shortfall. And the huge capital raising required would only repair the holes in the banks' balance sheets. Growth in lending and assets would require even more capital.
This, Das argues, has serious ramifications: "The banking system's ability to supply credit will be significantly impaired for the foreseeable future. If the banks are not able to recapitalise, then the contraction in credit will be even sharper."
The effects will flow on to what's known as "the shadow banking system" inhabited by thousands of hedge funds and other investment vehicles. When debt was cheap and readily available, hedge funds borrowed heavily. They used high levels of gearing or leverage to magnify their returns on investments. Now the high debt and gearing levels are magnifying their losses. The drying up of credit has already forced hedge funds and other investment funds into a fire sale of assets - if they can find buyers in markets now devoid of liquidity. And it's likely there is much more to come.
That's just the financial markets dimension of the problem. Look at what's happening in the real economy, starting with America where the problems began.
The credit crunch had its genesis in the housing market - or, more precisely, millions of dodgy home loans issued to borrowers in the United States with poor credit histories. Now the sub-prime mortgage meltdown has morphed into a nationwide slump in house prices.
The most reliable index of home prices in the US is S&P/Case Shiller Index, designed by the economists and academics Karl Case and Robert Shiller. It covers 20 metropolitan regions in the US. The latest figures show that for the first time in its 21-year history, every one of the 20 regions is down - with the average annual fall of nearly 13 per cent in nominal terms. Some 17 of the 20 metropolitan regions posted record falls. And the downturn is accelerating. Annualise the three months to February, and you're looking at a 25 per cent fall.
That won't just hit homeowners and estate agents. There are huge knock-on effects throughout the economy of a severe housing downturn. Sales of white goods and consumer electronics will suffer sharp falls and with them the profits of major retailers. Home construction will dwindle and with it the profits of building companies and building profits suppliers. Retail workers and trades people will lose their jobs.
Markets rallied when the latest employment statistics in the US came in stronger than expected; don't imagine it will last. Homeowners in the US are defaulting on their mortgages at record rates, and the house price collapse will make the mortgage meltdown a lot worse. According to one index, more than half of the people who purchased houses in 2006 now owe more on their mortgage than their house is worth. Negative equity - where the debt is more than the value of the property - significantly increases the risk of mortgage defaults. The problem is exacerbated in America because - unlike in Australia - mortgage holders can simply abandon the home and "walk away". (Here, the lender or the mortgage insurer can chase you for the outstanding debt and drive you into bankruptcy.)
Analysts at Barclay Capital argue the risk of default on about $US 800 billion in US mortgage debt is now much higher because the borrowers are in negative equity.
"If they have home equity left, borrowers are hesitant to default, even if in trouble,'' Ajay Rajadhyaksha and Derek Chen wrote in an April report.
"If the house is worth more than the loan, why default and leave money for the bank? Better to sell the house instead.''
The US Treasury has a tendency to accentuate the positives and play down the negatives - yet even it is forecasting that house prices will fall by another 10 to 15 per cent in America before they hit bottom. Others argue the bottom is nowhere in sight.
What's made the problem worse is that the housing boom in the US was built on absurd lending largesse: 100 per cent finance home loans; "piggy back loans" (more than one mortgage from more than one lender); teaser rate loans which seduce the borrower with a very low initial rate then reset at high rates that many people cannot service; and negative amortisation loans, where the loan repayments are less than the interest required to pay down the debt and the amount of principal owed grows over time.
There's a vicious cycle at play here. More mortgage defaults will generate more fear in the credit makets because the wonders of modern financial innovation mean the debt and the risk of default has been sold, in bonds and securities, around the world. More fear in the credit markets will reduce the flow of credit and push up the cost of borrowing. That will hit home lending and business lending, further undermining the 'real economy."
In case you haven't noticed, the US Treasury secretary, Hank Paulson, has stopped saying "the economy is sound".
And the housing woes are not confined to the United States. What's striking is the global nature of the downturn. Property prices are falling sharply in Britain, Ireland, Spain and France. The latest figures show that Britain has suffered its first annual fall in house prices in 12 years, and the slump is accelerating. Even in Australia, where the lending was by and large far more prudent than in the United States, the latest report from Australian Property Monitors says that house prices are flat in most of the major capital cities and headed for a serious tumble in some.
It's a classic asset price cycle. Look at just about every boom and bust cycle in history, and you'll find it was built on cheap credit, easy lending and lax underwriting standards. And this boom was the biggest. The legacy is a burden of household debt without precedent. As real estate prices boomed, households felt wealthier and borrowed against their (inflated) assets. As the price of property soared way beyond the growth in wages, people borrowed more and more to break into the market, running up debts on credit cards to make ends meet. In countries such as the US, where wages were stagnant or falling in real terms, people borrowed against property to maintain their lifestyles.
Now the easy finance is drying up. If there's a serious global downturn that pushes up unemployment rates, it could get ugly, as people unable to service their debts are forced to sell assets causing a further downward spiral. Default rates will rise and financial institutions will suffer further losses. Beyond the household sector, there's the vast army of self-employed workers who set up small businesses after the corporate downsizing cycle of the 1990s. Many borrowed against their homes to do so, and have survived on thin margins during good economic times. In any downturn, they'll be the first to go.
According to the official estimates, so far, at least, America has narrowly avoided a recession. It's a false assurance: the only reason the US economy registered growth was a run-up on inventories (stock), which counts as a positive in the national accounts. In this case, though, it's a sign of malaise. The key reason stocks are running up is because businesses can't sell stuff. The other likely explanation is that wholesale buyers are hoarding grains such as rice because of global shortages and soaring prices, but that's hardly a sign of economic health, either.
But still, there's a chorus of urgers out there saying it will all be fine. If there's a glimmer of hope, you're likely to see a trader or equity market analysts tell the TV wire services that happy days are here again - without any hint of irony.
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