By Chan Akya
I have previously written [1] about the impending failure of US mortgage borrowers, whose failure to pay would affect not only the US economy as many of them declare bankruptcy, but also worldwide markets, as the risk has been widely sold to investors in other countries, with the bulk of the losses coming in Asia.
Ratings, securitization in brief
Banks lend money to a number of companies but, more importantly, to millions of individuals. As banks themselves borrow money from other investors in the form of deposits and bonds, they would like to sell down some assets. However, anyone buying such assets from banks would be naturally worried about the quality of assets, and hence look to the banks to do two things: first, hold enough of the risk (what is called "skin" in the game) and, second, hire an independent evaluator of these securities.
When a number of similar receivables are packaged into a bond, what happens is that anyone buying the bond is dependent on the credit quality of people he or she has never met. For that reason, the markets depend on rating agencies such as Standard and Poor's or Moody's, two of the largest companies that perform such services and, coincidentally, both of which are American. The third major rating agency, Fitch, is European.
To a large extent, investors depend on these ratings for determining their investment appetite. Thus if you walked into an Asian central bank and asked what its criteria are for buying an asset, it might reply that it holds securities rated above a certain level, say double-A (the highest is triple-A, the lowest is D - as in "Default"). [2]
However, there are two immediate problems with this. First, ratings are paid for by the people issuing the bonds mentioned above, not the people buying them. Thus there is a logical business reason for maintaining the rating at a higher level than is strictly warranted by fundamentals. This is called a conflict of interest.
The second problem is that ratings are merely opinions. It is a bit like a film reviewer saying that the latest Bruce Willis movie is fantastic, while it may well turn out to be a stinker for most people. The difference, of course, is that a bad film recommendation only costs you US$10 (less if you buy a pirated disc in Shenzhen), but a bad ratings opinion can cost you millions. The agencies, while sophisticated, do not know the future any more than the typical astrologer. They therefore use masses of data to justify their opinions, all the while employing analysis of historical information.
This is not the first time the rating agencies have gotten it wrong in the markets. Whether it was their wrong ratings of emerging-market countries in the 1990s, or telecom companies earlier this decade, and now securitization, the agencies have been disastrously wrong on every new market. Still, investors and regulators trust them to provide judgment, as there are no alternatives.
The markets, though, always look ahead. In other words, if an investor expects to receive less interest on a particular bond, its price will fall well before the interest actually falls. Thus it is that markets are prone to overreact to information, while ratings slowly catch up.
There are, however, a number of investors - for example, central banks and pension funds - that rely only on the rating agencies for their information. Thus they fail to act when the markets start moving, and are forced to act when the rating agencies admit that the quality of the bond is actually lower than was previously thought. These investors are called "hogs" in the market - they are fattened up and then slaughtered.
Pay differential
Of course, it is also important to note a perverse incentive structure that exists in all this. Employees of investment banks are among the best paid in the world, with specialists in fast-growing areas such as derivatives commanding seven- and eight-figure (US dollar) annual salaries. In contrast, the people buying the risk from them, such as Asian central bank workers, are paid hardly more than $20,000-$50,000, with some of the best ones paid more than $100,000. Only Singaporean government employees are paid more than their counterparts on Wall Street; this is a subject I shall return to in a later article.
When such an incentive structure exists, it is natural for many kinds of corruption to take effect, including soft practices such as banks paying for lavish dinners and ranging to more contemptible practices such as bank-employed agencies helping to pay for the tuition of children of senior government officials in the name of "marketing".
Meanwhile, it is also important to note that there is no "crime" being committed by those buying such securities from investment banks, as they are required to invest their countries' reserves in securities as defined by a pre-set policy. Thus no one takes eventual responsibility for losses on investment accounts, especially in many Asian countries where foreign-exchange reserves are a matter of national security, and leaks about holdings, profits or losses are punishable by long jail sentences or worse. [3]
This week
What happened this week was a result of the prices of mortgage securities falling sharply in the past few weeks. Finally on Wednesday, the rating agencies moved to cut ratings of more than $12 billion worth of bonds. This forced the "hogs" mentioned above to sell their bonds into a market that was already nervous about further weakness in the US economy.
The result was, of course, carnage. Being unable to sell all the securities they had, many of the investors had to sell other securities, including corporate bonds hitherto unaffected by the rating moves.
The immediate question arising from the rating agencies' action focuses on timing. Why did they downgrade this week, based on information that had been available since February? The reason, of course, goes back to the conflict of interest - if agencies admitted that their ratings criteria were wrong, they would lose a lot of business. Indeed, financial newspapers have been pointing out over the past few weeks that smart investors such as hedge funds have been "short" the stock of rating agencies (or their holding companies) for precisely this reason.
As alluded to above, we can see that the extra time gave the big investment banks the opportunity to get rid of their existing positions, most often to big central banks around the world. We will know how much these banks lost, especially in Asia, only over the next few years rather than weeks.
Next steps
The subprime banana skin has thus claimed a number of victims, including Asian central banks that are forced to hold billions in US dollar securities because of their currency manipulation that pushes up reserves. It almost seems poetic justice that the manipulators are given losses by the very people they think they are helping, namely over-consuming Americans.
I believe that forced liquidation of many portfolios in Asia will create further losses, but American borrowers will emerge in essence unscathed from all this. Holders of mortgage securities do not have any claim on the underlying assets, only on the intermediate companies, which will of course declare bankruptcy, thus leaving empty shells for lenders to pursue. Unlike in previous crises such as that involving the telecom sector in 2002, most of the losses will be absorbed by central banks around the world rather than North American or European commercial and investment banks.
This is one of the greatest robberies of our time, and it will go unreported in essence. Hard-working Asian savers will see their central banks post billions of dollars in losses on the US mortgage crisis in the next few years, but nothing can be done about it given the general lack of accountability across Asia.
A more defensible long-term strategy for these central banks is to cut their reserve holdings by floating their currencies against the US dollar and invest in their own countries instead of in some distant delinquent borrower. What I wrote in the "scalded cats" [4] argument remains valid - Asians simply do not hold their governments and central banks accountable for performance. This allows all kinds of excesses to be permeated on savings in the name of national policy.
With more than $3 trillion in such reserves being invested (wasted) on low-return US and European securities just across Asia, perhaps it is time for citizens to raise the question with their central banks: Just whom are you working for, your citizens or American homeowners?
Saturday, July 14, 2007
Saturday, July 7, 2007
Asia's scalded cats
By Chan Akya
An ancient tale recounts the experience of a cat that is scalded with hot milk while still a kitten, and lives its life without ever tasting milk again. In the aftermath of the Asian financial crisis, regional authorities vowed that they would never again place themselves in a disadvantageous position with respect to foreign hot money, typified by avaricious hedge funds that were castigated for currency manipulation by many a leader.
The result of the crisis, which has yet to fully reverse itself when one looks at various indicators of credit-worthiness, has ironically been for Asian governments to emerge as the leading currency manipulators in the world, bringing in their wake a new financial crisis that threatens both America's heartland and their own exporting industries.
In a series of recent articles, I wrote about the social impact of government manipulation on the economies of India and China, which are related to the issues of planned economies and currency manipulation. The issue at hand is that being over-eager to manipulate currencies for the benefit of their exporters, even the two largest and fastest growing of emerging Asian economies are unable to provide enough economic growth for their underclass.
There is nothing to boast about having US$200 billion in reserves (India) or indeed more than a trillion (China), when basic infrastructure such as water and roads is lacking (India) and poor people still leave the country illegally in shipping containers in search of a better life (China). Perhaps the Indian government frets that if it provided roads and ports, its poor will also find their way into shipping containers as economic refugees even though that doesn't explain why so many Indians still have no access to clean drinking water.
Southeast Asia
For those who came in late, the Asian financial crisis in 1997 was caused by significant current account deficits in Asia, that were almost entirely funded by short-term flows from banks, hedge funds and similar investors who were keen to grab the high interest rate differential on offer between the bonds issued by Group of Seven countries such as the United States and those issued by Asian banks. The underlying logic was that so long as Asian currencies remained stable against the US dollar, one could capture a substantial premium for essentially no risk of losing money.
However, as money flows accelerated and Asians started taking higher risks, there soon emerged an unsustainable gap between the maturity of assets and liabilities for Asian companies, and in turn, their governments that had either fully or partially guaranteed the banking system that was facilitating such transfers of money. Eventually, smart investors worked out that the risks were actually higher than returns, and initiated a series of attacks on Asian currencies with a view to forcing the governments to allow them to depreciate.
The countries at the epicenter of the Asian crisis were of course those of Southeast Asia, which is not surprising given that hedge funds first focused on pushing the Thai baht away from its unsustainable peg to the US dollar. Indonesia was the next country to be hollowed out, although most of the damage was done by locals as compared to foreigners.
That being so, it is also true that it was the resolute action of Malaysia to establish a new peg along with capital controls in 1998 that helped to reverse the tide from the Asian crisis and eventually usher in a stable macro-economic environment. Most observers though quibble about giving Malaysia any part in the turnaround, instead preferring to focus on Hong Kong's intervention in its stock markets around the same time, as the action that broke the back of many hedge funds.
Whoever takes the credit for the reversal, it is perhaps beyond argument that Southeast Asia's economic growth has generally lagged behind the rest of Asia in the past 10 years, as officials have focused on retaining stable currencies at the expense of pursuing higher economic growth. This comment will probably strike the officials as counter-intuitive as they still believe that the path to economic stability lies with exports despite the patent inability of such countries to compete with China in manufacturing or India in services.
A variety of factors, including language and education, have prevented Southeast Asian countries from moving to higher value-added products, such as what Japan and more recently South Korea have achieved. To a large extent, the dysfunctional set up of ASEAN itself is to blame, as the main promise of economic co-operation has been realized in an overly staggered fashion that has done nothing for improving the competitiveness of local industry. In turn, that left many sectors such as textiles and auto parts too small and specialized thereby disallowing any advantage as Chinese manufacturers improved their product profile and production efficiency.
Allowing their countries to focus on areas of competitive strength, namely higher value industries, tourism, design and technology, logistics and other related businesses would have allowed Southeast Asia to emerge stronger than it currently is. Of course, that process also would have caused more painful structural reforms of the kind that Malaysia has consistently eschewed in the name of illusory social cohesion. By freeing up the currency and domestic ownership constraints that allow its entrepreneurial Chinese minority to flourish, Malaysia could have easily added many percentage points to its overall economic growth in the past ten years, instead of playing second fiddle to Singapore on services and Indonesia on manufacturing.
Pointless reserves
Asia has accumulated significant reserves well above what is strictly required, because of enduring fears about being found short of money to repay debt ever again - the scalded cat argument. As most of the countries, with the significant exception of the Philippines, do not have any external debt to speak of anymore, the problem has become one of currency peg maintenance that displays the utter lack of imagination of the ruling elite in these countries.
These foreign exchange reserves are used to buy assets in developed countries, but are mainly deployed in bonds. Returns being earned on such holdings barely compensate Asian central banks for even the managed depreciation of the US dollar against their local currencies, let alone the opportunity cost of investing such proceeds more productively in their own economies or indeed, those of neighbors. For example, Asian central banks do not invest significantly within the Asian region, due to self-imposed constraints on credit quality requirements. In turn, this has prevented the development of a strong bond market in Asian currencies that has perpetuated the vicious cycle of having to invest purely in "hard" currencies such as the US dollar.
The rule of the markets is that no good deed goes unpunished for very long. True to form, the excessive investments in America and Europe have engendered over consumption in the case of the former that now stands to collapse sharply as the housing debacle reaches its crescendo. As millions of Americans find that they cannot afford even mortgage payments on their houses, they will default - but the American financial system will not have to pocket the losses as the risk has already been sold down to Asian central banks in the form of mortgage backed securities.
Thus, the release of excess liquidity into the American economy that caused locals to borrow too much money will come around full circle to hurt Asian lenders. The circle can be stalled for some time by continued intervention, but eventually it will have to obey the law of gravity. House prices are falling everywhere in America now, and this combined with rising interest costs will create a painful recession. Painful for creditors, that is : ironical given that the Asian financial crisis was more painful for borrowers rather than the lenders.
Thus Asia finds itself in the unenviable position of having to take losses on billions of dud securities issued by American companies and individuals in months to come. If any central bank chooses to take action now and sell down its holdings of American and European bonds, it risks setting off a panic sale by compatriots around the region. I assume that any central banker who initiates such an action can kiss his invitations to major golf tournament a firm goodbye.
A conspiracy of inaction thus rules the corridors of Asian central banks even as their citizens toil outside in sheer ignorance. If that's called progress for 10 years, you can keep it.
An ancient tale recounts the experience of a cat that is scalded with hot milk while still a kitten, and lives its life without ever tasting milk again. In the aftermath of the Asian financial crisis, regional authorities vowed that they would never again place themselves in a disadvantageous position with respect to foreign hot money, typified by avaricious hedge funds that were castigated for currency manipulation by many a leader.
The result of the crisis, which has yet to fully reverse itself when one looks at various indicators of credit-worthiness, has ironically been for Asian governments to emerge as the leading currency manipulators in the world, bringing in their wake a new financial crisis that threatens both America's heartland and their own exporting industries.
In a series of recent articles, I wrote about the social impact of government manipulation on the economies of India and China, which are related to the issues of planned economies and currency manipulation. The issue at hand is that being over-eager to manipulate currencies for the benefit of their exporters, even the two largest and fastest growing of emerging Asian economies are unable to provide enough economic growth for their underclass.
There is nothing to boast about having US$200 billion in reserves (India) or indeed more than a trillion (China), when basic infrastructure such as water and roads is lacking (India) and poor people still leave the country illegally in shipping containers in search of a better life (China). Perhaps the Indian government frets that if it provided roads and ports, its poor will also find their way into shipping containers as economic refugees even though that doesn't explain why so many Indians still have no access to clean drinking water.
Southeast Asia
For those who came in late, the Asian financial crisis in 1997 was caused by significant current account deficits in Asia, that were almost entirely funded by short-term flows from banks, hedge funds and similar investors who were keen to grab the high interest rate differential on offer between the bonds issued by Group of Seven countries such as the United States and those issued by Asian banks. The underlying logic was that so long as Asian currencies remained stable against the US dollar, one could capture a substantial premium for essentially no risk of losing money.
However, as money flows accelerated and Asians started taking higher risks, there soon emerged an unsustainable gap between the maturity of assets and liabilities for Asian companies, and in turn, their governments that had either fully or partially guaranteed the banking system that was facilitating such transfers of money. Eventually, smart investors worked out that the risks were actually higher than returns, and initiated a series of attacks on Asian currencies with a view to forcing the governments to allow them to depreciate.
The countries at the epicenter of the Asian crisis were of course those of Southeast Asia, which is not surprising given that hedge funds first focused on pushing the Thai baht away from its unsustainable peg to the US dollar. Indonesia was the next country to be hollowed out, although most of the damage was done by locals as compared to foreigners.
That being so, it is also true that it was the resolute action of Malaysia to establish a new peg along with capital controls in 1998 that helped to reverse the tide from the Asian crisis and eventually usher in a stable macro-economic environment. Most observers though quibble about giving Malaysia any part in the turnaround, instead preferring to focus on Hong Kong's intervention in its stock markets around the same time, as the action that broke the back of many hedge funds.
Whoever takes the credit for the reversal, it is perhaps beyond argument that Southeast Asia's economic growth has generally lagged behind the rest of Asia in the past 10 years, as officials have focused on retaining stable currencies at the expense of pursuing higher economic growth. This comment will probably strike the officials as counter-intuitive as they still believe that the path to economic stability lies with exports despite the patent inability of such countries to compete with China in manufacturing or India in services.
A variety of factors, including language and education, have prevented Southeast Asian countries from moving to higher value-added products, such as what Japan and more recently South Korea have achieved. To a large extent, the dysfunctional set up of ASEAN itself is to blame, as the main promise of economic co-operation has been realized in an overly staggered fashion that has done nothing for improving the competitiveness of local industry. In turn, that left many sectors such as textiles and auto parts too small and specialized thereby disallowing any advantage as Chinese manufacturers improved their product profile and production efficiency.
Allowing their countries to focus on areas of competitive strength, namely higher value industries, tourism, design and technology, logistics and other related businesses would have allowed Southeast Asia to emerge stronger than it currently is. Of course, that process also would have caused more painful structural reforms of the kind that Malaysia has consistently eschewed in the name of illusory social cohesion. By freeing up the currency and domestic ownership constraints that allow its entrepreneurial Chinese minority to flourish, Malaysia could have easily added many percentage points to its overall economic growth in the past ten years, instead of playing second fiddle to Singapore on services and Indonesia on manufacturing.
Pointless reserves
Asia has accumulated significant reserves well above what is strictly required, because of enduring fears about being found short of money to repay debt ever again - the scalded cat argument. As most of the countries, with the significant exception of the Philippines, do not have any external debt to speak of anymore, the problem has become one of currency peg maintenance that displays the utter lack of imagination of the ruling elite in these countries.
These foreign exchange reserves are used to buy assets in developed countries, but are mainly deployed in bonds. Returns being earned on such holdings barely compensate Asian central banks for even the managed depreciation of the US dollar against their local currencies, let alone the opportunity cost of investing such proceeds more productively in their own economies or indeed, those of neighbors. For example, Asian central banks do not invest significantly within the Asian region, due to self-imposed constraints on credit quality requirements. In turn, this has prevented the development of a strong bond market in Asian currencies that has perpetuated the vicious cycle of having to invest purely in "hard" currencies such as the US dollar.
The rule of the markets is that no good deed goes unpunished for very long. True to form, the excessive investments in America and Europe have engendered over consumption in the case of the former that now stands to collapse sharply as the housing debacle reaches its crescendo. As millions of Americans find that they cannot afford even mortgage payments on their houses, they will default - but the American financial system will not have to pocket the losses as the risk has already been sold down to Asian central banks in the form of mortgage backed securities.
Thus, the release of excess liquidity into the American economy that caused locals to borrow too much money will come around full circle to hurt Asian lenders. The circle can be stalled for some time by continued intervention, but eventually it will have to obey the law of gravity. House prices are falling everywhere in America now, and this combined with rising interest costs will create a painful recession. Painful for creditors, that is : ironical given that the Asian financial crisis was more painful for borrowers rather than the lenders.
Thus Asia finds itself in the unenviable position of having to take losses on billions of dud securities issued by American companies and individuals in months to come. If any central bank chooses to take action now and sell down its holdings of American and European bonds, it risks setting off a panic sale by compatriots around the region. I assume that any central banker who initiates such an action can kiss his invitations to major golf tournament a firm goodbye.
A conspiracy of inaction thus rules the corridors of Asian central banks even as their citizens toil outside in sheer ignorance. If that's called progress for 10 years, you can keep it.
Tuesday, July 3, 2007
Of termites and index mania
By Julian Delasantellis
My wife and I now find that we have reached the stage in our lives where our son and daughter-in-law ask us questions on how to be better homeowners, as the two of them have now been in their first home for more than a year. One of my choicest pieces of advice is, "If you see a termite, take it seriously, because there are probably tens of thousands more."
My wife and I are grateful that our son and his wife now, through the bracing gut kick of instantaneous maturity acquired by producing and nurturing our infant granddaughter (what sociologists call a "parental emergency"), know what they must do upon seeing a termite.
A few years ago, during their pre-parental militantly vegan days, they probably would have told us that they were organizing all the house's occupants, bipedal and multipedal, for voluntary attendance at a multicultural, omni-species, all-property group grievance and discussion session designed to raise consciousness of the Western patriarchy's historic oppression of the Isoptera order. Now they know: see one sign of trouble, don't ignore it - take immediate action.
Would that high-powered investors in US subprime mortgages had done the same.
In two Asia Times Online articles last March, I introduced readers to the woeful state of US real-estate lending to homeowners with less than stellar credit records and payback histories, what became known as the "subprime" mortgage market crisis. In my March 6 article, Rocking the subprime house of cards, I explained how the global equity-market selloff then under way was not, as the conventional wisdom was declaring, resulting from sharp selloffs in the Shanghai Stock Exchange. It was more due to a growing realization that the problems in the subprime market could spread to present insolvency problems for some of global finance's most highly respected names, such as HSBC and Bear Stearns.
My second article, The subprime dominoes in motion (March 16), illustrated how concerns about subprimes were affecting the stocks of the companies involved. The frontline subprime lenders, mostly fly-by-night suburban office-park lenders such as New Century Financial and Fremont General, saw their stocks decline 80% or more in just a few weeks, and even more "respected" US mortgage lenders, such as Washington Mutual and Countrywide Financial, were seeing their stocks suffer steep declines.
There it was, plain for everyone else to see. The first termite.
Very much in contrast to what they say in those soft-focus, soothing-themed television advertisements for stock brokerages, professional investors and traders at the great houses of money do not come to work, fire up their quote machine, and sit tethered to the trading desk for 12 hours of Brobdingnagian stress every day to finance your, or even their, retirement or child's education.
Good traders were probably able to fund those requirements for themselves in the first six months or so of their careers, and having done so means they sure don't have to care about doing the same for you. It has to be some other challenge that keeps them coming back every morning for another bracing dose of ulcers, cold Chinese food and hypertension. For many, if not most of them, what keeps them in the business is the challenge of beating an index.
Most people are familiar with traditional market indices such as the Dow Jones or the Nikkei, but in the past few years, a bewildering array of new indices have arisen that track just about anything and everything traded in the financial markets. You have big stock indices, small stock indices, very small stock indices, government, corporate and government agency bond indices, commodity indices, mutual fund indices, indices of other indices, even indices that measure the performance of hedge-fund managers.
Index mania originated out of University of Chicago Professor Eugene Fama's Efficient Market Hypothesis (EMH), which stated that investors could not consistently outperform benchmark indices of whatever sector they were investing in. The theory originally was meant to apply mainly to stock investing, with the performance comparisons being applied to long-established indices such as the Dow or the S&P 500, but eventually, indices were established as benchmarks across the full spectrum of current investment.
This served two purposes. For those who believed the EMH, and thus thought the search for outperforming individual stocks, bonds or whatever ultimately fruitless, index-specific investment products were formed that allowed low-cost (no need to pay those pricey fund-manager salaries) investment in a specific index, with profits or losses accruing with concomitant moves in the index.
The second main function of financial-market indices is that they give ambitious fund managers a specific numerical target for which to aim to beat. Traders whose investment performance beats their specific sector index get big fat bonuses and press releases from their firms touting their accomplishments - even more so if they beat both the index and the other traders in their sector. As for the trader who can't beat the index - well, he might have been the guy from the dealership who sold you your new Buick.
Therefore, it should come as no surprise that an index has been established to track the performance of subprime mortgage loans bundled together and then sold to bond buyers seeking higher yields than traditional US Treasury or high-grade corporate debt. This instrument is called an ABX index.
The specific ABX index most applicable to subprimes, the ABX-HE-BBB-, started the year just under 100, and then, as whispers of subprime difficulties started to spread through the markets and, in early February, as HSBC confirmed that, at least for that bank, the rumors were true, the index fell to 77.5 by late February.
As it dawned on the world's investors that there might be a nightmare of spreading financial insolvency wrapped in the core of the great American dream of universal home ownership, the world stock selloff of the last week in February and the first week in March at last diverted the media's attention from the more important story they had been covering, namely where Anna Nicole Smith's methadone-pickled corpse would be interred.
Then, as the financial markets are frequently wont, the unexpected happened - nothing.
Things started to look brighter than the gloom and doom that pervaded the financial markets in early and mid-March. the US and world equity markets recovered (as did, to a much lesser extent, the ABX), quickly surpassing the levels of late February prior to the selloff. Although any and all of the statistics that measure the health of US real estate (new and existing home sales, prices, mortgage delinquencies or foreclosures) were coming in far weaker than in previous years, it began to be thought that the basic underlying strength of the US economy would act as a counterweight to the problems in the real-estate sector.
It was delicately noted that many of the subprime borrowers had skin colors other than white; if Wall Street had gone more than 200 years without caring about this population, it sure wasn't going to start now. (A Fox News financial commentator even used the subprime crisis as an argument against Bank of America's policy of giving credit cards to undocumented workers - as if US finance had to be forever vigilant against the dangers of extending excessive credit to "those people".)
Most important, it was thought that few of the great houses of US finance had been so rash as to have been much involved with subprimes.
It was surmised that many of the home-mortgage borrowers who got into trouble taking out more of a subprime mortgage than they could handle would be spared the ultimate sanction of foreclosure, since that option was said to be a difficult, time-consuming and not particularly profitable option for the lenders (not to mention being absolutely catastrophic for the borrowers).
Indeed, late May saw reports that some hedge funds (those without ongoing relationships with public relations firms, no doubt) were actually unhappy with what they saw as the sluggish pace of lender foreclosures. These funds had initiated trades that hoped to profit from a further fall in the ABX; for them, foreclosures would have in essence represented a climactic consummation of the act of seeking bliss from the gathering financial misery of the subprime borrowers.
And so, as June began, the sound of corks popping out of champagne bottles drowned out the sound of the termites continuing to eat through the foundation underneath US finance capital. Then it happened. Somebody put his hand through the wall, or tried to nail a picture, and all the sawdust started pouring out.
In my July 6, 2006, article Hedge funds: Playing dice with the universe, I explained that one of the major reasons hedge funds were able to exert such disproportionate market influence was that, besides the substantial pools of money the hedge funds were raising from their investors, they were also funding the huge positions they were taking in the markets with substantial borrowing, what the markets call leverage, in amounts sometimes up to 20 times their capital base.
The Bear Stearns brokerage house thought it had come up with some really neat ideas. It would set up two in-house hedge funds, the Bear Stearns High-Grade Structured Credit Strategies Fund and the High Grade Structured Credit Strategies Enhanced Leverage Fund. The funds' strategy for achieving those juicy hedge-fund-type returns would be to invest in pools of subprime mortgages bundled together with other loans into bond packages called collateralized debt obligations (CDOs).
Then, Bear Stearns had an even better idea. It would not just buy the CDOs and then sit on them until the mortgages were paid off in 10 or 20 years or so; that would have earned the funds a return roughly equal to the coupon yield of mortgage bonds, about 8-10% a year. That's a decent enough return for us average investing mortals, but for hedge-fund managers obsessed with having their names and pictures at the top of the performance rankings, it wouldn't even get them in line to rent a chaise longue at a public beach in the Hamptons - a popular vacation spot on New York's Long Island - this summer.
In today's era of turbo-finance, the distinctions between who the borrowers are and who the lenders are have become blurred; many borrowers borrow so they can immediately turn around and lend the proceeds to others, who will then do likewise. For Bear Stearns, instead of just buying the CDOs and sitting on them for a decade or two, it would now have the funds use them as collateral for big new loans from other financial institutions.
With the borrowed money, they could go back into the market and buy lots more high-yielding subprime-mortgage-based CDOs, in essence using the borrowed money to do more lending. Their high yields would substantially boost the reported returns of the funds and, since returns are measured against the percentage appreciation of the fund against its capital base, not the leveraged base, the funds would instantaneously be able to report much higher rates of return. For the fund managers, the temptation was irresistible - a better life and a shiny trophy wife were just the next reporting period away.
As long as the CDOs that Bear Stearns borrowed against maintained their value. As long as the ultimate money behind the CDOs, the homeowners who actually took out the subprime mortgages that made their way into the CDOs, kept making the mortgage payments that got passed through to the owners of the CDOs.
Uh-oh.
By early June, Bear Stearns and other titans of US finance had, both as borrowers and lenders, their subprime-based paper spread all over Wall Street, and that definitely presented a problem. The lenders who had accepted Bear Stearns' paper as collateral saw the price of the ABX index heading south once more, and knew that it meant that more subprime mortgage holders were becoming delinquent, and thus facing foreclosure, on their loans.
Of course, this implicitly reduced the value of the CDOs that Bear Stearns had proffered to be used as collateral. (I say "implicitly" because no one really knows what these CDOs are worth at any given moment - they are not traded, with reportable trade results, as are stocks and bonds. In financial-markets lingo, this is said to make them "illiquid".)
This put the lenders in a fairly tricky position. Written into the loan agreements in which they lent money to Bear Stearns' hedge funds were covenants that in essence allowed the lenders to seize the collateral that Bear Stearns put up as security, the CDOs. In essence, the lenders had the right, like Harry Dean Stanton and Emilio Estevez in the 1984 cult classic Repo Man (but without the glowing aliens or the weirdo nuclear scientist) to repo the CDOs and take them back to the yard.
This presented the lenders with another dicey situation. Much like the players in the classic game-theory exercise Prisoner'S Dilemma, there was a tremendous incentive for the lender who acted first; later lenders might find that quicker players might have already seized all Bear Stearns funds' capital away.
It was Merrill Lynch that sent the tow trucks in first.
So what did they get when they lowered the CDOs down from the hook?
Do you want to borrow some money from the bank, using the equity in your home as collateral? Fine, "just write us at the bank a check for about $500, so we can hire an appraiser to check your home's current worth". A core way that will be done is to have the appraiser check the recent sales prices of comparable homes in your neighborhood, what the trade calls "comps". No way will the bank allow you to borrow anywhere near what your house is worth. If you default, the bank wants to be sure it can get back the value of the loan through a foreclosure sale of your property.
Bear Stearns had to go through no such indignity. As CDOs are not actively traded in any secondary market, there were no available comps to compare their value against; in market jargon, they cannot be "marked to market". Instead, the international bank capital reserve regulations known as Basel II allow CDOs to be valued through an arcane process called "marked to model".
This involves Bear Stearns hiring some hungry underemployed math PhD, and having him construct a CDO pricing "model", in essence a series of complex algorithms, that allowed the company to enter a CDO's particulars on the front end, and then having the model spit out a SWAG (scientific wild expletive-for-posterior guess) value to Bear Stearns' liking out of the back end. The lenders, Merrill Lynch among them, knew full well the questionable nature of the process that valued the loans; then again, Bear Stearns was paying them a whole lot more on their loans than US Treasury bills were paying.
Merrill Lynch's traders virtually tripped over their Bruno Maglis in their rush to sell the seized CDOs. When they did, boy were they in for a surprise.
The CDOs were not fetching anywhere near the values the pricing models said they should. On June 24, New York Times finance columnist Gretchen Morgenson wrote an article about this; her editors gave it the title "When models misbehave"; evidently, the Old Gray Lady's honchos were hoping to get some interest from Times readers leafing through the business pages on the way to check the latest Paris Hilton news.
The Gospel of John teaches that "the truth shall set you free"; in 1881, US president James Garfield tacked on to the scripture the pithy addendum that "first, it will make you miserable". Instead of marking to model, holders of CDOs could now mark them to true market values, and yes, this made them really miserable.
Many of America's most illustrious names of finance, such as but not limited to Merrill Lynch, had been using them as capital reserves for high-powered lending or, like Bear Stearns, as collateral for borrowing. Basel regulations no longer allowed them to mark to model; in essence, just as in real-estate lending, there were now "comps" that were representing actual, much deflated prices.
The basic purpose of capital-reserve regulations is to make sure the value of loans made by financial institutions bears at least some relationship to the actual assets possessed by the institution. This prevents the tendency of capitalist economies to go through wild cycles of credit-fueled boom and bust. A bank with $100 in deposits cannot, much as it might like to, make $100 billion in loans. Various ratios exist for how much can be lent out per each particular type of asset held as a reserve.
This process can, and recently actually has, acted as a great wealth-creation machine when the underlying assets of the reserve holdings stays stable or goes up, as it allows a huge infusion of new capital into the world's money supply. It, the employment of once-dormant assets to facilitate massive new lending, is the primary reason for the great flood of world monetary liquidity that has supported inflated prices for everything from North African equities to Elvis Presley memorabilia.
But things are quite different when you throw the machine into reverse, as is happening now with the subprime CDOs. If the value of the underlying reserve assets declines, then Wall Street must pull back on the quantity of lending that it can base on it. This process is a lot like watching a video of a building being constructed in reverse as, brick by brick, the great edifice disassembles.
The fear that stalked the world's markets in March has returned. Bear Stearns has announced that it will provide up to $3.2 billion so that one of its struggling subprime hedge funds, the High-Grade Structured Credit Strategies Fund, can liquidate itself in an orderly fashion; for investors in the other fund, the more aggressive High Grade Structured Credit Strategies Enhanced Leverage Fund, well, for them, all the lifeboats seem to have left.
Even as US stock markets trade nervously around their recent highs, the Chicago Board Options Exchange's VIX volatility index, the fever thermometer for stock-investor unease, pushes back toward its March highs. The initial public offering of the private equity Blackstone Group (see my Febtuary 22 article on private equity, The highs and lows of buyouts) has foundered, with the stock now trading well below the IPO price. Considering how substantial a role private equity has played in the rallies of the world's major stock markets recently, this is certainly an ominous sign.
ABX subprime indices are pushing to new lows. If you would like a side order of Weltanschauung (knowing the current state of things) with your Schadenfreude (taking pleasure from the misfortune of others), check out the I Am Facing Foreclosure weblog (iamfacingforeclosure.com). Here lies a contemporaneous, near-Wagnerian saga of a young Californian's 2005 glorious rise to the heights of financial Valhalla, and current flaming fallback into earthbound insolvency, all effected by attempting to flip one two many investment properties.
One in five subprime mortgages is either seriously delinquent or has entered foreclosure; the real fear is that this number will skyrocket this year when millions of subprime mortgages taken out over the past two years with low initial "teaser" interest rates reset to rates well above current market rates. Very much unlike what they were told by their real-estate or mortgage brokers when they originally bought their houses, most of the borrowers have neither the equity in their homes (which is actually declining) nor the improved credit scores to bail themselves out of this situation with the real-estate industry's traditional life-preserver, a refinancing.
As these homes hit the market through foreclosure sales, further supply pressure will be put on a real-estate market already reeling from what could be only the commencement of this process. Like autumn following summer's joy and then winter's desolation following upon that, any economic historian will tell you that what is happening now in US real estate is only the natural turning of the economic cycle. The leaves of the boom have faded and fallen away, soon to be followed by lamentations resultant upon the bare branches of winter's bust.
In the fetid slough that is today's US public debate, it has been said that the entire subprime mess is only the expected result of attempting to make proper middle-class homeowners out of an underclass that lacks sufficient moral fiber to be so; all this proves is that, much like the current debate on illegal immigration, there will always be receptive American ears listening for any argument that blames all of today's troubles on people with black and/or brown skin.
The real moral deficiencies that led up to the subprime crisis are not on Main Street but on Wall Street. It was there that greed hatched the idea to turn the once-staid and predictable market for housing finance into something that could earn those big fat top-of-the-hedge-fund-rankings returns. In this tragedy, the only actual role of the borrowers was something like that of Beaker on the US children's TV program The Muppet Show, a helpless and hapless subject of another one of Dr Bunsen Honeydew's bizarre quasi-scientific experiments at Muppet Labs. They tried to mate a pokey groundhog, the slow and steady previously existent market for housing finance, with a glamorous thoroughbred, today's turbo-finance, and, in doing so, may just have killed both of them.
The I Am Facing Foreclosure site is up for sale. Down the street from where I live, in what is thought to be America's last red-hot housing market, a prospective development of 50 single-family homes, cleared out of the verdant northwestern US forest last winter with bulldozers and ambition, lies dormant. The wind whistles both through its acres of still-undeveloped dirt and some prospective real-estate entrepreneur's fading dreams of riches and glory.
As the rockets glare red and the bombs burst in the air over another US Independence Day this Wednesday, in the housing sector, winter falls soon.
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
My wife and I now find that we have reached the stage in our lives where our son and daughter-in-law ask us questions on how to be better homeowners, as the two of them have now been in their first home for more than a year. One of my choicest pieces of advice is, "If you see a termite, take it seriously, because there are probably tens of thousands more."
My wife and I are grateful that our son and his wife now, through the bracing gut kick of instantaneous maturity acquired by producing and nurturing our infant granddaughter (what sociologists call a "parental emergency"), know what they must do upon seeing a termite.
A few years ago, during their pre-parental militantly vegan days, they probably would have told us that they were organizing all the house's occupants, bipedal and multipedal, for voluntary attendance at a multicultural, omni-species, all-property group grievance and discussion session designed to raise consciousness of the Western patriarchy's historic oppression of the Isoptera order. Now they know: see one sign of trouble, don't ignore it - take immediate action.
Would that high-powered investors in US subprime mortgages had done the same.
In two Asia Times Online articles last March, I introduced readers to the woeful state of US real-estate lending to homeowners with less than stellar credit records and payback histories, what became known as the "subprime" mortgage market crisis. In my March 6 article, Rocking the subprime house of cards, I explained how the global equity-market selloff then under way was not, as the conventional wisdom was declaring, resulting from sharp selloffs in the Shanghai Stock Exchange. It was more due to a growing realization that the problems in the subprime market could spread to present insolvency problems for some of global finance's most highly respected names, such as HSBC and Bear Stearns.
My second article, The subprime dominoes in motion (March 16), illustrated how concerns about subprimes were affecting the stocks of the companies involved. The frontline subprime lenders, mostly fly-by-night suburban office-park lenders such as New Century Financial and Fremont General, saw their stocks decline 80% or more in just a few weeks, and even more "respected" US mortgage lenders, such as Washington Mutual and Countrywide Financial, were seeing their stocks suffer steep declines.
There it was, plain for everyone else to see. The first termite.
Very much in contrast to what they say in those soft-focus, soothing-themed television advertisements for stock brokerages, professional investors and traders at the great houses of money do not come to work, fire up their quote machine, and sit tethered to the trading desk for 12 hours of Brobdingnagian stress every day to finance your, or even their, retirement or child's education.
Good traders were probably able to fund those requirements for themselves in the first six months or so of their careers, and having done so means they sure don't have to care about doing the same for you. It has to be some other challenge that keeps them coming back every morning for another bracing dose of ulcers, cold Chinese food and hypertension. For many, if not most of them, what keeps them in the business is the challenge of beating an index.
Most people are familiar with traditional market indices such as the Dow Jones or the Nikkei, but in the past few years, a bewildering array of new indices have arisen that track just about anything and everything traded in the financial markets. You have big stock indices, small stock indices, very small stock indices, government, corporate and government agency bond indices, commodity indices, mutual fund indices, indices of other indices, even indices that measure the performance of hedge-fund managers.
Index mania originated out of University of Chicago Professor Eugene Fama's Efficient Market Hypothesis (EMH), which stated that investors could not consistently outperform benchmark indices of whatever sector they were investing in. The theory originally was meant to apply mainly to stock investing, with the performance comparisons being applied to long-established indices such as the Dow or the S&P 500, but eventually, indices were established as benchmarks across the full spectrum of current investment.
This served two purposes. For those who believed the EMH, and thus thought the search for outperforming individual stocks, bonds or whatever ultimately fruitless, index-specific investment products were formed that allowed low-cost (no need to pay those pricey fund-manager salaries) investment in a specific index, with profits or losses accruing with concomitant moves in the index.
The second main function of financial-market indices is that they give ambitious fund managers a specific numerical target for which to aim to beat. Traders whose investment performance beats their specific sector index get big fat bonuses and press releases from their firms touting their accomplishments - even more so if they beat both the index and the other traders in their sector. As for the trader who can't beat the index - well, he might have been the guy from the dealership who sold you your new Buick.
Therefore, it should come as no surprise that an index has been established to track the performance of subprime mortgage loans bundled together and then sold to bond buyers seeking higher yields than traditional US Treasury or high-grade corporate debt. This instrument is called an ABX index.
The specific ABX index most applicable to subprimes, the ABX-HE-BBB-, started the year just under 100, and then, as whispers of subprime difficulties started to spread through the markets and, in early February, as HSBC confirmed that, at least for that bank, the rumors were true, the index fell to 77.5 by late February.
As it dawned on the world's investors that there might be a nightmare of spreading financial insolvency wrapped in the core of the great American dream of universal home ownership, the world stock selloff of the last week in February and the first week in March at last diverted the media's attention from the more important story they had been covering, namely where Anna Nicole Smith's methadone-pickled corpse would be interred.
Then, as the financial markets are frequently wont, the unexpected happened - nothing.
Things started to look brighter than the gloom and doom that pervaded the financial markets in early and mid-March. the US and world equity markets recovered (as did, to a much lesser extent, the ABX), quickly surpassing the levels of late February prior to the selloff. Although any and all of the statistics that measure the health of US real estate (new and existing home sales, prices, mortgage delinquencies or foreclosures) were coming in far weaker than in previous years, it began to be thought that the basic underlying strength of the US economy would act as a counterweight to the problems in the real-estate sector.
It was delicately noted that many of the subprime borrowers had skin colors other than white; if Wall Street had gone more than 200 years without caring about this population, it sure wasn't going to start now. (A Fox News financial commentator even used the subprime crisis as an argument against Bank of America's policy of giving credit cards to undocumented workers - as if US finance had to be forever vigilant against the dangers of extending excessive credit to "those people".)
Most important, it was thought that few of the great houses of US finance had been so rash as to have been much involved with subprimes.
It was surmised that many of the home-mortgage borrowers who got into trouble taking out more of a subprime mortgage than they could handle would be spared the ultimate sanction of foreclosure, since that option was said to be a difficult, time-consuming and not particularly profitable option for the lenders (not to mention being absolutely catastrophic for the borrowers).
Indeed, late May saw reports that some hedge funds (those without ongoing relationships with public relations firms, no doubt) were actually unhappy with what they saw as the sluggish pace of lender foreclosures. These funds had initiated trades that hoped to profit from a further fall in the ABX; for them, foreclosures would have in essence represented a climactic consummation of the act of seeking bliss from the gathering financial misery of the subprime borrowers.
And so, as June began, the sound of corks popping out of champagne bottles drowned out the sound of the termites continuing to eat through the foundation underneath US finance capital. Then it happened. Somebody put his hand through the wall, or tried to nail a picture, and all the sawdust started pouring out.
In my July 6, 2006, article Hedge funds: Playing dice with the universe, I explained that one of the major reasons hedge funds were able to exert such disproportionate market influence was that, besides the substantial pools of money the hedge funds were raising from their investors, they were also funding the huge positions they were taking in the markets with substantial borrowing, what the markets call leverage, in amounts sometimes up to 20 times their capital base.
The Bear Stearns brokerage house thought it had come up with some really neat ideas. It would set up two in-house hedge funds, the Bear Stearns High-Grade Structured Credit Strategies Fund and the High Grade Structured Credit Strategies Enhanced Leverage Fund. The funds' strategy for achieving those juicy hedge-fund-type returns would be to invest in pools of subprime mortgages bundled together with other loans into bond packages called collateralized debt obligations (CDOs).
Then, Bear Stearns had an even better idea. It would not just buy the CDOs and then sit on them until the mortgages were paid off in 10 or 20 years or so; that would have earned the funds a return roughly equal to the coupon yield of mortgage bonds, about 8-10% a year. That's a decent enough return for us average investing mortals, but for hedge-fund managers obsessed with having their names and pictures at the top of the performance rankings, it wouldn't even get them in line to rent a chaise longue at a public beach in the Hamptons - a popular vacation spot on New York's Long Island - this summer.
In today's era of turbo-finance, the distinctions between who the borrowers are and who the lenders are have become blurred; many borrowers borrow so they can immediately turn around and lend the proceeds to others, who will then do likewise. For Bear Stearns, instead of just buying the CDOs and sitting on them for a decade or two, it would now have the funds use them as collateral for big new loans from other financial institutions.
With the borrowed money, they could go back into the market and buy lots more high-yielding subprime-mortgage-based CDOs, in essence using the borrowed money to do more lending. Their high yields would substantially boost the reported returns of the funds and, since returns are measured against the percentage appreciation of the fund against its capital base, not the leveraged base, the funds would instantaneously be able to report much higher rates of return. For the fund managers, the temptation was irresistible - a better life and a shiny trophy wife were just the next reporting period away.
As long as the CDOs that Bear Stearns borrowed against maintained their value. As long as the ultimate money behind the CDOs, the homeowners who actually took out the subprime mortgages that made their way into the CDOs, kept making the mortgage payments that got passed through to the owners of the CDOs.
Uh-oh.
By early June, Bear Stearns and other titans of US finance had, both as borrowers and lenders, their subprime-based paper spread all over Wall Street, and that definitely presented a problem. The lenders who had accepted Bear Stearns' paper as collateral saw the price of the ABX index heading south once more, and knew that it meant that more subprime mortgage holders were becoming delinquent, and thus facing foreclosure, on their loans.
Of course, this implicitly reduced the value of the CDOs that Bear Stearns had proffered to be used as collateral. (I say "implicitly" because no one really knows what these CDOs are worth at any given moment - they are not traded, with reportable trade results, as are stocks and bonds. In financial-markets lingo, this is said to make them "illiquid".)
This put the lenders in a fairly tricky position. Written into the loan agreements in which they lent money to Bear Stearns' hedge funds were covenants that in essence allowed the lenders to seize the collateral that Bear Stearns put up as security, the CDOs. In essence, the lenders had the right, like Harry Dean Stanton and Emilio Estevez in the 1984 cult classic Repo Man (but without the glowing aliens or the weirdo nuclear scientist) to repo the CDOs and take them back to the yard.
This presented the lenders with another dicey situation. Much like the players in the classic game-theory exercise Prisoner'S Dilemma, there was a tremendous incentive for the lender who acted first; later lenders might find that quicker players might have already seized all Bear Stearns funds' capital away.
It was Merrill Lynch that sent the tow trucks in first.
So what did they get when they lowered the CDOs down from the hook?
Do you want to borrow some money from the bank, using the equity in your home as collateral? Fine, "just write us at the bank a check for about $500, so we can hire an appraiser to check your home's current worth". A core way that will be done is to have the appraiser check the recent sales prices of comparable homes in your neighborhood, what the trade calls "comps". No way will the bank allow you to borrow anywhere near what your house is worth. If you default, the bank wants to be sure it can get back the value of the loan through a foreclosure sale of your property.
Bear Stearns had to go through no such indignity. As CDOs are not actively traded in any secondary market, there were no available comps to compare their value against; in market jargon, they cannot be "marked to market". Instead, the international bank capital reserve regulations known as Basel II allow CDOs to be valued through an arcane process called "marked to model".
This involves Bear Stearns hiring some hungry underemployed math PhD, and having him construct a CDO pricing "model", in essence a series of complex algorithms, that allowed the company to enter a CDO's particulars on the front end, and then having the model spit out a SWAG (scientific wild expletive-for-posterior guess) value to Bear Stearns' liking out of the back end. The lenders, Merrill Lynch among them, knew full well the questionable nature of the process that valued the loans; then again, Bear Stearns was paying them a whole lot more on their loans than US Treasury bills were paying.
Merrill Lynch's traders virtually tripped over their Bruno Maglis in their rush to sell the seized CDOs. When they did, boy were they in for a surprise.
The CDOs were not fetching anywhere near the values the pricing models said they should. On June 24, New York Times finance columnist Gretchen Morgenson wrote an article about this; her editors gave it the title "When models misbehave"; evidently, the Old Gray Lady's honchos were hoping to get some interest from Times readers leafing through the business pages on the way to check the latest Paris Hilton news.
The Gospel of John teaches that "the truth shall set you free"; in 1881, US president James Garfield tacked on to the scripture the pithy addendum that "first, it will make you miserable". Instead of marking to model, holders of CDOs could now mark them to true market values, and yes, this made them really miserable.
Many of America's most illustrious names of finance, such as but not limited to Merrill Lynch, had been using them as capital reserves for high-powered lending or, like Bear Stearns, as collateral for borrowing. Basel regulations no longer allowed them to mark to model; in essence, just as in real-estate lending, there were now "comps" that were representing actual, much deflated prices.
The basic purpose of capital-reserve regulations is to make sure the value of loans made by financial institutions bears at least some relationship to the actual assets possessed by the institution. This prevents the tendency of capitalist economies to go through wild cycles of credit-fueled boom and bust. A bank with $100 in deposits cannot, much as it might like to, make $100 billion in loans. Various ratios exist for how much can be lent out per each particular type of asset held as a reserve.
This process can, and recently actually has, acted as a great wealth-creation machine when the underlying assets of the reserve holdings stays stable or goes up, as it allows a huge infusion of new capital into the world's money supply. It, the employment of once-dormant assets to facilitate massive new lending, is the primary reason for the great flood of world monetary liquidity that has supported inflated prices for everything from North African equities to Elvis Presley memorabilia.
But things are quite different when you throw the machine into reverse, as is happening now with the subprime CDOs. If the value of the underlying reserve assets declines, then Wall Street must pull back on the quantity of lending that it can base on it. This process is a lot like watching a video of a building being constructed in reverse as, brick by brick, the great edifice disassembles.
The fear that stalked the world's markets in March has returned. Bear Stearns has announced that it will provide up to $3.2 billion so that one of its struggling subprime hedge funds, the High-Grade Structured Credit Strategies Fund, can liquidate itself in an orderly fashion; for investors in the other fund, the more aggressive High Grade Structured Credit Strategies Enhanced Leverage Fund, well, for them, all the lifeboats seem to have left.
Even as US stock markets trade nervously around their recent highs, the Chicago Board Options Exchange's VIX volatility index, the fever thermometer for stock-investor unease, pushes back toward its March highs. The initial public offering of the private equity Blackstone Group (see my Febtuary 22 article on private equity, The highs and lows of buyouts) has foundered, with the stock now trading well below the IPO price. Considering how substantial a role private equity has played in the rallies of the world's major stock markets recently, this is certainly an ominous sign.
ABX subprime indices are pushing to new lows. If you would like a side order of Weltanschauung (knowing the current state of things) with your Schadenfreude (taking pleasure from the misfortune of others), check out the I Am Facing Foreclosure weblog (iamfacingforeclosure.com). Here lies a contemporaneous, near-Wagnerian saga of a young Californian's 2005 glorious rise to the heights of financial Valhalla, and current flaming fallback into earthbound insolvency, all effected by attempting to flip one two many investment properties.
One in five subprime mortgages is either seriously delinquent or has entered foreclosure; the real fear is that this number will skyrocket this year when millions of subprime mortgages taken out over the past two years with low initial "teaser" interest rates reset to rates well above current market rates. Very much unlike what they were told by their real-estate or mortgage brokers when they originally bought their houses, most of the borrowers have neither the equity in their homes (which is actually declining) nor the improved credit scores to bail themselves out of this situation with the real-estate industry's traditional life-preserver, a refinancing.
As these homes hit the market through foreclosure sales, further supply pressure will be put on a real-estate market already reeling from what could be only the commencement of this process. Like autumn following summer's joy and then winter's desolation following upon that, any economic historian will tell you that what is happening now in US real estate is only the natural turning of the economic cycle. The leaves of the boom have faded and fallen away, soon to be followed by lamentations resultant upon the bare branches of winter's bust.
In the fetid slough that is today's US public debate, it has been said that the entire subprime mess is only the expected result of attempting to make proper middle-class homeowners out of an underclass that lacks sufficient moral fiber to be so; all this proves is that, much like the current debate on illegal immigration, there will always be receptive American ears listening for any argument that blames all of today's troubles on people with black and/or brown skin.
The real moral deficiencies that led up to the subprime crisis are not on Main Street but on Wall Street. It was there that greed hatched the idea to turn the once-staid and predictable market for housing finance into something that could earn those big fat top-of-the-hedge-fund-rankings returns. In this tragedy, the only actual role of the borrowers was something like that of Beaker on the US children's TV program The Muppet Show, a helpless and hapless subject of another one of Dr Bunsen Honeydew's bizarre quasi-scientific experiments at Muppet Labs. They tried to mate a pokey groundhog, the slow and steady previously existent market for housing finance, with a glamorous thoroughbred, today's turbo-finance, and, in doing so, may just have killed both of them.
The I Am Facing Foreclosure site is up for sale. Down the street from where I live, in what is thought to be America's last red-hot housing market, a prospective development of 50 single-family homes, cleared out of the verdant northwestern US forest last winter with bulldozers and ambition, lies dormant. The wind whistles both through its acres of still-undeveloped dirt and some prospective real-estate entrepreneur's fading dreams of riches and glory.
As the rockets glare red and the bombs burst in the air over another US Independence Day this Wednesday, in the housing sector, winter falls soon.
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
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