Credit:End Of Days?Or More Of The Same?
July 10, 2005
Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his newsletter.
There is an old saying (from the French, of course, originally) that the more things change, the more they stay the same. Surveying the present so full of anomalies, ridden with crosscurrents and yet frequently abandoned by volatility, it is easy to admit that these are fascinating times. In 50 years of exposure to Credit in its traditional and now creative states, this may be the first epoch where the fabled “C”s of credit are called into question as augurs of the future. Is it actually possible that the Credit Cycle has been repealed or altered? Are Capacity and Capital no longer germane? What about Character? Clearly the products and innovations in the recent world of credit are different this time. Does this negate the eternal verity that a bad credit will surface over time?
First, to the possible boredom of multiple readers, a few macro thoughts on how we got to where we are in the global credit picture and then a more focused effort on answering the questions above.
There is no question that national borders’ effect on credit has nearly vanished in terms of not only credit availability but also in terms of homogeneity. It is a truly global credit market, a situation never previously seen. The expansion of credit availability to anywhere and everywhere has fostered another situation never before imagined, much less seen. The United States, without question has been for years, and continues to be, the dominant nation on the planet by almost any metric, economic, military etc. Contrary to much of history, however, this predominant entity does not prosper as empires previously have.
History tells us that such dominance was accompanied by “tribute” in some financial form from others. An empire ran at a profit. Funds flowed from elsewhere to the center and became the capital for the expansion and maintenance of the dominance. Massive trade and current account surpluses (in today’s terms) created and maintained a currency with strength and attractiveness. The current financial situation of the dominant player is completely anomalous to the traditional. Essentially, the dominant state is absorbing the resources of the vassals in a completely different fashion. IT IS BORROWING THEM!
The massive borrowing, expanding exponentially since the Fed generated an “echo” boom with below 0% real rates would normally have run into resistance long before reaching current levels, but this time around, the Asian central banks have found it beneficial to depreciate their currencies along with the, until recently, depreciating U.S. dollar, and use export proceeds to accumulate Treasuries and Agencies. In a recent article of great insight, Richard Duncan explains the “conundrum” by noting that 2005 issuance of Treasuries is down as the force fed expansion of the last couple of years has hyped tax revenues and reduced the deficit from $460B to more or less $350B. Simultaneously, the Agencies, under a cloud, have almost stopped new issuance. The current account deficit hits new highs. Ipso facto, there is $300-400B in demand in excess of additional issuance. Higher prices/lower yields and a “conundrum” for the Maestro, our much revered Fed head.
There may or may not be, but likely there is, a hedge fund short squeeze mixed in. These worthies shorted Treasuries in the last few years to get the fodder for their spread/“carry” trades. The rising prices have created a problem for them in this area.
The same band of merry men “played” the reflation trade in 2004, among other things, going long foreign currency and short the dollar. This got reversed after booking gains at yearend at the high and the dollar has gone on a tear, up some 10% against most of the former star currencies, obviously also propelled by the rising spread in its favor as the former stars left rates unchanged and gave the dollar an edge. Simultaneously, the “conundrum” was producing higher prices for the long end of the curve. Putting together the gains in currency and the gains in price on the $1.8TRILLION in Govvies held outside the U.S., primarily by the afore-mentioned Asian central banks, it is apparent those guys, after a couple of rough years as the dollar declined, have several hundred billion of gain in the first half of 2005. The Japanese, with some $800 billion get both the currency benefit as the yen weakened and the dollar rose, and also the price gain. The next biggest, the Chinese, have had to satisfy themselves with the price gain. Not only does this ease any criticism by their politicians and make them, at least temporarily, look like smart investors, it certainly increases/sustains appetites for continuing purchases.
ALL OF THIS COMPRISES WHAT I TERM THE “WONDERFUL U.S. CENTRIC PERPETUAL MOTION MACHINE” - LOWER AND LOWER RATES IN TREASURIES PRODUCE LOWER MORTGAGE RATES---MORE REFI/CASHOUTS AND HOME EQUITY LENDING INCREASES (UP PRODIGIOUSLY SO FAR THIS YEAR)---MORE CONSUMER SPENDING WITH THE PROCEEDS---MORE TRADE AND CURRENT ACCOUNT DEFICITS----MORE ASIAN CENTRAL BANK $ HOLDINGS BIDDING FOR LESS SUPPLY AND! COMPLETING THE “VIRTUOUS” CIRCLE---LOWER RATES!
The old axiom has been repealed. Yes, Virginia, you can borrow yourself to prosperity.
At March 31, the U.S. owed an aggregate amount of $9.1 Trillion to the rest of the world. Over $6.6 Trillion of this was held by them in readily liquid assets. Truly the faith of our creditors is without measure. The observations above would lead to the belief that this will continue for at least the near future.
After a lapse of a couple of years, we recently revisited a website for appraisers. On the last visit, we were struck by the not infrequent anecdotes from the appraisal fraternity on pressure to produce the buyer/lender desired number. The site is now awash in such comments. Residential real estate shares one aspect with equities; a rise in the price of one unit (share) causes a rise in the price of all (comparable). With rises in sales prices at a record pace, we had thought that the pressure on the appraiser would have been reduced, rather than the opposite. On second thought, the pressure on the appraiser may be more of a factor in the rise in the number of real estate agents, mortgage brokers and mortgage origination and resale capacity. These numbers are rising equally or in excess of the rise in house prices.
I have not seen any study encompassing the entirety of influence of all of the employment factors involved in the “Perpetual Motion Machine” described above but have seen some of the salient parts. An ambitious but not necessarily complete list would include the aforementioned directly employed in the sale/purchase/home equity/refi/cashout aspects of residential housing enterprise (agents are apparently up some 40% in the last 3 years) and also all of those employed in the financial aspects of residential housing; loan officers, appraisers, supervisors, securitization originators, sales force, rating agencies, etc. Let’s not forget the highly compensated thinkers creating “new” mortgage product and the wizards of “creative” finance in a dizzying array of tranches, credit derivatives and other exotica. We have not yet included the homebuilding industry, the material supplier base to the industry and the financial supplier base to the industry. A little more imponderable but nevertheless massive economic factor in the machine are all the consumer goods going into each of these new residences, the material and financial supplier bases thereto and all of the myriad seemingly necessary upgrades in the humongous world of residential home re-sales. The mind boggles. To hypothesize that all of the above, in the aggregate, comprise a very substantial percentage of the employment and GDP growth in the last 3 years labeled as RECOVERY is not difficult.
NO WONDER THE U.S. ECONOMY IS OUT THERE LEADING ALL OF THE ECONOMIES IN THE “DEVELOPED” CATEGORY IN RATE OF GDP GROWTH! THE OLD GERMANS ONLY HAVE 40% OF THEIR POPULATION AS HOMEOWNERS. IF THEY WOULD JUST GET WITH IT AND OFFER 40 YEAR INTEREST ONLY OPTION ARM’S, THEY COULD RAPIDLY MOVE TO THE HALCYON U.S. LEVEL OF 70% (WSJ RECENTLY REPORTED ON THE NEW 10 MILLION MARKET WHICH MAY TAKE THIS RATIO EVEN A FEW PERCENTAGE POINTS HIGHER AS WE MAKE THE 10 MILLION ILLEGAL ALIENS HOMEOWNERS) IF THOSE SILLY JAPANESE WOULD ONLY GIVE UP SAVING 15% OF THEIR INCOME AND SPEND IT ALL AND THEN BORROW SOME MORE, THEY WOULDN’T STAY MIRED IN A STALLED ECONOMY!
Out of courtesy to Bernanke, Kudlow and other proponents of such policies, we won’t mention that the Chinese are out there with a rate of GDP growth 3 times the U.S., a savings rate of an astounding 40% and international reserves doubling in 2004. Simply an anomaly. At least they know how to borrow too!
At the outset, there was mention of the verities of credit which have previously stood the test of a tremendous amount of time and a question as to whether or not the “New Finance” had repealed or repudiated them. Sir Greenspan has an oft repeated theory that the “New Finance” has redistributed credit risk, thereby providing stability never before seen. There are other adherents to versions of this assumed truth. One version is the new refrain that there cannot be a housing bubble because: Housing is a “sticky” asset, housing markets are all local, people always pay their mortgages first. One opinion now out there by more than one bear is that there can’t be a bubble as long as so much ink is devoted to the question. The most pervasive argument is that the “New Finance” securitizations diminish risk to the point of rendering bubble theory inoperative. Walter Wriston once entitled an article “Never mind the noise in the market, what is the price of fish?” I paraphrase: Never mind the apologia on the strength of residential, what is affordability and what capacity, capital and character do the mortgage borrowers have?
So far, these questions have had the same relevance as whether anyone hears it if a tree falls in the forest. Virtually nowhere in the entire chain from purchase of another lot by the nascent homebuilder to the sale of the last I/O tranche to a nomad in Timbuktu is there any relationship, personal examination of the ultimate payer of the debt acquired to finance the ongoing splurge or responsibility on anyone to track the individual borrowers after credit initiation. The few banks which actually look at the “Cs”, with concentration on the borrowers themselves in this credit process run into criticism from the regulators for not having up to the minute, infallible “scoring” models from the regulators. For a while, desirous as they were of volume and constantly relaxing standards, the Agencies, Fannie and Freddie, at least, had minimums which required some perfunctory certification of a borrower’s credit “Cs” for inclusion in a pool or guarantee of a mortgage backed security. Too intense scrutiny was compromised to make certain the earnings/profit/dividend model they promised analysts and the compensation and option gains desired were not afflicted, but some semblance of credit process was vetted.
In examining the process, however, the era of the Agencies as the ultimate buyer/guarantor/seller of mortgage credit, even with all the deficiencies which eventually led to the tarnished current state of these pseudo central banks the process was superior to the increasing current concentration in “private, financially engineered” conduit mortgage credit. There was also the mortgage credit insurance required by the Agencies when minimal or virtually no CAPITAL was available to the borrower, i.e. down payment or equity. The new world of financial engineering obviates even this slight additional protection through the wizardry of tranches and derivatives as evidenced by the flat mortgage insurance in force number in the current screaming higher housing market. A cursory examination of the world of appraisals reveals that there is a number available when a number is desired, compromising further that CAPITAL as one of the “Cs”, the bedrock of the former credit process.
CAPACITY, another of the ancient “Cs” is becoming more and more of a question in the mortgage sector of credit as this nearing 15 years continuous expansion in residential blows off in truly spectacular fashion. Essentially, this “C” examines the capability of the borrower to repay in contrast to CAPITAL which measures how much skin the buyer has in the game. Ability to repay is under attack, simultaneously, from both ends in the question of repayment ability. At the front end, the hallowed ratios of debt service to income, total debt to worth etc. are fast vanishing as criteria. “Low doc”, Alt A, No doc, income verification, tax returns, who needs all “thees steenking paper” to paraphrase an old movie classic. The anecdotal on who can qualify is astonishing. We are past the “fog a mirror” to not long enough deceased to freeze a mirror. At the other end of the process are the “NEW MORTGAGE PRODUCTS”! Let’s call them reverse tontines (a tontine being a multi-generational asset compounding mechanism from times gone by and people really wanted to save). Buyers are being offered the opportunity to buy a couple of million dollar house for pretty much whatever they want to pay (option arm) after some front end “teaser rate” as low as 1%. Yeah, they have the capacity to pay the teaser (or maybe not depending on how corrupt the front end of that particular loan process was) but what next? Simply on adjustables already written, there is well over $1 Trillion in resets coming in 2007. Fed Funds at minus this time around? Jim Stack of Investech Research (your author is a paid up subscriber) says it has been reported that 40% of new jobs created in this economic recovery are in real estate related industries. We would argue the number is higher when all the peripheral financial, construction and home product jobs are thrown in, but the 40% figure is high enough. The ability to repay is normally a function of employment income although recently, obviously, a large and increasing part is in home equity loan takedowns, cashout refi’s and sale at appreciated price. When, not if, these alternatives are no longer attractive/available, employment, certainly at least at the fringe, in these industries is going to contract. This may come after the 3% 10 year refi wave or the 2%, or whatever, or sooner if the dollar resumes it’s inevitable decline. Eventually, recessions always ensue. The computer models, now predominantly the ultimate determinant on capacity to repay, will be tested for the 1st time.
CHARACTER: In 50 years of lending money, the undersigned acknowledges some bad loans. Looking back at the cause underlines the FACT that the vast majority of these failures was a misjudgment in the critical area of the borrower’s character. Consumer Lending, Small business lending, Corporate Lending, Bank Lending, Government lending, Asset based lending, etc. – all of which we were involved in during that time had the same commonality of failure to accurately judge the integrity of the borrower when looking back after the loan went bad. Sure, the violent overthrow of a government, a regional depression due to concentration, a collapse in an industry or another exogenous factor may have been the headline cause for the eventual loss. Nevertheless, in every instance there were several to very many loans to near identical borrowers and the losses were clustered in (hindsight apparent) loans to those lacking integrity. With the exception of a few community banks and the minuscule number of large banks still attempting to do true relationship banking, the mortgage today is a computer driven product. In some of the loans made over the years, a failure to accurately determine integrity at the outset was offset by noticing during the following relationship contacts the error before the loss occurred. Mortgage lending, as practiced in today’s environment has little or no, mostly no, human involvement on this most important determinant of future loan losses.
Yes, it will be pointed out that mortgage loan losses are at historical lows. This is accurate but no repudiation of the foregoing. An old law of credit frequent readers have heard ad nauseam is that growth of high teens to even 20-30% annually in the loan category will, not astonishingly, result in the small numerator totally losing the race the rapidly growing large denominator. A report in June from the Harvard University Joint Center for Housing Studies states that the current housing boom has lasted 13 years! The next longest historic streak of uninterrupted growth in residential was only 5 years.
Long, long time for that powerhouse denominator to do its work at keeping the ratio of bad loans in line. It really isn’t that our computer models are better judges of character than the anachronistic relationship lending officer. They simply haven’t been tested!
Obviously, this curmudgeon does not think the “Cs”of credit have become extraneous.
OK, maybe the credit cycle has been repealed or extinguished by Central Banks in general and the Fed in particular. Certainly, their singular but more recently collective tsunamis of liquidity at the slightest sign of distress in any market has postponed the ending of a cycle. The borrowing/investing class to paraphrase the inimitable Kudlow has come to expect this as just dues. 2 years of 1% (below 0% actual) Fed Funds was the super cortisone for the last abortive downturn (Character as the point in Enron, Worldcom, Adelphia, etc. as well as the lenders “neither admitting or denying any wrong”) in the relatively few disasters before the injections kicked in ?
We think the credit cycle will find its way back. Looking at the ammunition for the cabal of central banks, the Fed has 3.25% to 0%, the ECB 2% and the Japanese a fraction. No doubt that they will fire it and maybe do the Bernanke bit of forcing the 10 yr to 0% also.
At whatever point the cycle arrives and, none of the above takes into account what such rates might do to the most indebted currency, the result will reaffirm the fundamentals of credit.
We have concentrated so far on mortgage credit as the example of our views on credit. In a prior piece we mentioned the massive migration of the banking system into a reliance on consumer backed credit including mortgages, Agencies, mortgage backed credit etc. In addition there is all the “non-recourse” securitized housing credit held outside the banking system, truly only the deity knowing where. Should the verities of credit return from their tsunami money induced long absence and bring the cycle with them, residential will be the epicenter or the now familiar “ground zero” of the event.
This is not to say that the recent strong expansion in C&I credit is without risk. As usual in 2004 and more recently, the regulatory bodies, spurred on by Sarbanes Oxley, have done their utmost to make certain that reserve levels are whittled down to the absolute minimum. As in prior credit cycles, this reduction always occurs as the improvement in credit peaks. On average, banks have only 1.3% of loans in the reserve account. This writer has always believed that consumer credit requires much more than this pittance, which is even low for commercial credit in a period of rapid expansion. The current conventional wisdom is that mortgage credit is always so impeccable as to really not constitute consumer credit but rather asset backed lending of some superior nature (It used to be thought that asset backed carried more risk and was entitled to more spread and more reserve but the house is clearly trumpeted as being a house of a different color. All in all, underwriting standards in the Fed survey show falling due diligence and higher leverage, particularly in the burgeoning fee rich revivified world of leveraged buyouts. Commercial real estate is in another run for euphoria and the myriad of “structured finance” opacities grows exponentially.
Yet to be tested is the $ 8 Trillion in credit default swaps. Why do we not believe the Maestro that this innovation safely spreads risk? Maybe it is different fro a new product this cycle and it will be a panacea, not a peril.
Usually, by now, the end of a commentary would be heading towards Gotterdammerung. Contrarily, and we always seem to be that, for the macro reasons described at length earlier, we think that we can put off the “End of Days” a bit further. Trust the market to take this comment as the capitulation of a bear and act to the contrary. |
