NC Classic: The Tinkerbell Market

Yves here. Since many financial publications are using the ten year anniversary of the crisis as an excuse for mining their archives for articles that have withstood the test of time, I though we might as well join the party.

Earlier this month, I reproduced a post, Has the Credit Contraction Finally Begun? in which I called the turn in the credit markets on July 11, 2007.

This was based on two factors. One was that the astute market watcher, the Financial Times’ John Authers, had pointed to a significant break in the Treasury markets on May 5. He depicted it as a decisive reversal of a long-term disinflationary trend. The second was that the meltdown of two highly leveraged subprime hedge funds managed by Bear Stearns that started in June turned out to be a train wreck, delivering losses vastly in excess of what anyone had anticipate when they started to list. This was a price discovery event demonstrating that investor assessment of the true risk of lower-rated subprime tranches was much worse than many conventional measures signaled at the time.

Note that just the way the NBER, which is responsible for officially saying when US recessions have started, inevitably winds up dating their onset in retrospect, and often before most commentators were sure they were underway, so too it was hard to see that the Bear Stearns hedge fund meltdowns were a turning point. I actually thought I was a bit late in saying they were a critically important and stuck my neck out by saying they were decisive. Others who were involved in the financial markets generally saw the first phase of the crisis starting in July and August 2007.

Thus it’s distressing to see many major publications engaging in revisionist history ten years out, by dating the start of the crisis as when the chronically behind-the-curve central banks woke up and took notice that something was seriously amiss. That didn’t occur till August 9, 2007. That was when BNP Paribas froze the assets of three funds because could no longer value the subprime-related CDOs in them, and the Fed and the ECB reacted by making liquidity injections.

The post below ran roughly three months before that date, in March 2007. Notice our worried reading on the market was tentative. That was in large measure due to the fact that we were entirely dependent on MSM sources and the credit market reporting was poor. The Financial Times was far better than any source then and even so, it only had a few reporters keeping an eye out. But even with their (and therefore our) limited window, they were clearly alarmed, which is not what you typically see from financial journalists, whose usual stance ranges from jaundiced to bullish. The reporters who had their eye on the ball were cognizant of the fact that credit spreads, meaning the risk premiums being paid for various loans and bonds, were insanely small across all credit markets. That means investors were being paid way too little for the risks they were taking.

To translate this into layperson terms, that means there was a monster bubble in lending of all types of unprecedented historical scale. But even so, I’d thought the dotcom mania was nuts in 1998. How could you invest in the stocks of companies that not only had no realistic path to profit, actually admitted they’d never make any money but would somehow make it up on eyeballs? That experience taught me that even when it’s apparent that a big bubble is underway, they can run longer than you’d ever think possible.

In the past, when there have been credit excess, they’ve tended to take place when banks all got high together and handed money out based on stupid fads, like the idea that countries can never go bankrupt (note that sovereign currrency issuers can always voluntarily default, as Russia did in 1998, or can go bankrupt if they don’t borrow in their own currency, like Greece borrowing in euros or Latin American borrowers dollarizing their currencies). Here, even though the epicenter of the crisis was US subprime lending, we saw implosions in numerous other markets: housing lending in numerous advanced economy markets, as well as lending excesses that were forestalled by the Fed’s emergency operations and protracted period of super cheap rates. For instance, there was also a tsunami of lending to private equity deals in 2006 and 2007, with the expected collapse in lending standards. Numerous experts expected widespread defaults starting in 2012 due to what should have been difficulty in refinancing these loans. But rates were still super cheap then and investors were eager to shovel money at any investment that offered a premium return.

This post first appeared on March 14, 2007
One of today’s lessons is to have greater courage in my convictions. In a number of earlier posts (such as “The Rising Tide of Liquidity,” part 2 and part 3 of the same, “Where Has the (Perception of) Risk Gone“) I pointed to how toppy the markets have been, and how much capital has flowed into risky assets, particularly in the credit markets. I’ve also lived through several bad times in the securities markets (1980-81, the 1987 and 1989 crashes, which preceeded the nasty 1990-1991 recession, and the unwinding of the bubble in Japan) so I have seen how rapidly sentiment can shift.

I’ve also been struck by the generally grim tone of reporting in the Financial Times for the last few months. The Brits have a higher tolerance for bad news than we do.

Commentary in the US has gone from a Pollyanna market to a Tinkerbell market. If enough people believe in it, the markets, or in this case, market valuations, won’t perish. And in fact, confidence is a heady elixir. Look how long the dot com mania persisted, despite the patent lack of grounding in reality and positive cash flow.

The optimistic commentators here have stressed how the economy is strong, the subprime market is a just a sector of the overall mortgage market, concentrated in lower-priced housing. Any damage, they argue, will be localized. Default rates are a function of employment, and unemployment is low.

One can make a counterargument around particulars, for example, that latest job additions were weak, which doesn’t bode well for unemployment. But the fundamentals aren’t really what is driving this correction. They may appear to be the cause, but are merely triggers. A different mechanism is at work.

As John Authers pointed out in the FT last weekend, credit is overvalued. Lenders have given borrowers way too generous terms, and not just in the subprime market, but in junk bonds, emerging markets, and so on. And even equities are overvauled, just not to the same degree.

So this correction is really about valuations. Investors are realizing that the prices that assets have been trading at are high, systemically high. That knowledge will precipitate a rush for the exits, since investors that can realize these unduly high prices will. That’s why the price drops in equities and riskier fixed income instruments have seemed out of proportion to events.

Let us not forget that more stringent lending will be a damper on growth, and may finally put a crimp in the free-spending ways of US consumers, who have been the engine of growth for the US and an important contributor internationally. So the change in the financial markets doesn’t simply anticipate worsening fundamentals; it will feed them. That’s why the Tinkerbell crowd is so eager to keep belief going any way they can.

The Tinkerbell fans do have a case, that in the long run, investors have to put their funds to work, that most of the time markets go up, because most of the time we have economic growth. So if and when confidence returns, the markets will resume their general march upwards.

The problem, of course, is when confidence is shaken, it can take a while for it to return. And the latest reports aren’t very cheery.

The much decried New York Time story by Gretchen Morgenson, “Crisis Looms in Mortgages” doesn’t appear as overblown as it did two days ago. The front page of this morning’s Financial Times, “Fears of subprime fallout escalate,” had a paragraph that fit the thesis, if not the overwrought style, of her piece:

The rapid decline of New Century, the latest in a wave of problems at US subprime lenders, raised concerns that problems could spread in the $8,000bn (£4,000bn) mortgage industry and other parts of the capital markets.

The FT gave this recap of today’s events, “Markets slide as subprime woes escalate:”

A steep sell-off swept through global stock markets on Tuesday as investor confidence was hit by the escalating woes of the US subprime mortgage market and weak US retail sales data.

Stocks began the day on a bearish note but selling pressure intensified after the Mortgage Bankers Association said that the rate of late payments and defaults on US home loans hit 4.95 per cent in the fourth quarter, up from 4.67 per cent for the prior quarter.

The problems were particularly severe among subprime borrowers – people with patchy credit histories. Delinquencies for subprime adjustable rate mortgages rose to 14.4 per cent, up from the third quarter’s 13.2 per cent…

GMAC, a financial services group 49 per cent owned by General Motors, said subprime lending woes contributed to a $651m fourth-quarter loss at its home lending arm.

Sentiment across markets was driven by fears that subprime problems will slow consumer spending and hamper economic growth, leading investors to sell risky assets and seek the safe haven of government bonds.

The S&P 500 tumbled 1.6 per cent, while the yield on the 10-year Treasury note fell below 4.50 per cent. The Dow Jones Industrial Average was trading more than 1.7 per cent lower in afternoon trading, having fallen 200 points earlier. London’s FTSE 100 and France’s CAC 40 both closed more than 1 per cent lower…..

An odd news item on the Wall Street Journal’s website, and it looks to be the lead item in their news summary for the print edition: “Goldman Goes Hunting in Battered Loan Sector After a Record Quarter.”

Seeing growing turmoil in the market for risky home loans as an opportunity, Goldman Sachs Group Inc. is looking at pushing deeper into the business, ramping up its own subprime-lending operation and pondering the purchase of another.

Although David Rothschild attributed his wealth to buying a little early and selling a little early, this appears to be more than a bit early. There are going to be more subprime failures, and more important, Congress has taken interest in the question of regulating lending practices. Capacity clearly needs to leave the subprime sector; it’s never going to be as big as it was. Failures of originators like New Century are part of this process. But the market, even in its reconstituted form, will be much smaller, and could be less attractive if new rules are imposed. Goldman appears willing to take that chance.

Or could Goldman have a completely different set of motivations? Could this be a cheap way to show confidence the subprime market to help calm investors? After all, this is a mere announcement of an intent to look, nothing more.

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