Did you guys read this:
Which Japanese (Or Chinese) Owns Your House?
March 26, 2003
Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his March 15 newsletter.
WHICH JAPANESE (OR CHINESE) OWNS YOUR HOUSE? Having been purchasers of an astounding $150 billion in Governments and Agencies over the last year, primarily Agencies, these two nations, accumulating surpluses with the U.S. of well over $10 billion per month, are indirectly becoming the creditors for the marginal U.S. residence.
THE QUESTION POSED IS OVER-SIMPLIFICATION BUT, NOT BY MUCH!
A completely wrong-headed approach of liquidity to the maximum to deal with the bursting of the internet/telecom/nasdaq bubble, which he finally admits can be seen “in hindsight”, by the revered Mr. Magoo, the Chairman of the Fed, has led to a 5% of GDP trade deficit, sending these funds to these export-driven nations which recycle them back into the afore-mentioned securities. Only this “virtuous circle” has permitted the headlong expansion of GSE balance sheets and guarantees over the last several years. That expansion has been the driving force for reliquification in the economy leading to bubble type housing price elevation permitting multi-hundred billion dollar equity extraction in refinancings driven by the double digit number of rate cuts by Magoo. Even Sir Printsalot of the Fed, as others have described him, admits that these “cashouts” have been a powerful force in sustaining consumer spending, perhaps the major force.
AND THE BEAT GOES ON! De facto, the GSE’s are considered by buyers to be the same as Govt. securities. The recent spread below 30 basis points between the two illustrates this. The astonishing fact is that, thus far this year, with the dollar down significantly last year and thus far this year, the willingness of these Asian countries to continue buying is not only intact but expanding exponentially! The March 10 adverse comments by Fed Regional President Poole about Fannie and Freddie may have bashed the stocks for a few points but the sell-off in their bonds was limited and quickly reversed. The usual self-serving “We are impervious” comments came from each.
With the headlong rush into Treasuries in these early March weeks occasioned by the concomitant headlong rush by the current administration to get to war before the climate (actual in Iraq and sentiment at home) changes, rates have hit lows not seen in 40+ years. This prolongs and intensifies the Great Mortgage Refinance Bubble, now approaching 40 weeks, another record. The prepayment speeds provoked by this phenomenom leave holders of mortgage backed securities stripped away with no option except temporary extension of duration by purchasing long governments, further reducing yields on those instruments and making refinance rates even more attractive. The financial centrifuge created by the self-reinforcing cycle is truly awesome. We are not so ignorant as to prophesy the slowing or disappearance of such a Brobdingnagian financial spectacle. All other forms of borrowings are granted the benefit of the centrifuge (with the exception of those credit card debtors who have hit a floor). Corporate issuance is thriving as is home equity. The last gasps of the auto industry are provided oxygen by diminishing costs to throw away 0% for as much as 5 years.
ALL OF THIS, AT THE MARGIN, FACILITATED BY THE WILLINGNESS OF THE CHINESE TO ACCUMULATE HOUSING BACKED PAPER IN RETURN FOR THE MASSIVE AMOUNT OF LOWEST COST GOODS THEY SELL US! While not attempting to foresee the end, we stand committed to our theorem that the present situation is one of massive DISEQUILIBRIUM!
Perhaps mixing a metaphor, we are convinced that ever increasing disequilibrium in this centrifuge will produce an end result that is catastrophic. No system, human, electronic, economic or financial can cope with the ever-increasing stress of endless expansion. This is particularly true of credit systems. Checks and Balances usually prohibit something of the order of expansion we are seeing. We surmise that the expansion in the Mortgage Refinance Bubble proceeds unchecked because it actually constitutes something entirely new. To the best of our knowledge of financial history, no nation has ever previously produced a dual credit creation mechanism. There have been attempts such as the Japanese zaibatsu postwar II, or the proliferation of “fellow traveler” companies such as the Hudson Bay Co. in the British Empire, but they fell far short of the ingenious credit creation mechanism embedded in the GSE’s and the mortgage industry. “Government Sponsored” (whatever that means) but widely believed to be Government Guaranteed, the “Fannies, Freddies, Sallies, FHLB’s” have proliferated credit as never before seen, in both magnitude and speed. At each nascent economic downturn in recent years, they have stood ready to re-open the floodgates of liquidity.
There are still some who fail to understand that these entities constitute a completely different credit creation system apart from the Fed(Central Bank)/Bank system all other nations must make do with. To them we say, there ain’t no fractional reserve requirement, capital and credit reserves are formula driven by internally generated formulas and issuance of liabilities all along the maturity spectrum is limited only by the willingness of the buyers (at the margin Chinese and Japanese) to continue buying.
HOW ELSE DO THESE ENTITIES EXPAND AT 20-30% WHEN NEEDED, DOUBLE IN FIVE YEARS AND ALWAYS FIND WILLING TAKERS OF THEIR PAPER?
For those who still cavil at the thought, we commend the archive available “T-Account” explication by Doug Noland of Prudent Bear. If this does not satisfy, we recommend another try at Accounting 101 or better yet, take up some profession such as massage. Another fascinating benefit to the United States of having dual credit creation mechanisms is that the burden of Government Debt is drastically understated and misperceived. This is not the only such deception pursued, the entirety of the eventual debt burden attributable to Social Security and Medicare is also understated and misperceived. Looking at the actual Government Debt, only the “on the books” $3.7 Trillion actually shows. Add in the “Debt” issued to Social Security and Medicare and we go north of $7Trillion. Throw in the GSE’s and FHLB as well as Ginnie and we are well over $10 Trillion. That’s about 100% of GDP, usually the number marking the basket cases of the planet. For example, bankrupt Uruguay comes in at 85%. The Mortgage Bankers Association reported March 12 that “refinancings” as a % of total mortgage applications reached nearly 80%, a new all time record. Purchase volume is actually declining slightly. The refi number is up an astronomical 20% this month.
As defined earlier, there is no way to predict how long this manic expansion can continue. As with all bubbles, however, there are usually straws in the wind. For the author, at least, one infallible indicator is the frequency of our financial leaders stating for a variety of reasons why this mania cannot be a bubble. The old “methinks he doth protest too much” indicator is time tested. At this juncture, it is hard to find a Greenspan speech without such a protestation. Everybody else from Bernanke (the Fed Governor who attained instant notoriety by espousing instant printing press money) to the revered Franklin Raines of Fannie who never met a mortgage he didn’t like; cloaking his sermons in the “American Dream”! Our favorite rationale was from an Economist (capitalized) who will remain nameless. This inestimable worthy proclaimed that there “can’t be a bubble, supply is very tight”. We asked him to no avail how bubble prices can occur in an oversupply situation.
Alas, supply is no longer tight. The abstemious construction industry (which restricted supply to only 97% growth in per annum residential construction from 1997 to date) has begun to overshoot and the house inventory supply is now expanding rapidly. We don’t purport to know anything about supply. We like to keep track of the credit side of things. Here too, the straws in the wind are beginning to resemble a haystack in a tornado. Our favorite is a member of the Fed losing religion. President Poole of a Midwestern Fed bank stated during the week that Fannie and Freddie didn’t have any clothes on. Naturally, Franklin derided his lack of understanding but this was pretty gutsy stuff for a government minion. Guy must be really scared.
Warren Buffett increased his fame if not his friendships by calling the very derivatives which have fueled the idiocy weapons of mass destruction. Looks like we are going to war in the wrong direction.
Various folks at PIMCO who look after the largest aggregate of debt extant have weighed in with dubious thoughts on the future of interest rates, the dollar and credit trends. Personal bankruptcies keep hitting new highs weekly. One fascinating manifestation we have been tracking is the packaging of “reperforming” mortgage loans. From a standing start these instruments are passing the $20 Billion level annually. We found the genesis and history of a creature entitled “C-Bass” fantastic. This enterprise, 46% owned each by mortgage insurers MGIC and Radian, is big in the reperforming game. They get the securitizations to a level necessary for sale by various means. One is holding all of the subordinate tranches themselves. Since there is obviously no market for this stuff, they still have it. We would describe it as potential toxic waste but, in their self-valuation, it’s as good as par. The company is highly levered but pays a ton of dividends. It is more than demonstrably important to MGIC, providing more than 100% of their earnings growth in ’02. We wonder how many repackaged, reperforming mortgages would have been charge-offs if these inscrutable entities and their programs were not transforming them into “good, saleable” assets all over again.
We also wonder whether these things can be repackaged indefinitely. In the wonderful world of Structured Finance, is there ever any necessity to take a loss? We have been accused of boundless cynicism; we admit to it! This is in introduction to our latest thought on the wonderful world of refi’s. We have run across too much anecdotal evidence for there not to be a lot of this chicanery going on. Obviously, there is no way to expect to find it, even in the footnotes, in the 10k”s and Q’s.
With appraisals available for whatever number the home-owner might want (And there is plenty of real evidence on the laxity of the present appraisal process), we wonder how many refinanced mortgages are simply repackaged to perform. Think of it: most areas have dwelling prices up from high single digits to low double in the last year. You call in the varmint who is more than 90 days past due; have the happy appraiser verify that he has more than enough over the level of the outstanding amount in untapped equity and write him a new mortgage with enough to clear up arrears, make a nice fee, provide a couple months to the escrow and ride into the sunset.
When it gets worse and/or even the appraisal smells piscatorial, call for the real fish, “C-Bass”! What the hell, as long as you are in good standing with Franklin, one of his counterparties or one of the PMI’s, it susceptible to guarantee, rating and sale. It is not as if you have to take this stuff onto your balance sheet, god forbid!
We reiterate, at this point, our old adage. This nostrum opines that, as long as growth in assets stays high enough, THE RATIO of bad loans stays acceptable. The danger posed by all of these straws is that rate of growth may have to slow. The equity action of virtually all of the players in Structured Finance was a misery after the Poole broadside. Face it, the traders have seen it before; a drop in volume like an outgoing tide, exposes all of the rot below the high water mark.
In a previous missive, we reprised the story told about MBIA. More recent news is that the redoubtable Elliot Spitzer, who can’t manage to jail Grubman, has a new target, the hedge fund that exposed this insurer! While Spitzer spurs his white horse in pursuit of short-selling malefactors, MBIA is fessing up to some stuff in the CDO portfolio, warning on earnings and assuring us that if Spiegel chapters, their $800MM is not going to hurt. Dream On !
The opacity of Insurance financials is partially due to the fragmented regulation of the entities. RAP accounting was designed for another era and seldom produces the same figures as would GAP. Couple this with the ability to hold to maturity at par unless you, yourself see impairment and mark to model, and there is a lot to wonder. These folks have also become very big in derivatives. Here we go through the looking glass. In the wonderful world of over the counter derivatives, there is no way to see how much is concentrated and how many of these companies are taking how much of each other’s laundry’s. Only default opens the situation to external view. Buffett had a lot to say on this, his missive, available all over the web and in Fortune, is well worth reading. In the $8 trillion world of Structured Finance, it is nearly impossible not to have some form of derivative embedded in the instrument if a guarantee is conceded to be a derivative.
Guarantees have undergone a sea change from the best one this writer ever saw. In the 1960’s, presented with the need for an instrument for a potential guarantor, this then wet behind the ears credit guy had the opportunity to confer with one Henry Harfield, a senior partner of what still is Shearman and Sterling. The instrument went much as follows:
I, ……….. , hereby guarantee all obligations of………..to Citibank irrevocably and unconditionally. Date: Signature:
Asking Mr. Harfield if that was all that was necessary, this neophyte was told: “Keep it simple, stupid and no opposing attorney can dispute it.” The instrument held up! Now we have MBIA issuing credit default swaps on itself to carry it’s own AAA paper into it’s portfolio to meet the required percentage and/or to narrow the spread on such instruments when coming under pressure. (THESE INSTRUMENTS TAKE MORE THAN 2 LINES) WE AIN’T IN KANSAS ANYMORE, TOTO!
Getting back to the wonderful world of housing finance, we were looking at an article on housing bubbles in the Economist recently. The U.S. isn’t the only nation undergoing one. We have taught the English speaking world how to do it. Others with bubbles even in excess of our own are the Brits, Irish and Australians with the Canadians coming on fast. We draw no conclusion from the language, the Japanese and Germans have already had their bubbles. Speaking of the Japanese, we have looked for but found little documenting their residential bubble.
Their commercial bubble sank or crippled a lot of their banks but the rationale of low interest rates cushioning a housing bubble decline has some merit. Prices in Tokyo have fallen 60-90% but extension to 100 years in some cases and interest rates of 1% have provided a long slide rather than a collapse. In a long enough slide amortization can possibly keep up with price deterioration. Concomitantly their economy underwent a decade long slide in equities, gdp, credit and prices and profits. Since they save 15% per annum and little of the JGB’s are held outside the country for obvious reasons at their current yield, the negative results have resembled the old water torture rather than an implosion.
THE UNITED STATES DOES NOT SAVE 15% OR ANYTHING NEAR IT AND MASSIVE AMOUNTS OF GOVERNMENT DEBT AND QUASI GOVERNMENT DEBT (THE GSE’S) ARE HELD OUTSIDE THE COUNTRY. WE THEREFORE CONCLUDE THAT THE LIKELIHOOD OF THE 0% INTEREST RATE SCENARIO WORKING AS THE ULTIMATE WAY OUT FOR THE CREDIT BUBBLE IN THE U.S. IS HIGHLY UNLIKELY! To us, the most ominous aspect of the $32 trillion in credit washing around the United States credit system is the complacency abounding. We happened to be in the office of a trading firm the morning LTCM was crashing. Panic was clearly evident in the marketplace. The traders could not believe the quotes. As we all know, a multi-billion dollar bailout orchestrated by the New York Fed temporarily (at least, in our opinion) solved the problem.
Last October, some four years later, there was another instance of systemic distress. Again, by happenchance, I was close enough to the trading environment to witness the reaction. This time around, there was far less fear; instead there was a “Waiting for Godot” type of ennui. The Fed will take care of things was a mantra quoted and believed. The afore-mentioned speech which made Bernanke famous/infamous has had a further effect of strengthening the belief that bad things don’t happen to good markets. I can only liken this, in my experience, to the wonderful world of Latin American finance in the 1990’s. There was a certainty that this time, they were bullet-proof. There was no way of convincing the latter day lenders that it should be déjà vu, not new Latin America. Only a decade earlier predecessors in the former Bank of America (weakened enough that the present Bank of America, then NCNB wound up taking them over) and Citibank had gotten killed there. Then came 2002 and Argentina, Venezuela, Colombia and a year or so earlier, Ecuador with Brazil yet to come, ruined 10Q’s all over again. However, the similarity to the recurrent belief in spite of history is one of likeness, not magnitude.
THE MAGNITUDE IN STRUCTURED FINANCE IS SO GREAT THAT THE INEVITABLE BURSTING OF THE BUBBLE CANNOT BE CONTAINED. THE ONLY POSSIBLE RESULT OF THE CURRENT COMPLACENCY IS THAT THE EXPANSION OF THE BUBBLE WILL CONTINUE TO THE POINT OF GREATEST POSSIBLE DAMAGE! We believe that THE MINDLESS COMPACENCY we are witnessing is due to our Long-stated position that the Structured Finance/Derivatives megalith created over the last couple of decades has a number of characteristics/advantages over previous credit mechanisms permitting expansion without apprehension or comprehension:
1. The credit generated is not retained on the balance sheet of the originator.
2. The credit generated is enhanced/derivatized/guaranteed/insured and packaged to the point where it can be rated/measured against the yardstick of the purchaser. The end product is tailored to assure purchaser acceptance.
3. The credit generated is sold to widely dispersed holders. Most of these are not burdened with mark to market requirements. The width and depth of the end purchaser world is astonishing and humongous. Imagine Disney as the purchaser of a synthetic airplane lease, truly Disneyesque!
4. The credit enhancements/derivatives/guarantees/insurance are obviously not on the balance sheets of the issuers.
5. Netting is permitted among the large players of the derivatives they have issued.
6. Ratings Agencies, which are trailing indicators at best, have a self-interest in maintaining their ratings of the players. These Agencies have no way and no power to get “behind the veil” on all the over the counter transactions.
7. No Regulator (Particularly an Insurance Regulator or the OFHEO) has the resources, sophistication and authority to actually examine the Structured Finance area to the transaction level.
8. The Federal Reserve has leapt to the rescue often enough (And made such promises as the Bernanke speech often enough) that the market perceives a Guaranteee.
9. Clearly, the Chinese/Japanese believe their Agencies are, at least, implicitly guaranteed as they accumulate hundreds of billions of them.
10. Even having lost significant value in exchange deterioration in the last year, there is still a willingness on the part of buyers, internal and external to accumulate U.S. debt. Maybe they just have not noticed All of the foregoing, we believe, have led to a world permitting the U.S. to sustain a consumption driven economy beyond any lengths previously seen. The complacent view that this can continue ad infinitum seems to have much danger.
At the outset, we stated that our ignorance was not so great as to predict the end of this phenomenal explosion of credit. We admit ignorance freely in being unable to penetrate the world of Structured Finance to the point of knowing the current state of the credits outstanding. The number of “straws in the wind” is increasing geometrically. That does not provide a timetable.
We will close with an admonition. IF YOU OWN SOMETHING THAT IS NOT “PLAIN VANILLA” IN THE WAY OF CREDIT; DO NOT BE REASSURED BY A RATING OR AN ENHANCEMENT! IT IS PROBABLY SAFE TO SAY THAT THE FANNIE/FREDDIE WORLD IS AS GOOD AS A GOVERNMENT (YOU FIGURE OUT HOW GOOD THAT MAY BE IN TERMS OF EXCHANGE RISK). RISK MEASUREMENT ON ANYTHING ELSE IS, IN OUR OPINION, AN ART NOT A SCIENCE. WE WISH YOU WELL IN YOUR EFFORTS! |
