Thursday, January 31, 2008

Last Straw for the Consumer

A while back I suggested that smart homeowners were loading up their HELOCs before the door was shut. Turns out the door is being shut on Monday. Calculted Risk reports that both Chase and Countrywide are placing new limits on how much consumers can borrow.

Without access to Mortgage Equity can the consumer continue. Moreover, consider the on going possibility that high US consumption is being driven by a minority of consumers who have been drawing on heavily on home equity. With the door shut on those high spending consumers we could see a dramatic realignment in the US savings rate and with that a global recession.

Wednesday, January 30, 2008

50 Bps ???????

I am at a loss for the move today. On the one hand I think the Fed can safely cut 50 without spooking the markets. There is a hope at least that swift cutting now can avoid us having to go all the way to zero if the recession gets out of hand. Remember that we went to 1% last time and we started from a higher funds rate.

On the other hand the SocGen incident has to be a little embarrassing personally for the FOMC. There is certainly the sense that they may have been jumping at shadows. This argues for 25 bps if any.

At the end of the day, however, avoiding the Japan type scenario has got to be the priority. And, with slowing global growth inflation concerns may be moderating so. 50 bps and say something like:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.

In recent months the outlook for growth has weakened. Credit markets have remained strained and the slowdown in housing has continued to diminish output growth. Some businesses and households are finding it more difficult to obtain credit.

Commodity prices have moderated in recent weeks and inflation pressure appear to be weakening. Nonetheless, the committee will monitor incoming data for signs of increases in inflation expectations.

Some downside risks to growth remain. The committee is monitoring incoming data as it becomes available and is prepared to act in a timely manner to address those risks.

Acknowledgment that oil prices are retreating. Direct references to financial institutions removed. Appreciable downside risk becomes some downside risk.

Wednesday, January 23, 2008

Did The Fed Cater to Wall Street

Do I think anyone on the Federal Open Market Committee said "Look these losses in the stock market are unacceptable we need to move" - no I don't.

Was there concern that widespread panic was ensuing that would result in a capital market freezing up - likely. Moreover, it was a sign that market participants were significantly increasing the likelihood of a major financial institution failing, this concerns the Fed deeply.

Look, I was shocked at the move and I am not certain that it was the right thing. Only hindsight can tell. However, we had started to get conclusive data that the US was slipping into recession. Because credit quality is already slipping a US recession is likely to be self-reinforcing.

That is, high unemployment leads to more foreclosures which leads to less lending which leads to higher unemployment.

So there was definitely a need to act. Last week I was even open to 75bps at the Jan 30 meeting. My biggest concern was spooking the market. But, the market was already spooked, so no loss there. So I believe the cut was designed to stem the recession. The collapse in equity markets was a sign that the recession was worsening and could itself contribute to the recession if it resulted in less spending or lending.

However, that being said the members of the FOMC are human. It was hard to watch the entire world selling off and not do something. I mean you could see that markets tumble literally as the world turned. As soon as daylight hit a region, it was in the red.

As for the ECB's tough talk. Number one, they do not have a dual mandate. Technically, they are responsible only for managing inflation not unemployment. However, I also think they are somewhat in denial. We have seen this before. We saw Japanese central bankers in the early 90s in denial about how bad it could get.

What we are looking at are severe downside risks and now it the best time to stop them. If a Japan type scenario is on deck for the US, this would be the time to prevent it. So while the move shocked me, I understand it.

I am sure Bernanke does not want to leave his post wondering if he stood by while the same forces that engulfed Japan, take down the US. If that means that he has to risk his rep now, I am guessing he says, so be it.

Tuesday, January 22, 2008

Rate Cuts and You

Mike asks how the rate cuts will help the common man. In some ways this question cuts to the heart of monetary theory and policy. In principle the sole purpose of monetary policy should be to help the common man. Is that whats going on now.

Yes, and no. Its very very tempting for the monetary authority to focus heavily on assets prices and as such the upper class. You get instant feedback about expectations, liquidity, and overall wealth by looking a equity and credit markets.

To find out whats happening to the Joe on the street takes years and even then we are often not sure if we have the right metrics. Moreover, Wall Street is often clamoring for help while the Joe Sixpack may not even know what the Fed is.

However, cuts (and hikes) do wind up having their biggest effect on the weakest members of society.


Because, those members are the most vulnerable to inflation and unemployment. When the Fed cuts now the hope is threefold.

1) This will lead to more favorable mortgage and credit card rates which will relieve the payment stress on average consumers

2) That if consumers can slowly, rather than dramatically reduce spending growth (as they must) then businesses can adjust without resorting to mass layoffs.

3) That we can ease pressure on the banking system so that more people and businesses will be able to get credit when they need it.

All of these things should ease the stress on the common man. The reason I did not believe we would have cuts this morning and some economists are upset about them is because it looked as if the Fed was going to far to stem losses in financial markets.

This is a really hard call because losses in financial markets can lead to pains for the average worker if it means that corporations have a hard time raising capital and need to instead turn to layoffs.

At the same time, however, more vulnerable Americans who have relatively fixed incomes are susceptible to inflation and there is some evidence that inflation causes the entire system to be sluggish. Not to mention the problem of encouraging financial speculators to take risks if they believe the Fed will bail them out.

So, the upshot is that the cuts should reduce some stresses on average people and hopefully reduce painful layoffs.

Monday, January 21, 2008

Bernanke needs to Speak Tomorrow Before the Open

if this continues . . .

The key word is promptly. The Fed is prepared to act promptly to signs of further deterioration in output and employment.

Further the Fed is prepared to act to support the smooth provision of credit and stability in financial markets consistent with the dual mandate.

50 now and hints at Intermeeting Cut

I'll put up a more definitive rate preference and statement later, but right now I lean towards:

1) Cutting 50 bps on the 30th

2) Saying something like "The Committee is monitoring the data closely and is prepared to act promptly to increasing signs of deterioration in growth and employment"

A growing risk is now generalized, rather than simply asset, deflation. It is quite a difficult time for central bankers, when both inflation and deflation are credible risks.

This makes language crucial in communicating to the markets. In particular, participants need to know what the key data measures are so they can update their expectations. In particular I would point the markets towards unemployment and agricultural prices. Although these may not be leading indicators they are quite solid indicators of where the pressures are and we can feel more confident in taking large actions based upon them.

In particular if Ag prices fall I don't see how general inflation holds up in this environment. Not that Ag prices are pushing general inflation but they indicate a worldwide slowdown in demand growth.

Friday, January 18, 2008

Dark Matter in Action

The Economist is concerned about Sovereign Wealth Funds and it appears Washington is as well. My personal reaction when I heard that international investors were pouring another 12.5 Billion into Citi on top of the 7.5 Billion they received at the end of last year was a bit different. This, I thought, is Dark Matter in action.

Dark Matter was a much ballyhooed hypothesis that the US could manage to run such large trade deficits because it was making a killing on its investments overseas. Think of it this way. Suppose you borrowed $100,000 at 5% interest. You took half of that money, $50,000, and blew it on a big screen TV, new stereo, trip to Thailand etc. You took the other $50,000 and invested it at 15% guaranteed.

So you end up having to pay $5,000 a year in interest, but you are receiving $7,500 in interest. On net are in debt? What does it mean to be a net debtor if you are actually taking in more money on your investments than you are paying out.

Yet, someone who looked at your spending habits would say, "you borrowed $50K and blew on junk, you must be in debt."

In a nutshell is the situation the US finds itself in. Went spent a bunch of borrowed money on junk but we managed to invest the rest at incredible rates - or so it seemed.

A more careful examination of the data revealed that it wasn't that the US was earning amazing returns on its investments. It was that foreigners were getting a lousy return on the money they loaned to us or otherwise invested in the US.

Which brings us back to Citi. Are foreigners swooping in to buy one of the US's venerable institutions at fire sale prices, or like the Mitsubishi purchase of Rockefeller Center, are they overpaying for a famous property that can no longer produce. My guess is that it is more the latter than the former.

Monday, January 14, 2008

On Going Issues

1) On Thursday Bernanke started to use the kind of language that I was hoping he would use. Hints that the FED would be highly responsive to further deterioration. Thats the kind of assurance that helps smooth the non-linear waters of the market. Sometimes, a big move or the potential for a big move can have a stronger effect than several smaller moves of equal total magnitude.

2) We'll get retail sales tomorrow. Thats the last piece of the January data set I expected to justify strong action. If retail sales is as ominous as I suspect we should start talking about 50 bps with a strong bias towards cutting.

I am also not completely and totally immune to arguments that push 75bps. Though I would have substantial hesitation on many fronts including the risk of spooking the market. I don't think we have seen a cut above 50 bps since the early 1980s.

3) I have mixed feelings about the increasing realization that subprime was just the canary in the mine shaft. Alt-A mortgages, credit cards and CDS on corporate issues are next. There is some sense vindication in that this is turning out not to be a housing bubble but a credit bubble all around. However, of course it would have been better to be wrong.

Friday, January 11, 2008

What Bank of America Was Thinking

I was on the inside of Bank of America for a while as a consultant. I signed a deal that said I wouldn't talk about anything I overheard for three years but it has been much longer than that and I am sure that my thoughts are generally old news. Nonetheless I think they are worth sharing.

Bank of America was heavily investing in Consumer Real Estate, thats what they call mortgages, when the subprime boom hit. The goal at The Bank, was to streamline the entire haphazard process of mortgage application and underwriting. In particular they wanted a single computer system that could automate the entire process. In the past there had be a hodge podge of different systems and departments that did everything from taking applications, to verifying income and assets, to making sure the house wasn't in a flood zone.

The idea here, and behind a lot what The Bank, was doing was that consumer banking was about information. Their real asset was that the mortgage application let them stick their noses in all of your nitty gritty financial information, which they could then use to sell you every product under the sun.

In particular a few key executives were really into this notion that The Bank could be a conduit for every imaginable service related to a home. Bank of America could arrange your lawn service, your pool service, your home security service, everything you wanted. And since, they knew so much about you they could figure out exactly what you wanted.

It was the fees on these service that were going to be real winners. So, what is The Bank getting when they buy Countrywide? They are getting the largest mortgage servicer in the country and access to lots of homeowners whom they plan to sell lots of other stuff to as well.

My concern, however, is this - Bank of America looks so responsible because they didn't really dip into the subprime waters like other banks. My feeling, however, is that this is because they already had a big project going when subprime came along and they didn't want to muddy the waters with this new poorly understood stuff.

However, The Bank is heavily into credit cards, which are going to be the next take a hit. The Bank also is taking on a lot of servicing responsibility with Countrywide. To the extent that
not just subprime but Alt-A and even adjustable rate prime mortgages start to go delinquent, The Bank is going to be responsible for advancing interest payments to the investors in those loans. That is a heck of a liquidity responsibility. I would like to hear more about how The Bank would fare if prime ARM delinquency rose substantially.

Wednesday, January 9, 2008

What Happened in New Hampshire

There is a lot talk about what turned the tide for Hillary; the cry, the contrarian nature of New Hampshire, Chris Matthews, the debate.

Yet, in my mind I cant help but wonder how many women in Iowa were afraid to tell their husbands and boyfreinds that they supported Hillary. Caucus is out in public and subject to public pressures. Women may have decided to keep the peace rather than echo their support.

The when the pollster called New Hampshire the next day the state was swept up in Obama fever. By Tuesday, however, when women were all in alone in the voting booth and had to decide whether they were going to kill the hope of Hillary being president or let her live for the day, they went with their gut.

Monday, January 7, 2008

Will The Recession Be Outsourced?

So, US consumption growth will decline - that much is clear. Indeed, in the short term consumption is likely to contract in real terms.

The quandary now is how much of that reduction in consumption will raise unemployment in the US. Traditionally, declines in consumption translate into declines in manufacturing employment. Yet, these days a smaller and smaller fraction of the US population is employed in manufacturing.

Can manufacturing still cause a recession when it employs only 10% of the workforce? Will the declines in employment cut deeply into the traditionally stable service sector? Or will the recession be outsourced? That is, will the decline in manufacturing jobs that typically accompanies a US recession really hit manufacturing employment in other countries.

My intuitive take is that the service sector will take an unprecedented hit but that much of the increase in unemployment will be exported. My pet theory is that we are moving into a strange world of recessions without large increases in unemployment.

The pain of the recession will be felt in asset declines, and workforce relocation. Workers will slide into lower paying less productive jobs but not on to the unemployment rolls. These working recessions will see declines in productivity and an evisceration of corporate profits.

But thats just a pet theory. Time will tell.

Thursday, January 3, 2008

All For The Want of A Nail

So, John Berry looks like the standard bearer for those who think the sub-prime crisis is overblown. So Berry says

A more realistic amount is probably half or less than those exaggerated projections -- say $150 billion. That's hardly chicken feed, though not nearly enough to sink the U.S. economy

There are a couple of problems here. One, Berry isn't factoring in the effect of declining collateral values when he says

First, the mortgages are backed by collateral, a house or condominium, and in a foreclosure a home typically retains significant value. When it is sold, the lender often will get 50 percent to 60 percent or more of the loan amount after foreclosure expenses.

That’s in world where the value of the home often exceeds the value of the loan. This is not where many of the defaulting sub-prime borrowers will find themselves.

More deeply, however, Berry is conflating losses with defaults. Indeed, a commenter on Naked Capitalism summed up the no-big-deal viewpoint nicely when he said

If for the want of a nail the battle is lost, then the battle can be won for the price of a nail.

This comes from a poem often used to describe the Butterfly Effect

For want of a nail a shoe was lost,
for want of a shoe a horse was lost,
for want of a horse a rider was lost,
for want of a rider a charge was lost,
for want of a charge a battle was lost,
for want of a battle the war was lost,
for want of the war the kingdom was lost,
and all for the want of a little horseshoe nail.

Berry and the commenter seem to be implying that a $150 Billion nail is not a hefty price for the US economy to pay. The problem, however, is that we don’t know which nail is bad.

This is the essence of risk.

If for example, we knew exactly which homeowners were going to default then we could correctly value each Mortgage Backed Security. Once, we had written them down for the value of the bad loans they would be AAA securities, since there is no remaining default risk. The CDOs which hold those securities could be written down, the SIVs that hold them could be written down and so forth until the $150 Billion had been distributed accordingly. We could then all go about our business as if nothing had happened.

Alas, this is not the situation we find ourselves in. We don’t know which nails are bad and we don’t have the resources to check every horseshoe. To make matters worse the CDO revolution convinced us that bad nails didn’t matter and so we went about shoeing horses like crazy and sending their riders into far flung battles around the world.

In other words, because there seemed to be little risk in making loans, we made lots of very risky loans and drove up asset prices on the basis of those loans. Now, the whole thing is supported on a foundation that is not only not as secure as we thought but due to lax underwriting standards, less secure than normal. So we have higher assets prices supported by weaker fundamentals. That’s a prescription for a fall.

The real question then is not, how much we will lose from defaults. The real question is how much of a return would we have demanded to risk these types of defaults and how low asset values have to fall before they can guarantee us that type of return.

For example, Berry estimates a 12% loss after default rate for subprime mortgages. Well that means that we have to shed 12% of the value just to bring us back to the expected return we had before. We have to shed much more than that to compensate investors for the fact that an individual security might lose a great deal more than 12%.

Even more stunning than that is the fact that the huge profits coming out of the financials drove increases in stock indicies. Now the financials are taking losses on the very securities that made them so profitable. This means not only is there less capital inside of those companies but that the run of profits we saw before was an illusion. It wasn’t possible to generate those types of returns without taking on lots of risk.

So we have a smaller company now with lower growth prospects. This implies quite a bit of fall in value.

Stack on top of that the fate of the US consumer. For a while now the consumer has been spending like gangbusters no matter what happened to the aggregate economy. Now, it seems that this spending was likely fueled by imprudent loans.

Going into detail about this requires another post, but imagine if the American spending spree was conducted by a small portion of the population spending way beyond their means. Now, imagine that this is the very population who is being foreclosed upon right now. It is at least possible then, that the American economy could swing from a negative savings rate to a more traditional savings rate very rapidly.

That is, imagine that most people are saving just as they were 25 years ago, but a select few have been borrowing so much that it drove the average savings rate negative. When those free speding few have their Home Equity Lines of Credit canceled, we will be left with only the spending of the traditional consumer.

In the long run that’s a good thing. In the short run it’s a very painful thing.

All of these possibilities are why the credit defaults imply asset value collapses that are much greater in magnitude.

Fed Credibility

Henry Kaufman is significantly more critical than I am.

This post from Naked Capitalism is well worth the read.

In some sense Kaufman is saying that the market cannot be treated as an equal partner with the Fed when the market is in no position to bear the level of accountability the Fed must shoulder. The Fed can't make the market clean up its own messes because the market is not capable of doing so without damaging Main Street, the constituency the Fed is supposed to protect first.

Though it disturbs my liberaltarian sentiments, I find it difficult to disagree.