"Debt Reckoning: U.S. Receives a Margin Call"

I rarely feature Wall Street Journal articles in long form because I figure most readers will find them on their own. But the Journal’s Saturday edition isn’t as widely read, and this is an exceptionally good piece, particularly given that the Journal is not the best source on credit market reporting. The ongoing crisis seems to have put them in catch-up mode.

Readers will recognize many themes discussed here and in like-minded venues: the unsustainability of “global imbalances” (code for nice savers in China, Japan, and the Gulf States funding our profligate consumption); the deep downside of deleveraging; the fact that the Fed has been aggressively using the wrong playbook, treating the credit crunch as if it were a liquidity crisis rather than a solvency crisis.

Although the Journal does not draw this comparison, the US is in very much the same boat as Thailand and Indonesia in 1997, during the emerging markets crisis. And although the US arguably has a more diverse economy, the main things that differentiate us from them is the dollar’s reserve currency status (which means if we implode we do a great deal of collateral damage) and our nukes. We also like to think that because the US has been the biggest buyer of global exports, we are effectively too big for our cash rich trading partners to allow us to fail. Even if they accept that proposition (not clear, BTW), it’s not obvious in practical terms how they might act on it.

The last time the Journal had such a downbeat piece on its first page over the weekend, I was convinced that it alone would push the market down on Monday. Yet for some reason I cannot now recall, it staged a peppy rally.

With Bear in play and the Fed likely to pull more tricks out of its sleeve, it’s hard to know what the next week will bring, save volatility.

From the Wall Street Journal:

The U.S. is at the receiving end of a massive margin call: Across the economy, wary lenders are demanding that borrowers put up more collateral or sell assets to reduce debts.

The unfolding financial crisis — one that began with bad bets on securities backed by subprime mortgages, then sparked a tightening of credit between big banks — appears to be broadening further. For years, the U.S. economy has been borrowing from cash-rich lenders from Asia to the Middle East. American firms and households have enjoyed readily available credit at easy terms, even for risky bets. No longer.

Recent days’ cascade of bad news, culminating in yesterday’s bailout of Bear Stearns Cos., is accelerating the erosion of trust in the longevity of some brand-name U.S. financial institutions. The growing crisis of confidence now extends to the credit-worthiness of borrowers across the spectrum — touching American homeowners, who are seeing the value of their bedrock asset decline, and raising questions about the capacity of the Federal Reserve and U.S. government to rapidly repair the problems.

Global investors are pulling money from the U.S., steepening the decline of the U.S. dollar and sending it below 100 yen for the first time in a dozen years. Against a trade-weighted basket of major currencies, the dollar has fallen 14.3% over the past year, according to the Federal Reserve. Yesterday it hit another record low against the euro, falling 2.1% this week to close at 1.567 dollars per euro.

Lenders and investors are pushing up the interest rates they demand from financial institutions seen as solid just a few months ago, or demanding that they sell assets and come up with cash. Banks and Wall Street firms are so wary about each other that they’re pulling back. Financial markets, anticipating that the Fed will cut rates sharply on Tuesday to try to limit the depth of a possible recession, are questioning the central bank’s commitment or ability to keep inflation from accelerating.

There are other symptoms of declining confidence. Gold, the ultimate inflation hedge, is flirting with $1,000 an ounce. Standard & Poor’s Ratings Services, a unit of McGraw-Hill Cos., predicted Thursday that large financial institutions still need to write down $135 billion in subprime-related securities, on top of $150 billion in previous write-downs. Ordinary Americans are worried: Only 20% think the country is generally headed in the right direction, nearly as low as at any time in the Bush presidency, according to the latest Wall Street Journal/NBC News poll.

“Clearly, the whole world is focused on the financial crisis and the U.S. is really the epicenter of the tension,” says Carlos Asilis, chief investment officer at Glovista Investments, an advisory firm based in New Jersey. “As a result, we’re seeing capital flow out of the U.S.”

That is a troubling prospect for a savings-short, debt-heavy economy that relies on $2 billion a day from abroad to finance investment. It is raising the specter of the long-feared crash in the dollar that could further rattle financial markets and boost U.S. interest rates.

Though the risks of an unpleasant outcome are worrisome, the effects of Fed interest-rate cuts and fiscal stimulus have yet to be fully felt by the U.S. economy. Moreover, the combination of a weakening dollar — which remains the world’s favorite currency — and still-growing economies overseas is boosting U.S. exports and offsetting some of the pain of the housing bust and credit crunch.

But while cash continues to pour into the U.S. from abroad, this flow has been slowing. In 2007, foreigners’ net acquisition of long-term bonds and stocks in the U.S. was $596 billion, down from $722 billion in 2006, according to Treasury Department data. Americans, meanwhile, are investing more of their own money abroad.

Hopes are fading fast that the U.S. economy was suffering from a thirst for liquidity that standard Fed remedies could quench. Former Treasury Secretary Lawrence Summers, speaking in Washington yesterday, said he sees “an increasing risk that the principal policy tool on which we have relied — the Federal Reserve lending to banks in one form or another” — is like “fighting a virus with antibiotics.”

Bob Eisenbeis, a former executive vice president of the Federal Reserve Bank of Atlanta, says the problem is more than an inability to find ready buyers for assets. “It is time to step back and recognize that the current situation isn’t a liquidity issue and hasn’t been for some time now,” said Mr. Eisenbeis, the chief monetary economist for Cumberland Advisers. “Rather, there is uncertainty about the underlying quality of assets — which is a solvency issue, driven by a breakdown in highly leveraged positions.”

President Bush, speaking in New York and in a television interview yesterday, showed little appetite for further action. Detailing the steps the administration has already taken, the president in a speech knocked a couple of pending proposals. “Government policy,” he said, “is like a person trying to drive a car on a rough patch. If you ever get stuck in a situation like that, you know full well it’s important not to overcorrect — because when you overcorrect you end up in the ditch.”

But few in markets and elsewhere are convinced that the worst is over for the U.S., as each player moves to protect its own interests against potential calamities seen as improbable just a few months ago. Bear Stearns reassured investors earlier this week that it was solvent, but speculation that Bear faced a liquidity crunch had some traders and hedge funds moving to limit their exposure to it. Yesterday, J.P. Morgan Chase & Co. and the Federal Reserve Bank of New York offered emergency funds to keep the troubled investment bank afloat.

The loss of confidence is now spreading beyond the biggest banks, with their well-publicized losses on subprime and other risky assets, to regional and small banks. In the fourth quarter, U.S. banks reported their smallest net income — a total of $5.8 billion — in 16 years, according to the Federal Deposit Insurance Corp.

There’s little sign yet that the worst is past. The “moment of recovery” is when forecasters turn out to be too pessimistic, says Mr. Summers. That point hasn’t likely arrived. A Wall Street Journal survey of more than 50 economic forecasters in early March found a profound shift toward pessimism: About 70% say the U.S. is currently in recession, and on average they put the odds that this recession will be worse than the past two mild, short recessions at nearly 50%. Most expect house prices to decline into 2009 or 2010.

This couldn’t come at a worse time for U.S. homeowners. American household debt has more than doubled in a decade to $13.8 trillion at the end of 2007 from $6.4 trillion in 1999, the vast majority of it in mortgages and home equity lines, according to Fed data. But the value of U.S. householders’ biggest asset — their homes — is now falling.

The response of the Republican White House, Democratic Congress and Federal Reserve have been substantial. President Bush and Congress, with remarkable speed, agreed to a $160 billion fiscal-stimulus package that will put money in consumers’ wallets soon. The Fed already has cut interest rates by 1 1/4 percentage points this year, and markets anticipate another 3/4 point cut on Tuesday. The Fed has moved to buy $400 billion worth of mortgage-backed securities for its $800 billion total securities portfolio in an effort to jolt that crucial market back to life and prevent rising mortgage rates from further depressing the U.S. housing market.

While there is continued debate about how to treat the current disease, there is a consensus emerging on the causes. “Soaring delinquencies on U.S. subprime mortgages were the primary trigger,” the heads of the Treasury, Federal Reserve and Securities and Exchange Commission said in a lessons-learned report. “However, that initial shock both uncovered and exacerbated other weaknesses in the global financial system.”

Kenneth Rogoff, a Harvard University economist, says the current difficulty has many mothers — the housing bubble, the subprime problem and the fact that the value of U.S. imports has long outstripped the value of exports. The current account deficit — the broadest measure of the trade deficit — burgeoned, and the U.S. needed to borrow ever larger amounts of cash from abroad to fund it.

For years, Mr. Rogoff and like-minded economists harped that the U.S. current account deficit was unsustainable. But despite the belief that it would necessarily reverse, it kept growing through the first part of this decade, going from 3.6% of gross domestic product at the end of 1999 to a record 6.8% at the end of 2005. Lately, the deficit has seen a slight narrowing, but the combination of credit crisis and the economic downturn may have proved the catalyst for a faster, and potentially more dangerous, adjustment.

Pressures in one market spread rapidly to other, often more distant markets. “The dollar and subprime — they’re two sides of the same coin,” says Princeton University economist Hyun Song Shin. Many U.S. hedge funds and financial institutions were speculating in mortgage-related securities with money that was ultimately borrowed in Japan, where interest rates have been low for years. He notes foreign banks’ net liabilities in the yen interbank market surged between April 2006 and April 2007. As investments bought with money borrowed in Japan get sold and converted back into yen, he says, “we see both a fall in asset prices and a fall in the dollar.”

The resulting blow to confidence threatens to further weaken lending, borrowing, spending and investment in the U.S. economy. “Hedge fund blowups have so far been one-off situations. One worry is that we’ll cross some line and there’ll be a systemic wave of fund failures. It’s a reason why the market is so nervous,” says John Tierney, credit derivatives strategist at Deutsche Bank.

Banks also are increasing the collateral they demand when they lend to hedge funds that hold municipal bonds. One hedge fund manager described what appears to be a coordinated effort by big investment banks to reduce their risk as they faced quarter-end pressures to cleanse their balance sheets. Lenders declared “by fiat,” he said, that municipal-bond-fund managers needed to post more collateral to back their borrowings.

As a result, funds run by Blue River Asset Management, 1861 Capital Management and others circulated lists of assets to raise cash. The sell-off flooded the market with municipal bonds, making it more expensive for municipalities to borrow and upending the traditional relationship between tax-exempt municipal bonds and taxable U.S. Treasury bonds. For the first time in memory, yields on tax-exempt municipal bonds jumped above yields on taxable U.S. Treasury debt.

Now, many hedge fund managers say, access to borrowed money, essential for many of their investment strategies to work, has become virtually impossible.

Mohamed El-Erian, co-chief executive officer of Allianz SE’s Pacific Investment Management Co., says the hedge-fund community is unwinding its leverage. “This will push more of them into ‘survival mode,’ further accentuating distressed sales and nervousness among the prime brokers,” he wrote to his colleagues Thursday morning. “In such a world, the quality of the assets matters less than whether you can finance them [or] how liquid they are.”

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  1. Anonymous

    Interesting history IMHO:

    Remarks by Governor Ben S. Bernanke
    Before the National Economists Club, Washington, D.C.
    November 21, 2002
    Deflation: Making Sure “It” Doesn’t Happen Here

    But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

    Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).8

    Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

    8:Keynes, however, once semi-seriously proposed, as an anti-deflationary measure, that the government fill bottles with currency and bury them in mine shafts to be dug up by the public.

    Oh My God!

  2. Max

    At least Keynes recognized the importance of hard work in digging up the money. In a sense he was right, in that if at a certain deflationary period everything is seized by fear, and liquidity preference is maximally shifted to the present, the best way to loosen-up the system would be to offer work for the money. I believe, if we actually applied Keynes ideas throughout the numerous recessions by letting the government to be the employer of last resort for infrastructure projects, we would be in a much better shape. Here, in San Fran Bay Area, the land of tech millionaires and billionaires, the public roads are so crappy, I wonder how is it possible if everyone is so rich.

  3. Anonymous

    Take another look at this passage in the Journal article:

    Though the risks of an unpleasant outcome are worrisome, the effects of Fed interest-rate cuts and fiscal stimulus have yet to be fully felt by the U.S. economy.

    This passage comes from the reporters (as opposed to a person interviewed or cited). And, too typical of the Journal, it is poorly reported/written.

    Think about it. Basically, the sentence structure communicates: “Not to worry”.

    And the reason for ‘not to worry’ is that the ‘effects of Fed action are not yet fully felt’.

    But, if those of us who follow Yves think for just a second, the effects of Fed actions are negative, not positive. When they get fully felt, we’ll all be witnessing a greater disaster.

  4. Anonymous

    March 15, 2008
    Thinking Required

    Testing The Assumptions
    (Looking for love [financial market truth] in all of the wrong places?)

    I speculated in my “Through the Looking Glass, and Down the Rabbit Hole” paper
    (Scroll down the page), a few “What if”, and/or, “Bigger than a bread basket” business man’s conclusions. Over the last few days I’ve been pounding on these conclusion trying my best to prove myself wrong, while waiting for someone, (Where are you?), to come back and explain to me why I’m just full of #%&*. So far not a peep in reply. In the rapidly developing meantime, I’ve had moments of “Uh-Oh, I didn’t know that”, “Wonder if that makes my conclusions off base?”, “How in the hell do you factor that in?”, and then ending with, for the moment, “Uh-Oh, again, these numbers look more on the mark than I had ever imagined they would be”, not that that is any comfort to me. It isn’t!

    I started with a report that there were presently “900,000 in foreclosure” which led to my saying in the above paper:

    “It is reported in the last few days that there are 900,000 homes presently in foreclosure. Taking businessman’s approach, lacking any “for certain” data, I’ve assumed a $200,000 to $400,000 per home amount for those homes in foreclosure. So…current non-performing mortgages industry wide could be in the range of $180 billion to $360 billion.”

    But wait! As they say in the TV steak knives ads, it was “reported” in the financial news this week that “2.2%” of the total numbers of US homes were “in foreclosure”. Earlier this week Moody’s, Economy.com “…estimates 8.8 million homeowners, or about 10 percent of homes, will have zero or negative equity by the end of the month.”
    So if 8.8 million equals 10% of the total homes, then 2.2% would equal 1.936 million homes presently in foreclosure. Now that’s quite a spread, 900,000 over 1,963,000 or more than twice, or 100%, of the original number I used. If we quickly apply the above “what if” per house values then this becomes an estimated range of $392 billion to $785 billion of loans in foreclosure right now, as we speak. Forget about what might be coming in the short term for the moment.

    Then to make things even more interesting S&P had this to say today:

    “NEW YORK (Reuters) – Standard & Poor’s said on Thursday write-downs for large financial institutions on subprime debt are likely past the halfway mark, but could still hit $285 billion. S&P’s estimate of write-downs was up from the $265 billion figure it published in January, but the credit ratings agency said an end to subprime write-downs was in sight.” (March 13, 2008)

    Now the fun really begins. If you divide 1.936 million homes into $285 billion you get an average “loan” amount of roughly $132,000 per house. Can it be true? Not on either of the “coasts” for sure which were referred to today as being the “major areas where loans were in default”, and I think the “coast areas” probably mean somewhere East of the Mississippi and then East again, and the Rockies West. This leads to another number crunching exercise. It’s been quoted all over the place in the last ten days that the total US Mortgage market is $11 trillion dollars. So if you divide 88 million homes (see above) into $11 trillion you come up with an average mortgage amount of $125,000 per home in the whole wide USA. Now this begins to smell. Did someone at S&P do what I just did, and apply a “national average” to come up with their “$285 billion” quoted above. It sure as hell looks like it. Or you can try a backdoor approach, and multiply $11 trillion by 2.2% which yields $242 billion or $121,000 per home for another very “smelly” “national average”.

    Let’s digress for a moment and see how these present “total foreclosure” numbers above stack up against what the Fed has been doing regarding bailout funds. A report today stated that the Fed has dumped in $900 billion so far “going back to the summer of 2007”. Already in 2008 they have put up a total of $140 billion in TAF’s in January and February, 2008, (I think) announced an additional $100 billion in TAF funds and another $100 billion “for related financial institutions” for March 2008, and then topped things off yesterday with another $200 billion for “who knows what”. That’s $540 billion so far in 2008 which means they put out $360 billion in the last half of 2007. That’s quite an acceleration of funding. And the first March announcement did say that they, the Fed, were committed to keeping up this funding for the “next six months” if necessary. So if you add up the already spend, or committed funds, of $900 billion, and you then add on another $200 billion times 6 months, with no further accelerations of funding, the total comes out to $2.1 trillion. It would seem that even the “$900 billion” already spent is an over kill to S&P’s “$285 billion sub-prime markdowns” much less the stated commitment by the Fed for an additional $1.20 trillion in 2008. What could the Fed and the financial market be possibly thinking? I’ll tell you what.

    The “Moody’s Economy.com” report, quoted part above, said in total:

    “Economy.com estimates 8.8 million homeowners, or about 10 percent of homes, will have zero or negative equity by the end of the month. Even more disturbing, about 13.8 million households will be “upside down” if prices fall 20 percent from their peak. The latest Standard & Poor’s/Case-Shiller index showed U.S. home prices plunging 8.9 percent in the final quarter of 2007 compared with a year earlier”.

    And since this quote from last week there have been recent estimates that housing market values were going to drop as much as 30% to 40%. If you again apply my “what if” numbers from above, the potential default amounts then rocket up to, for the “10%, 8.8 million homes” is $1.76 Trillion to $3.52 trillion, and up to, for the “20% ,13.8 million homes, $2.76 trillion to $5.52 trillion.

    Then I’ll reverse course and go back to S&P’s “estimate of write-downs”i.e. “$285 billion”. Hmmm…”write downs” says S&P, which seem to point to their meaning not “gross loan” amounts. So… using all of my circa 1962 “Money, Credit, & Banking” class skills, I am beginning to see that we have two, not one, financial mortgage market “default” distinctions being thrown around, “net loss”, “write down”, numbers that banks experience once a default property is sold, and/or have been traded into the Fed for shiny, (well maybe not so shiny) bars of gold (AAA Treasuries), and then the second being the gross initial loan amounts that default. So…As I remember, once a mortgage becomes “non-performing” it has to be taken out of the bank’s Fed mandated balance sheet requirements, and placed over in a “not to be used” loan multiplier, say 10 to 1 (my guess), category. With this said, one thing finally seems to be making sense, and that is Bernanke’s very smart move to allow banks to quickly “trade in” these toxic “non-performing” loans for “bars of gold”. And this then leads to a very poignant, and pointed, question of S&P’s statement “…write-downs for large financial institutions on subprime debt are likely past the halfway mark…” made on March 13, 2008. And then finally, once again, the Fed commitment of $2.1 trillion total amount, so far, of announced bail out funds beginning from last summer, as stated above, begin to also make some sense. And I would also quickly, and seriously, suggest that someone run over to S&P and give their gear head financial analysis guys and gals, a strong slap in the face to wake them up.

    So back to some more number crunching for the 0.0001% of you still with me.
    If you take S&P’s “$285 billion” number for presently forecasted “write-downs” yielding a $132,000 average per house number, it seems that one should ask, “What does that amount then yield in gross mortgage per house value of the present number of houses reported to have been to be “sold”, and “resolved”, since the beginning of the melt down last summer of 2007?.” The only number that I’m able to come up with to “test” this “assumption”, at the moment, is the reported “8% to 10% home price, year on year, drop” of “national home prices” that was recorded, and reported, for the last quarter 2007”. To make things easy I’ll use the 10% number which should mean that the average total home mortgage would be $1,320,000. While that number would be a “non brainer” for someone like me sitting in the high rent district of California, I would question that value when being applied nationwide, and that assumption, re: question, then leads to even more questions. One way to “think about it” might be that the percent of the total amount of mortgage “write downs” might be greater than 10%, say 30% to 40%, or that circling back to my “California” interpretation, you might concluded the “biggest” were first to fall. What can be said at the moment is that “We don’t know”, and I will stretch the point by saying that I’m not sure that any one else “knows”.

    What might be at play here is the dusty old accounting inventory distinctions of LIFO-FIFO (Last In First Out-First In First Out). Well…If you were to take a 30 year total market assumption of the “total mortgage market”, pretty safe I would say, and then extrapolate, and apply, that which has gone on since the advent of the sub-prime loan market it does seem reasonable to me, to assume that it is a FIFO (First In-First Out) number that is now coming back to bite us in the ass with vengeance. And then, and then again, what is the total of these, about to be, toxic sub-prime loans when compared to the currently quoted total $11 trillion mortgage market in value, and in per house, numbers? The list of questions then goes on and on, but let’s try to give it a whack. And if you haven’t already figured it out, I’m now “Way Out There” in the California surfer vernacular. A number, “1995”, keeps rolling around in my brain. It is the year that “Derivatives’ were invented in a similar manner to the totally bogus (sorry) Big Bang” “Ex Nihilo”, i.e. “from, our out of, nothing, re: Webster”, creation story. So is the front loading “13 over 30” re: a 1995 start of “sub-prime lending” or is it safer to assume a “7 over 30” number starting in 1980. Again who knows? And then the “$64 trillion dollar question” is (My haven’t the times changed?) how much, and what percentage of the “total $11 trillion mortgage market” gets factored into “being at risk” in the front loaded estimated amount, right now, and as of, today? My WAG (you do what that means) would be in the $5.5 to $6.6 trillion dollar range. Now we’re talking serious money, and even though it just may be a coincident these numbers are within shouting distance to the “13.8 million homes [yielding] $2.76 trillion to $5.52 trillion [in zero or upside down mortgage debt equity]” as stated above.

    Now that I’ve got “that all figured out” what is to say about the following?

    “We are becoming increasingly concerned that the authorities in the world do not get it,” said Bernard Connolly, global strategist at Banque AIG. “The extent of de-leveraging involves a wholesale destruction of credit. The risk is that the ‘shadow banking system’ completely collapses,” (Circa March 10, 2008.)

    Well, again, who knows? It does seem like that we’re all standing in front of the big “Wizard of Oz” screen trying to find some truth through all of the smoke and mirrors of this “Shadow banking”, read derivatives, system.” I suspect that it is the “Varmint in the Wood Pile”. We can smell it, we can hear it, and we can see all of the dead chickens spread around the barn yard, and we still don’t know what it is, and/or how to do anything about it. Not a very happy ending, but that is the best I’ve got for the moment, like it, or not. And if you happening to be wondering, I don’t like it one bit.

    For all of Standard & Poor’s Home Market Analysts.
    (99% of Final Grade)
    (Weighed questions. 10% total #I.0 through #3.0. 90% for #4.0)
    (Sorry no multiple choice questions. Essay only.)
    (Please write clearly in ink only on your bluebooks.)
    (Be cautioned that what you write today may not be valid tomorrow.)
    (You may freely consult the sum total of all of the World’s information systems during testing)
    (After the workday week has ended you may take your bluebooks home, and continue to write over the weekend. You may also consult with your family members if you choose, and please be cautious. No need to worry the innocent.)

    S&P Pop Quiz Essay Questions:

    1.0 What is the gross home market mortgage debt numbers underlying your last week quoted $285 billion mortgage “write down” numbers?
    2.0 What is the actual number of homes that you have in these calculations?
    3.0 Have all of your “homes in foreclosure” leading to your “write down” number that you have quoted actually been resolved i.e., sold and done with, our have you extrapolated the numbers. If so what are those two categories of numbers in gross and net values, as well as per home numbers in each class.?
    4.0 Do you ever, or have you ever, (sounds familiar doesn’t it) looked ahead to April 15, 2008 to see where your numbers might be after all of the first quarter 2008 Stats are in? (Probably a question for Moody’s, but what the hell, I might as well ask S&P.)


    Best regards,

    Earl L. Crockett
    March 15. 2008

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