Who is to Blame for the Mortgage Carnage and Coming Financial
rgemonitor.com
Disaster? Unregulated Free Market Fundamentalism Zealotry
Nouriel Roubini | Mar 19, 2007 The sub-prime and overall mortgage carnage is now likely to lead to a financial crisis whose cleanup and bailout costs will make the S&L bailout bill look like spare change. We are only at the beginning of this fallout but, already, several proposals and bills in Congress have been submitted to help millions of sub-prime homeowners on the verge of bankruptcy and foreclosure. The prospect of millions of homeowners thrown homeless on the street is already shaking politicians of every stripe. The relatively modest bailout envisaged by the first bills currently proposed in Congress will mushroom into a much bigger fiscal bailout of homeowners, borrowers and lenders once the garbage of sub-prime, near-prime and pseudo-prime toxic waste spreads around the economy and likely leads to a hard landing recession that will cause a much bigger financial and banking crisis.
Given the fallout and real, social and financial costs of this disaster the political blame game will soon start. So it is important to make sure that the self-serving spin game that accompanied the game of those who happily ignored since last summer the looming housing, mortgage and economic mess will not be repeated again. Powerful political and financial interests will spin their self-serving ideological spin on who is to blame for this mess. Specifically be ready for a cabal of supply side voodoo ideologues - from the Wall Street Journal editorial page (and its invited op-ed writers) to hacks (calling them economists would be an insult to my profession) such as Arthur Laffer, Steve Hanke and other assorted voodoo religion priests - to start spinning a tale blaming government regulation and interference for this disaster that has instead its core in the lack of sensible government regulation, not the existence of such regulation. In the meanwhile powerful financial interests that repeat the mantra – or better the proof-less dogma - of unregulated free markets and do not like any – even sensible – supervision and regulation of the financial system will happily blame government action – rather than their own reckless greed and stupidity - for this disaster while happily demanding and receiving billions in bailout funds from the same government that they so happily disdain. This will be the most appalling form of corporate welfare: privatize the profits in good times and socialize the losses in bad times.
This fairy tale spinned by free market supply side voodoo fundamentalism zealots will blame the otherwise appropriate current Congressional action on predatory lending for being one of the main causes of the credit crunch that will lead to a painful recession (as the WSJ editorial page recently claimed) while forgetting that predatory lending practices developed by free unregulated markets created the toxic waste that is subprime and near-prime mortgages.. This voodoo religion cabal will also incorrectly blame regulators – whose true blame was being asleep at the wheel for six years while being drugged by a philosophy of “laissez-faire” non-interference with free markets while this free market garbage was being originated – for now finally starting to crack down on monstrous “free market” practices such as zero downpayments on mortgages or NINJA (No Income, No Jobs and Assets) loans; this cabal will thus now blame regulators for “destroying” the sub-prime and near-prime mortgage market with their intervention into “self-regulating free markets”. The same voodoo economics religion priests has and will incorrectly blame the “easy” Fed monetary policy – rather than the lack of any sensible regulation of credit and mortgage market lending – for creating the housing bubble and letting it fester for too long. It will also incorrectly blame the GSEs for creating “moral hazard” via guarantees of mortgages and thus causing this mess when, instead, the GSEs largely got out of the subprime business in the last few years - and let the free market flourish to originate this toxic waste – when politicians and policy makers started to bash the GSEs for their “excessive” role in the mortgage market.
Since a lot of nonsense and financially self-interested ideological spin will be written and said in the months and years to come it is important – from the beginning – to be clear about who is at fault for this utter housing and financial disaster. The answer is clear: the blame lies with free market zealot and fanatics and voodoo economics ideologues who captured US economic policy in the last six years in the same way in which a bunch of neo-cons high-jacked US foreign policy to bring “democracy” to the Middle East while instead leading the country into the Iraq and Mid-East quagmire and now disaster.
According to these ideologues – listen for example Larry Kudlow extolling every evening on CNBC the virtue of unregulated wild-west cowboy capitalism - government is always utter evil and the economy could never have a financial or economic crisis if taxes are low, government spending is minimal and government intervention and regulation of the economy and of financial systems is inexistent. This nonsense about bubbles, financial crises and recessions being impossible unless the government over-regulates the economy and/or makes monetary policy mistakes is the main religious dogma of this cabal, an axis of ideological zealotry that goes from the WSJ editorial page to a gang of voodoo economic hacks and to some segments of the financial television.
The truth is the contrary: unregulated free market capitalism that has no sensible rules, regulation and supervision and sensible countercyclical monetary and fiscal policies of financial markets leads to credit and asset bubbles, financial excesses and economic and financial crashes. Economic and financial booms and busts were much more severe in the US in the 19th when there was no central bank and no welfare state fiscal actor trying to fine tune the economic business cycle. And business cycle swings have become less frequent since Keynesian countercyclical use of monetary and fiscal policy has been introduced from the Great Depression on.
The reality of the last three US recessions – the 1990 recession, the 2001 recession and the coming 2007 hard landing – is that each of these recessions started when the government stopped regulating and supervising in moderate and sensible ways financial institutions and allowed credit and financial and investment bubbles to rise and fester until they ended up in bursting bubbles and leading to recessions.
Take the latest subprime and mortgage disaster: the WSJ editorial page will certainly in due time blame the coming recession (that it now happens to predict as likely) on Congress meddling with markets on predatory lending, on excessive regulation of what financial institutions do and on the moral hazard evils of expected bailouts of mortgage lenders and borrowers. But this argument is confusing totally cause and effect. The housing and mortgage and subprime bubble and bust did not occur because of government interference and regulation of free markets. It did instead occur because government regulators were asleep at the wheel while a bunch of voodoo priests of laissez-faire capitalism were running US economic policy and let the housing and mortgage bubble fester. Blaming the now too late government crackdown on free market mortgage practices that were utterly reckless for the final bust and crash is like blaming the doctor for imposing bitter medicine to cure the disease of a reckless patient who lived in a bubble and spent the last few years on a diet of booze, drugs and artery clogging junk food. This latest mortgage carnage did not happen because of excessive over-regulation of markets by the government: it happened instead because – blinded by the anti-regulation dogmas of a bunch of priests of a voodoo religion – the government and regulators did nothing to sensibly regulate the housing and mortgage market and thus allowed this cancer to grow and fester.
Booms and busts are regular features of market economies that do not have sensible government supervision and regulation of financial and credit markets. The S&L crisis that led to the credit crunch that caused the 1990 recession started when previously regulated S&Ls were deregulated and there was no sensible supervision of their activities while deposit insurance led them to “gambling for redemption” reckless lending. And blaming “evil” government-provided deposit insurance for their moral hazard gambles is again confusing cause and effect: financial institution that do strictly need deposit insurance to avoid free-market capitalism liquidity and bank runs during panic episodes do require sensible government-imposed and monitored capital adequacy ratios as well as supervision and regulation of their lending activities to avoid moral hazard-induced distortions in their lending behavior. It is not government-generated moral hazard via insurance that lead to reckless gambling for redemption: it is the lack of sensible government-based regulation and supervision that leads to credit and asset bubbles.
In the 1980s this deregulation of S&L then led to a real estate bubble – both in commercial and residential real estate in the South of the US – that ended up in a bust once a glut of shopping strips, shopping malls, office centers, and residential homes piled up as a result of unregulated credit creation by the S&L. Then, the ensuing credit crunch – rather than the necessary but late government intervention to control this free market made disaster – led to a painful recession in 1990-1991, a systemic banking crisis and a bailout of these S&Ls that ended up costing the US Treasury – or better the US taxpayer – about $200 billion. Unregulated wild-west capitalism without rules and regulations was the cause of the S&L boom and bust, not the eventual government intervention to deal with this mess as the priests of the free markets voodoo religion would want you to believe.
Similarly, the last six years’ housing and subprime mortgage bubble and bust had little to do with excessive government intervention – either ex-ante or ex-post. Instead they had all to do with the lack of any basic sensible government regulation of the mortgage market, regulation in practice rather than in theory. Dozens of new subprime lenders emerged and were allowed to lend via monstrous credit practices – liar or NINJA loans, no down-payment loans, interest rate only loans, negative amortization loans, teaser rates, option ARMs with no limits or controls - that should have never been allowed in the first place. Even now that regulators are starting to crack down on the most patent monstrosities such as zero down-payment and no documentation of income, jobs and assets the voodoo priests and their acolytes in the mortgage industry are starting to blame the government for interfering with free market practices: in their ideological view there were optimal reasons for all of such practices: in market fundamentalism if such practices emerged there was a good reason for them and now the government interfering with these monstrosities will cause a credit crunch that will damage the mortgage market and cause a nasty credit crunch that will lead to an economy-wide recession. What a bunch of nonsense and self-interested baloney!
These practices instead emerged because the voodoo free market system of financial incentives for lenders – deceive borrowers with predatory practices, originate reckless mortgages to pile up fees, then securitize those mortgages and shove them on some other investors who had no clue of which toxic waste they were buying – became a whole con scheme. The way a senior and unnamed market participant put it in a bit exaggerated terms this was “an unregulated scam where a bunch of con artists fooled a bunch of clueless deadbeat borrowers”.
So do not blame excessive government regulation; it was the lack of any basic regulation that created the bubble. Do not blame Congress for being the cause of the coming credit crunch because of it totally appropriate predatory lending investigations and soon legislation. If such legislation will lead – as some recent analyses have suggested to the disappearance of one third of the subprime mortgage market, so be it as part of these subprime loans were deceptive, predatory and should have never been made in the first place. Lenders were systematically deceiving poor and uninformed borrowers, many of which minorities who had no clue of what they were getting into. Suppose you were a poor African American or Hispanic or a white poor with low income and no assets who wanted to pursue the American Dream of home ownership and you did not qualify for a regular mortgage because of your low income. No problem – told you the mortgage broker – we will give you a NINJA (no income, no job and assets) or liar loan, i.e. a loan with no documentation of your income and assets. You did not afford any down-payment because of little assets? No problem as we will let you to put zero down-payment so that you start with zero equity in your home. You could not afford principal payments? No problem as we will give you an interest only loan. You could not afford a fixed rate mortgage? We will give you a 2-28 ARM where the rate is fixed at low level for two years and then you move to much higher market rates. You did afford even that? We will give you a teaser rate for a little while. You could not afford even that? We will let you capitalize interest on a higher face value of the mortgage for a while so that you will have negative amortization and you pile up negative equity on your home from the very beginning. And the poor, hapless and clueless borrowers said yes to all of this as the lender never told him that after two years its debt servicing rate would balloon by 500% once he/she had to start paying high market rates and principal on an ever increasing –not decreasing – stock of mortgage debt. So do not blame Congress for necessary legislation on predatory lending for causing the current credit crunch; it was the lack of such legislation in the first place that allowed millions of mortgages that should have not been originated in the first place to mushroom without control.
Also, did the originators care or had any interest or incentive to warn the borrower that he/she could not afford such predatory and deceptive mortgages? No way as the originator would get very fat originations fees/commissions. then package this toxic waste into mortgage backed securities, get a nice rating on that garbage from oligopolistic credit rating agencies whose income derived from giving a high rating to this junk – under the pretense that tens of thousands of piles of toxic waste would turn by miracle into gourmet food – and then sell this securitized toxic junk as if it was fresh roses to even more clueless “savvy” investors desperately searching for yield and being dumbly ignorant of the risks that they were taking. These investors were not innocent victims; they were blinded by their own search-for-yield greed and did not bother to figure out non-transparent and totally opaque new financial instruments may be toxic waste.
Then this entire housing and mortgage and securitization bubble fed an entire industry of originators, brokers, banks, broker dealers who created and securitized this junk and created CDOs, synthetic CDOs, CDOs of CDOs (CDO squared) , CDOs of CDOs of CDOs (CDOs cubed) and another totally not-transparent fog of credit derivatives – that were being priced based on intuition rather than true analysis of risk. These credit derivatives went, in less than a decade, from non-existent to a notional value of over $26 trillion. In the meanwhile this industry sold this garbage and provided financing for these investments as well as a variety of other prime broker services to a rising mountain of thousands of hedge funds. The fortunes of some of these broker dealers were partly fed for a decade from lending to home builders, to subprime originators or originating the mortgages themselves, securitizing the mortgages into RMBS, creating and managing the CDOs (and all their endless synthetic and cubed variants of them), offering aggressive prime brokerage services to the hedge funds buying this toxic waste, as well as trading on their own accounts the variety of these new instruments. No wonder these broker dealers and large financial institutions stocks are now under pressure while their arguments that they are only marginally directly exposed to subprime sound so lame: they are directly and indirectly exposed to this toxic waste via a dozen of different channels.
Also, please do not blame the GSEs (Fannie and Freddie) for this mess even if the GSE do have very different problems that need to be addressed. The GSEs were bashed for years by Greenspan, Treasury, Bernanke and a wide variety of observers for their excessive size and role in the mortgage market (securitization and guarantees of mortgages), for how they were managing their risks and for the potential moral hazard deriving from an alleged implicit bailout guarantee that allowed them to borrow at quasi-sovereign rates. Indeed some of these critiques of the GSEs do have some merit.
But the paradoxical effect of the backlash against the GSEs has been that in the last few years these institutions have significantly reduced their role in securitizing and guaranteeing mortgages. Specifically Fannie and Fannie significantly reduced their presence in the MBS market, especially among subprime mortgages and the MBS related to them. Reacting to the persistent arguments from many fronts that the two GSEs should reduce their role in the MBS market, in the last few years the job of originating and securitizing subprime mortgages and many near-prime mortgages was mostly taken over by private sectors institutions. As the GSEs got out of this business, subprime lenders and other major financial institutions originated sub-prime and near-prime mortgages, repackaged them and securitized into MBS then sold to investors and to CDOs. So, the growth of subprime and near-prime toxic waste had little or nothing to do with the role of the GSE in the mortgage market. Fannie and Freddie may have many faults but this subprime disaster is certainly not one of them. So beware of misleading attempts to blame the GSEs and moral hazard distortions from their perceived semi-public status in contributing to this subprime and mortgage disaster.
The paradox is instead the fact that pulling the GSEs from any role in the subprime market allowed the “free market” to develop the excesses and monstrosities that the rise of subprime and near-prime mortgages generated in the last six years. It was the absence of the GSEs from this market, not their presence that contributed to this mess; and it was the presence of an unregulated free market system that allowed this monstrous bubble to be created, to be allowed to fester and to now burst with the nasty collateral damage that is coming with it.
Given the total lack of a role of the GSEs in this subprime and near-prime disaster it is really paradoxical that Bernanke, in his speech last week about the GSEs, pushed for reducing further their financial portfolios and recommended that the main role that they should have from now on should be the one of help support “affordable housing”, i.e. originating or underwriting and securitizing subprime mortgages. After years of ideological battles against them and after they moved out of the subprime market, and after the unregulated free market was allowed to develop the subprime market and create the toxic disaster whose collateral damage will now be paid by the US taxpayer Bernanke is now telling us that the subprime mortgage business (“affordable housing”) should not be managed by the private sector but should instead be fully given to the GSEs. He formally fudged the proposal by saying that greater role of GSEs in affordable housing finance does not mean a greater role in the subprime market. But he contradicted himself: having GSEs having a center role in affordable housing means a central role in securitizing subprime mortgages. This is the same ideology that led to the subprime disaster in the first place: privatize the profits of greed and unregulated gambling for redemption; and socialize the costs and losses when disaster from free market fundamentalism occurs. This is outright corporate welfare chutzpah.
Also, it is now clear that making subprime loans is clearly not an economically rational business for the private sector given the current subprime disaster. However whether Fannie and Freddie should do it instead or not is not obvious. If there is a role for the government in this markt then one may want to tax those who can afford to finance the subsidies for affordable housing. So Bernanke wants to reduce the GSE's interference with free markets by giving them and the public sector a greater role in affordable housing. But if the GSE have to do - and be perceived as doing - business as private sector firms that do not benefit from moral hazard related government how can they subsidize affordable housing and make a profit? If they get a role in affordable housing effectively Bernanke is telling us that they are public institutions, not private ones. So implicitly Bernanke is undermining all his attempts and those of others to make the GSEs truly private institutions that are not perceived as being protected by a Treasury bailout guarantee.
The same free market fundamentalist zealots – at the WSJ editorial page, among voodoo economics hacks and among the policy makers that mis-managed US economic policy for the last few years – who bashed the GSEs were also pushing the other mantra of the benefits for growth of low taxation of capital. But take housing. The taxation of investment in housing – an effectively unproductive form of capital - not only is not heavy; it is rather tax-preferred relative to other productive forms of capital. The zealots who want low taxation of capital got it all in the tax-favorite status of housing investment by households. The result has been another monstrosity: a decade of massive overinvestment by the US in one of the most unproductive forms of capital, housing. This overinvestment fed by low taxation of housing investment has led to large current account deficits - via the increase in housing investment and the fall in private savings that the housing wealth effect had on consumption - and to the accumulation of trillions of foreign liabilities. So instead on increasing its stock of productive physical capital the US has spent a decade piling up trillions of dollars of investment in unproductive housing capital that has no effects on the rate of productivity of the economy. The rest of the world spent the last decade investing in factories that produce world class, high-quality and low costs goods; the US invested in McMansions that have zero productivity value and spillovers for the economy. Again thank the free market fundamentalist zealots who love no regulation and little taxation of capital for this sorry state.
The same free market zealots have now started to blame the Fed for causing the housing bubble. In their view the Fed, by aggressively easing rates after 2001 and keeping the Fed Funds rates too low for too long, created the housing bubble that is now bursting. So they blame the Fed for a disaster that had its source in the private sector behavior and actions. The same free marketers argue that the Fed created the tech bubble that burst in 2000 and led to the 2001 recession.
But while easy Fed policy had some role in the three private sector bubbles of the last two decades that ended up in a recession bust - late 1980s real estate bubble that led to S&L bust and 1990s recession, the late 1990s tech bubble that led to the 2000 tech bust and the 2001 recession, the 2000s housing bubble that led to the housing bust of 2006 and the coming recession of 2007 – the center of the problem in each one of these three booms and busts was not – as voodoo religion hacks and zealots spin it now - excessively easy monetary policy by the Fed but rather proper regulation of financial and credit markets.
The center cause of these disasters was the lack of appropriate regulation of free markets. First, in the 1980s S&L were deregulated and wild-west capitalism became the norm of the credit policies of the S&Ls in the South and South-West of the US: then, a bunch of greedy cowboys and at time criminal con artists high-jacked the credit policies of the S&Ls and triggered a private sector real estate boom that, like today, created a massive amount of toxic waste in real estate. This toxic garbage then exploded in the late 1980s in a nasty bust that triggered a credit crunch that was the main cause of the 1990-91 recession.
Second, in the 1990s, the attempt to avoid the liquidity run and crunch caused by another unregulated private sector-related reckless leverage – the near collapse of LTCM and its collateral damage – induced the Fed to ease the Fed Funds rate by 75bps in the fall of 1998 and let the tech sector “irrational exuberance” - that Greenspan had already identified in 1996 - to fester even longer. But higher Fed Funds rates would have not stopped this private sector crazed mania. What was necessary then was again better regulation of the financial system: much tighter margin requirements on leveraged stock market investments; control of leverage in the financial system and among highly leveraged institutions such as hedge funds. Failure to implement sensible regulation – such as margin requirements on leveraged tech investments - allowed the tech bubble to fester, then go bust in 2000-2001 and cause a painful recession in 2001 .
Third, this time around it is not true – like the WSJ editorial page has repeatedly and wrongly argued – that the housing bubble was mostly caused by a Fed that kept the Fed Funds rate too low for too long. Higher interest rates sooner would have made only little difference, especially in a world where long rates and mortgage rates depended more on global factors - that kept such rates low - rather than on monetary policy. The central Fed failure was not that of keeping the Fed Funds rate too low for too long (that was only a modest misdemeanor) but rather its failure (as well as that of other banking regulators) to control the credit bubble in the housing market via appropriate supervision and regulation of mortgage finance and via prevention of monster lending practices.
Greenspan allowed the tech bubble to fester by first warning about irrational exuberance and then doing nothing about via either monetary policy or, better, proper regulation of the financial system while at the same time becoming the “cheerleader of the new economy”. And Greenspan/Bernanke allowed the housing bubble to develop in three ways of increasing importance: first, easy Fed Funds policy (but this was a minor role); second, being asleep at the wheel (together with all the banking regulators) in regulating housing lending; third, by becoming the cheerleaders of the monstrosities that were going under the name of “financial innovations” of housing finance. Specifically, Greenspan explicitly supported in public speeches the development and growth of the risky option ARMs and other exotic mortgage innovations that allowed the subprime and near-prime toxic waste to mushroom.
In a world where the leading ideology was to reduce regulation to a minimum, not only closing one’s eyes on monster lending practices but rather actively praising them as brilliant financial innovations, bashing GSEs in the name of letting the superior private sector to take a bigger role in monster housing finance, it is not a surprise that the biggest bubble in U.S. history was created, incentivated and allowed to fester until it imploded. Free market fundamentalist zealotry that did not understand that market capitalism needs some basic and sensible rules, regulation and supervision to control excesses, bubbles, greed and investors’ manias and panics.
The political neo-con freedom and liberty fundamentalists deluded themselves that free elections and military invasions will automatically lead to democracy in the Middle East. Instead, their free elections and freedom-agenda ended up getting Hamas, Hizbollah and Shite fanatics to come to power in Gaza, Lebanon and Iraq and while destabilizing Iraq and soon a good chunk of Middle-East. In the same way the free market fundamentalism zealots deluded themselves that unregulated free markets and low taxes could never do anything wrong or harm. Too bad that unregulated free markets that systematically lead – as two hundred years of US economic history show - to bubbles that end up in busts and nasty recessions have been the source of the last two US recessions. The implementation of this ideology is also the source of the latest housing boom and bust that is already leading to a severe credit crunch in the mortgage market and that will lead to an economy-wide recession in 2007 that will be deeper and more painful than those in 1990 and 2001.
So it was a vast range of dogmas and free market fundamentalism pushed by a bunch of ideological zealots - that were handmaiden to financial interests that enjoy private profits in good times and corporate welfare paid by the US taxpayer when their free market greed and excesses lead to nasty financial busts - that created this disaster. It was not an evil, large and over-regulating government that created this disaster. It was instead an ideology and practice of unregulated free markets that fed this mess.
Now that the mess has occurred and the financial costs of widespread bankruptcies among borrowers and lenders will be severe the issue will be the one of how to clean up this mess by helping the true victims while not bailing out the true culprits.
The main challenge will be to help the victims of this disaster – those households that were duped into predatory mortgages and who are now unable to service their resetting ARMs – without bailing out the private “free market” institutions that created this mess in the first place. Market capitalism works if equity holders first and bondholders second take the losses of their own investment mistakes. So wide-scale public bail-out of financial institutions should be strictly avoided and minimized. The trouble is that when deposit-taking institutions fail because their net worth is negative (as a consequence of bad lending) deposit insurance limits the losses that can be inflicted on these effectively senior creditors of these banks. Thus first losses should be taken by shareholders and other unsecured bondholders and creditors of the banks. In the case of the subprime lenders until now the failures have been concentrated among institutions that relied on capital markets for funding, rather than on insured bank deposits. Thus losses can and should be allocated to owners and bondholders of these institutions with no use of public money to bailout anyone. However, we cannot exclude that in due time some commercial banks and other deposit-taking institutions will get into trouble and public money may be needed to clean up the balance sheets of such institutions.
Public funds to help borrowers should be used with care for several reasons. First, some forms of borrowers’ financial support end up bailing out also the culprits of this mess; thus, these specific forms of support of homeowners under financial distress should be avoided. For example, direct subsidies to households who cannot afford their now-reset and excessively high mortgage payments end up helping the victims as well as the culprits. Thus, this kind of support should be avoided.
Second, across the board support of all sub-prime borrowers would be inappropriate: while many borrowers were duped into predatory mortgages by lenders who did not explain to them what were the true terms of these loans, a minority of borrowers recklessly borrowed well knowing they could not afford the terms of the mortgage. They borrowed either gambling into capital gains that never occurred (speculative investment in homes) or planning strategic early default on their mortgage. The latter phenomenon is represented by the epidemic of early payments defaults that we have seem among some subprime mortgages: given the time that it takes to foreclose a home some borrowers intentionally took mortgages that they were not planning to service at all to enjoy the benefits of a few months of free rent of a home. However, these few deadbeat borrowers were able to dupe lenders because underwriting standards of originators were recklessly loose to begin with: anyone lying about their income, job and asset could get a mortgage.
The analysis above suggests some principles for the coming financial support that will be given with public funds to clean up the unfolding mortgage disaster. First, distinguish between true victims of predatory lending and deadbeat borrowers who were into early strategic default. Early payments default is a clear way to distinguish between inability to pay and unwillingness to pay. Also, means testing for financial support is crucial: low income and low asset households who were pursuing the American Dream and were deceived by lenders may deserve support. But subprime borrowers with higher incomes and/or assets do not deserve support and should be pushed into foreclosure if they are unable or unwilling to service their mortgages. Also, condo-flippers and other individuals who bought homes for speculative purposes such as speculating on price increases (i.e. folks who were not first time homeowners who lived in their homes) would get no financial relief at all and will be forced to foreclose if they are unable or unwilling to service their mortgage. Second, financial support to households who were victims of predatory lending (and owners of overvalued homes whose value was incorrectly assessed as much higher than equilibrium) should take the form of reduced debt servicing (as in some recent proposals) rather than subsidies to borrowers; this to prevent the support of the borrowing victims from indirectly bailing out the culprits of reckless or predatory lending.
For example, suppose that the value of a home (with zero down-payment) has fallen 10% (following the current housing bust) and that the borrower cannot now pay the full value of the mortgage debt servicing payments that are now being reset at much higher interest rates. Then, if the borrower can afford a lower string of service payments that, in NPV terms, is 10% lower than the initial terms of the mortgage (and equal to the true value of the home), the solution will be to allow a reduction of 10% (in NPV terms) of the debt-servicing payments for the borrower. Instead, a public subsidy to the borrower in the same amount would have the same effect on the borrower while bailing out a reckless or predatory lender.
Suppose instead that the home value has fallen 10% but the household cannot afford even a 10% NPV reduction of the stream of debt payments associated with the initial mortgage (say at zero initial down-payment). Then, the household – duped or not – was buying a home with a bundle of housing services that was too large relative to its ability to afford it even after the value of the mortgage has been adjusted to the lower market value of the home. In this case if it takes more than a 10% reduction in the NPV of the debt payments to allow the household to be able (or equivalently willing) to afford the home. Thus, it make sense to foreclose the home and not provide financial support to the household: duped or not the household had bought a home whose real housing services were too large relative to even its ability to afford it at a reduced market value. Thus, financial support of the household is not warranted and foreclosure is a socially efficient solution. The bank should take the loss of a mortgage with a home value lower than the mortgage. And such household should rent a lower amount of housing services by renting a smaller home/apartment rather than own a home with a bundle of housing services that it cannot afford.
Finally, if deposit-taking institutions whose depositors benefit of deposit insurance go bankrupt (have negative net worth) because of housing related losses, equity holders should be wiped out first and unsecured bondholders should suffer next before any public funds are used to recapitalize and fiscalize the losses of the bank. This simple principle would minimize the fiscal costs of cleaning up distressed banks while minimizing the moral hazard distortions of deposit insurance.
In summary, lack of sensible supervision and regulation of banks, mortgage lenders and other financial institution – partly induced by an ideology of free market fundamentalism – has been the core cause of this private sector created disaster, not excesses of regulation or of government policy. Thus, to minimize the fiscal costs of cleaning up this mess, use of public funds should be carefully managed and targeted to help the true victims of this mess – borrowers duped by predatory lending practices – while avoiding any bail-out of the culprits of this mess. Privatizing profits in good times while socializing losses in bad times is another form of reckless corporate welfare that generates moral hazard while fostering new bubbles. Ideological supply side voodoo zealots should not be allowed to spin a tale where evil government intervention caused this disaster. And the private sector institutions and investors that indulged in this unregulated reckless behavior should take their losses. Market economies are the best economic system but they work properly when private greed, manias, panics, stupidity and recklessness is tempered by sensible supervision and regulation. And may the unfolding mortgage disaster bury once and for all the neo-con supply side voodoo economics religion of unregulated free markets fundamentalism.
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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.
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Steve Pearlstein of WaPo on Liar Loans, Teaser Loans, Stretch Loans, NINJA Loans and Other Mortgage Monstrosities
Nouriel Roubini | Mar 14, 2007 Sometimes it takes a brilliant writer to express in concise and simple ways - that the common "human" can understand - what a few of us express in a much more technical language. This week I spoke at some length with Steve Pearlstein (the business columnist of the Washington Post) and discussed, among other issues, the intricacies of how a disruption of the CDO market would lead to a seizure of the RMBS market and a systemic - not just subprime - credit crunch. And today Pearlstein has instead this clear and brilliant column that says:
'No Money Down' Falls Flat
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"?
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Mainstream Monday Morning Quarterbacking on Subprime Mortgages..While Still Being Blind to the Spillovers and the Coming Credit Crunch
Nouriel Roubini | Mar 13, 2007 The subprime disaster is now in full swing with the second largest subprime lender (New Century Financial) effectively bankrupt and another one comatose today. Now that 30 plus more subprime lenders have gone out of business since December, even mainstream analysts are finally recognizing the subprime "carnage" and "meltdown" (to use words of the thoughtful, soft-landing mainstream and usually not-hyperbolic Richard Berner of Morgan Stanley).
However, the mainstream consensus is still arguing - with little evidence - that "this is only a subprime problem" , that "there is no risk of a credit crunch" and that this problem "will have no macro effects". I disagree on this optimistic outlook as my last blog discussed in detail.
A minority of scholars and analysts - including Robert Shiller, David Rosenberg, the blogger Calculated Risk and a few others - already warned last summer about a severe housing recession (not the conventional consensus about a "housing correction"), about the risks and consequences of falling home prices (not the consensus about a "slower growth of rising home prices"), and about the risks of a fallout of this severe housing recession on mortgages, first subprime ones and then more broadly to the rest of the mortgage market.
I was not the first one to worry about housing and mortgages as a few others distinguished observers had already observed the incoming housing recession and its fallout. On my modest side last August, when I started to forecast a recession in the US in 2007 by Q2 that would be triggered by the housing bust, I also argued that this housing bust would soon also lead to serious risks and distress in the financial system. I pointed out that such stress and vulnerabilities would first be noticed in the subprime segment of the mortgage market as many (but not all of) of the excesses of the last few years in mortgage finance were concentrated in this market. I pointed out that the housing bubble and the credit bubble associated with it reckless lending practices and with regulator being asleep at the wheel while this unregulated gambling was taking place. I argued that the result would be financial distress and bankruptcy for many lenders and a systemic banking crisis similar to - or most likely worse than - the S&L crisis. As I put it last August:
“…not only we have had in the last few years a massive credit boom associated with the debt financing of the housing bubble; this lending boom has also been associated with an extreme loosening of credit standards that allowed the boom to continue and feed an ever more unsustainable housing bubble. Indeed, many mortgage lenders have gambled for redemption during the bubble years and engaged in extremely risky and reckless lending practices that may eventually lead to financial distress, or even their outright bankruptcy; we may be soon facing the same mess and systemic banking crisis that we had in the 1980s with the S&L crisis.
The lending practices of mortgage lenders became increasingly reckless in the last few years: indeed, in 2005 a good third of all new mortgages and home equity loans became interest rate only; over 40% of all first-time home buyer were putting no money down; at least 15% of buyers had negative equity; and an increasing fraction of mortgage came with negative amortization (i.e. debt service payments were not covering interest charges, so the shortfall was added to principal in a Ponzi game of accumulating debt). Finally, at least 10% of all home owners with mortgages currently have zero equity. This reckless lending scam was fed by ever loosening lending standards, the massive growth of sub-prime lending and over-inflated valuations of homes to justify new mortgages and refinancings (when significant equity extraction was occurring). It was a vast and growing lending scam where lenders’ behavior was distorted by serious moral hazard incentives driven by poorly priced deposit insurance, lax supervision of lending practices by regulatory and supervisory authorities, slipping capital adequacy ratios, too-big-to-fail distortions and the distortions created by the financing activities of the too-big-to-fail government sponsored enterprises (Fannie Mae and Freddie Mac). …
…the scariest thing is that the gambling-for-redemption behavior…are not the exception in the mortgage industry; they are instead the norm. There are good reasons to believe that this is indeed the norm as lending practices have become increasingly reckless in the go-go years of the housing bubble and credit boom. If this kind of behavior is – as likely – the norm, the coming housing bust may lead to a more severe financial and banking crisis than the S&L crisis of the 1980s. The recent increased financial problems of H&R Block and other sub-prime lending institutions may thus be the proverbial canary in the mine – or tip of the iceberg - and signal the more severe financial distress that many housing lenders will face when the current housing slump turns into a broader and uglier housing bust that will be associated with a broader economic recession. You can then have millions of households with falling wealth, reduced real incomes and lost jobs being unable to service their mortgages and defaulting on them; mortgage delinquencies and foreclosures sharply rising; the beginning of a credit crunch as lending standards are suddenly and sharply tightened with the increased probability of defaults; and finally mortgage lending institutions - with increased losses and saddled with foreclosed properties whose value is falling and that are worth much less than the initial mortgages – that increasingly experience financial distress and risk going bust.
One cannot even exclude systemic risk consequences if the housing bust combined with a recession leads to a bust of the mortgage backed securities (MBS) market and triggers severe losses for the two huge GSEs, Fannie Mae and Freddie Mac. Then, the ugly scenario that Greenspan worried about may come true: the implicit moral hazard coming from the activities of GSEs - that are formally private but that act as if they were large too-big-to-fail public institutions given the market perception that the US Treasury would bail them out in case of a systemic housing and financial distress – becomes explicit. Then, the implicit liabilities from implicit GSEs bailout-expectations lead to a financial and fiscal crisis. If this systemic risk scenario were to occur, the $200 billion fiscal cost to the US tax-payer of bailing-out and cleaning-up the S&Ls may look like spare change compared to the trillions of dollars of implicit liabilities that a more severe home lending industry financial crisis and a GSEs crisis would lead to.”
It took less than four months after these warnings for the financial distress among subprime mortgage lenders to fully come to the surface leading to severe distress in this industry – both among the borrowers and the lenders – and creating serious stress in the ABX, RMBS and CDO markets.
By mid-December the subprime meltdown and carnage was clear, the ABX indices started to plunge and the first signs of disruption of the CDO and RMBS markets started to appear.
Then many more started to follow this unfolding disaster, including myself as I analyzed in this blog this developing carnage and its financial fallout almost daily throughout the fall and the winter.
This rising mess - from a housing recession to the severe financial fallout of it - started to be seriously considered by conventional consensus in late January when it became front page in some financial press and when even mainstream soft-landing analysts started to talk about the subprime "disaster", "meltdown" and "carnage".
Now that the subprime carnage is so evident that even a visually-challenged person would notice it, the new conventional wisdom is that this is only a sumprime problem, that the credit crunch in subprime will not become a generalized credit crunch, that there is no disruption of the CDO and RMBS market, and that this disaster will have no macro effect. As I discussed in detail in my last blog this new conventional wisdom has little basis for its argument. First, this is not just a subprime problem as up to 50% of originations in the last two years are seriously problematic (narrow subprime, Alt-A, other near prime and part of the prime mortgages that had the same reckless features of subprime). Luckily this week a minority of Wall Street analysts (including Ivy Zelman of Credit Swiss) are starting to recognize the extent of the overall coming mortgage distress, not just the "now-obvious-to-the-blind" subprime distress; see the details of these excellent analyses below. Second, the severe credit crunch in subprime is now spreading to the other risky mortgages. Third, there are sign of the beginning of a disruption in the CDO market affecting the RMBS markets (see for example the articles in the WSJ and Bloomberg today).
Fourth, all the growth forecasts for the US economy by the consensus analysts were made before the fallout from subprime started. So how come almost none of those forecasts has been revised to incorporate any - even small - effect of the subprime and mortgage fallout on the macro outlook? Even Goldman Sachs - that has been much more pessimistic than the consensus about 2007 growth - says that the subprime credit crunch will reduce new home sales by another 200K relative to the already currently highly depressed level of 933K (that is already down a whopping 32% from its peak). So, 200K less new home sales in 2007 - let alone the fallout to other mortgages and to other housing related sectors of the economy- will have no macro growth effect according to most - but not all - macro forecasters. But what is the analysis of most macro analysts that leads them to argue that all this will have close to zero macro effects? Not even an epsilon reduction in their 2007 growth forecasts, not even a meagre 0.1% change, when their forecasts were made before the subprime fallout even started. Shouldn't they at least reconsider and revise such forecasts? Greenspan says that there is now a 30% probability of a recession; while the Fed model - based on the yield curve - says the recession probability is at least 53%. But the Blue Chip panel forecasted yesterday a growth of 2.5% for H1 and rising to 3% by H2 of 2007.
But now the subprime and mortgage and credit crunch genie is out of the bottle and no amount of self-serving spin will be able to lock it back in the bottle. So kudos to Shiller, Rosenberg, Calculated Risk, Zelman and a few others who braved early on to say that the housing and mortgage emperor had no clothes.
Indeed, both the mainstream press and some serious analysts are now recognizing the full extent of the coming financial train wreck. Lets see now some details of this...
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From the current subprime credit crunch to a generalized credit crunch: the incoming financial train wreck
Nouriel Roubini | Mar 09, 2007 It is now totally clear that there is a severe credit crunch in the subprime segment of the mortgage market. We have now over 30 subprime lenders out of business (the last one being New Century – the second largest subprime lender – that is now on the verge of bankruptcy); many more lenders are losing massively on their subprime operations; lending standard have been sharply tightened by lenders; regulators are starting to crack down after being asleep at the wheel; Congress is making noises about predatory lending; many near prime and prime mortgages had the same “monstrous” features as subprime ones; the current disruption of the CDO market is starting to affect the RMBS market . Thus, we have certainly a serious credit crunch in the subprime market that even mainstream analysts are recognizing. But, as I will argue below, we also have the beginning of a much broader credit crunch among many other mortgages that could have severe macroeconomic effects.
Regarding the credit crunch in the subprime market, let us start with what the Wall Street Journal reported in its lead article today:
"The last couple of weeks have been almost catastrophic," said Armand Cosenza, a mortgage broker in Cleveland. Mr. Cosenza said he turned down eight loan applicants on Wednesday because he couldn't get them a mortgage. At least five of them would have qualified for a loan six months ago, he said.George Hanzimanolis, a mortgage broker in Tannersville, Pa., says his office has turned away 30 to 40 people in the past week because of tighter lending standards. "It's scary how quickly these very large lenders are just...imploding," he says. "The situation will get uglier before it gets better."Many economists say that the subprime crunch won't cause big problems for the U.S. economy. But economists at Goldman Sachs in New York said in a report this week that the tightening of subprime credit could cut annual demand for new homes by 200,000 units, or about a fifth of new-home sales last year."This credit tightening potentially will create another leg down in housing," said Ivy Zelman, a Cleveland-based housing analyst for Credit Suisse Group.[bold added]
Words such as “catastrophic”, “imploding”, “scary” and such coming from market participants cited by the WSJ are worth pondering. One could of course provide more formal data and analytics to prove this serious credit crunch in the subprime segment of the mortgage market: many investment banks – GS, JPM, MS, Citi - are now doing that in their research this week; see also my recent paper with Christian Menegatti and my recent blogs.
But I would argue that the quotations above from the WSJ – as well as Mr. Tomnitz of DR Horton statement this week that housing will “suck” every month of calendar 2007 – should be sufficient to prove the existence of a serious credit crunch to any reasonable person who follows the simpler “smell test” or “duck test” or “obscenity test” (to paraphrase Justice Stewart definition) to prove an argument: “if it walks, quacks, ducks, looks and stinks like a rotten duck it is a rotten duck”. And subprime looks and stinks in every way and shape like a rotten duck.
Since the credit crunch in subprime is now finally not under question any more - as it was two months ago when most mainstream analysts were barely starting to become aware of the subprime “meltdown” or “carnage” - it is worth doing a little more numerical work and figure out how bad things could be if we end up in a generalized credit crunch (rather than a sub-prime credit crunch alone) or in an economy-wide recession, rather than just the current deep housing recession. It is also important to consider the likelihood of a generalized credit crunch. Thus, here are a few crucial question that are worth considering
First, are the growing distress, defaults and foreclosures only a problem among subprime mortgages or will they become soon a big problem among a wider range of mortgages?
Second, will the current subprime credit crunch become a generalized credit crunch that will hit a much large fraction of mortgage lenders and borrowers?
Third, what is the role of a possible disruption in the CDO market in transmitting the subprime carnage and credit crunch to a broader range of mortgage credit risks (see ABX and TABX) and to the overall RMBS market? I.e. could the RMBS market end up in a seizure if the CDO market is disrupted?
The current mainstream “consensus” answers to these questions is as follows. First, the subprime carnage is a niche problem; other mortgages are not problematic in terms of actual or expected distress and default rates. Second, there may be a credit crunch in subprime but there is no evidence of a general credit crunch in most mortgages. Third, there may some losses among CDO investors, sellers of protection in the ABX market and other investors in a variety of housing products; but there is not much evidence of serious problems in mortgages related credit derivatives (excluding subprime) or in corporate credit risks.
But why should be believe the conventional wisdom when – since last summer – the consensus altogether missed the boat on every single developing problem in housing, mortgages and the economy? Note that:
In early December no subprime lender had gone out of business; now over 30 have shut down operations (including today the second largest one) and many more have serious losses and/or are in trouble. A few concerned analysts – including yours truly – started to warn about serious subprime problems last summer when mainstream analysts were simply ignoring and denying the existence of any problem.
In early December the ABX indices – even the BBB- ones – were priced near par value of 100; now they have collapsed and are fluctuating between the low 60s and 70 with massive daily volatility. While some warned about this problem early on, most analysts started to discover the existence of the ABX indices – and to write about it - only when they had plunged into a free fall.
In early December, mainstream analysts were barely talking about “subprime problems” and arguing that such problems were minor; now – too late - they talk daily about subprime “carnage” and “meltdown” while arguing that this is only a niche “subprime” problem that will not affect any other mortgage.
In early December the conventional wisdom was that the housing recession was close to “bottoming out” (and last summer the conventional wisdom even denied the existence of a housing “recession” hiding behind the “housing correction” spin). Now, after 14-16% plunges in housing starts and new home sales in January alone and after Mr. Tomnitz declared that housing will “suck” all of calendar 2007, few have the chutzpah to speak about a bottom of the housing market.
Now, after all this mess the conventional wisdom - that was altogether wrong and missed the boat on the housing recession, on the subprime mess, on the ABX collapse, on the subprime credit crunch - is telling us today that subprime is a niche problem and that other mortgages are fine, that there is only a minor credit crunch in subprime that will have no effect on other mortgages, that there is no problem in the CDO and RMBS market, that the macro effects of the subprime disaster will be between tiny and non-existent, that the economy will have a happy soft landing. Since the conventional wisdom completely missed the boat since the last summer on all the main developing disasters why should we believe it now that it has lost all credibility?
Since last summer I argued against the conventional wisdom consensus; and now I do not find the new current optimistic consensus about the future any more convincing. But let me flesh out now in more detail why my answers to the three questions above are very different from consensus and why the risks ahead of a general credit crunch and of a seizure of the mortgage market are high...
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