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Pimco’s Bill Gross: Financial Firms Will Write Down $1 Trillion

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Bond maven Bill Gross has raised his estimate of losses from the credit crunch to $1 trillion. One has to note that his firm is a large holder of Freddie and Fannie debt and he issued this pronouncement the day after the GSE rescue bill passed the House and looks certain to become law.

Note also that this is far from the gloomiest view on record. Well respected analyst Frank Venerose now predicts $2 trillion in credit related losses; Hedge fund Bridgewater, whose research is read by central banks, expects $1.6 trillion in markdowns; hedge fund manager John Paulson, who bet aggressively and successfully on the subprime debt debacle, anticipates $1.3 billion.

From Gross’ August newsletter:

The deflating U.S./global asset markets are much like Churchill’s Russia: a riddle wrapped in a mystery, inside an enigma. “Who is driving delevering?” asks the Financial Times, and the answer comes back, “all of us;” yet it is hard to see it except in the headlines or to fix it, given a lineup of 6.8 billion suspects….

Yves here. This is a tad disingenuous. The “who” question implies the deleveraging may not be warranted. As Veneroso stresses, it is necessary, inevitable, and long overdue. US debt totals nearly $50 trillion. GDP is a tad over $14 trillion. That gives a debt to GDP ratio of 350%. That is vastly in excess of anything this economy has seen, excluding the parabolic rise to this level. The previous peak was around 260% of GDP during the Depression, when Roaring Twenties debt reached unprecedented levels and then (in relation to GDP) spiked higher as GDP fell dramatically but the loans were slower to be written off..

Back to Gross, who compares capital to the mother’s milk of capitalism and then uses bovine metaphors:

Let’s blame it on the barn, or if you must, home prices. Here is one asset that all observers can agree is going down in price for justifiable reasons….

Yet housing, unlike other asset classes, carries with it an aura more like a bad dream than a fairy tale. Unlike the frog that when kissed turns into a handsome prince, housing can morph a froglike economy into something resembling Godzilla. That is because it is the most levered asset class and the one held by more “investor” citizens than any other. U.S. homes are market valued at over 20 trillion dollars with nearly half of the value supported by mortgage finance of one sort or another. At first blush that appears to be reasonably levered, but at the margin, homes purchased in 2004 and beyond are now at risk of turning upside down – negative equity – and there are some 25 million or so of those. The “upsidedownness” in many cases results in foreclosures, or outright abandonment and most certainly serves as an example of what not to do for millions of twenty-somethings or new citizens choosing between homeownership and renting. The dominoes fall month-by-month…. An asset deflation in turn becomes a debt deflation, as subprimes, alt-As, and finally prime mortgages surrender to the seemingly inevitable tide. PIMCO estimates a total of 5 trillion dollars of mortgage loans are in risky asset categories and that nearly 1 trillion dollars of cumulative losses will finally mark the gravestone of this housing bubble. The problem with writing off 1 trillion dollars from the finance industry’s cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth, creating what Mohamed El-Erian fears as a “negative feedback loop.”

A trillion dollars is a lot of money, but in this age of photoshop wizardry it seems that experts can make just about anyone or anything look good. Lose a trillion? Well, just write it off a little more slowly, or suggest that mark-to-market accounting is not applicable to banks and investment banks. As a matter of fact it may not be. GaveKal’s Anatole Kaletsky points out that “the whole point of a bank is to exchange short-term, liquid liabilities for long-term illiquid assets whose value is hard to gauge. This liquidity and maturity transformation, in fact is the main social function that a banking system provides.” I and others on PIMCO’s Investment Committee wholeheartedly agree. But the reluctance to remark rancid mortgage loans rests on the heretofore inevitable conclusion that home prices will bottom and then reflate within a reasonable period of time. If they go down even more, and stay down, well then Washington – Wall Street – and ultimately, Main Street – we have a problem. That is why Hank Paulson and in turn Christopher Cox are waving their independent but coordinated wands in an effort to 1) prevent a market run on the price of bank and investment bank stocks until there is enough time to reflate the U.S. housing market, and 2) ultimately recapitalize our primary mortgage lenders – FNMA and Freddie Mac. An interesting press release by the CBO on July 22nd, by the way, points out that the GSEs are barely solvent (9 billion dollars) when their assets are valued at current market prices. Housing’s cow needs to turn into a bull real quick.

Make no mistake, the current conundrum that must be solved is: how to make the price of 120 million U.S. barns stop going down in price and then to make them go up again. That, however, is easier said than done. One of the wisest men I know has this serious but admittedly impractical solution: have the government buy one million new/unoccupied homes, blow them up, and then start all over again. Absent that, he’s not quite sure what to do, nor am I, with the exception of the next paragraph’s proposal.

Up until this point, the joint efforts of the Fed and the Treasury have been directed towards maintaining the stability of our major financial institutions, recapitalizing their balance sheets in “current form,” and lowering the cost of mortgage credit. All are crucial to any solution, but it is this third and last point where markets have failed to cooperate. With Fed Funds having been lowered from 5¼% to 2%, it would have been logical to assume that the price of mortgage credit would go down as well and that the price of homes would at least slow their current descent. Not so. As Chart 2 points out, the yield on a 30-year agency mortgage-backed loan has actually risen since the Fed somewhat unexpectedly began to lower Fed Funds in early September of 2007. Add to that of course, the increased fees, points, and total spread that an actual homebuyer pays to finance his purchase now as opposed to then, and it is obvious that homes are not the bargains that starving realtors claim they might be. Financial asset prices, as well as those for homes, are really the discounted present value of what investors believe those assets will be worth far into the future. When the discount rate – in this case a 30-year mortgage – rises faster than the expectations for home prices themselves – then the price of a home falls. 7% + “all in” yields for current home financing, in contrast to prior periods of monetary easing, are lowering, not raising the discounted present value of an existing home. Blow them up? Well, yes, I suppose if we could. But absent that, lowering the cost of mortgage credit via the omnibus housing/GSE bill now placed before the Congress and the President is the best way to begin the long journey back to normalcy.

To return the housing, cow milking, asset price deflating metaphor to its broader context, the increasing price of credit is a common denominator worldwide in the delevering process which it drives, or in turn, is driven by. If the cost of credit – the discount rate for present value – would go down, then asset prices would be better supported. Stocks wouldn’t sink so fast, commercial real estate wouldn’t wobble so, and Donald Trump wouldn’t have to exaggerate as often about how rich he is (make sure to buy T-Bills or GSE mortgages with that $95 million, Donald – if it closes). But the cost of credit is going up, not down, in contrast to prior cycles, because astute investors recognize the myriad of global imbalances that threaten future stability. In addition to home prices, $130 a barrel oil and their resultant distortion of global wealth and financial flows head that list. For now, investors should remain in high quality assets – until – until, well…until the prospect for home prices points skyward or until the cows come home, whichever one’s first.

Readers will no doubt note the curious failure to acknowledge the delevering as the result of mounting insolvencies, which makes the idea of stopping the fall in loan prices an exercise in fantasy.

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28 comments

  1. Unsympathetic

    Of course backstopping the GSE’s is a good bet – for Gross, because he holds risky bonds that he purchased because he was looking for a phantom return above Treasuries. If FNM/FRE are backed by the government, the return should be the same as T’s.

    FNM/FRE should therefore be put into runoff, or bailed out explicitly through raised taxes on the mega-rich who were the sole beneficiaries of the financial engineering fraud machine.

    FRE/FNM’s outstanding bonds offer a higher return than T’s because they state very clearly that they’re NOT backed by the US Gov’t. Gross is in trouble if FNM/FRE default.. because he got greedy, not because those entities should be a destination for US tax dollars.

  2. S

    Remember Gross was a buyer of WB at $36. Why is it so hard for Gross to wrap his intelligent mind around the idea that there is gross overcapacity in pretty much everything in the USA. In this light, why stop at housing. Maybe we can outrun the financial markets and bulldoze out way back to the 1930s.
    It comes as no surprise that Gross is now essentially pedling interest rate caps for all intensive purposes. Incredible.

    If the consumer bridge loans faqcilitiated by the perves incentives in the system were the only thing that justified the lofty house prices and those incentives are going to be regulated away (well SEC Cox seems to think that is now not a good idea this as he is impeding free markets with his shorting moratroium)what exactly are the fundamentals that would justify rising prices. Must be all that pricing power from employees and those rocketing wages.

    Fantasyland which sets against a perfect backdrop down there in newport beach…

  3. James

    “Make no mistake, the current conundrum that must be solved is: how to make the price of 120 million U.S. barns stop going down in price and then to make them go up again.”

    This, I think, gets to the heart of Gross’s misreading of the situation. The problem, in his view, is not that prices got too high and credit too loose. No, the main problem is that prices are now coming down, and that must be stopped at all costs. Gross is, in many ways, an astute observer of the credit markets, but somehow he’s managed to retain this one huge blindspot.

  4. Anonymous

    Our government is fighting an up hill battle especially when the market place is bigger than the any government. The markets are demanding higher interest rates and the government goes in the opposite direction, something has to give or snap. The cushion with thin padding is the taxpayer/consumer.

  5. wintermute

    I was a fan of Bill Gross for two years when he wrote about the shadow banking system, risks of CDS and other matters.
    Now I realise how self-serving he is – begging for a taxpayer bailout of FNM and FRE.
    I hope he loses his shirt on them. He knew better in the first place!

  6. Anonymous

    “With Fed Funds having been lowered from 5¼% to 2%, it would have been logical to assume that the price of mortgage credit would go down as well and that the price of homes would at least slow their current descent. Not so.” — Bill Gross

    It might have been logical if you assumed that the core inflation rate was only 2% or so, so that 10-year note yields and the mortgage securities which price off of them would remain nice and low.

    But commodity prices are in their seventh year of rise, the PPI is running 9% annually, and overnight real rates are at minus 3%. It would be logical, under this dismal set of facts, for bond vigilantes to SELL LONG-TERM DEBT SECURITIES LIKE THERE’S NO TOMORROW.

    Bill Gross has commented in the past that inflation measures are “stepped on” to keep them artificially low. As one of the world’s largest fixed-income investors, he knows that bond buyers want a real yield of 2 or 3% above inflation, which is currently running 5% on the CPI. When you’re printing money to pump up the next Bubble (as Gross freely admits), why would you not expect T-notes to head toward fair value — around 7% yield — and mortgage securities to price at 7.50% or 8.00%?

    Bill Gross wants to have his cake and eat it too — that is, to pursue wildly inflationary “Bubble III” policies, while expecting bond yields to remain tame. You’re a typical American, Bill — living in La La land, both culturally and geographically. Maybe you should quit while you’re ahead, as your svengali Greenspan did.

    Then you two could go fishing, and chew the cud over the good old days when you Bubbled the known universe together.

  7. Anonymous

    … creating what Mohamed El-Erian fears as a “negative feedback loop.”

    Gahhh, no surprise if we are in such a pickle if the alleged elder statesmen of the financial world have such mush in place of their brain and don’t even have the most basic notions of system control.

    No, it’s not a “negative feedback loop.”. Quite the contrary. It’s a strongly positive feedback loop, meaning that a variation of the output of the system is fed back in the system to produce further variation in the system in the same direction. That’s what positive means. For economists, it means pro-cyclical.

    And as nearly all electronic, robotic or system control engineers know, a system with a positive feedback loop is inherently unstable and always ends going to its physical limits and break apart.

    Stable systems require a negative feedback loop so a variation in output in either direction quickly throw the system back in the other direction and stabilize it around a defined value.

    What we have here in the asset market is a strongly positive feedback loop with very unpleasant consequences. Positive is not always a good thing.

  8. Michael

    Boy, reading Gross gets more and more difficult. I’ve lost a lot of respect for the man.

  9. s

    Please note the NY Fed PDCF auction today. Bid to cover was 2x (neary a mention anywhere) which is the hgihest since inception. Granted $ on offer was “only” $25B, but the bids tendered were $52B! This while the ted spread is going down. This is interesting

  10. Anonymous

    For many, many, many of the 25 million homes that are “under water”, the fact that they are under water will make no difference to their owners, who will simply keep living in them and paying their mortgage. That 25 million figure since 2004 includes existing homes that were resold. Many of those buyers were also sellers, selling one house at a high price to buy another at a high price. What matters is not the number of people who are underwater but the number of people who will default.

    The “serious but impractical” suggestion of blowing up 1 million homes is foolish and cannot be taken seriously, not because of its impracticality but because of the very notion that somehow an economic crisis can be solved with a massive destruction of real property. You would be better off giving the homes away than blowing them up. Or allow 1 million more educated hard working immigrants to come in and buy them.

    It is a bad thing, not a good thing, for a society and an economy to have inflated home prices. Excess housing has been built, obviously, just like excess railroad capacity once was built, and excess optical fiber was laid. But houses and railroads and optical fiber are useful in the long run. It is not as though the money was spent on tulip bulbs.

  11. Anonymous

    Until housing becomes affordable (2.5 to 3 times income) and banks do due diligence (instead of their doo-doo diligence), this mess will not stop.

    It would be nice if wages would go up for a while, too – at least for those earning less than $100k.

  12. Anonymous

    The 1 trillion figure sounds scary but even if it occurs, a good portion of it is simply represented by changing claims on the system-wide assets, not by changes in the actual value of the assets. Much of the 1 trillion writedown, if it materializes, will be just a reclassification of debt to equity as ownership is transferred from original buyer to foreclosing lender to new ultimate owner. Very painful for the person being foreclosed, but across the economy, it is not as bad as it sounds, it is not as though 1 trillion of assets are impaired.

    He says 1 million too many houses were built. Lets say these 1 million were completely worthless (as they would be after you blew them up per the “serious” proposal). That still wouldn’t get you to an asset impairment of 1 trillion unless you thought that the cost of building those houses was 1 million each.

    The economy made a mistake and built too many houses for a while. We’ll recover, same as we recovered from the effect of building too many dot coms.

  13. Anonymous

    Wages will go up in nominal terms when inflation takes hold. That’s part and parcel of how the debtors get bailed out by inflation.

  14. Francois

    “Wages will go up in nominal terms when inflation takes hold.”

    Pray tell how is this going to happen when:
    1) Credit is contracting
    2) Overcapacity is rampant
    3) Consumers AND businesses are scaling down at a very rapid clip.

    I think (and dread) we will see deflation before long.

    That is truly scary!

  15. Anonymous

    I would guess that Paulson’s estimate is 800K billion Thats the amount the debt ceiling went up.

    BTW somewhere I read that Sen. Reed “broke an impass” by throwing in section 8 money to bail out the mortgageable.
    That screws a lot of really poor honest folks who need section 8 as rent subsidy. Many are the working poor

  16. Anonymous

    WaMu!!!

    The FDIC is bankrupt.

    I have $1m in cash and have placed it in 10 FDIC guaranteed banks.

    If one million others do the same (and they are there) the FDIC will have an additional $900Bn to insure.

    If 10% of that goes bad the FDIC will have to get an additional $90Bn just to stand still.

    I don’t think China/Japan/Q8 will have the appetite for much more of this nonsense.

  17. GeorgeNYC

    These types of proposals reveal the compete disconnection from reality that has resulted from our focus on the “markets.” Just move these levers here and Presto! Everything will be better.

    It calls to mind (in a perverse way) the book Enders’ Game. In the book Children were pulled from their families at an early age and “trained” in various contests. I the end they were told that they were engaged in simulated wargames as part of their “tests” to graduate. In fact, they were fighting real battles but they were led to believe they were just “games.” The point was that these “kids” were better at fighting than generals trained over many years. In part, because they failed to grasp what was at stake.

    I thinkof this now as I realize that our financial “leaders” are really no different.(although perhaps in an “opposite” kind of way) They have been trained to react to blips on a screen as though they were reality. Thus the “solution” to housing it to make the interest “blip” go down and all will be well. Does it even occur to these guys that in the “real” world people who have no jobs or whose income is being eroded by higher taxes and lower wages and higher gas prices are really not in a position to respond to these “blips.”

    We have spent all of “investment” money to build ourselves lovely new houses and nice shopping malls. What we have not done is “invest” in anything truly productive as our manufacturing base gets outsourced and dismantled. Our “service” economy is nothing more than selling stuff to each other.

    Yes everything seemed to be “booming” when we were building all of these homes and shopping centers (and cars and trucks to get there and build them). But now what do we do? Where does the “income” come from to pay back all of the debts that were built up to build ll of the houses.

    This is not some computer game like “Civilization” where resources just appear from turn to turn. We have just finished a HUGE period of dysfunctional capital allocation. We need leaders who do more than check Bloomberg charts on their computer. We need people who can nurture real investments in tangible industries. This takes time and patience and hard work. We need leadership who can realize that the true “stars” of the economy are those hard working types who really establish, maintain and grow small businesses. Not some hot shot hedge fund kid who trades assets and lives off commissions while he destroys everything around him. We need to value industries that EMPLOY people rather than merely shift money around.

    Unfortunately the true strength of the economy is in all of these “boring” areas that employ untold millions of people. we should be somewhat more concerned about markets that create jobs rather than markets that trade things. Money will always find a way to make money.

  18. Anonymous

    Sy Krass said…

    I actually saw Larry Kudlow short circuit today! I believe he believes if he talks loud enough, reality will bend to his whim. I have heard of whistling past the graveyard, but not covering your ears, closing your eyes and yelling, ‘LA- LA- LA-’ past the graveyard.

  19. Anonymous

    Sy Krass said…

    ‘I don’t think China/Japan/Q8 will have the appetite for much more of this nonsense’

    Again ladies and gentleman, The China’s and Japan’s of the world have benefitted from our debt policies as much as we have. I strongly disagree with those who say if we fall other places will be safe havens to park your money. That being said, other places may eat our lunch and leave us in the dust eventually. That being said when the game ends here, the game ends everywhere. A massive deflation here means a massive deflation everywhere.

  20. S

    do you think bill gross wants another rate cut? Do you think that BOA CEO Lewis who on his call said he spoke with PAulson saturday and is on the Fed advisory committe wants anther rate cut? Bond markets are pricing in 88% chance of rate lift by year end — best value in the market at the moment. There will be no rate cuts anytime soon. The chances of a rate cut are approaching 100%

  21. outhouse

    According to wording in a Bloomberg news story describing how FNM and FRE took on twice as many unsold homes as they’ve sold, said agencies are in the business of:

    “They bundle home loans into securities to sell to investors and use cash from the sales to fund mortgage lenders.”

    This is more commonly described as a circle jerk. Gross is one of those in the circle.

  22. Anonymous

    Temasek
    Selling Merrill Lynch
    Half or total of 87m shares have been sold off at a loss, according to US recorded filings. By Seah Chiang Nee
    Jul 24, 2008

    Temasek Holdings has sold off half its ill-timed investment in Merrill Lynch – or about 87m shares, according to a mutual funds report on institutional trades on US stocks.

    The online report, MFFAIRS (Mutual Fund Facts About Individual Stocks), reported it sold off 86,949,594 shares (50%), leaving a current holdings of 86,949,594 shares (50%), according to the filings made public.

    The report gave no exact date or price of the sale.

    Neither has there been any confirmation from Temasek, which had paid US$48 a share last year. http://www.mffais.com/newsarticles/2008-07-22/2473637-211738.html

    Last week Merrill Lynch was traded at $31.

    At that price Temasek would have suffered a loss of $17 a share – or a total loss of about US$1.48b for the 87mil shares.

    Despite massive write-downs and capital injection, Merrill Lynch’s outlook remains uncertain, reports Bloomberg.

    The company’s equity capital position is weak relative to competitors, said Brad Hintz, a New York-based analyst at Sanford C Bernstein, reports Ambereen Choudhury.

    “With $19.9b in CDOs still frozen on the balance sheet and with counterparty risk rising on the hedges underlying these troubled positions, the potential for additional material write-downs remains a concern,” Hintz said.

    The New York-based firm’s credit rating was cut last week by Moody’s Investors Service to A2 from A1.

    The third-biggest US securities firm probably will report a loss of $6.57 a share this year, compared with an earlier forecast of $1.07, Hintz said.

    The revised estimate assumes the company generates no earnings in the second half.

    Merrill may have to take an additional $10 billion of pre-tax write-downs related to its holdings of mortgage securities, Moody’s estimates.

    Huge paper losses

    The disposal leaves Temasek Holdings and the Government Investment Corporation (GIC) still holding substantial parts of big troubled Western banks.

    Its remaining investments in UBS (Switzerland), Citigroup, Barclays and Merrill Lynch – at an original cost of US$21.88b – have declined on by some 47 percent in value.

    That is a paper loss of US$10.28b. However, Minister Mentor Lee Kuan Yew had said these investments were made as a long-term strategy of 30 years.

    But as the Merrill Lynch sale shows, Temasek is not inflexible about cutting losses, if things threaten to get worse.

    The political leadership has defended its investment of these sub-prime banks as “an opportunistic” foray that can happen once in a long while.

    It believes these companies will survive the crisis and emerge stronger.

    Some experts believe that Temasek has made an error of judgment.

    Investment guru Jim Rogers said in July he believed that US bank stocks could fall further and predicted that Singapore’s state investors would lose money on Citigroup and Merrill Lynch.

    “I’m shorting investment banks on Wall Street,” the successful investor said. “It grieves me to see what Singapore is doing. They are going to lose money.”

    At the Nomura Dialogue recently, Minister Mentor Lee Kuan Yew reported to investment mistakes, but that no one had benefited from it.

    Singaporeans who want to see greater transparency in the government’s investments in troubled companies are unhappy with this vague answer to a serious problem.

    One writer said, “Should we just move on? I do not think so. The patently huge mistake is not merely the result of recklessness but rather a systemic lack of accountability in making some of our largest investments.

    “Let it be clear, the harm is terminally done. The entire reserves system must be re-examined and audited.”

    Said slohand, “I saw the interview on TV last night and felt shortchanged.

    “He brushed aside the issues with the logic that since the officers who made the decisions were not the beneficiaries in any sense of the word, such lapses are mistakes and are therefore acceptable…

    “..The size indicates that it can only come from the very top.”

    The skies are dark but the storm has not broke yet.
    By Seah Chiang Nee

  23. Anonymous

    If you have a million bucks you need to put in 11 different banks to allow for interest so not to exceed the $100,000 FDIC limit.

    Actually I’d stash it in foreign treasury bonds starting with Canada.

  24. reason

    Why is buying up houses and blowing them up impractical? The US government is very good at blowing up houses (just ask Iraqis). What he means to say it is that it is politically unpalatable. That is something else.

  25. Richard Kline

    ” . . . [H]have the government buy one million—” *HAHAHAHAHAHAHHHAA* I can’t finish. So Bill, if overcapacity is the problem draggring down phoney asset prices, I suggest instead that the current holders of those unoccupied ‘negativity nodes’ to which you refer _blow them up themselves_ and mail the land titles to the local county assessors. That work for you? What makes no sense in this is for the PUBLIC to pay idiot speculators for their losses for the privilege of preserving irrational asset prices for those in occupied dwellings—and the bond holders of their securitized mortgages such as, say, well YOU. I’d go on, but that remark from Willy der Grosser doesn’t merit the pixels I’ve already expended.

  26. Richard Kline

    To Anon of 2:53, you are of course completely correct. The problem here is with Gross’s (mis)quote, or that of his intermediary source. El-Arian had used ‘negative’ in a different but appropriate phrasing implying an accelerating spin down, i.e. a ‘positive loop.’ I saw the original remark several times months back, though I do not remember the exact formulation. This was not a good choice on El-A’s part exactly because it confuses lay observers including Bill Gross. The point was to indicate that actual declines, not simply flattened growth, were in the pipeline, but still, not a good choice of terms. Oh well: We’ll all be going back to school to learn how to be productive in our ‘New New Economy,’ as this shakes out; we’ll get our heads around this come the day.

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