The Ten Faulty Consensus Views about Sub-prime and Soft-Landing…and the Ten Ugly Truths about the Coming Economic and Financial Hard Landing
Nouriel Roubini | Mar 15, 2007
The sub-prime carnage is now front page news on every possible media; soon enough it may be even become cover story on People magazine as even Britney Spears will soon be asking about it. But many sophisticated observers and investors tell me they had not even heard once about this term until January. Too bad that a minority of observers including - but not only – myself were warning about sub-prime, housing and this incoming disaster since last August; but then no one was listening and/or scorn was thrown on the few that were warning about the worst housing recession in decades and its financial fallout in the mortgage market.
So now that the disaster is too big for anyone to ignore the new conventional wisdom is to try to minimize the extent of the problem. The new consensus view is that “this is only a sub-prime niche problem that is contained and will have no spillover and contagion effects to other mortgages, to the credit market, to the economy and to the US growth rate”. This new consensus is as wrong as the systematic ignorance since last summer by the consensus of that unfolding housing, mortgage, financial and economic train wreck.
So, today the consensus is spinning ten soothing new arguments that have as little basis and evidence for them as the consensus ignoring what was going on in the housing and the mortgage market since last summer. The consensus was wrong then and will be proven wrong now.
Since daily “don’t’ worry” fairy tales are now being spinned around every hour on many outlets – while a rising number of analysts, media folks and scholars are now recognizing the extent of the unfolding financial and economic wreck – let me present the new ten consensus views about the sub-prime carnage and its fallout (or lack of fallout in the consensus view); and then present the ten ugly realities on how this consensus is wrong on each one of these points.
I have already extensively discussed each one of these ten issues in my recent blogs and papers; so I will here summarize my main views and refer you to the more detailed analysis of each argument in my recent writings. But I will soon come back to each of these questions and explain in more detail why – on each – the consensus view is faulty.
So here is the top ten list of faulty consensus views followed by the ten ugly realities about then coming economic and financial hard landing…
Consensus View #1:
The Housing recession is bottoming out.
Ugly Reality #1:
The housing recession not only is not bottoming out; it is getting worse and it will be the worst housing recession in the last five decades as my recent analytical paper with Christian Menagatti shows.
Consensus View #2:
The subprime carnage is only a narrow and niche problem; other mortgages are fine. So there is no risk of contagion to other mortgages.
Ugly Reality #2:
The same garbage lending practices used for sub-prime – no/low down-payment, no/low documentation of income and assets, interest rate only, teaser rates, negative amortization, option ARMs - were prevalent among near prime and other (option ARM) prime mortgages.
These risky mortgages add up to about 50% of originations in 2005 and 2006, as my research and that in Credit Swiss (among others) shows.
Consensus View #3:
There may be a credit crunch in subprime but not generalized credit crunch in the mortgage market.
Ugly Reality #3:
Not only there is a severe credit crunch in subprime (30 plus lenders out of business); there is also the beginning of a generalized credit crunch for the broader set of near prime and other risky prime mortgages.
Default and foreclosure rates sharply up in all mortgages, including near prime such as Alt-A. Lenders and regulators are seriously tightening standards for all mortgages. There is now a sharp swing from very loose to very tight lending behavior by every type of mortgage lender. Ivy Zelman of Credit Swiss recently published an excellent analysis showing that is not just a sub-prime problem. As she put it this credit crunch "will affect the entire housing food chain." There is also a risk of a systemic banking crisis if the economy has a hard landing.
Consensus View #4:
The market for securitization of mortgages (RMBS and CDOs) is fine; there is not contagion or distress in it.
Ugly Reality #4:
There is a severe disruption of the CDOs market – given the losses of CDO managers and investors - that risks to lead to a seizure of the entire RMBS market as CDO investments are the foundations of the mezzanine tranches of the RMBS market. See the recent excellent Rosner and Mason paper.
Consensus View #5:
There is no contagion from mortgages to other credit risks.
Ugly Reality #5:
There is the beginning of a slow contagion to other credit risks: widening of spreads to near junk for major broker dealers; widening of CDS spreads for corporates and non residential real estate as measured by CDX, iTraxx and CMBX indices.
Consensus View # 6:
There is no contagion from the housing recession to other sectors of the economy.
Ugly Reality #7:
There is already significant contagion from the worst housing in decades to the other sectors of the economy: auto is in a recession; manufacturing is in a recession; employment growth is slowing down; every component of real investment (residential, non-residential, equipment and software, inventories) fell in Q4 and is falling at a faster rate in Q1. And now the saving-less and debt-burdened consumer is faltering too as two mediocre consecutive months – January and February – of retail sales show. The US consumer is on the ropes and at its tipping point.
Consensus View #7:
The economy will experience a soft landing and the mortgage disaster will have no macro impact.
Ugly Reality #7:
The economy will experience a hard landing, at best in the form of a growth recession (growth in the 0%-1%) for most of 2007 or, more likely, an actual recession starting in Q2. Greenspan thinks a recession by Q4 has a 30% probability; the Fed’s yield curve model prices a 54% probability of a recession in 2007.
Consensus View #8:
If the soft landing is at risk and the economy may have a hard landing the aggressive easing by the Fed will prevent such a recession.
Ugly Reality #8:
The coming aggressive easing by the Fed will not prevent the US hard landing for the same reasons why the aggressive Fed easing in 2001 did not prevent a recession then: when you have a glut of investment/capital goods – then tech goods, today housing glut, consumer durable and auto glut – the demand for such goods becomes interest rate insensitive. So the Fed will try but will not be able to rescue the economy.
Consensus View #9:
The world will happily decouple from a US hard landing
Ugly Reality #9:
Decoupling of growth for Europe, Asia and emerging markets will occur only if the US has a soft landing. If the US experiences a hard landing there will be no decoupling whatsoever.
Consensus View #10:
The recent financial markets turmoil is a temporary blip; the financial party will happily continue.
Ugly Reality #10:
Previous market corrections were temporary blips and market opportunities because macro fundamentals were sound. The spring 2006 “inflation scare” turned out to be a “scare” without basis; thus markets recovered after a brief turmoil.
Today we do not have a “growth scare”; we have US growth fundamentals that are severely weakening and leading to the risk of a hard landing. In that scenario the market will not have a brief correction; instead all sorts of risky assets – equities, commodities, corporate credit risks, emerging market assets – will have a severe downturn once sucker rallies following expectations of a Fed ease will run out of steam when the reality of a hard landing sinks in.
By Steven Pearlstein
Wednesday, March 14, 2007; D01
Today's pop quiz involves some potentially exciting new products that mortgage bankers have come up with to make homeownership a reality for cash-strapped first-time buyers.
Here goes: Which of these products do you think makes sense?
(a) The "balloon mortgage," in which the borrower pays only interest for 10 years before a big lump-sum payment is due.
(b) The "liar loan," in which the borrower is asked merely to state his annual income, without presenting any documentation.
(c) The "option ARM" loan, in which the borrower can pay less than the agreed-upon interest and principal payment, simply by adding to the outstanding balance of the loan.
(d) The "piggyback loan," in which a combination of a first and second mortgage eliminates the need for any down payment.
(e) The "teaser loan," which qualifies a borrower for a loan based on an artificially low initial interest rate, even though he or she doesn't have sufficient income to make the monthly payments when the interest rate is reset in two years.
(f) The "stretch loan," in which the borrower has to commit more than 50 percent of gross income to make the monthly payments.
(g) All of the above.
If you answered (g), congratulations! Not only do you qualify for a job as a mortgage banker, but you may also have a future as a Wall Street investment banker and a bank regulator.
No, folks, I'm not making this up. Not only has the industry embraced these "innovations," but it has also begun to combine various features into a single loan and offer it to high-risk borrowers. One cheeky lender went so far as to advertise what it dubbed its "NINJA" loan -- NINJA standing for "No Income, No Job and No Assets."
In fact, these innovative products are now so commonplace, they have been the driving force in the boom in the housing industry at least since 2005. They are a big reason why homeownership has increased from 65 percent of households to a record 69 percent. They help explain why outstanding mortgage debt has increased by $9.5 trillion in the past four years. And they are, unquestionably, a big factor behind the incredible run-up in home prices.
Now they are also a major reason the subprime mortgage market is melting down, why 1.5 million Americans may lose their homes to foreclosure and why hundreds of thousands of homes could be dumped on an already glutted market. They also represent a huge cloud hanging over Wall Street investment houses, which packaged and sold these mortgages to investors around the world.
How did we get to this point?
It began years ago when Lewis Ranieri, an investment banker at the old Salomon Brothers, dreamed up the idea of buying mortgages from bank lenders, bundling them and issuing bonds with the bundles as collateral. The monthly payments from homeowners were used to pay interest on the bonds, and principal was repaid once all the mortgages had been paid down or refinanced.
Thanks to Ranieri and his successors, almost anyone can originate a mortgage loan -- not just banks and big mortgage lenders, but any mortgage broker with a Web site and a phone. Some banks still keep the mortgages they write. But most other originators sell them to investment banks that package and "securitize" them. And because the originators make their money from fees and from selling the loans, they don't have much at risk if borrowers can't keep up with their payments.
And therein lies the problem: an incentive structure that encourages originators to write risky loans, collect the big fees and let someone else suffer the consequences.
This "moral hazard," as economists call it, has been magnified by another innovation in the capital markets. Instead of packaging entire mortgages, Wall Street came up with the idea of dividing them into "tranches." The safest tranche, which offers investors a relatively low interest rate, will be the first to be paid off if too many borrowers default and their houses are sold at foreclosure auction. The owners of the riskiest tranche, in contrast, will be the last to be paid, and thus have the biggest risk if too many houses are auctioned for less than the value of their loans. In return for this risk, their bonds offer the highest yield.
It was this ability to chop packages of mortgages into different risk tranches that really enabled the mortgage industry to rush headlong into all those new products and new markets -- in particular, the subprime market for borrowers with sketchy credit histories. Selling the safe tranches was easy, while the riskiest tranches appealed to the booming hedge-fund industry and other investors like pension funds desperate for anything offering a higher yield. So eager were global investors for these securities that when the housing market began to slow, they practically invited the mortgage bankers to keep generating new loans even if it meant they were riskier. The mortgage bankers were only too happy to oblige.
By the spring of 2005, the deterioration of lending standards was pretty clear. They were the subject of numerous eye-popping articles in The Post by my colleague Kirstin Downey. Regulators began to warn publicly of the problem, among them Fed Chairman Alan Greenspan. Several members of Congress called for a clampdown. Mortgage insurers and numerous independent analysts warned of a gathering crisis.
But it wasn't until December 2005 that the four bank regulatory agencies were able to hash out their differences and offer for public comment some "guidance" for what they politely called "nontraditional mortgages." Months ensued as the mortgage bankers fought the proposed rules with all the usual bogus arguments, accusing the agencies of "regulatory overreach," "stifling innovation" and substituting the judgment of bureaucrats for the collective wisdom of thousands of experienced lenders and millions of sophisticated investors. And they warned that any tightening of standards would trigger a credit crunch and burst the housing bubble that their loosey-goosey lending had helped spawn.
The industry campaign didn't sway the regulators, but it did delay final implementation of the guidance until September 2006, both by federal and many state regulators. And even now, with the market for subprime mortgages collapsing around them, the mortgage bankers and their highly paid enablers on Wall Street continue to deny there is a serious problem, or that they have any responsibility for it. In substance and tone, they sound almost exactly like the accounting firms and investment banks back when Enron and WorldCom were crashing around them.
What we have here is a failure of common sense. With occasional exceptions, bankers shouldn't make -- or be allowed to make -- mortgage loans that require no money down and no documentation of income to people who won't be able to afford the monthly payments if interest rates rise, house prices fall or the roof springs a leak. It's not a whole lot more complicated than that.
For those of you not familiar with ABX, TABX, CDOs, MBS, RMBS, CMBX, Alt-A, sub-prime, near-prime and the other arcane alphabet soup of credit derivatives and mortgage jargon, Pearlstein's column say it all in plain English.
My favorite of his terms was the NINJA loans or "No Income, No Job and No Assets" loans. In other terms, suppose I - Nouriel Roubini - am a homeless bum with no income, no job, no assets and living on the streets of Manhattan. Then I could go to a mortgage lender in my street-bum fashion clothes, declare that I had income of $10 million a year and the wealth of a billionaire. Then the hapless mortgage lender would say: "Of course Sir; for sure. Here is your pre-approved NINJA mortgage to buy a McMansion built by Mr. Toll". A bit of an extreme caricature of what has been happening in the mortgage market but not too far from reality.
Even leaving aside the Super-NINJA subprime mortgages, the supposedly less-risky and "near-prime" Alt-A loans - that accounted for about 14% of originations in the last two years - were essentially NINJA loans.
And the this garbage lending - no downpayment, NINJA documentation, interest rate only, teaser rates, negative amortization, option ARMs - added up to about 50% of originations in 2005 and 2006. So garbage in, garbage out. So much for those who claim this is "only a small subprime niche problem"...Who are they trying to kid or induce to get intoxicated with "Kool-Aid"?
MORE
rgemonitor.com
Posted by WADE here ...
Message 23379133 |
