Yes, sports fans, I am late in reporting on this, but since the focus of the RGE Monitor-sponsored panel discussion was fundamental in nature, the loss of a few days in a slow news period has not lead to any sightings that would contradict either the tone or the specifics of the discussion.
The panel of six (Nouriel Roubini, Chris Whalen of Institutional Risk Analytics, Josh Rosner of Graham Fisher, Andrew Pollack of the American Enterprise Institute, Martin Mayer (author and guest scholar at Brookings), and Sylvian Rayner of R&R Consulting was more bearish than I am (and remember, the AEI was represented). And the group I met for dinner (which included a hedge fund manager) was even more downbeat.
Consider further that these views were based on factors already at work; no allowance was made for oil at $135 a barrel. If this holds, the entire US airline industry will be begging for a bailout by early 2009 (my travel agent, who is a wholesaler, tour organizer, and works with the majors on revenue planning, tells me that the airlines are having trouble filling business and first class seats, a reversal of recent patterns)
And the news and anecdotes since then have if anything highlighted the not-too-pretty prospects for the economy. Calculated Risk pointed out that the number of miles driven year to year had declined (and this was March ’08 versus ’07. Wonder what April and May will show). The last two times this happened, 1973 and 1979, was at the beginning of very nasty recessions.
In my typical contrary fashion, I generally don’t go away on long weekends (Manhattan is nice when it empties out). More people in my building chose to stay in town than is normal (Barry Ritholtz provides confirmation from the Hamptons end that people stayed home). I also noticed the complete absence of commercials (not trailers, commercials) when I went to catch a movie. I’d heard the ad cutbacks were serious, but this was the first tangible sign I’d seen.
Roubini gave an overview, which aside from his dogmatic comment that there was now a consensus that the economy would have a hard landing, was factual and informative. Although some of this will repeat comments Roubini has made on his site, let me give his main points:
Housing is set to fall further. Case Shiller says prices have declined 14% so far. RGE thinks it’s more like 20%. Unsold inventories are still increasing. Housing prices will continue to fall through at least 2009. RGE sees the bottom at a 30% fall, which equates to a $6.6 trillion loss of wealth. That’s equal to 1/2 year of GDP>
With a 10% fall in housing prices, you have about 8 million mortgages underwater. At 20%, it goes to 16 million and at 30%, 21 million. That’s 40% of the mortgages (roughly 51 million homes are mortgaged).
Then the question becomes what losses result. Assume a 20% fall in housings prices. Assume 50% loss severity (as in you get 50 cents on the dollar). The question is how many walk away, If you assume as Roubini does, that 50% will walk away (note most analysts assume more like 20-25%)), losses will be $1 trillion. But the equity of US banks is only $1.3 trillion. Admittedly, not all the losses will hit banks, since a lot of the paper was sold to institutional investors and overseas, but even if you get only 25% walking away, that’s losses of $500 billion.
Yves here. I am still a bit leery of the use of the term “walking away” when defaults on 2006 subprimes have hit 37%. Still, no matter what the fact pattern, the point is that a lot of mortgages are going unpaid, and the number is rising. Back to Roubini
Next, we have unprecedented levels of debt economy-wide. Debt to disposable household income rose from 100% in 2000 to 138% . We have a subprime financial system in residential mortgages, commercial real estate (in which deals were financed at more than 100% of property value), consumer credit, and LBOs (debt to equity went to a range of 8-10X versus a historical norm of 4x).
Consider corporate defaults. Historically they have averaged 3.8% a year but they went to .8% due to low interest rates and the ease of refinancing. In each of the last two recessions, the peak default rate went to 15%. Moveover, recoveries are 70% between recessions but 30-40% during recessions.
Consider further: we have a $62 trillion notional credit default swaps market versus $6 trillion in cash bonds, The market has been tested only for a couple of individual defaults, not a large scale downturn. The bulk of the CDS protection-writing is likely to be concentrated in a comparatively small number of hands. The mere downgrade of Ford and GM when the market was 1/3 its current size led to major upheaval.
Now the panel discussion opened, and moderator Chris Whalen asked the participants to highlight an aspect of the US financial situation that they felt wasn’t sufficiently appreciated.
Most people forget what the government can do in extreme times. The US made it illegal to own gold in 1933 when it went off the gold standard and confiscated all gold (they did pay for it in currency). Recommended reading: False Security: The Betrayal of the American Investor by Bernard Reis (1937).
If we compare the increase in corporate defaults to that of previous cycles, corporate defaults will reach twice the level seen in 1990-1991, (Yves here, you can question the projection of the end point. What I took away was that the situation is deteriorating more rapidly than most people realize, and there is good reason to think the peak will be worse than 1990-1991).
We are currently in a quiet period. We will see another leg down on the credit side by June-July. So far, the focus has been on large institutions. While 47% of the assets at big banks are real estate related, RE is 67% of the assets of smaller banks (my notes aren’t as clear as I like here, I think the break point was $5 billion in assets). My hedgie host noted that 29% of the smaller banks in the US have more than their net worth in construction loans.
Martin Mayer, who was the greybeard on the panel, pointed out that commercial and investment banks have different primary objectives. A commercial bank’s is “Will I get paid back?” while an investment bank’s is “Can I sell the paper?” They don’t sit well together.
Mayer also got quite agitated when the subject of credit default swaps came up. He considered them to represent a huge regulatory failure. In the late 1960s and early 1970s, Wall Street had a back office crisis that led a number of firms to fail and led to the creation of centralized clearing operations. CDS are settled bi-laterally, which never should have been permitted. In fact, a few years ago, 80% were not registered in a form that was legally enforceable. Mayer said the situation had improved: “a fair percentage now have juridical existence.” That isn’t what the ISDA would lead you to believe!
Most analysts have glosses over the fact that 40% of the homes purchased from 2005 onward were second homes.
One speaker (I cannot recall which one) argued that the push for more affordable housing was to mask the political impact of stagnant wages. “We needed to show some form of economic progress to meet social goals.” Yet channeling so much investment capital into housing has certainly not helped, and probably weakened US competitiveness, thus in the end making workers worse off in the long haul.
Several speakers noted that this would be a consumer-led recession, and those were deeper and nastier than business-led contractions (1990-1991 and the dot-bomb era both fit that pattern). Rosner walked through how real estate has been subsidizing consumption, and that is rapidly coming to an end. The difference between subprimes versus Alt-A and prime is that they hit the wall first.
As of the fourth quarter, there was $8.4 trillion in revolving lines of credit and HELOCs. The drawdowns are accelerating at a time when the banks are cutting the lines. Push come to shove, many consumers are going to favor keeping their consumer revolver (their credit card) over their house (note this is reinforced by the bankruptcy law changes).
The policy goal is not to halt the correction but to attenuate it. But that alone could put us into a decade-long slump.
MBIA has written $135 billion of CDS and has only $1 billion of reserves against it. Rosner believes the Fed has not looked at any of the supposedly AAA paper it has taken to see whether it is natively AAA or has achieved it by virtue of being wrapped. AIG expected its CDS-related losses only to be $900 million and then took writedowns of $9.1 billion.